As we have hammered away at for years, "the math doesn't work", and it appears The Fed just admitted it.
In a stunning admission that i) US economic potential is lower than consensus assumes and ii) that the Fed is finally considering the gargantuan US debt load in its interest rate calculations, moments ago the Fed's Kaplan said something very surprising:
- KAPLAN SAYS NEUTRAL RATE MAY BE AS LOW AS 2.25 PCT, LEAVING FED "NOT AS ACCOMMODATIVE AS PEOPLE THINK"
Another way of saying this is that r-star, or the equilibrium real interest rate of the US (calculated as the neutral rate less the Fed's 2.0% inflation target), is a paltry 0.25%.
What Kaplan effectively said, is that with slow secular economic growth and 'fast' debt growth, there's only so much higher-rate pain America can take before something snaps and as that debt load soars and economic growth slumbers so the long-term real 'equilibrium' interest rate is tamped down. It also would explain why the curve has collapsed as rapidly as it did after the Wednesday FOMC meeting, a move which was a clear collective scream of "policy error" from the market.
This should not come as a surprise. As we showed back in December 2015, in "The Blindingly Simple Reason Why The Fed Is About To Engage In Policy Error", when calculating r-star, for a country with total debt to GDP of 350%...
... The equilbirium real rate is around 0.4-0.6% at most, certainly below 1%, and as low as 0.30%.
Furthermore, as Deutsche Bank's Dominic Konstam said almost two years ago, "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.
To be sure, the Fed hinted as much two days ago, when on Wednesday it lowered its longer-run federal funds rate to 2.75% from 3.00%. Another hint came last week from the BOC which, together with Bill Dudley, hinted it was willing to considering changing its mandate, i.e. lowering the inflation target, thereby unlocking some potential upside to the Real Interest Rate.
In the meantime, however, the mere fact that another Fed president is once again hinting that r-star is far lower than consensus, is an indication that the central bank is very limited in how much more tightening it can pull out this cycle. The simple math is that if Kaplan is right, the Fed has at most 3 more hikes left before it prompts yield curve inversion and another recession.
Expect to hear much more on this now that the r-star genie is out of the bottle. Finally the other consideration is that with the Fed once again talking about cutting the neutral rate, is means that not only is tightening approaching its end, but that the Fed may soon be forced to ease, by either cutting rates or QE.
Which also explains the second part of Kaplan's statement: that the Fed is not as "accomodative as people think." That is basically the Dallas Fed president jawboning risk assets lower, an implied warning that the market is not appreciating how close to capacity the economy currently is. Of course, the question why stocks aren't dropping is best left to the ECB and BOJ...
Then again, maybe this time the market will notice, as LT yields are finally starting to move.