Wednesday, July 20, 2016

The Fed is Trapped in a Rate Hike Talk Cycle

The Wall Street Journal reports Fed officials are once again signaling their desire to raise interest rates: 
Federal Reserve officials are looking more confidently toward an interest-rate increase before year-end, possibly as early as September, now that financial markets have stabilized after Britain’s vote to leave the European Union and the economy shows signs of picking up. 
This narrative should sound familiar. Since mid-2014 the Fed has been talking up interest rate hikes--as seen by the movements in fed fund futures rate--but only has a 25 basis point rate increase to show for it. This is because the Fed's plans often bump up against unexpected economic developments. And lately, this seems to be happening in a cycle that goes as follows: the Fed talks up interest rate hikes → bad economic news emerges → the Fed dials down its rate hike talk → good economic news emerges → repeat cycle.

To see this cycle, recall what has happened this year. After the FOMC did its 25 basis point hike in December 2015, FOMC members were talking up four more rate hikes in 2016. Then in early 2016 concerns emerged about financial stress and the global economy that caused Fed officials to dial back their rate hike talk. By the time of the March FOMC meeting, some members were even concerned about raising rates in April. Over the next few months, however, incoming economic data was improving so Fed officials once again began dialing up their tightening talk. A rate hike at the June FOMC seemed possible. The rate hike rhetoric quickly changed, however, when the the awful May jobs report--only 38,000 jobs--came out on June 3. Indeed, the FOMC passed on a rate hike at its June meeting.  The Brexit vote reinforced those concerns.

Now the cycle is starting over. The gangbuster June employment report and strong retail sales are causing Fed officials to get itchy trigger fingers again, as seen in the above Wall Street Journal article. Fed officials are increasingly "confident" they can raise rates in September this year. But will they be able to follow through? Or will this cycle repeat itself?

It is almost inevitable, in my view, that this cycle will repeat itself for two reasons.

First, much of the bad economic news that has caused the Fed to repeatedly dial back its rate hike talk has not been a series of random events. Rather, they have been a byproduct of the rate hike rhetoric itself.Whenever the Fed talks up rate hikes it also talking up the value of the dollar which, in turn, creates a drag on many parts of the global economy. This is because a large swath of the global economy has its currency linked to the dollar and because there is almost $10 trillion in dollar denominated debt issued outside the United States. The former means Fed tightening gets exported to other countries (assuming capital flows) while the latter implies Fed tightening raises real debt burdens abroad. Since mid-2014, the Fed's rate hike talk has driven up the trade-weighted dollar about 20% and through these two channels has been the key reason for global economic slowdown over the past year. It also a key factor behind much of the global financial stress this year according to the Bank for International Settlements and Greg Ip.

Given the ongoing strength of the trade-weighted dollar, the above analysis implies the Fed cannot do much rate hike talking without triggering more global economic problems. The dollar growth has plateaued at about 20% growth and that seems to be the tolerable level for now. It is the first reason why Fed officials cannot credibly talk up rate hikes.

The second reason is that the Fed's desire to raise interest rates is pushing up against the Tsunami forces behind the global race to the bottom of safe asset yields. As seen in the figure below, long-term safe asset yields have been on a steady downward path since 2008 that has now pushed some of them below zero.

This downward march of interest rates has occurred prior to and after QE programs and is therefore not the result of central bank tinkering. Rather, it is the result of far bigger global market forces. One interpretation of this movement (based on the expectation theory of interest rates) is that the market expects future short-term interest rates to be increasingly lower. As Tim Duy notes, the Fed is fighting against this force and is unlikely to win. Put differently, interest rates are being suppressed by market forces despite the Fed's best efforts. The Fed will not be able to raise interest rates this year and maybe even next year.

Now the Fed could still force up its target interest rate temporarily. But it would learn the hard way what the Riksbank in 2010 and the ECB in 2011 learned: getting ahead of the recovery and market forces will only make matters worse. In the case of the ECB, it created another recession for the Eurozone. Ultimately, interest rates cannot be exogenously pushed up. They have to be endogenously pulled up by a healthy economy. Until this happens, the Fed is trapped in a self-defeating rate hike talk cycle.

1One clear exception was Brexit.


  1. Great post! Could you help me find out the answer to my paradox (in my blog) please?
    (you should probably add a "be" on the "They have to.." sentence)

  2. There's really nothing to worry about. The rate of money growth, after falling since January 2014, is now rising, possibly because of inflows from Europe and Japan, where interest rates have turned negative.

    See the graph on

    When the Fed raised rates in December 2015 a lot of economists predicted the sky would fall down. If it did not happen then, when money growth was falling, it won't happen now.

  3. Excellent blogging.

    The Fed continues to fight the last war (or the one before that).

    Central banks today should ponder boosting economic growth, and avoiding the zero bound. Instead central bankers jibber-jabber about inflation and financial instability.

    But not promoting growth at this stage is promoting financial instability.

    Send in the helicopters. Really, send in the B-52s.

  4. Thank you for saying it David. Downward trend in bond yields is not the result of Fed tinkering. They went down, of course, after QE ended. What the market monetarists, or at least Scott Sumner and some others refuse to acknowledge is that there is massive demand for bonds as the new gold collateral for derivatives. Interest rate derivatives are the largest of the derivatives markets and bonds are scarce and needed for the clearing houses. I don't know why Scott refuses to acknowledge this reality. It would explain why the Fed is not too keen on NGDP targeting, since too much inflation would destroy the collateral!!!