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No reason to fear the Fed

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One day, the Federal Reserve’s long-running stimulus will end. This means that interest rates will start to go up and that the Fed will begin to sell trillions of dollars’ worth of securities it bought during Quantitative Easing, or QE. The market is afraid that interest rates could go up a lot, or that the Fed will dump the securities quickly, or both. Either scenario could be quite disrupting. Fortunately, those fears are overblown.

Interest rate hikes and security sales are likely to be gradual and predictable, as the Fed itself has committed to do in writing (in the “Policy Normalization Principles and Plans” of September 2014). More to the point, nothing will happen soon. But the market is afraid nonetheless.

The concern that interest rates could rise a lot stems from past Fed moves. Last time the Fed Funds rate went up, in 2004, it soared from 1% to 5.25%. The time before that, in 1994, it climbed from 3% to 6%. And before that, in 1987, from 5.875% to 9.75%. This suggests that the Fed does not fool around when it changes policy.

Accordingly, the market seems to think that once the Fed sets out to change course it will do so with a damn-the-torpedoes approach, ignoring all sorts of dislocations in the prices of securities and bringing the economy to a grinding halt. This is evident by the market reaction to news. Anything that pushes forward the starting date, like soft data or a dovish statement from a Fed official, sends the market up. Strong data or hawkish comments, however slight, send the market down. The media’s obsessive focus on Fed policy makes this worse.

Investors should relax. The Fed is a long way off from changing course in any meaningful way. Not only it said in its last statement that “it can be patient in beginning to normalize monetary policy” but also that interest rates will remain where they are for a “considerable time” as long as inflation runs below 2% and “employment objectives” remain unattained. Both conditions are likely to remain in place for a while.

Deflationary pressures around the world will keep US inflation below 2% for the time being. The eurozone is now officially in deflation, and China’s inflation numbers keep falling. An economist at Citi in Hong Kong was quoted last week by Reuters saying that “deflation [in China] this year is definitely a risk.” All indications point to the fact that US inflation will remain where it has been for the past 2 and a half years, well below the 2% target, for most of this year.

The Fed’s “employment objectives” are a bit more difficult to define. The official measure of employment the Fed follows, forecasts, and targets, is the unemployment rate. But “employment objectives” may now include wage growth, a measure that does not seem to be defined precisely in the discussions that take place during Fed meetings, but to which Janet Yellen, the Fed’s chair, has called attention as a key factor in judging the economy’s health.

It follows that as long as wages remain weak, policy changes are unlikely. And so far, wages have shown very little improvement relative to the rest of the economy, as we noted in a previous newsletter. The last employment number release, in fact, shows the steepest one-month decline in private hourly earnings since the series was first compiled, and the year-on-year rate of wage growth has now gone down four months in a row.

Hourly Earnings Growth Rate, YoY

Things, of course, could change. Economic growth is picking up, and wages could start rising. If so, the Fed may start normalizing policy sooner. For now, however, the data shows no reason for that.

What about the Fed’s balance sheet? The Fed bought an enormous amount of bonds and mortgage-backed securities to bring down long-term interest rates and to inject money in the economy. The first goal was achieved: market rates went down a lot. But the money the Fed wanted to supply to the system in order to spur spending ended up being deposited back at the Fed instead, in the form of excess bank reserves.

The extent of how much money took this round-trip is remarkable. Excess reserves that banks hold at the Fed now equal the entire stock of money in circulation, or M1.

Excess Bank Reserves as % of M1

The accumulation of excess reserves is seen by some as a partial failure of monetary policy: it happened because a lot of the money created by the Fed never reached the real economy. However, there is a silver lining to this. When the Fed finally decides to start taking back some of that money, it may initially be reflected in a decline of excess reserves. This will have a very small impact, if any, on economic activity, because excess reserves are not being put to any kind of productive use anyway.

There are those who fear that if the economy starts to heat up, loan demand could cause all those reserves to gush suddenly into the economy before the Fed has a chance of reducing its balance sheet. This could spark the inflation they have been predicting (wrongly) for years. At a time when the last GDP reading came at 5%, this is a reasonable concern.

But the Fed has said, in its “Policy Normalization” plan, that it intends to move rates by adjusting the rate that it pays on those excess reserves (currently 0.25%), which would be a way of controlling the supply of funding to a sudden increase in the demand for loans. This is indeed one of those tools that the Fed has in its bag. Despite loud criticisms of the central bank’s novel policies, the Fed has several tools at its disposal to steer policy back to normal. Thankfully, they also seem to be quite capable of using them.

A change in Fed policy is a monster under the bed keeping investors awake at night: scary, but not real. There is no doubt that there are always reasons to worry, but investors who think their main threat today is US monetary policy are barking at the wrong tree.

What now?

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