January 2014
Seminar Presented November 12, 2013
While it can be difficult to predict what is to come with Monetary Policy and Interest Rates, the outlook for the next six months should be very exciting due to the change of the Chairman of the Federal Reserve. When discussing the outlook, you have to take into consideration a few variables, including the economy and in particular GDP, unemployment and inflation; Federal Reserve policies such as Fed Funds rates and Quantitative Easing Tapering; investor expectations as well as unexpected tail events that cannot be predicted such as natural disasters. GDP- In the past there might have been a great deal of variability in GDP but predictions need to be mathematically realistic and based on statistical analysis. So while the forecasted growth of 2-2.5% of real growth might seem slightly pessimistic it is the highest number statistically supported.
CHART 1 – INFLATION RATE
Source: US Department of Commerce, IHS, Global Insight and Wells Fargo Securities LLC
GDP does seem to be constrained by several factors and the trend is toward modest growth because consumption is not doing all that bad but it’s not all that good either.
Many people might think otherwise, but daily occurrences such as bankruptcies or Quantitative Easing (QE )announcements really do not influence GDP. In the past, the government contributed 1-2% to GDP, but now they are not only not contributing, but are acting as a drag because our debt is getting bigger and bigger so the expenditure is not there.
As we look into the future, we see that factors that usually push interest rates higher are not there.
Inflation– It would be difficult to argue that inflation is going to take off. For the first time, the US has actually had deflation. The lesson here is-any number above 3% is very bad because this causes interest rates to rise, but deflation is worse because it means everyone is postponing making an investment because tomorrow’s prices will be lower than today’s.
As you look forward to 2014, the best models we have, do not predict inflation above 2/2.5%. If this is the case with inflation, long term interest rates will not likely go up much higher from current level.
Unemployment- Inflation might not be a problem, but unemployment is. People get excited when the job report comes out but we need to rely on a 6 month moving average for an accurate picture of the trend of unemployment. As long as unemployment is high and inflation is low, the Federal Reserve is free to follow an easy monetary policy.
The best models show that unemployment may take a few years to reach an acceptable level.
If we take a 2% goal of inflation and 5/5.5% for unemployment, we would be moving very slowly but getting closer to the target.
Fed– The Federal Reserve has evolved into an extremely influential institution, as it is now almost the exclusive agency that tries to guide the economy. Tools being used are: Fed funds rate, 3 rounds of quantitative easing to reduce longer term interest rates and great effort towards transparency, communication and forward guidance. As is well known, President Obama has nominated Dr. Janet Yellen to succeed Chairman Bernanke and markets expect a very smooth transition.
QE– QE3 has lasted longer and been more substantial than the others and we are not anywhere close to finishing it. The markets are uncertain about the tapering process. Mortgages and 10 year notes rates differ by approx 200 basis points between the two. If the t-notes take off housing may basically come to a standstill.
How good has QE been? Numerous papers have analyzed it and some key findings from John Williams of the San Fransisco Fed were: QE2 may have reduced 10-year Note rates by 20 basis points. QE3 was a little more effective, may have reduced 10-year Note rates by 40-50 basis points. On average, a 1% reduction in Fed Funds reduces 10-year Note by 20 basis points. Equity Markets have done very well, over 140% increase since March 2009. Unemployment has also been reduced. There appears to be a relationship between unemployment and quantitative easing but no mathematical causality.
As we move forward, given this background, the issue is not fed funds, it is quantitative easing. Fed Funds will probably remain at 25 basis points until the end of 2014. But what are the choices and implications in terms of interest rates? Most likely we will continue with the $85 billion current program. There could be a small, symbolic change when Yellen becomes Fed Chairwoman. This would probably be a reduction of about $10 billion per month. Another option is a much larger, $50 billion per month reduction, but this would have to be data driven showing that inflation is increasing or unemployment is going down radically. There could be a little fluctuation of these numbers because there are a few months between now and March. But if there is not a big change, when will it end? Since inflation is not expected and employment is moving down very slowly, it could be that quantitative easing is not going to be terminated soon. Is QE3 done or not and what could happen if it does end? The history of Japan helps us understand that deflationary expectations are hard to change.
We found out that when there are certain bubbles that collapse and we push the economy a little higher, it is difficult to remove the economy from a continuous process of Quantitative Easing.
QE is a method that is useful but it is difficult to remove once you start. There were thoughts of ending QE3 back in June, but based on how the economy looked, it was not the best idea for that time. QE will end eventually, but it does not mean that the process of helping the economy will end. Ultimately QE has helped the US Economy from moving into deflation and experiencing what Japan experienced. Watching unemployment is important, but watching inflation and deflation is equally important.
Note: During the November 12 seminar, three scenarios were considered, one of which addressed a small 10 billion reduction in the monthly Fed purchases; sure enough this is exactly what the Fed announced on December 18.
A.G. (Tassos) Malliaris, PhD, joined Loyola University Chicago in 1972 and is currently Professor of Economics and Finance and holds the Walter F. Mullady Sr. Chair in Business Administration. He specializes in financial economics and has made significant contributions in the area of futures and options markets.
