WEEK AHEAD

"The world has gone from flat to fast, to deep.  It's all what you can do now with no touch...

I think the next step is psychic. I now know your psychograph from your phone I will just push you your groceries, push you the supplies you need, push you the information you need."

-- New York Times Columnist Thomas L. Friedman, McKinsey Global Institute, March 5, 2019.

Can the Fed stick the "landing? R-Star revisited

If there was ever a moment that fits the old adage "rearranging the deck chairs on the Titanic," this may be it when spending a lot of thought on when the FED's first rate cut will be.  Moreover, we aren't even on the Titanic; we're less than 100 feet above the runway, easing into a landing in a commercial jet that lost power at 30,000 feet. We've dead-sticked our jet through a Covid engine blowout.  As an aside, extreme air turbulence in flight has been reported to rise due to climate change – warmer air is altering the invisible air currents!

But real props to Jay Powell and what we learned through the Great Financial Crisis—lessons learned and applied by the Fed during the COVID crisis. This leads us to the current exercise, which I have characterized as trivial: " When and how many rate cuts?" I guess it is worth at least revisiting the foundation that monetary policy is built on, and that is R-star, or r*.

r* is the natural rate of interest, or the real interest rate that would prevail when the economy is operating at its potential and is at equilibrium.  The neutral rate is neither inflationary nor deflationary, AND we have maximum employment and stable prices.

Phew… Quite obviously, this doesn't sound like something you can "put a pin into," but see the chart below provided by Federal Reserve Bank of New York President John Williams. It should be noted here that r* is also abstract and can only be estimated, not directly measured.

If you are still with me, it's this "rate" that FED policy pivots around when targeting and setting FED policy, and, quite noticeable on the chart, is the post-financial crisis (GFC) change in estimated r*.  In fact, this chart showed that r* was not as stable as initially thought, and there have been dramatic shifts in the factors affecting the natural rate. Understanding this dynamic better would affect and explain monetary policy.  This was the case as monetary policy remained accommodative far longer and to many economists' surprises, without inflation.  This amazing decline in estimated r* was caused by the secular changes in global supply and demand for savings. Changes in workforce demographics, workforce productivity, and, of course, investment and innovation caused r* to fall.  For example, a savings glut would provide more capital to finance investment, pushing r* lower.  Innovation can drive productivity, again pushing estimated r* lower.  Lastly, there is demand for safe assets, and despite stronger economic conditions post-GFC, there is still demand for risk-free assets, and COVID didn't help again.

So, let's get back to the Fed and move those deck chairs.

I contend that the FED must first forecast the elusive r*, and if we step back for a moment, this is important to the FED because the last part of the "landing" is the desire to "stick it" and not risk something happening in the last 100 feet. That "thing" would be the resurgence of inflation, which would cause them to take forceful action to raise rates again. Despite the calls for immediate cuts now, the current situation's worst-case scenario is a mild recession or slowdown, which would be very palatable to the FED, not to mention the early and often fiscal stimulus that can viewed as baseline inflationary at its core and very concerning.

Below is the most recent dot plot for the target federal funds rate, and it's clear that all indicators point to rate cuts, and that alone should be a comfort that the worst is over, and it doesn't really matter about when and how much.  What really matters is getting r* correct so that any subsequent rate cut is on the right side of the projected policy direction and targeted outcome.  If they cut rates it better be accommodative relative to estimated r*. The Fed judges whether the interest rates it sets are stimulating or restraining the economy from the natural rate of maximum employment and stable prices.

As Prescott advised at the Battle of Bunker Hill, "Don't fire till you see the whites of their eyes!" all we need to know is the FED won't cut until they see and stick the landing.