Act Accordingly

The textbook says that whenever the central bank raises its policy rate that means tightening. Actual experience over more than just this last lost decade demonstrates that at the very least it is much more complicated than that. There is far more evidence of monetary policy being nothing more than a response, as that reverse condition can absolutely be established by global monetary behavior time and again. Alan Greenspan “tightened” from June 2004 forward to no effect, and then Ben Bernanke “accommodated” in perfectly equivalent fashion from September 2007 forward, likewise to no effect.

In the past month and three days we have run into the same sort of contradiction. The FOMC voted in mid-March to “raise rates”, but all it really did was increase the upper and lower boundaries for the federal funds rate. Unlike the pre-crisis era, there is today much more looseness as money market hierarchy was obliterated (not by regulations or bank reserves) by the paradigm shift of bank balance sheet behavior (risk vs. reward). Federal funds are completely irrelevant, but for practical purposes they might as well be. Therefore, as little as a “rate hike” might have meant in 2005 or 2006, it means even less in 2017.

That doesn’t necessarily leave, however, monetary policy changes as completely benign and totally extraneous; it merely means that whatever effects it might create aren’t likely to be what is described of them. With rates falling and the eurodollar curve collapsing again, we know without fail that “rate hikes” deserve fully the quotation marks. But since this latest trend now undoing the whole of the range of the past few months dates back to the FOMC vote exactly, we are forced to consider just how the Fed (if not China and CNY) might have played a role in establishing it no matter how counterintuitive it might be in relation to the textbook approach.

I have written for several years that the best way to frame expectations over monetary policy in this fashion is to realize that the central bank’s role is usually only to make whatever bad situation worse. I described this way in late July 2015:

In other words, as the shorter end rises up in anticipation of the Fed’s raising rates (generically, there are further complications about how they might actually be able to do it, or not be able to do it, which are certainly a part of this doubtful curve narrowness all along) the back end and even the middle 3-5 year section has dropped and flattened. You can make a couple of interpretations about that, but I think the broader context of “dollar” behavior and evidence these past two years are strikingly consistent about what that means of market expectations: the Fed’s “tightening” will only make a bad situation worse.

If the yield or eurodollar curve were steepening as well as rising nominally, “rate hikes” would require no quotation marks. But these curves have been uniformly consistent, outside of a few months in later 2016, dating all the way back to the first tapering of QE at the end of 2013. Therefore if the latest pessimistic trend goes back to March 15 then it must be something else with the Fed that could have triggered it.

Viewing all this from the textbook perspective means expecting monetary policy to set conditions for the markets, both bond as well as funding. Rearranging the flow of causation instead reveals what markets might be thinking about these “rate hikes” and what they actually mean. In the context of late 2015, it was actually pretty clear what the Fed was doing even though the media was very confused about it (in no small part because policymakers were caught off guard, too). The rest of 2016 as well as the latest “rate hike” in 2017 have simply recommended this view.

What drives UST yields or eurodollar futures prices is therefore not “hawkishness” or “dovishness”, but rather perceptions about whether “hawkishness”, “dovishness”, Trump, or even Paul Krugman’s fake alien invasion scenario will amount to anything positive and the significance of it. It is the translation of current conditions into considerations about the future, captured in prices and yields – the actual discounting of information, of which monetary policy is only a (variable) part.

In other words, what the Fed has been doing the last year and four months is confirm that they are getting out of the “stimulus” business altogether – no matter what. For only a brief period largely in November did that suggest anything positive, meaning that “rate hikes” might actually be the rate hikes needed to get ahead of overheating. The past few months after the bond selloff have been nothing but confirmation that just isn’t the case, and without a tangible response from somewhere else (Trump or ECB, BoJ, PBOC, etc.) “raising rates” does nothing but confirm the durability of weakness in the form of, at best, a persistently low growth state – and likely low growth at uneven rates still, including what is shaping up to be the worst quarter for GDP (despite “residual seasonality”) in three years.

In short, even though monetary policy clearly didn’t work, so long as the Fed was willing to stay at ZIRP there was some (highly debatable) chance they might transition to something else that might. The second “rate hike” and really the third just settled that won’t be the case until long after the next big problem is already well underway (central banks are always behind, the other basis for reactive monetary policy). Monetary policy in the US is now completely off the table even though the economy remains in this weak state without any recovery from the Great “Recession” at all. None.

And that was, in my view, the real “making a bad situation worse” of March 15. The media and most mainstream commentary still fail to see it, Janet Yellen especially but not just Janet Yellen made it plain that the Federal Reserve sees no actual improvement, either, despite all rhetoric about their exit (that they, for obvious reasons, refuse to clear up in a more forceful style). Not only, then, is monetary policy no longer any option no matter how remote it may have been, the Fed doesn’t even have any positive economic surprises up its sleeve to help make up for it.

If something changed on March 15 it was that nothing changed, and nothing is likely to any time soon. There was no actual “tightening” due to the FOMC vote last month, as monetary policy was instead a complete washout for other reasons. The markets are merely acting accordingly.

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