“Why is the Fed so desperate to raise rates and tighten financial conditions? Why has the Fed shifted from a dovish to a hawkish bias?”
That is the question on every trader’s, analyst’s and economist’s mind in the past month. Is it because the Fed is suddenly worried it has inflated another massive equity bubble (major banks now openly warn their clients the market is in frothy territory, if not inside a bubble), or is the Fed just worried that it will fall too far behind the curve and be unable to regain control of the economy once inflation spikes, without creating a recession (in what will soon be the second longest, if weakest, economic expansion of all time).
This is also what BofA’s chief economist Ethan Harris tried to answer over the weekend, when he recalled that while from 2013 to 2016 the Fed seemed to have a “dovish bias” signaling a slow exit from super easy monetary policy, but pausing at any sign of trouble, this year the Fed appears to have shifted to a “hawkish bias:” signaling a slow exit, but only pausing if the outlook changes significantly. He says that this was most evident when the Fed hiked rates and signaled balance shrinkage at its June meeting despite weak growth and inflation data.
Why the change of Fed feathers? In BofA’s view, three factors are at play, in increasing order of importance.
First, the Fed is worried a bit about financial stability and overheating markets. However, the bank puts a relatively low weight on this argument, as Chair Yellen and her allies have repeatedly underscored the idea that macro prudential policy is the first line of defense against asset bubbles and monetary policy is a distant “Plan B”, although to this we can add that macroprudential policy has yet to demonstrate its effectiveness in preventing even one asset bubble.
The second reason for the Fed’s hawkish turn is that it is probably encouraged by how easily the markets have absorbed its forecasts. Since the start of the year the Fed has hiked more than expected and has accelerated its balance sheet shrinkage plans and yet, as Goldman has repeatedly noted and all other banks have promptly followed, stocks have rallied while bond yields have been little changed on net. If a steady exit is causing no apparent pain, why not continue? (for one answer, read the latest note from Deutsche Bank on Conundrum 2.0)
Here Bank of America is worried that the Fed is being lulled to sleep: the bond market is pricing in only about a 50 bp increase in the funds rate by yearend 2018 compared to the FOMC median forecast of 100 bp. Moreover, despite firming plans for balance sheet shrinkage, bond term premia have actually declined (Chart 5). This suggests the markets don’t entirely believe the Fed’s hawkish message, and with good reason: every time the Fed has blustered on the hawkish side in the past, it has quickly retreated the moment markets sold off even modestly. Although this time, Harris warns that if the Fed follows through on its plans, he sees the potential for a tightening in financial conditions.
Which brings us to what BofA believes is the third, and most important, reason for the Fed’s change inoutlook: a shift in the Fed’s risk rankings. As BofA explains, for years the focus was getting inflation back to target. They did not want a recession to occur before inflation (and interest rates) had normalized. Now the focus has shifted more to the risk of undershooting on the unemployment rate, which has fallen well below even the Fed’s revised estimate of NAIRU.
As several Fed officials have pointed out, undershooting full employment can and will be problematic. Dudley recently noted: “if we were not to withdraw accommodation, the risk would be that the economy would crash to a very, very low unemployment rate, and generate inflation.” He continued, “then the risk would be that we would have to slam on the brakes and the next stop would be a recession.”