While Janet Yellen, chairwoman of the board of governors of the Federal Reserve, testified before Congress on Feb. 10 and 11, the global stock and bond markets acted as a grim Greek chorus. As Ms. Yellen noted that the near-term risks of recession were low (a view consistent with our own), the U.S. stock market was putting the odds at more than 60%. The corporate bond market sounded a similarly baleful note.
Inflation expectations are another sign of nervousness. Since 2008, market-based inflation expectations, derived from U.S. Treasury bonds, have hovered above 2%. In the past few weeks, these projections have tumbled below 1.5%. The Fed typically has paid less attention to market-based measures than to the more stable survey-based forecasts, but pessimism in the former can eventually begin to shape the latter.
The markets’ distress and recessionary signals had little to do with China, oil or even the Fed’s 25-basis-point rate hike in December. These developments were either old news, already priced into the markets or generally positive for the economy.
The source of distress was less obvious and more secular. It’s the divergence between the Fed’s plans for long-term monetary policy and growing awareness of a global economic future that, even in periods of expansion, will be frustratingly fragile, with frequent growth scares and deflationary pressures.
As of December, Fed projections of future monetary policy — the so-called dots — indicated the federal funds fate would rise to 3.3% by 2018, even as Japan and some countries in Europe wrestle short-term rates into negative territory. This forecast is even more aggressive if one acknowledges the Atlanta Fed’s estimate that a hypothetically unbounded, or “shadow,” Fed funds rate might have been as low as -3% two years ago. (The shadow rate is an estimate of what the Fed funds rate would be if it were not bounded by zero.)
Even if the pace of Fed normalization is gradual, the Fed’s 3.3% projection would imply a 630-basis-point rise in the Fed funds rate from the shadow rate, the most aggressive monetary tightening since the early 1980s. As global monetary policy diverges and the U.S. dollar strengthens, the Fed’s guidance could be too hawkish globally.
In our view, the Fed’s optimal response would be not to fight the bond market, but rather embrace it, even if the bond market turns out to be too pessimistic. As the Fed prepares to release its latest rate projections at the conclusion of its March 16-17 Open Market Committee meeting, it might wish to stop publishing its long-term dots or at least lower them over the next two years. The Fed could also consider telegraphing an extended pause at 1% (yes, the Fed should and likely will raise rates several more times this year), acknowledging that growing policy divergence around the globe warrants a course correction at home. By lowering its final destination (rather than just underscoring a gradual rise), the Fed would show skittish global markets that it recognizes this frustratingly fragile global reality, and that it’s once again increasing the U.S. economy’s chances of ultimately escaping it.
Market volatility is mostly noise, a dangerous distraction from the boring business of successful long-term investing. And that remains our counsel to clients.
Amid the noise, however, we’ve detected a signal from the fragile economy that can provide insight to the Fed as it seeks to sustain the U.S. expansion in the months ahead.
Joseph H. Davis is global chief economist and global head, investment strategy group, at Vanguard Group, Malvern, Pa.
