Why the Fed Will Hike Sooner Than You Think
Expectations, expectations, expectations
So, Powell’s back in the cockpit. Pity that a man always gets to take credit for a woman’s accomplishments. It was, after all, Lael Brainard who led the intellectual revolution at the Fed, ushering in the New Empiricism. To cut a long story short, the Fed technocrats are just as alarmed by the breakdown of elite-mass relations as anyone else in the professional class. Their solution is to run the economy hot in order to deliver broad-based growth. In practice, this means not only that the Fed will tolerate above-target inflation but also that it will not fight tight labor markets — that it will only hike when it actually sees inflation coming in. With help with politicians in Congress, who opened the public purse wide open over the past year, they have succeeded in igniting broad-based growth in American incomes.
Fed technocrats insist, and we should take their word for it, that they will look at broader measures of labor market slack — such as wage growth differentials — in order to measure just how hot the labor market is getting. So, let’s begin by looking at what they must be looking at.
The wages of low skill workers are now growing faster than that of the highly skilled.
The wages of high school graduates are growing faster than the wages of college graduates.
The wages of hourly paid workers are growing faster than the incomes of salaried employees.
By any measure then, working class wages are growing faster than those of the middle and professional classes. On the other hand, the latter have benefited from rising asset valuations — the intended consequence of the Fed’s extraordinarily accommodative policy; in particular, it’s asset purchases.
Meanwhile, a great debate has broken out over whether the current bout of inflation is transitory or not. There are a lot of claims flying around, most without any evidence whatsoever. What is clear is that supply-chain bottlenecks, together with a massive shift towards goods and away from in-person services, are responsible for surging prices.
Matt Klein’s breakdown shows that most of the current bout of inflation is driven by idiosyncratic factors related to the pandemic. This does not mean, however, that the case is quite solid for patience on inflation.
What is fundamentally at issue is the incentives and constraints faced by the Fed technocrats. In order to understand the Fed’s response function, you have to understand what the Fed can and cannot tolerate. The Fed has made it clear that it can tolerate high inflation for a while. What the Fed cannot tolerate, as I have argued previously, is inflation expectations getting de-anchored. Keeping inflation expectations anchored is, as Powell put it, ‘the key to the whole thing’ — the whole thing being the technocratic project of political stabilization through broad-based growth to be achieved by running really tight labor markets. In other words, if inflation expectations were to remain firmly anchored, the Fed is prepared to tolerate persistently high inflation. But it won’t tolerate even transitory and moderately high inflation if inflation expectations were getting out of hand.
The rise of inflation expectations can force the hand of the Fed, no matter what they say now. Once you understand this, you can predict what the Fed will do by looking at the trajectory of inflation expectations.
There are three ways of getting a handle on where economic actors expect inflation to be in the policy-relevant future: market-based measures, survey-based measures, and the real-time behavior of the slowest price setters in the economy. We look at each in turn.
According to the Minneapolis Fed tracker that backs out probabilities from options prices, traders reckon that the probability that inflation comes at higher than 3 percent of the next five years is now higher than 60 percent. So, it is getting expensive to buy protection against high inflation. Meanwhile, the price of buying protection against lowflation has collapsed.
The Michigan Survey of Consumer Expectations has also climbed to its highest level in two decades, modulo a brief panic during the financial crisis.
Breakeven rates over a 5 year horizon have also climbed to a 20 year high. Although it must be noted that the breakevens are confounded by term risk premia — the collapse in the price of risk across the board also compresses these spreads. The ACM decomposition of yields by scholars at the NY Fed shows this explicitly. The yield on Treasuries maturing a year from now is 22bp (basis point = 1/100 percent). But the 1-year term premium is -32bp, meaning that markets are actually pricing in 54bp a year from now — that is, two rate hikes, not one.
Similarly for the 2 year note. The 2 year yield is 61bp but, because of the compression of the term premium, the expected rate two years from now is 90bp, or nearly four rate hikes.
Putting the above together, we are forced to conclude that the markets expect the Fed to hike faster than they say they will. But that they will not hike very much more: markets expect 2-3 quarter point hikes within a year, but only 3-4 within two years. Although one should be careful of attributing intelligence to the “wisdom” of crowds, markets seem to think that the economy will cool off enough that the Fed’s policy rate won’t get much above 1 percent per annum even two years from today.
From the Fed’s point of view, more important than the markets are the inflation expectations of price setters in the economy. These are captured only very noisily by consumer surveys. We can instead get a handle on them by looking at the behavior of the slowest-moving price setters. These are product or service markets where the prices are changed very infrequently, implying that when firms in these markets do change their prices they must do so paying very careful attention to what inflation will do over the near term. Put another way, there is good reason to believe that, say, the lowest volatility quintile of CPI price series contains a very strong signal of the inflation expectations of these price setters out in the brick and mortar economy.
Looking at the lowest volatility quintile of the 174 price series reported by the BEA, we find that it has climbed to its highest level since the onset of secular stagnation. Not only is it at its highest level in over a decade, it is approaching pre-GFC cyclical highs.
When we last looked at this indicator in mid-July, it was around 2.6 percent per annum — already higher than the past decade. By now, as of the end of November, it has climbed to 3.3 percent. This is well above the Fed’s target rate of 2 percent, the level at which they really want expectations to be anchored.
So, because inflation expectations are really threatening to get de-anchored, the Fed will soon be forced into a course correction. The markets may, in fact, turn out to be too complacent. That is, the Fed may have to hike faster and more than current market prices suggest. This is what we should expect if we are, as we have argued before, at the turning point of the secular cycle. If there is indeed a regime change underway, then we can say bye bye to ‘the New Normal’ of low rates. This does not mean that we’re entering a new era of stagflation — that’s pretty much ruled out by the response function of the hard currency-issuing central banks, who will, in fact, never let expectations get de-anchored ever again after the debacle of the 1970s. What it means instead, is that we’re going to get back to a ‘normal’ monetary cycle, with moderately high inflation and interest rates. Or at least that’s the wager of this analyst.