Imagine you are a football player, and you just sacked the opposing team’s quarterback for a ten-yard loss. You are pumped, doing your little sack-dance, when suddenly you see the yellow flag flying and the referees come sailing in. Turns out, the NFL just changed the rules. You’re not allowed to hit the quarterback unless you’re one of the defensive linemen, and you’re just a linebacker.
You now have an idea what it may be like to be in the markets following the Federal Reserve (FED)’s decision not to raise interest rates in yesterday afternoon’s press conference. FED Chair Janet Yellen made a number of remarks that raise the question: has the FED changed the rules in the middle of the game?
The Former Rules
The dual mandate given to the FED by Congress has long been seen as the “rulebook,” and the FED, by this rulebook, has two goals:
- Maximum sustainable employment
- Price stability, also viewed as low, stable inflation
Let’s tackle employment first. The unemployment rate in August was 5.1%, and has been trending downward in the past few months, down 0.6% since January. Yellen stated in her press conference that “the labor market has shown further progress so far this year towards our objective of maximum employment,” but that “the participation rate is still below estimates of its underlying trend, involuntary part-time employment remains elevated, and wage growth remains subdued.”
As far as inflation is concerned, the committee seems quite insistent on a 2% inflation target, as Yellen stated, “Inflation has continued to run below our 2% objective, partly reflecting declines in energy and import prices” and that the FED Committee “anticipates that inflation will remain quite low in the coming months.”
Yet as we tweeted yesterday, according to Bloomberg Business News, if the Fed had a 2% inflation target for the past 20 years, it would have fallen short 74% of the time.
A close look at Yellen’s conference, however, reveals some statements that slap a question mark on the ostensible dual mandate. In the process of her Q&A, Yellen made the following points
- “Housing is now a very small sector of the economy”
- “Accommodative policy helps put people back to work”
- “Can’t entirely rule out chance of staying at zero”
- “FED credibility hinges on defending 2% inflation target”
- “Concerns about global outlook drove financial turmoil”
Taking each of these points individually yields some questions:
- Rule Change #1: Housing Doesn’t Matter. Can we interpret this as a statement that the American Dream is dead? That somehow housing is now unimportant in the eyes of the Federal Reserve? Why the downplaying of housing?
- Rule Change #2: Accommodative Policy Puts People back to Work. One could argue that a consistent theme in this recession and recovery has been the divergence between Main Street and Wall Street. That accommodative policy has helped Wall Street is beyond question: surely it is not difficult to see how pumping cash into the system and driving people to higher-risk assets with zero-interest-rate policy (ZIRP) would boost the stock market. But with an extremely lackluster recovery, Yellen seems not to realize the difficulty in explaining to average Americans that that 0% rate on their money market mutual fund is somehow responsible for giving them their job.
- Rule Change #3: ZIRP may be the “New Normal”. This rule change, if legitimate, is significant. Zero interest rates are supposedly the end of the line, the last-ditch emergency measure beyond which it was necessary for the FED to go to the untested Quantitative Easing. Yet is Yellen suggesting now that ZIRP may be, rather than a six-year stopgap, a “new normal”? If the market is to operate in a zero interest rate environment throughout this recovery, then the old rules have changed entirely.
- Rule Change #4: 2% Inflation is Now Gospel. Again, Yellen stating that FED credibility rests on a 2% inflation target is akin to stating that inflation has fallen below the FED’s target 74% of the time in the past 20 years. 2% inflation means a year-over-year increase of 2% in the price of goods in this country: can we continue to consider this a definition of “price stability”? If the result of an inflation target is that inflation is almost always running below that target, and thus accommodative policy is almost always necessary, then what is the purpose of the inflation target? Again, the rules have changed: investors are now dealing with an environment in which previously-“emergency measures”—ZIRP—is now the default policy 74% of the time.
- Rule Change #5: Oil and China Now Matter to the FED. This decision not to raise rates comes on the heels of an IMF request that the FED take exactly the position they are taking. While this does not indicate that the FED is somehow listening to the IMF, Yellen’s statements make it clear that the FED is looking at their decisions now just in a US-context but in a global This rule change is tremendous: it means that investors can no longer look to the US economy as an indicator of FED policy. We may see inflation and low unemployment, but if China crashes, or emerging markets face liquidity issues, or oil plummets, or corporations express fears about a rising dollar and overseas profits, there is the possibility now that the FED will actually take this information into account.
In other words, what Yellen has signaled with this rule change is that the FED now has a new triple mandate. Low US unemployment—yes, but only if it is accompanied by wage inflation. Price stability—yes, but only if it attains a mark reached less than 27% of the time in recent history. The third part of the mandate is this: Global GDP growth. The FED is concerned about the global situation and has now taken that into account in its policy decisions. Since when have America’s interest rates been determined by the price of oil or the performance of the Chinese stock market?
The FED has thrown the yellow flag and declared that getting into the endzone is no longer enough for the 6 points of a touchdown.
How do we score now? It seems we’ll just have to wait and see.