Friday, March 25, 2016

Macro: FOMC Dot Plots, The Secular Stagnation Illusion

One of the major surprises in the March FOMC meeting was the re-marking of the long term rates as expressed by the Fed dot plot.

While most speculators were cutting their short bets on the 10-year treasury (as per CFTC commitment of traders reports) and were actively going bullish on the long-end, the short end short positioning was mostly maintained. This was especially supported by the up-tick in the inflation data in core and headlines before the FOMC (as well as inflation now-casting from the Cleveland Fed).

There are conspiracy theories about the Fed's worry and motivation for a weaker dollars in response to the bold liquidity enhancement actions from other major central banks. However, if we really take a deeper look in to it, a different story emerges(1).

FOMC started publishing the dot plot in 2012, between the QE2 and the QE3 phase. Looking at the evolution of the dot plot implied fed fund term structure, there have been two major changes since. First one happened just before the start of the QE tapering. That was the beginning of a steady upward shift for the fed funds rate in the near horizon (~3 year), where they stabilized. The second set of changes came in later half of 2014, which resulted in another gradual move. This time it was a downward shift of the long term rate forecast. From the peak of 2014, the FOMC estimate of long term fed fund rate is down by 75 bps. (Note I have projected the long term rates from the dot plots to 5-year maturity bucket.) Some suggests the Fed is slowly embracing the secular stagnation theory.

There are certain amount of merit in that hypothesis. The current projection implies, assuming Fed's target inflation of 2 percent is realized, a long run real rate of 1.25 percent. And irrespective of your view on the r-g model, a lower r does signify a lower level of long run real GDP growth. For the balanced case of r=g, this implies a growth rate of 1.25 percent.

This seems pretty pessimistic from the recent trends in real GDP. Figure(2) below shows the trend in real GDP (normalized at 100 at the beginning).  The post crisis slope (since 2013) is definitely flatter than early 2000, but not by a huge margin (except Euro area). Add expected inflation to this numbers to get the long run nominal rates. Depending upon your preferred choice (10-year and 5-year swap market breakevens at 1.8 and 1.6 percent respectively, 5y5y TIPS breakeven at 1.66), this seems to imply a long-run rate in the range of 4.1 to 4.3 percent. Almost a full percentage point above FOMC dot plot.
The market seems to be even more pessimistic. The chart(3) shows the spread of 1 month USD Libor (implied from the euro-dollar futures and swap curves) vs the FOMC dot plot. The 2013 taper tantrum was the only time when the market got spooked with a rate hike and over-estimated the future path of rates. Since then, it has steadily become more and more pessimistic to the FOMC prediction. The largest disagreement is in 3 years and beyond.
This level of suppressed nominal rates means either the market is pricing a marked departure in the growth trend from what we have seen even post-crisis so far. Alternatively it means a near term recession and/ or more liquidity measures from the central bank. Or at least it is pricing in the Fed's inability to hike rates substantially given the situation in China and Europe and Japan. So far the Fed has been doing the catch-up to the markets pricing.

The first possibility is what secular stagnation is all about. So far most of the evidences have been important and potentially even supportive, but at the same time inconclusive. It is not certain the impact attributed to secular stagnation is really a not cyclical effect attributed to a long run structural change. In fact Larry Summers, who revived this idea of secular stagnation in 2013, is himself very much aware of this. See the disclaimer in the last paragraph here. There has been many different views on this, for example see here for the counter-view from former Fed Chairman Bernanke. Real-time economics is hard. It will be much easier to settle this debate after a decade or two. But right now, I think the biggest argument against secular stagnation is the prior probabilities. The long run world growth rate data (for example see here) shows a staggered improvement, with last great bottom around just before the Industrial Revolution.  All recent variation in world GDP since post war seems more or less cyclical phenomenon in this scale.

And the other possibilities to justify such depressed nominal rates are definitely cyclical. In fact the FOMC statement and general stance so far, downplaying secular stagnation and emphasizing inflation, clearly shows the Fed is eager to keep its options open. Secular stagnation is a rather long-term commitment to a particular view around equilibrium rates, GDP and inflation. It does not come handy to set appropriate monetary policy expectation and maintain credibility at the same time in real-time economics.

And in that scenario, near to medium term growth and inflation outlooks are much more critical. This also means a higher volatility and data dependency as the markets as well as the Fed react to data. The recent inflation uptick has been feeble, but definite. The fear of Yuan devaluation has subsided significantly. Given Fed's stance, it is perilous to believe the only move for the long term rate for the dot plots are down.

(1) data from Federal Reserve
(2) data from BEA, Office for National Statistics, Eurostat
(3) data from Federal Reserve, Bloomberg

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