The Real Risk That the Fed Misinterprets Bond Yields
At the end of March, New York Federal Reserve President William Dudley gave a speech on the interaction between financial conditions and monetary policy. When he discusses this topic, I always fear he is laying out a road map to the next recession.
Sure, this is a complex issue. As Dudley notes, financial conditions can move counter to expectations in response to monetary policy. Yet I am concerned that he loses sight of some broader lessons of the past few cycles. Two stand out in particular. First, be cautious in interpreting a weak response of long rates to policy tightening as sign of loosening financial conditions. And second, if the Fed waits for equity markets to crash before reversing course, the central bank has almost certainly waited too long.
Here is Dudley’s analysis of the last tightening cycle, the one that preceded the Great Recession:
In June 2004, the FOMC decided to begin raising the federal funds rate target in order to remove policy accommodation. It raised the target in 25-basis-point increments at 17 consecutive meetings, pushing the rate up from a starting point of 1.0 percent to a peak of 5.25 percent. Despite this tightening of monetary policy over two years, financial conditions failed to tighten in a similar manner. This can be seen by looking at the behavior of well-known measures of financial conditions during this period. The rise in short-term rates was offset by a decline in long-term yields, a rise in equity prices and narrower credit spreads.
Should we interpret the decline of long-term yields as an indication of easier financial conditions? This implies that the Fed should have been more aggressive in the 2004-2006 period.
That is a dangerous interpretation, particularly toward the end of the cycle. It suggests ignoring the message sent by an inverted yield curve. For example, after the curve first inverted in the waning days of 2005, the Fed raised short-term rates four more times to push up long rates. After the fourth time, long-term rates remained lower than short-term ones. This did not indicate loose financial conditions. It pointed to the opposite -- conditions were so tight that financial markets anticipated the Fed would need to reverse course and start cutting rates.
Not only did long rates fall after the last hike, equity prices soared. In Dudley’s analysis, this would give the Fed a false sense of security about the health of the economy as it saw loosening financial conditions, thus delaying the rate cuts that would eventually come.
It is interesting that the Fed pursued a remarkably similar course before the 2001 recession. First, the Fed continued to hike rates even after the yield curve inverted.
In this case, too, equities’ behavior lagged the inversion of the yield curve and continued to rise until the fall of 2000. In both instances, the Fed began cutting rates only after equities had crashed. By that time, the seeds of a recession were already sown in the Fed’s fertile soil of tight policy.
Would the Fed have been able to prevent recession by backing down on rate hikes before they inverted the yield curve? I don’t know. Perhaps a recession was inevitable given the declines in technology stocks and, later, home prices. But even so, the aggressive raising of rates after a warning signal from an inverted yield curve, coupled with a delayed reaction to growing weakness as officials confused low long-rates and high equity prices with loose financial conditions, probably ensured a deeper and longer recession in both cases.
Compare these two episodes with the tightening cycle of the mid-’90s.
First, the Fed stopped rate hikes before inverting the yield curve.
Then rising equity prices did not deter them from cutting rates to support the economy:
What can we take away from these episodes? Take notice of how the Fed reacts to the fading Trump trade in Treasuries. Fairly low long-term rates suggest to me not that the financial markets are defying the central bank’s efforts, but that the Fed has less room to maneuver than implied by its estimates of the neutral rate. But if the Fed follows the model of the last two cycles, you can expect policy makers will continue to tighten after the yield curve inverts as officials confuse the lower longer-term rates with easy monetary conditions. If so, be on red alert for a recession.
The Fed will be more prone to this error if it sees inflation as persistently above target and demand growing faster than their estimate of potential. Also, it is likely that equity prices will continue to rise even after the Fed ceases rate hikes. In fact, rising equities during a tightening cycle is the norm, not the exception.
This shouldn’t come as a surprise due to the lagged impact of monetary policy on the actual economy. But this might lull the Fed into a sense of complacency, delaying rate hikes even if the economy shows signs of cracking.
It is important that the Fed take account of financial conditions when making policy. But it is not clear to me that they are taking away the right lessons from the last two episodes. Those seem to me to be cases where their interpretation of financial conditions pulled the bank to tighten policy too much and resist easing too long. The Fed can gain some valuable insight from the mid-’90s, when policy makers reversed course in time to prevent recession. Will this Fed do the same? Or repeat the mistakes of the last two cycles by keeping their foot on the brakes for too long? I fear that Dudley’s interpretation of financial conditions will lead to the latter.
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