The art of negotiating (monetary) curves

“After a long straight, the driver downshifts and brakes slightly before going into a curve. When the curve proves to be tighter than expected, and with the car still cruising at high speeds, the driver hits the brakes harder. The wheels lock and the car skids out of control.” This metaphor seems to fit the challenges currently facing the US Federal Reserve: how to slow an economy cruising along at full employment, to prevent inflation from spinning out of control. So far, the three monetary tightening moves this cycle – in December 2015, December 2016 and March 2017 – didn’t have much of an impact. This is undoubtedly due to the usual lag in monetary policy transmission, but it is also because the cumulative increase is still very small. The bond market was not particularly impressed either by the publication of the FOMC members’ assessments. The median projection calls for a Fed funds target rate of 2.1% at year-end 2018, and 3% at year-end 2019. This has not prevented 10-year US Treasury yields from fluctuating within a narrow band of 25 basis points since early December (the current yield is 2.34%). Probably, the ECB’s euro bond purchases as part of its quantitative easing programme (QE) have fuelled European demand for US paper, but this substitution effect does not explain everything. Other components of “financial and monetary conditions” illustrate the absence of any economic dampers. Corporate bond yields are still very low and the spread with US Treasury bonds has not widened. The bond market’s calm is a blessing for the stock market. The fear gauge –VIX, which measures the implicit volatility of S&P 500 index options – is still very low, signalling that investors are still confident. The dollar’s effective exchange rate has also stagnated. Theoretically, the prospects of higher key rates should drive up the dollar, curb exports and strain growth. In reality, however, the euro is benefiting from expectations of a change in ECB policy. Sterling had already fallen sharply against the dollar, while several emerging market currencies have appreciated, bolstered by recent capital inflows.

For investors, the absence of a significant tightening of US financial and monetary conditions has been a relief in the short term, but ultimately it risks becoming a source of anxiety. It’s relieving because economic growth prospects won’t have to be revised downwards just yet, and most importantly, because the appetite for risk remains high. Here it is tempting to quote Chuck Prince, who as CEO of Citigroup said in July 2007: “As long as the music is playing, you’ve got to get up and dance.” Yet it is also a source of anxiety, because the longer Janet Yellen’s policy seems to be ineffective, the greater the risk that inflation could skid out of control. If this were the case, then long-term rates would rise sharply in anticipation of a more aggressive response from the Fed.

As if life is not complicated enough for investors, the Fed’s leaders have now begun to refer explicitly to the symmetrical nature of their 2% inflation target, letting it be understood that they were willing for inflation to rise above target, as long as it remains limited. This announcement can be interpreted in two ways. The first is positive: accepting temporary overruns would prevent long-term rates from rising rapidly once inflation begins to converge on the target, as the market anticipates more rapid monetary tightening. In contrast, the second interpretation is less optimistic and raises a lot of questions. How much of an overrun is the Fed willing to tolerate? How will the bond market react when inflation rises above target? Will the Fed lose credibility or will the markets expect a much more aggressive message? Either way, long-term rates could rise strongly. In conclusion, the absence of a tightening of monetary and financial conditions, combined with the acceptance of inflation rising above target, has created a relative calm in the markets, but raises fears that a much rougher transition lies ahead.