Two weeks ago, when deciphering the FOMC's latest minutes, the market surged after paying particularly close attention to an extended Fed discussion of a heretofore little known aspect of the Fed's monetary policy decisionmaking, namely its focus on r*, or the "equilibrium" growth rate.
As Goldman then summarized [11], "minutes from the October 27-28 FOMC meeting indicated that most FOMC participants thought that the conditions for liftoff "could well be met by the time of the next meeting.” The minutes also noted staff estimates that the short-run equilibrium real interest rate is currently around zero and the long-run equilibrium rate would likely remain lower than was the case in previous decades."
For those unfamiliar, the equilibrium growth rate is roughly coincident with the Fed's long-term inflation goal which over the past several decades has been around 2%. However, as a result of secular stagnation even the Fed has been forced to admit that not only is US potential growth lower, but so is r*, or the equilibrium growth rate.
This is what Deutsche Bank said recently, when explaining the Fed's rush to hike rates:
The logic for reducing accommodation is embedded in a cyclical view of the economy that defines a real rate equilibrium in the short term with a long rate equilibrium anchor based on price stability defined around 2 percent. There is a presumption that inflation is naturally pulled towards a 2 percent “long run” equilibrium as long as the economy grows above potential. And there is a presumption that if the actual real rate is below the short-run equilibrium rate, then growth will be above potential. The fundamental question is whether the underlying inflation equilibrium is actually 2 percent or lower. If for example we have been growing above potential for a while, then maybe inflation is also exaggerated higher now.
The reason why the Fed's latest Minutes resulted in a jump in the market is because if indeed r* is around zero or well below 2%, then the Fed's rate hiking cycle will be very quick before the Fed is forced to abort it and resume easing: perhaps as low as 3 rate hikes tops before r* is hit and the economy can not sustain any more tightening.
As Goldman summarized the Fed's thinking on this matter, "participants also noted that the lower long-run equilibrium rate implies that the near-zero effective lower bound could become binding more frequently. As a result, “several” participants indicated that it would be “prudent” to consider “options for providing additional monetary policy accommodation” should the economic recovery falter."
Well, yes, by now it is no secret that the Fed is only hiking so it has dry powder to easy in the coming quarters when the US recession can no longer b ignored by the NBER and various tenured economists.
But, as Deustche Bank took the question one step further, what if r* is already negative? In that case, the Fed should be easing, not hiking, and any tightening in financial conditions would mean a policy error.
Here is Dominic Konstam with this troubling line of inquiry:
Even if the equilibrium real rate does not change, the Fed might at least be able to get to the market’s view of the terminal rate – slightly below 2 ½ percent – without inflicting serious damage on the economy. If the equilibrium real rate does rise, all the better – the markets would move to the Fed’s dots, and the terminal rate would be around the Fed’s target of 3 ½ percent.
The alternative view is more worrying. In this view, the equilibrium nominal rate is at present much lower than the Fed thinks and the equilibrium real rate is meaningfully negative. Policy at present is not very accommodative, and to the extent that it is, inflation is actually running above its equilibrium level, which is close to 1 percent.
And here, the Deutsche Banker does something no other economist has considered: assume that the US long-rate growth rate is curbed by something as simple as massive amounts of debt. To be sure, debt is something the US has loads off. As we reported two months ago, following the recent revision to the Fed's Flow of Funds report, total debt/gdp was "revised" from 330% to 350 [12]%.
[13]
How should this figure into the Fed's equilibrium rate calculus? It's actually very simple. Cue Deutsche Bank:
One might argue for low “implied” equilibrium short rates via debt ratios. For example, if nominal growth is 3 percent and the debt GDP ratio is 300 percent, the implied equilibrium nominal rates is around 1 percent. This is because at 1% rates, 100% of GDP growth is necessary to service interest costs.
In this case, real growth would slow in response to rate hikes because productivity would stay weak at full employment and companies would be profit/price constrained around paying higher wages. Moreover, nominal growth would then slow even more than real growth does because inflation would fall to 1 percent or below.
Wait, growth is limited due to 350% (sorry, it's not 300% any more) in cumulative debt/GDP as a result of which all "growth" is being used to pay down interest expense? Now how did not a single Fed economist think of that? Oh yes, because it is so blidningly obvious!
Which brings us to DB's punchline:
This is the important policy error scenario because even a very shallow path of rate hikes might drive the real Funds rate well above the short-term equilibrium real rate, further depressing demand. It is then plausible that the economy would be driven into recession, and the Fed would quickly be forced to abort the hiking cycle. As an aside, such a policy error could reinforce itself by causing structural damage that puts additional downward pressure on the equilibrium real rate. In this case the yield curve would flatten meaningfully, at least until the Fed actually reversed course by cutting rates.
In summary, a rate would lead to the proverbial cats and dogs, living together, mass hysteria [14], etc., but on the condition that r* is indeed far lower than the Fed thinks it is.
So to help the Fed and pundits calculate just where r* is in an economy where total debt/GDP is 350% and rising, and where GDP is 2% and falling, we present a sensitivity table which looks at just two simple variables: nominal growth, or GDP, and total debt/GDP. Assuming the current leverage of the US and assuming 2% in nominal growth, the short-run equilibrium real interest rate is just about 0.57%.
[15]
In other words, two rate hikes... and the Fed will have no choice but to cut rates all over again.
