The future perspective on current monetary policy

 

Ever since the Fed and the ECB have embarked on their journey of rapid tightening, there was a heated debate about the appropriateness of this policy. Ultimately, this question rests on the persistence of current inflation, which pits against each other the by-now-infamous team transitory against their opponents of team persistent. At this point it is fair to say that we really don’t know which side was correct, or maybe more precisely, which side was more correct, as neither of the extreme perspectives were likely correct. But what about in future, will we know? I don’t think so. I think both sides will claim forever that they were correct, and ultimately, the actions of the central banks will prove both of them correct.

What do I mean? Imagine that in a 1-2 years  from now inflation is back to around target. What does that mean for team transitory and team persistent? Team transitory will be able to point out to inflation back to target and say “See, the inflation spike was after all not persistent, given that we went back to target. Of course, the team persistent will say that the only reason why inflation went back to target was because of the action by central banks, which broke down the persistent inflation, and that without such action the inflation would be persistent. And as for central banks themselves, clearly, if inflation comes back to target, they will feel vindicated, claiming that their policy was correct all along. Hence, inflation going back to target settles nothing.

Arguably, if inflation only goes back to 2% and not below, I would conclude that team transitory was not correct: the rapid tightening clearly will have impact  on inflation rate, and hence if even with it we do not undershoot, then in absence of it we would have overshot the target.

Now imagine that in 1-2 years from now, inflation is actually well below target, likely in combination with recession between now and then. Does this change the debate? Does it vindicate team transitory? I don’t think that team persistent will accept defeat in this situation. They will claim that the inflation was persistent, and that central bank had no choice but to tighten rapidly, even if it meant recession and below-target inflation rate. They will point out that in absence of such action the sky-high inflation rate would lead to de-anchoring of expectations and inflation persistently above target. In other words, the argument was that breaking down the high inflation and landing exactly on target simply was not in cards.

Arguably, in such situation I would conclude that team persistent was not correct: while I can see a case to be made about inflation expectations de-anchoring, like this kind of Jedi Mind Economics is not really persuasive for me: we have very little understanding of how expectations get formed, what can cause inflation expectations to de-anchor, and whether that would actually meaningfully influence inflation. So if the argument rests solely on theocratizing about evolution of inflation expectations, count me out. (I am not saying that inflation expectations are irrelevant, just that given our current empirical understanding, I would not make them central to my explanations of empirics).

Only if inflation even after 2 years is still clearly above target is there a chance that the discussion will be concluded. It will be hard for team transitory to argue that 4 years of high inflation is really a transitory phenomenon. That is, unless there is further shock along the way, but again, that to me will start to feel tenuous.

 

“Markets are now firmly signaling recession in euro zone”, aka continuing in the folly of more inversions, more recessions

 

Following the ECB December meeting, which brought strong hawkish surprise, we woke up to headlines of markets now more firmly signaling recession for euro zone, given that German yield curve has inverted. These articles we accompanied by graph showing inversion between 2yr and 10yr yield curve reaching levels not seen in decades.  Among other places, here is FT from Dec 16^th:

 

Of course, the movements in the yields after the ECB meeting were not in any way driven by expectations of coming recession. The 2yr yield jumped by 25bps (a 6-sigma event, apparently) on the day of the meeting, and surged by further 20 bps since then. The 10yr yield also increased, albeit by smaller 14bps on the day, and since then by further 30 bps. This is hardly the stuff preceding recessions. Aren’t yields supposed to go down in recessions?

The story is the same as in U.S.. The ECB made it clear it will go further above neutral then previously thought, with markets now pricing further 125bps hikes or so in coming months. This will take the overnight rates to around 3.25%, way above any reasonable estimate of long-run neutral rate. By simple arithmetic in the form of expectations hypothesis, this means much higher 2yr yield than 10yr yield, since policy rates will be above neutral only temporarily.

So no, markets are not suddenly signaling recession in euro zone. They are just signaling that the central bank will take rates further above neutral and stay there longer. Of course, this makes recession more likely – my subjective recession odds have increased on the day – but that is not what is behind the market moves.

 

 

The folly of more inversions, more recessions

 

With the whole yield curve now inverted (see below), and 2s-10s yield curve most inverted since 1980s,  the talk of inversions signaling recessions is growing louder and louder. This, to me, is simply baffling.

 

The case for linking inversions to recessions was always simple. Indeed, it is more of an observation connected with somewhat sound logic: Inversions occurred before all the recessions[1], and there is reason why inversions could be reflection of collective wisdom about coming decrease in interest rates below neutral due to coming recession (and hence signal of coming recessions).

That is all fine. Where I get lost is how does this apply to current inversions. For example, the 2s-10s inversion deepened significantly following the lower than expected US CPI report two weeks ago. This report led markets to (a) reprice the future path of federal funds, (b) correspondingly lower the 2-year yield, and also (c) lower the 10yr yield. Since (c) happened to a larger extent than (b), we ended up with deeper inversion.  On face of it, this might seem to somebody like bad news causing deeper inversion, right?

Do not count me in that camp. To see why, notice that the decrease in 10yr yield was different from the decrease in 2yr yield in that it mostly was not about lower expected path for fed funds rate.[2] Moreover, in so far as it was it was about expectations about future policy, it did not reflect expectations that policy rates will move eventually below neutral level, which is at the core of the signaling theory of yield curve inversion. Rather it reflected expectations that policy rates will rise less above neutral than was expected before. And if it was not about below neutral expected future rates, it is hard to argue that it was in some reflection of markets increasing their odds of recession, even though the inversion deepened significantly. If anything, it is hard to find anybody who thought the news were not good, as indicated by a positive stock market reaction. I am therefore struggling to follow the people who say that this development to them suggests risk of recession has increased.

Or take the most extreme example, the policy rate yield curve, which inverted only now. Is this in any way further strengthening of a signal of coming recession? Again, I struggle to see the argument. There are two reasons why the policy yield curve inverted now: the drop in 10yr yield, which I already argued was not a portend of coming recession; and increase in fed funds rates by the Fed during the November meeting. Of course, the increase in fed funds rate on its own can cause recession, but that is not the argument of yield curve believers. Rather, they argument is “Hey, it inverted, it must be a bad signal.” But if the inversion is caused by the central bank that increased fed funds rate, as expected, how can anybody interpret it as a signal of anything? Will it recession suddenly become much more likely on December 14, when policy yield curve will invert even more following the next hike, compared with December 13? I did not think so.[3]

So why are we having inversions if it is not because markets are pricing lower future rates because of recession? In other words, what do I say to somebody who might argue that long-term rates are always above short-term rates, unless markets expect policy rates to decrease, which is typically due to recession? Well, as you might guess, it is the typically, which is the problem. This inversion is not typical in that it is caused by the central bank itself. In other words, the central bank’s plan is for policy rates to follow an inverted “roof-shaped” path – rising significantly and temporarily above neutral before declining back to neutral.

This on its own should mean inversion, if bond yields are expected average future short-term interest rates (aka the expectations hypothesis). Therefore, the current inversions do not need to signal anything about the financial markets’ recessionary beliefs, just that they believe Fed’s intentions to go above neutral.[4] And this is what makes current inversion different from previous experiences: Back then, central bank was not hell-bent on going above neutral in fight against inflation, rather, it was trying to find neutral. And this, I think is an appropriate end to blog that has “folly” in its title: ending it with variation on the biggest folly of all, “this time is different”.

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[1] Of course, the statistician in me wants to scream something about N<10, but that is not the point for today.

[2] This is of course unsurprising, because changes in expectations about future rates rarely shift enough to move the 10yr yield, which is presumably the average expected value of fed funds rate over the whole 10yr horizon. Rather, the CPI report was catalyst for more broad repricing, which showed up as much lower real 10yr yield. Personally, I think it was in the spirit of coordination games a signal that this is finally the time when everybody will stop worrying that 10yr yield will rise further, and hence signal for everybody to buy 10yr yield, but that is purely speculation on my part.

[3] Similar argumentation applies to the 3m-10yr yield curve, even though there things are of course continuous.

[4] Note that the standard rules of logic apply – I am not saying markets are not expecting recession, or that recession will not happen, just that current inversions do not imply that markets are expecting one (even if they might be).