Return of the Yield Curve
- The U.S. Federal Reserve has begun the process of normalizing interest rates following massive quantitative easing during the Great Recession.
- Achieving rate normalization is essential to bolster confidence in the economy and will reinstate a normal yield curve after a decade when it was flat.
- Currently on a path for three increases in 2017, the pace of rate hikes could accelerate if the effect of President Trump’s tax cuts and fiscal stimulus are felt before 2018.
- The Republican reform agenda contains multiple opportunities for Fed reform, which could alter or potentially derail the current path towards rate normalization.
Many Americans take for granted the institutions and activities that enable and improve the functioning of our economy, like the Federal Reserve System. Through its implementation of monetary policy, the Fed plays a pivotal role in moderating the swings in business cycles. However, few Americans understand the Fed’s history, or the unique structure that has led to its success.
As the U.S. economy continues to emerge from the Great Recession, the ability of the Fed to normalize interest rates, and their timeline for doing so, will be a crucial input to every business leader’s planning decisions. Will the Fed succeed in normalizing rates? How quickly will rates rise? How could the Trump administration potentially impact the path of rates? Let’s start by reviewing some history.
BIRTH OF THE FEDERAL RESERVE
After two failed experiments with privately owned central banks, followed by a period of so-called “free banking”, our modern system began to emerge in the late 1800s. In 1863 Civil War financing needs resulted in the creation of a banking system to issue common currency under the National Currency Act, then the following year the National Banking Act created a formal system of national banks overseen by the Office of the Comptroller of the Currency. To this day the OCC examines and supervises all federally chartered banks.
This structure of national banks and national bank currency did not achieve systemic stability, since currency value was based on the value of treasury bonds and a complex reserve system created periodic seasonal liquidity crunches linked to the agrarian U.S. economy. Further, there was no FDIC and limited deposit insurance, so the first signs of a liquidity crunch resulted in runs on banks. Throughout the last part of the 19th century and the early 20th century, the U.S. economy went through a series of tumultuous events. Following a particularly severe bank panic, Congress established the National Monetary Commission in 1908 to study banking and currency reform.
Lead by a prominent Republican senator, the bipartisan National Monetary Commission studied both the American system and European central banks. The reform plan it ultimately proposed contained many features of our current system, and sparked years of public debate, but lacked enough support to pass Congress. Action finally came when the Democrats and President Woodrow Wilson swept the 1912 election with a mandate for banking reform. After an intense year of hearings, debate and compromise, the Federal Reserve Act was passed in December 1913, creating the unique solution we have today.
THE MODERN FED
Born out of crisis and compromise, the Federal Reserve is a hybrid private-public centralized-decentralized system consisting of the Board of Governors or Federal Reserve Board (FRB), the Federal Open Market Committee (FOMC), 12 regional Federal Reserve Banks, numerous private member banks and related councils. The President appoints the members of the FRB for staggered terms of 14 years. They comprise seven of the twelve members of the FOMC, the balance of which come from the regional Federal Reserve Banks. The structure and operations of the Fed are uniquely independent among central banks -- it does not receive congressionally appropriated funding, the FRB members span multiple presidential and congressional terms and its monetary policy decisions do not require executive or legislative branch approval.
Without minimizing the importance of its other functions, the Fed’s monetary policy activities are its most pervasive and well-known. From a theoretical perspective, the Fed employs a Keynesian approach to using monetary policy to stabilize the economy over the life of the business cycle, and recognizes the Phillips curve inverse relationship between inflation and unemployment. Not surprisingly, those academic views are supported by current Fed Chair Janet Yellen. Policy and market operations are conducted by the FOMC, which holds eight annual meetings, publishes numerous policy statements, sets target interest rates and conducts market operations.
Of its available policy tools, the FOMC relies primarily on open market operations - purchases and sales of treasury and agency securities designed to achieve a desired fed funds rate by increasing or decreasing the money supply - in an effort to promote maximum employment, stable prices and moderate long term interest rates. Changes in the fed funds rate have a massive ripple effect, causing changes in both short and long term interest rates, foreign exchange rates, the availability of credit and ultimately employment, economic output and the prices of goods and services.
THE YIELD CURVE – LOST AND FOUND
Debt instruments, and interest rates charged on them, touch every sector of the economy. That pervasiveness explains why rates are such an effective tool in executing monetary policy. It also makes the yield curve – a graphical representation of short to long term interest rates at a given time – an extremely powerful analytic tool. Yield curves can vary from the upward sloping “normal” curve, where short term rates are lower than long term rates, to the reverse -- an "inverted" yield curve.
Beyond helping fixed income analysts identify trading opportunities, the slope of the yield curve is one of the most powerful predictors of future economic conditions. Multiple scholars have shown the predictive power of an inverted yield curve to forecast U.S. recessions, and in fact all U.S. recessions since 1970 have been preceded by an inverted yield curve. In fact, the New York Fed believes the yield curve can predict recessions two to six quarters ahead, and publishes a monthly prediction of recession probability based on the yield curve.
As the Great Recession began to unfold, the FOMC began a series of reductions in September 2007 to its target fed funds rate that by December 2008 left that target at 0.25% or effectively zero. To achieve those rate objectives, the FOMC began a program of quantitative easing the magnitude of which had never been seen before. Those activities kept the target fed funds rate at essentially zero, and against the backdrop of the severe recession, expectations about long term rates were uncertain. This combination resulted in a flat yield curve, with little predictive value, for most of the preceding decade.
Recently that has begun to change. As GDP grew and unemployment declined during the recovery, the FOMC raised its target fed funds rate in 0.25% increments in December 2015 and again in December 2016. Both times, broad FOMC policy statements described a slow path -- stating that "…economic conditions will…warrant only gradual increases…" and that they plan to continue aggressive open market activities "…until normalization of…the fed funds rate is well under way."
THE TRUMP EFFECT
Coming in the midst of the recovery from a deep recession, many have tried to assess the impact of President Trump’s upset victory on the normalization of interest rates. Candidate Trump promised significant tax cuts combined with infrastructure and other forms of fiscal stimulus. Commentators initially concluded that these actions would accelerate GDP and inflation growth, thereby accelerating the pace of interest rate increases. However, the Trump Administration has found many aspects of its reform agenda will take longer than expected, suggesting a slower pace. Based on current schedules, many of President Trump’s economic initiatives won’t be enacted until Fall 2017 or later, and their effect won’t be felt until 2018. This suggests the pace of rate increases will remain modest in 2017, but is likely to increase in 2018.
As the first quarter of 2017 unfolds, the U.S. economy is getting much closer to the Fed’s goals of full employment and 2% inflation, potentially accelerating those expectations. In fact last week, four of the five members of the FRB made speeches that note improving economic conditions and signaled an imminent rate increase at the March FOMC meeting. We believe the key factor accelerating growth, in the absence of major policy changes, has been the wealth effect from post-election stock market gains. This was also noted by Fed Vice Chairman Stanley Fischer in a March 3rd speech -- "If you look at what's been happening to the economy since November 8…and to the asset markets….there has been a substantial wealth effect." Until President Trump's policy changes take effect, the expectations around growth are indirectly driving it.
We note one potential problem on the path toward rate normalization. The Republican proposal for Dodd Frank reform - called The Financial CHOICE Act – takes specific aim at the Fed. It proposes a number of changes to the existing structure and operations of the Federal Reserve System, including changing the composition of the FOMC and the powers of the FRB. This bill also requires that certain functions of the Fed be brought into the Congressional appropriations process, which looks like a disguised attempt to politicize the Fed and reduce or eliminate its independence. Further, it establishes a Centennial Monetary Commission to review and report on the effectiveness of the Fed in conducting its activities and achieving its goals, which throws the door open to major reform of the Fed.
Americans should be collectively worried by potential changes to the structure or operations of the Fed. This uniquely American institution has been successful at moderating the swings of the American business cycle. Both potential Republican changes - reducing the Fed’s independence in the shorter term, and potentially over hauling it in the longer term – could easily upset the path to normalization of interest rates. Worse still, they could diminish the effectiveness of this important institution to deal with future financial crises.
Since its formation a century ago, the Federal Reserve System has not only enabled the smooth operation of the U.S. economy, it has successfully moderated economic swings during multiple business cycles. The modern Fed has been particularly successful, providing initial stability during the Great Recession and a path toward rate normalization as we emerge from it. While progress may seem slow, the American public should be appreciative of the Fed’s judgement and talent. During this return to normalcy, we should be skeptical of short term changes to the structure and operation of the Fed and longer term plans for study and potential Fed overhaul, particularly where politically motivated.
Direct Swap is keenly interested in the path of interest rates and potential Federal Reserve reform, and will be monitoring both as they evolve.