Atlanta Federal Reserve Bank President Dennis Lockhart, a long-standing member of the Federal Open Market Committee (FOMC), generally gives speeches and interviews worth reading not only because they are thoughtful and witty but also because, judged by his public comments and past voting behavior, he is probably close to the median of FOMC participants’ views and policy leanings. His latest speech emphasizes the importance – both in his pastime fly-fishing and in conducting monetary policy – of exercising a little patience and letting the waters clear. It also expands on the impact of uncertainty, a topic close to my heart.
The Atlanta Fed also provides good data and research on the U.S. economy. Many market participants follow its GDPNow tracker, which ticked up to 2.4% for Q2 last week. Another popular series is the Wage Growth Tracker (WGT), arguably a better gauge of wage trends than the official Average Hourly Earnings or the Employment Cost Index. The WGT shows wages accelerating to a healthy annual rate of 3.6% in June – much stronger than the official data would suggest. Yet, how many of you have heard of this Atlanta Fed offering: the Wu-Xia shadow federal funds rate? Take a look – it may change your thinking on monetary policy!
Shadow fed funds rate
A quick explanation: The Wu-Xia shadow fed funds rate looks back to estimate the hypothetical (negative) short-term interest rate implied by longer-dated U.S. Treasury bond yields from October 2008 to December 2015. During that time, the actual fed funds rate was stuck at the zero lower bound (a range of 0%–0.25% to be precise), and the Fed pushed bond yields lower with the help of unconventional policy tools: quantitative easing (QE) and forward guidance. The Wu-Xia shadow rate estimates which negative level of the fed funds rate would have achieved the same depressing effect on the yield curve as the combination of the zero-bound rate and unconventional tools.
And here’s the result: The shadow fed funds rate troughed during the first half of 2014 at around -3% and has been rising ever since as the Fed ended QE and started to prepare the market for liftoff. The shadow rate converged with the actual fed funds rate when the Fed lifted off zero last December (see chart).
Put differently, in this sense the Fed didn’t start to tighten policy in December 2015 – it had already begun almost two years prior. Today, after more than 337.5 basis points of tightening from the -3% trough, the rate hike cycle is already in a mature stage. Against this backdrop it is perhaps not surprising that the yield curve is so flat, that growth has slowed over the past two years and that core inflation is struggling to make progress toward the Fed’s 2% target – that’s exactly what you would expect during mature tightening cycles.
Bottom line: Given how much the FOMC has tightened policy already, it may decide it is right to pause for longer and wait till the waters clear.
Joachim Fels is PIMCO’s global economic advisor and a regular contributor to the blog.