Our kids are the worst drivers ever.
- Our oldest was involved in two different accidents while stopped at intersections. Plus, she killed a deer in a separate incident.
- Our second hit our mailbox while trying to record her odometer flipping over to some unique number. To this day, her Camry has a giant line down the entire driver’s side of the car.
- Our third hit our house. The actual house. Straight on. Wtf? He was no better in reverse. He also backed up so hard into our second oldest’s that he pushed it into the yard, leaving skid marks in our driveway. Can you imagine hearing the sound of crunching metal and thinking, “I should press down harder on the gas pedal”? Plus, he left his lights on so often that the tow service guy joked, “keep my card so you can just text my cell. I think we’ll be seeing each other again.” He used it several times.
- The fourth was probably the best because he only ran over the trash cans. Then again, we once made fun of him for claiming “cops are pretty chill.” What makes a teenager declare that? It took us a year to dig into that statement and learn that he had been pulled over for speeding not once but twice, both times getting let off with a warning. Hence, the perception that cops are chill…
- And our youngest might be the worst. He has hit three different cars. How do you get in a car with another car parked directly behind you and then back into it?
I thought of all of this weekend while we were in Indianapolis for a volleyball tournament. The Real Boss™ was driving. She got into the wrong turn lane and tried to back up. The car had a weird reverse and she couldn’t figure it out. Just then our 17 year old says, “There’s a car behind us.” It had been there the whole time. She absolutely would have hit it if she had been able to figure out reverse. Shortly thereafter, she turned the wrong way down a one way street. It was quite the adventure.
At least I know where the kids get it from. And all of those thoughts led to this week’s newsletter where I compare the Fed to a teenage driver approaching an intersection. I wish there was a Driver’s Ed of monetary policy, but then again all my kids took that and look where it got them.
Last Week This Morning
- 10T: 4.41%
- 2T: 4.37%
- SOFR: 4.57%
- Term SOFR: 4.59%
- Fed Goolsbee Speech: “We don’t need to get to that place immediately, but if we look out over the next year or so, it feels to me like rates will end up a fair bit lower than where they are today.”
- UMich Consumer Sentiment Report: 71.8 v 73.9 expected
Where is Fed Funds Headed?
It’s been quite a rollercoaster for rates lately. Fear of deficits. A Trump win. Lower taxes and stronger growth. Risk on mentality.
Last week we discussed that deficit concerns absolutely apply pressure on fixed yields over the long term, but I don’t think they are the primary driver of yields in the midst of a Fed easing cycle. Traders are shortsighted and deal only with what’s in front of their faces, while deficits are the long game.
Said another way, deficit concerns likely exacerbate movements higher and dampen movements lower, but right now it is the noise, not the signal.
The signal is Fed monetary policy. Or, rather, expectations for monetary policy.
In 3 months, we’ve gone from 8 cuts to 2 cuts and the T10 has jumped 80bps. You think that’s a coincidence?
You tell me where the Fed is headed, and I can tell you where the T10 is headed.
Are Rates Restrictive?
I’ve used the braking action analogy for two years now. When Fed Funds is > inflation, we have positive real interest rates. That, in turn, applies the brakes on the economy. Don’t worry, I’m not going to beat a dead horse but I do want to set the stage for what follows.
In March ’22, I was on a ULI panel with a Fed economist. It was the week the Fed was hiking. I was skeptical the Fed would be able to raise rates 2.5% because that would slam the brakes on an economy addicted to 0% interest rates.
He popped me on the nose. It was the moment I realized the Fed would be hiking more than I expected. “Until Fed Funds is above inflation, we aren’t pressing on the brakes. We are easing off the gas pedal.” I was wrong and he was right.
But that also means the Fed isn’t pressing on the gas pedal by cutting rates – it’s easing off the brakes. Fed Funds is still above inflation, just less so.
With Fed Funds at 4.5% - 4.7% and Core PCE at 2.7%, we have positive real rates of 2%, aka braking action.
This is why Powell continues to stress that rates are restrictive. CPI has fallen from 9.1% to 2.6%. Monthly job gains have dropped from 550k to 150k.
How can anyone argue with a straight face that we aren’t slowing down? We don’t need the same amount of braking action going forward that got us here.
Is the Light Going to Change?
The question then becomes – what is the appropriate amount of braking action?
You know when you are approaching a stop light that’s about to change and you are trying to time it just right? Your foot isn’t on the gas, but it’s not on the brakes, either. You’re coasting, trying to figure out what’s next. That’s the Fed.
They are approaching the intersection. The “walk” sign has changed to a “do not walk” signal. The light is still green, but they know a change to yellow might be coming. They want to approach the intersection while coasting, prepared to react if necessary.
With that mentality in mind, let’s talk about the ultimate destination for Fed Funds. The mythological unicorn of monetary policy - the natural rate.
r*
The natural rate is the equivalent of monetary policy coasting. Rates are neither encouraging nor discouraging growth. It’s an unobservable hypothetical rate. The Fed has multiple measures of r*.
You care more about where Fed Funds neutral rate is, though. To translate the natural rate into the neutral rate, just add inflation. Let’s use the long term inflation target of 2% to set a base case, as well as 3% to help illustrate a realistic high side scenario.
Let’s start with the easiest way to think about the Fed’s mental model for r*. The Summary of Economic Projections (SEP), aka blue dots. Every other meeting, they anonymously project things like GDP, the unemployment rate, inflation, and Fed Funds. The “longer run” timeframe is their view on neutral.
When you read a headline that the Fed’s expectation for long term neutral is 2.8%, it’s really the median blue dot of these projections. Here’s September’s projections.
- if the 3.75% dot is accurate, we are just 0.75% away from neutral
- if the 2.25% dot is accurate, we are still 2.25% away from neutral
The range is 2.3% - 3.75%. That’s a huge range, which signals uncertainty and a widening difference of opinions.
But every single one of them is below the current level of 4.5% - 4.75%, which is why it’s reasonable to conclude they will keep cutting. It’s also why Chicago Fed President Austan Goolsbee said, “I still think we’re far from what anybody thinks is neutral. We still got a ways to come down.”
How do they arrive at their estimates? There are fun economic models!
The Laubach-Williams puts r* at 1.2%. Sticking with our assumption of inflation between 2%-3%, that means the Fed Funds neutral rate is 3.2% - 4.2%. Anywhere from 1-5 cuts away from current levels.
The Holston-Laubach-Williams model puts it at .74%. That would put the neutral rate at 2.7% - 3.7%. That’s about 3-8 cuts away from current levels.
What’s interesting to me is that both of these models reflected an increase from the covid surge, but a lowering since then.
In other words, Covid stuff was a one-off disruption to r*, not a fundamental shift towards higher neutral rates. I think tariffs might be like that. They are a one time spike, not a fundamental shift.
There are models that estimates a much higher natural rate, such as the Lubik Matthes model. This one puts it at 2.6%. That would put neutral at 4.6% - 5.6%. In other words, we are already at neutral and are coasting. Any further cuts are pressing on the gas pedal.
Before you freak out, keep in mind this one also put the implied neutral rate between 2010 – 2020 around 2.5% when we were at 0%. I don’t remember anyone screaming how overheated the economy was during that decade.
Bloomberg has a natural rate estimate as well, which is similar to Lubik Matthes. Same caveat as before, that it implied a Fed Funds of 2.5%-ish during a decade when it was really 0% and no one thought of rates as stoking a growth/inflation fire.
How Quickly Can r* Change?
Not very. We measured the change in r* across a one year and a three year timeframe. Muhammed El-Erian is far smarter than me, but his call that neutral is now north of 4% would necessitate a spike in r* that we’ve never experienced before.
1 Year Change
Generally +/- 25bps. Nothing earth shattering.
3 Year Change
Generally +/- 75bps. And the biggest moves are down, not up. Things like the GFC have a bigger impact than the high inflation of the late 70s.
To close the loop, let’s bring out the Wayback Machine.
Here’s the blue dots from three years ago – September 2021 - before the tightening cycle began. The neutral rate clustered around 2.5%. Over the last three years, the median has only increased from 2.5% to 2.8% (even though range has substantially widened).
That’s why you are seeing an uptick in the projected Fed Funds landing spot, but nothing crazy. It’s more likely that 2.5% has become 3% than that it’s become 4%.
Even if you disagree with the Fed, it’s helpful to understand how the people in charge of setting rates are thinking about it.
I also think the growing uncertainty and divergence of opinions is why Powell has signaled a willingness to be cautious as the Fed approaches neutral, whatever that is.
But it sounds an awful lot like he believes it is below 4%, which means the pauses will come around that level, not today’s levels.
I said at the beginning that I view the current state of the economy as this. Decent, with some warning signs.
Just keep in mind that monetary policy only really effects the “demand” side component of inflation, which isn’t even half of the 2.7% overall inflation picture.
I think if jobs continue to deteriorate as I expect, the intersection looks like this sometime next year.
But braking too hard, ignoring the concrete signs of a slowdown from 9.1% to 2.6% in exchange for worrying about 2.6% becoming 2.9% leads to this…we come to a screeching halt and everyone conveniently blames the Fed for waiting too long again…
Jay Powell doesn’t want his legacy to become the guy that crashed the car into a stationary object.
That’s why I think the Fed will continue to cut, but gradually. The reason cutting cycles are usually slash and burn is because the Fed waits too long to act. We can’t complain about that and then also bark at them for moving proactively. Pick a lane…preferably one without my kids in it because I will have to fix your car.
Last But Not Least
That same Fed economist that popped me in the nose a few years ago joked, “I can give you the rate or I can give you the timeline, but never both at once.”
The economy has precedent for numerous years of 2%+ positive interest rates.
- 3 years leading into the GFC
- 7+ years of the 90s (arguably the only soft landing)
Keep in mind, that’s not necessarily inherently bad news as long as inflation doesn’t reaccelerate, but it does imply higher for longer
Let’s say inflation over the next year is stuck at 2.8%. A 4% Fed Funds implies 1.2% of braking action.
- If inflation increases to 3.5%, that’s just 0.5% of braking action
- If inflation falls to 2%, that’s 2% of braking action
In all scenarios, monetary policy is still restrictive, it’s just a question of how much.
And that’s why Powell is stressing, “The economy is not sending any signals that we need to be in a hurry to lower rates. The strength we are currently seeing in the economy gives us the ability to approach our decisions carefully.”
The economy is good, but not overheated.
The Week Ahead
FOMC minutes are the highlight of the week ahead with Core PCE, GDP Growth, and Personal Income and Spending reports rounding out the week before markets close on Wednesday. Markets are closed for Thanksgiving and will reopen for a half day on Friday.
