By Steven K. Beckner
AMELIA ISLAND, Fla. (MaceNews)– Nettlesome uncertainties about inflation, trade and now financial stability are keeping U.S. monetary policy stuck firmly where it’s at for the foreseeable future.
For now, the economy is doing too well for the Federal Reserve to cut interest rates, but those concerns seem equally likely to prevent a resumption of rate hikes.
That’s the reality that emerged over the last two days at the Atlanta Federal Reserve Bank’s annual Financial Markets Conference on Amelia Island and elsewhere.
Fed officials comfort themselves believing they have kept the federal funds rate at some semblance of “neutrality” in the target range of 2.25% to 2.50% since December. But they are tormented by the thought that this monetary limbo land leaves them precious little room to maneuver — to conduct counter cyclical policy.
If things go seriously wrong, instead of the 500-600 basis points of easing the Fed has typically fired at past recessions, it now can cut the funds rate no more than 240 basis points before it finds itself back to the zero lower bound contemplating a resumption of quantitative easing with a still bloated balance sheet.
Fed Chairman Jerome Powell added another concern Monday night: potential financial instability. Not that it’s an entirely new issue: it was global market instability that led the Fed’s policymaking Federal Open Market Committee to pivot away from rate hikes in early January. But it refuses to go away and keeps showing new facets.
The Atlanta Fed conference took place against the backdrop of renewed market turbulence that seemed to bely the comments Powell made at his May 1 post-FOMC press conference.
At that time, Powell minimized financial stability risks. He told reporters “some asset prices are somewhat elevated” but “not extremely so.” He acknowledged “some concerns around nonfinancial corporate debt,” but called financial vulnerabilities “moderate on balance.” He said the financial system is “quite resilient.”
Subsequently, global markets have been sorely tested. The Dow Jones Industrials swung 1253 points from its high to its low in the last two weeks as U.S.-China trade tensions intensified. The VIX volatility index jumped to its highest level since January 4. As anxious investors fled equities for safe havens like Treasury securities, the 10-year note yield fell as low as 2.36% last week — lowest December 2017.
Fed watchers were entitled to wonder if Powell’s view has changed.
Well, yes and no.
Powell did sound significantly more anxious tone in his keynote speech. While he continued to speak of a strong economy and a “more resilient” financial system, there was an unmistakable heightening of concern about financial stability.
The Fed chief focused on the build-up of business debt to “near record levels.”
He downplayed similarities to the mountain of subprime mortgage debt that triggered a financial crisis and recession in 2008. What’s more, he said better capitalized banks are more able to weather problems than they were 11 years ago. But Powell said rapid growth of “leveraged loans,” extended to already indebted firms with poor credit, to more than $1 trillion does pose a threat.
“If financial and economic conditions were to deteriorate, overly indebted firms could well face severe strains,” he said.
For now, Powell sees the economic environment as favorable:
“Despite crosscurrents, the economy is showing continued growth, strong job creation, and rising wages, all in a context of muted inflation pressures.”
“But if a downturn were to arrive unexpectedly, some firms would face challenges,” he said. “Not only is the volume of debt high, but recent growth has also been concentrated in the riskier forms of debt. Among investment-grade bonds, a near-record fraction is at the lowest rating — a phenomenon known as the ‘triple-B cliff.'”
Powell warned “in a downturn, some of these borrowers could be downgraded into high-yield territory, which would require some investors to sell their holdings, thereby confronting traditional high-yield investors with a sudden influx of bonds.”
Powell also noted “sizable shifts within the non-investment-grade, or riskier, debt universe” toward faster growth of leveraged loans and noted “the rise in riskier business borrowing has been funded principally by nonbank lenders.”
Although business debt not pose the same threat to financial stability as subprime mortgages, Powell implied it’s looming larger on the Fed’s radar. “If lenders face defaulting borrowers and have too little loss-absorbing capacity, they risk insolvency. At best, they will cut back on lending to other borrowers, dragging the economy down. At worst, they will fail, which can lead to severe economic damage to households and businesses.”
“Finally, when the financial system funds long-maturity assets with short-maturity liabilities, we risk a classic ‘fast burn’ crisis — a bank run, or its equivalent involving investors and institutions outside traditional banking.”
Having said all that, Powell ratcheted his alarm back down. Although business debt has risen rapidly, he noted it has slowed recently and is “one-third of the increase in household debt seen in the previous decade.”
Valuation pressures also point to “moderate risks to financial stability,” he went on, and “there does not appear to be a feedback loop between borrowing and asset prices, as was the case in the run-up to the financial crisis.”
“While borrowing by businesses has been strong, it is not fueling excessive prices or investment in a critical sector such as housing, whose collapse would undermine collateral values and lead to outsized losses,” Powell elaborated. “Instead, the increase in business borrowing has been broad based across sectors, including technology, oil and gas production, and manufacturing.”
Powell went on to note that banks are “fundamentally stronger and more resilient” than in 2007-8, with “robust capital requirements backed by strong stress tests.” What’s more, he said “funding risk — the susceptibility of the financial system to runs also appears low.”
After marching his audience up that treacherous hill, he marched them back down again: “Overall, vulnerabilities to financial stability from business debt and other factors do not appear elevated. We take the risks from business debt seriously but think that the financial system appears strong enough to handle potential losses.”
While he might be whistling past the graveyard, the Fed chief did reveal a higher level of concern about financial conditions and their implications for the economic and monetary policy outlook.
When I asked Atlanta Fed President Raphael Bostic the following morning whether financial instability risks had become another reason for the Fed to proceed cautiously on monetary policy, he responded, “it’s always on the list to the extent we’re starting to see building exposures there.”
ostic told me and a few colleagues financial stability risks have “not risen to what I would consider crisis levels at this moment,” but added that the Fed is watching it closely.
Plainly, Fed policymakers have been virtually immobilized into inaction by multiple uncertainties.
Bostic, a voting member of the FOMC, fully reflected the view of Powell and the rest of the Fed leadership in saying Monday there is no clear case at this time for moving rates in either direction.
Many financial market participants would like to think otherwise. They have priced in fairly high odds of at least one rate cut later this year.
But Bostic downplayed such expectations in a CNBC appearance: “The market is ahead of where I am,” he said. “I would say I’m not expecting a rate cut to be imminent, certainly not by September. Things would need to happen in order for that to play out.”
Chicago Fed President Charles Evans, who with Bostic has voted to leave the funds rate unchanged since December, is one of a few Fed officials who have openly said they would support a rate cut if inflation fails to run at least 2%.
Evans told the conference that. in a world of lower trend growth rates and undershooting inflation, if the Fed wants to avoid returning to the zero lower bound and having to resort to quantitative easing again, the Fed needs to get inflation back to its average 2% target — even it means tolerating inflation as high as 3% or even 4% for a year.
Earlier this month Evans said there might be a case for a rate hike, but also cautioned, “if activity softens more than expected or if inflation and inflation expectations continue to run too low, then policy may have to be left on hold — or perhaps even loosened — to provide the appropriate accommodation to obtain our objectives.”
Apart from trade-induced market volatility and mounting corporate debt, Fed officials have been frankly surprised, not to say bewildered and flustered, by the economy’s behavior. Vice Chairman Richard Clarida highlighted three key issues facing the central bank at yet another “Fed Listens” event Monday in New York:
- “(A) fall in neutral rates increases the likelihood that a central bank’s policy rate will reach its effective lower bound in future economic downturns. That development, in turn, could make it more difficult during downturns for monetary policy to support household spending, business investment, and employment and keep inflation from falling too low.”
- “(I)nflation appears less responsive to resource slack, implying a change in the dynamic relationship between inflation and employment. This change is … a double-edged sword. It permits the Federal Reserve to support employment more aggressively during downturns…because a sustained inflation breakout is less likely when inflation is less responsive to employment conditions. However, that dynamic also increases the cost, in terms of economic output, of reversing unwelcome increases in longer-run inflation expectations… .
- “Finally, the strengthening of the labor market … has highlighted the challenges of assessing the proximity of the labor market to the full employment leg of the Federal Reserve’s dual mandate. The unemployment rate, which stood at 3.6 percent in April, has been interpreted by many observers as suggesting that the labor market is currently operating beyond full employment. However, the level of the unemployment rate that is consistent with full employment is not directly observable and thus must be estimated… .”
Asked whether the economy is “overshooting” full employment, Bostic said he estimates the “natural” rate of unemployment (or NAIRU) at 4.1%, but said the fact that “we’re finding workers faster, and workers are finding jobs faster — suggests natural rate should be lower.” He said he and his colleagues have been forced to reevaluate both the labor market and the inflation process.
Boston Fed President Eric Rosengren also grappled with the ostensible dilemma of historically low employment and unacceptably low inflation Tuesday morning. Contrasting the 3.6% unemployment rate to the FOMC’s median 4.3% median estimate of the longer-run unemployment rate, he said “if the central bank focused only on labor markets, the current level of unemployment might call for a somewhat more restrictive monetary policy.”
But with core PCE inflation running just 1.6%, he said, “lower than desired inflation might imply a somewhat accommodative, or looser, policy stance — to ensure that inflation rises more persistently to the Fed’s 2 percent target.”
In other words, Rosengren added, “The two elements of the Fed’s mandate are sending opposing signals for monetary policy, with low unemployment perhaps suggesting a bit tighter policy, and low inflation the opposite.”
The erstwhile hawk saw “no clarion call to alter current policy in the near term… . (T)he Fed can afford to wait to see if that (2% inflation) forecast does indeed materialize. In addition, the presence of a prominent downside risk — more disruptive trade negotiations — seems to me to be another important reason for policymaker patience until this source of uncertainty is more resolved.”
In short, the uncalculable new labor and inflation “dynamics” together with trade uncertainties and financial risks seem likely to leave U.S. monetary policy unchanged as far as they eye can see.