U.S. rates – Headwinds

Zach Pandl, Portfolio Manager and Strategist | March 17, 2014

  • At this week’s meeting, the Federal Open Market Committee looks likely to rework its forward guidance for short-term interest rates once again.
  • We expect revised forward guidance to lean heavily on the idea of “headwinds”; this is a stand-in term for a low equilibrium real rate.
  • We expect that the new guidance will make three main points: (1) that the FOMC is in no hurry to raise rates, (2) that rate hikes can proceed gradually once they begin, and (3) that short-term rates could remain below pre-crisis levels even when the economy returns to normal.

At this week’s meeting the FOMC looks likely to rework its forward guidance for short-term interest rates once again. By our count this will be the seventh variation since the funds rate reached zero (the previous six being “some time”, “extended period”, “mid-2013”, “late 2014”, “mid-2015” and the current 6.5% unemployment threshold). All signs suggest that Fed officials favor replacing the current threshold-based forward guidance with a framework tied to their qualitative assessment of economic conditions. We expect that the new guidance will make three main points: (1) that the FOMC is in no hurry to raise rates, (2) that rate hikes can proceed gradually once they begin and (3) that short-term rates could remain below pre-crisis levels even when the economy returns to normal. In each case, we think that the committee will lean heavily on the idea of “headwinds” to justify these views.

The concept of “headwinds” sounds vague, but we think Fed officials actually have a specific issue in mind: the right way to determine whether monetary policy is easy or tight. The diagram below illustrates the basic point. Monetary policy responds to the output gap (the reaction function) and also affects the size of the output gap (the normal transmission mechanism). However, there are many other things that affect the output gap besides monetary policy. These can include non-financial factors like fiscal policy and oil prices, as well as financial headwinds/tailwinds such as credit standards, household balance sheet stress and capital market regulation (financial headwinds could be thought of as affecting the output gap directly or as impairing the transmission mechanism).

Diagram: Factors influencing monetary policy

Simple benchmarks like the Taylor Rule only consider the size of the output gap (and inflation gap) to determine the stance of policy. But what does it mean to say that monetary policy is “easy” if factors outside the Fed’s control prevent the output gap from closing? A holistic view of policy should take into account all the other headwinds and tailwinds that drive the economy—it would not only consider the left side of the diagram above. Looked at in this way, monetary policy may not be exceptionally easy today (though we will take up that issue below). Rather, the Fed’s stance could be thought of as the mirror image of the constraints on growth from other sources: tax increases, underwater mortgages, impaired securitization markets, etc. To close the output gap, Fed policymakers need to offset these headwinds complicating their job.

For economists the term “headwinds” is just a stand-in for a familiar concept: the short-term equilibrium real rate (also known as r*). The specific definition for this variable that the Federal Reserve uses in its Blue Book is the real interest rate that closes the output gap in three years, given a certain model’s forecast for the economy. Conceptually, if the funds rate is above the equilibrium rate monetary policy should be considered “tight”, and if the funds rate is below the equilibrium rate, monetary policy should be considered “easy”. Unlike the Taylor Rule, the equilibrium real rate incorporates both the size of the output gap and the impact of other factors on growth (to the extent they are included in the model). In other words, it tries to account for headwinds and tailwinds.

The chart below, for instance, shows the Fed staff’s estimates for the short-term equilibrium real rate presented at the FOMC meeting in December 2008 (made public for the first time last week). The staff’s estimates collapse at the end of 2008, both because of the increase in unemployment and because of strains in the financial system. Tight financial conditions—a type of headwind—meant that the real funds rate would need to be kept lower than normal to close the output gap in three years.

Chart: Short-run estimates with confidence intervals

We suspect that Fed officials have a chart like this in mind when they frame the funds rate outlook in terms of “headwinds” today. Barriers to growth from fiscal policy and other sources mean that the equilibrium real rate remains low today, and monetary policy is not overly easy, in their view. Because of these headwinds, the Fed can be patient in raising rates and move slowly once started.

Generally speaking we agree with this basic framework: policymakers need to take into account other drivers of growth in order to ensure they meet their goals. But the “headwinds” idea does not necessarily imply “lower for longer” and/or tranquil bond markets. First, equilibrium real rates depend on the size of the output gap. And as we have noted elsewhere, output gaps may be smaller than commonly appreciated. Second, headwinds to growth seem to be abating. For instance, the drag from fiscal policy should be much smaller this year and financial conditions have improved—New York Fed President Dudley said last week that they were now “quite accommodative”. Third, policymakers’ views on headwinds are only a forecast. Central bankers communicate two kinds of things to markets: information about their reaction function and information about their forecasts. The former is very valuable, because policymakers can control the way they respond to the data. Forecasts are much less valuable because the outlook is anybody’s guess, and the Fed’s credibility is not on the line if the economy performs differently than expected.

It’s in this way that we recommend investors read the Fed’s revised forward guidance this week. Headwinds matter, and the concept is not as fuzzy as it sounds. But the Fed’s guidance about the funds rate is just a byproduct of their forecasts for fiscal policy, financial conditions and all the other headwinds and tailwinds in their models. Markets seem to treat the guidance much more like a promise, and we worry that this could lead to volatility if the guidance were ever revised.