Figuring the Fed's Exit StrategyMichael Englund
Many observers have described the recent surge in Treasury yields and the falling dollar as an "unwinding" of the risk aversion trade, in which investors sought the safety of U.S. government debt and the greenback, amid the financial crisis. But these developments can also be seen as a shift in market concerns toward the timeliness of the Federal Reserve's exit strategy from its policy of ultra-low interest rates.
The presumed fear in the market, of course, is that the Fed is poised for the usual policy mistake of taking back accommodation by too little, too late. And that raises the question: Will the Fed soon articulate the parameters for its exit from the U.S. version of ZIRP (zero interest rate policy) in an effort to restrain yields from shooting even higher, boost the dollar, and cap commodity price increases?
At issue is the atypically low Fed funds rate target at the end of this cycle (0%-0.25%), and the phrase repeated in each FOMC policy statement since December that "conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period."
Rates Reflect Risk Aversion
If the U.S. economic downturn ends in June as we assume, the rate trajectory into the next expansion will substantially undershoot the path at the start of the prior seven cycles, as the Fed funds rate has a remarkably long way to climb to return to historically normal levels. Though the Fed's stated commitment to low rates was intended to keep longer-term rates low, would long yields now be more successfully restrained by words from the Fed on the exit strategy?
Yields on nongovernment debt have remained quite high through this recession as a reflection of risk aversion, and though Treasury yields dropped through the turn of the year, these yields are now rising rapidly. Similarly, as market risk aversion surged through 2008, the dollar soared, but these gains are now rapidly unwinding.
Alongside these yield and foreign exchange movements, the implied "breakeven" inflation rate from yield spreads between the Treasury and TIPS market plummeted through 2008 alongside economic collapse and commodity price freefall, but this pattern has been mostly reversed in 2009.
Crude Has Doubled
Similarly, oil prices have surged this year from the fourth-quarter lows—with Nymex crude nearly doubling in price—alongside firmness in other commodity prices that have defied Fed deflation fears. Oil prices are now rising sharply into the July driving season, as we have seen in each of the last four years. But will we give these gains back in the third and fourth quarters? The markets may be discounting a more permanent ratcheting-up in commodity prices as the world economy emerges from recession.
It certainly is the case that the combination of rebounding commodity prices and a falling dollar will boost the trade price indexes through May and June following the stabilization in early 2009, and freefall in late 2008. Will prices keep rising in the second half of the year?
Wholesale inflation will also get a big boost from commodity price gains, and we expect next week's May producer price index (PPI) report to show a big 1.2% headline surge.
Bucking Deflation Fears
The Fed focuses on the personal consumption expenditures (PCE) chain price figures as its inflation yardstick, and these figures provide more support to the Fed's deflation concerns. Yet, for these figures, we currently only expect a drop in core year-over-year inflation to the bottom of the Fed's 1%-2% comfort zone by yearend from current readings at the high end of the range and, as with PPI, the headline year-over-year rate is falling now but will bounce into year-end as easy comparisons scroll off the calculation.
Indeed, recent core PCE chain price figures have substantially bucked market deflation fears, with gains that exceed the "comfort zone" pace in each of the past four months. We project a moderation in these figures going forward, but the actual readings thus far in 2009 have failed to cooperate with Fed assumptions.
The U.S. consumer price index (CPI) data tend to run about a half a percent hotter than the PCE chain price figures, though the "core" gap has narrowed in recent years. This has left a more encouraging trajectory for these figures, though we face the same issue here that year-over-year figures will lose the benefit through year-end of last year's big commodity price drop.
Different from Previous Cycles
In comparison to past economic cycles, Treasury yields are rising early at the turn of this cycle, and at a surprisingly rapid clip, while non-government yields remain unusually high—though we do expect these spreads to narrow quickly as the expansion unfolds. In short, one could see current yield movement as reflecting heightened inflation fears in this cycle relative to past cycles, and not the opposite as many assume — with the accompanying assumption that we are simply unwinding the risk aversion trade.
One atypical inflation benefit in this cycle is the remarkable overperformance of productivity growth, which is absorbing some of the inflation effect of firming prices. We are thus far seeing little of the usual cyclical slowing in productivity that usually boosts unit labor costs at this phase of the cycle.
And as evidenced in the May U.S. employment report, we are seeing an unusually large and rapid climb in joblessness in this cycle, and a commensurate large drop in the capacity utilization figures from the monthly industrial production reports, which should cap any upside surprises in the underlying inflation rate over the coming few years. While we have argued that the market may not share as much of the Fed's deflation fears as many think, we also think accelerating inflation is probably not likely to be a problem over the immediate horizon — even if it proves the dominant policy problem by the end of the coming expansion.
Rapidly rising Treasury yields in the U.S., and a falling dollar, may as much reflect concerns about the Fed's timely exit from its current aggressive easing strategy as it does an unwinding of the risk aversion trade, and the market may be pricing in less of the deflation fears often articulated by Fed policy makers. Indeed, the Fed's verbal commitment to an "extended period" of low rates may be more damaging than helpful at this point for holding U.S. Treasury yields down.
What can Ben Bernanke & Co. do to manage expectations? It could well make sense for the Fed to rotate its rhetoric toward a focus on the exit strategy and away from the details of the diminishing downdraft in the second-quarter economic data if it seeks to limit the rise in bond yields, the drop in the dollar, and the surge in commodity prices as we approach the second half of the year.