Since December, we have been covering a steadily building conversation on Wall Street about the possibility that the Federal Reserve seeks to move early in exiting its zero interest rate regime of extraordinary monetary stimulus, especially if the unemployment rate continues to tumble and wage growth continues to accelerate.
This idea has caused a backlash in the media.
“If the Fed tightens prematurely, it could end up trapping us in lowflation; essentially, it would have completed the Japanification of the U.S. economy, putting us into a trap that’s very hard to exit,” writes Paul Krugman today, providing the latest of many examples.
“So let’s not panic over rising wages, OK? The only thing we have to fear is fear of full employment itself.“
We’re going to keep talking about it, though, because market participants are going to keep talking about it.
And market participants are going to keep talking about it because there’s a lot of money on the table.
Everyone has an opinion on what the Fed should do in this case. Much of the media backlash has come from those who, like Krugman, argue that even though wage growth has shown nascent signs of acceleration, the risks of premature tightening of monetary policy outweigh the risks of staying easy for longer. Moreover, everyone can agree that wage growth is a good thing, so why try to choke it just as it begins making a comeback?
As Bloomberg News Federal Reserve reporter Josh Zumbrun puts it, “They are so caught up arguing what they think should happen that they have stopped paying attention to what is happening.”
What is happening: labour markets are getting tighter, and there’s a growing constituency inside the Fed that believes zero interest rate policy will not be appropriate for very much longer.
Still, for now, the Fed’s official line is that interest rates will be at zero until late 2015. Market prices are calibrated for that outcome.
The question for market participants is whether the labour market will continue to show signs of tightening, and how much pressure that will put on those inside the Fed who believe zero rates should be maintained for an extended period of time, regardless of how fast wages are rising.
Martin Enlund, a fixed income and foreign exchange strategist at Handelsbanken Capital Markets, calls it “the big battle brewing inside the Fed.”
One camp, personified by Fed Chairwoman Janet Yellen and the “optimal control” approach to monetary policy, would allow for inflation to rise above the Fed’s 2% inflation target in order to return the labour market back to full health sooner rather than later — these are the “doves,” and their stance implies no rate hikes for a while, especially given how low inflation is.
Others, like Dallas Fed President Richard Fisher and Philadelphia Fed President Charles Plosser — both of which are new additions to the voting ranks of the Federal Open Market Committee this year, and thus exert more influence on monetary policy decisions that before — are traditional monetary policy “hawks”, which means they will likely be arguing for rate hikes sooner rather than later.
There’s more going on at the Fed than just that, though. For example, San Francisco Fed President John Williams — who is usually classified as neither a hawk nor a dove, but rather a centrist, somewhere in the middle — spoke in a recent speech about the “risks of overshooting” the Fed’s 2% inflation target, suggesting that resistance to such a course of action may be more widespread on the Committee than just among the hawks.
Furthermore, there are Fed governors like Jeremy Stein and and Daniel Tarullo, who have devoted a lot of time recently to discussing financial stability issues. The Fed arguably has a de facto financial stability mandate in addition to its mandates of full employment and stable inflation, and while Fed officials say this isn’t a big concern yet, the cost-benefit tradeoff of financial stability may change over the coming year, depending on what happens in the marketplace.
Put this all together, and you have hedge funds looking for the next big macro trade licking their chops.
At the end of 2013, there was a widespread acknowledgment in the investor community that “tail risks” — outlier events with a small chance of occurring that could have a big impact on market prices — appeared to be few and far between as downside risks to global economic activity were receding.
This impression was largely spurred along by an acceleration in the pace of growth in economic activity in the second half of 2013, and the idea was that the most likely tail risk could actually come from an upside surprise in economic growth relative to expectations as the Fed began tapering down its quantitative easing program, setting in motion the path toward monetary policy normalization.
That is why there has been an explosion of interest in just how tight the labour market is becoming.
Portfolio managers have been chattering about it, and that’s prompted Wall Street strategists and economists — and those like us who try to keep our finger on the pulse of the conversation — to look into it.
It’s not about trying to figure out what the Fed should do, but what they will most likely do.
To quote Bloomberg News Fed reporter Josh Zumbrun again: “Some folks think the Fed should stay at 0 until thwacking full employment. Not how the Fed thinks.”
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