The Restoration of Monetary Policy Equilibrium

Rick Rieder, Russ Brownback and Trevor Slaven contend that much of the recent criticism brought to bear against Fed policy makers is misguided, and in fact the central bank has done an admirable job of pivoting toward a pragmatic equilibrium in recent months.

We have talked in the past about how global digital distribution capabilities are re-shaping the rules of economics, where supply can expand nearly instantaneously to fill a void. Nowhere is supply in over-abundance today more than in the critical comments appended to every policy headline, or action. In this world of seemingly perpetual disapproval, and unfounded criticism without consequence, we would like to acknowledge and commend the leadership and staff of the Federal Reserve for what they have recently accomplished. Many observers will suggest that last week’s quarter-point policy rate move was a muddled “hawkish cut,” or an insignificant step in a waffling “mid-cycle adjustment.” But we see the cumulative 2019 rate cuts, combined very importantly with much needed new liquidity provisions, as an historic restoration of policy neutrality. That is a very big deal, and the Fed’s actions are worthy of recognition.

The path back to policy neutrality

From our perspective, “neutral” Fed policy going forward is a Funds Rate that hovers around 2% (perhaps in a range of 1.5% to 2.5%) alongside healthy liquidity provisioning. As monetary policy strives to achieve its dual mandate in the years ahead, some combination of debt, deficits, and demographics will present a significant challenge. We believe this policy mix will help equilibrate savings and investment in the household and corporate sectors by setting a reasonable level of real risk-free returns, without incentivizing unproductive leverage. And as deficits and debt almost certainly expand as we approach Social Security and Medicare spending booms, improved liquidity growth, even if limited to the “natural” rate of nominal GDP growth, will free up tremendous amounts of private sector capital for more productive uses that can sustain and improve the economic outlook for future generations.

From this neutral stance, the Fed enjoys tremendous flexibility to respond to future shocks, both positive and negative, but the bar should be sufficiently high to move meaningfully away from policy neutrality going forward. It’s fair to ask, if 1.5% to 2.5% represents a neutral policy rate, why was the move to 2.5% so difficult in 2018? In our view, it was a mix of decelerating global growth and liquidity contraction via the experimental Fed balance sheet run-off that were primary culprits. Starting in the second quarter of 2018, overt U.S. dollar strength and aggressive yield curve flattening signaled that the policy cocktail of raising rates and reducing liquidity was too onerous for the prevailing economic backdrop. That burdensome policy continued into 2019 with rolling bouts of stress in USD funding markets and continued deceleration in emerging market (EM) growth. However, since July of this year, the Fed has proactively maneuvered back toward policy equilibrium, which can and should be very effective in arresting the global growth slowdown, and in restoring the smooth functioning of the financial economy.