- Dovish comments by Fed officials lead us to believe that normalization in interest rates could take a more circuitous route.
- While the steady economic recovery makes higher yields inevitable, the path we take to get there is dependent on the Yellen Fed’s policy approach.
- We remain underweight duration, but are now less sure 3-5yr yields will lead the way over the near-term.
Textbooks would have us believe that monetary policy is a hard science—it’s only a matter of loss functions, dynamic systems and optimization. In reality, there is a big subjective component. Here’s what we wrote about this issue in our primer on Janet Yellen:
“By and large Fed officials agree on their goals for the economy over the longer run … Where they disagree is on what should happen between now and then: how costly is high unemployment; what are tolerable paths for bringing inflation and unemployment back to normal levels; how aggressively should the Fed work to achieve its goals; and what are the risks to action versus inaction. In our experience, the relative views of individual policymakers on these types of questions line up surprisingly often. This is what is meant by ‘hawks’ and ‘doves’ in central banking: there is a subjective component to policymakers’ views that remains pretty constant over time and explains why some officials always seem to be on one side of the debate.”
There are few remaining questions around the objective data on slack in the U.S. economy. Taking into account signals from the broader U6 unemployment rate, the “true” U3 unemployment rate would be around 7.0-7.5% instead of 6.7%. The drop in the unemployment rate is broadly consistent with other measures of economic slack from a verity of sources. The labor force participation rate has declined very sharply since 2007, but 45% of labor force exits represent retirements and 20-25% represents new disability recipients—categories that historically have seen very low re-entry rates. The decline in the participation rate also looks much like the pattern in other post-financial crisis economies. For these and other reasons, the Congressional Budgets Office (CBO) now projects that the employment-to-population ratio will remain roughly flat for the next decade (figure 12 here).
While almost nothing has changed in the data, we’ve learned more about how Fed officials are interpreting the facts in hand—the dovish feathers are starting to show through.
First, Yellen made clear last Monday that she views the “extra slack”—that portion not accounted for by the U3 unemployment rate—as extremely costly. She said, for example: “In some ways, the job market is tougher now than in any recession”.
Second, the FOMC meeting minutes hinted that the upward shift in the funds rate forecasts may have overstated the change in the views of the committee leadership (although there remains some question about exactly what the minutes were trying to convey).
Third, comments yesterday from Fed Governor Tarullo and Chicago Fed President Evans stressed the Fed’s willingness to risk some overshooting to reach their employment goals. Tarullo said: “We should remain attentive to evidence that labor markets have actually tightened to the point that there is demonstrable inflationary pressure that would place at risk maintenance of the FOMC's stated inflation target … But we should not rush to act preemptively”. President Evans was even blunter: “The surest and quickest way to reach our objectives is to be aggressive. This means, too, that we must be willing to overshoot our targets in a manageable fashion.”
It’s important to mention that these three officials have tended to fall on the dovish end of recent debates, so it’s possible that we are missing the other half of the argument. But Yellen is the Fed Chair, and we suspect that her views are not that far from those of Evans and Tarullo. So the latest comments arguably deserve attention even if they do not describe the full picture.
For bond investors, the main implication is that the normalization in interest rates could take a more circuitous route. The steady economic recovery means that higher bond yields are eventually inevitable. However, the path we take to get there is uncertain, and is dependent on the Yellen Fed’s policy approach. We had expected Fed officials to tolerate small increases in yields throughout this year as the exit drew closer, but the dovish pushback after the last FOMC meeting suggests some committee members think these increases are coming much too soon. As a result, we are questioning some of our views on the yield curve. With Treasury yields below fair value across the board, it makes sense to remain underweight duration. But we are now less confident that the 3-5 year point will lead the way, and have become more cautious about the long end of the curve (10- and 30-year points).