Thoughts on US Monetary Policy Prepared for Hutchins Center Conference, March 21, 2016 Richard H. Clarida Professor of Economics and International Affairs Columbia University Global Strategic Advisor PIMCO pg 0
QE and Nominal GDP the Collapse (and Rebound?) of the Money Multiplier 1.0 US 0.8 0.6 0.4 yoy growth in nominal GDP growth in balance sheet (yoy) 0.2 0.0-0.2-0.4-0.6 % change in money multiplier % change in money demand (inverted) -0.8 Note that quarter by quarter the growth in nominal GDP is exactly accounted by these three factors -1.0 Dec '06 Sep '07 Jun '08 Mar '09 Dec '09 Sep '10 Jun '11 Mar '12 Dec '12 Sep '13 Jun '14 Mar '15 Dec '15 As of 31 December 2015 SOURCE: Haver Analytics pg 1
Maturity profile of the Fed s balance sheet through 2030 200 TSY, TIPS, and Agency Debt MBS 180 160 140 120 USD $bn 100 80 60 40 20 0 Q1 2016 Q3 2016 Q1 2017 Q3 2017 Q1 2018 Q3 2018 Q1 2019 Q3 2019 Q1 2020 Q3 2020 Q1 2021 Q3 2021 Q1 2022 Q3 2022 Q1 2023 Q3 2023 Q1 2024 Q3 2024 Q1 2025 Q3 2025 Q1 2026 Q3 2026 Q1 2027 Q3 2027 Q1 2028 Q3 2028 Q1 2029 Q3 2029 Q1 2030 Q3 2030 As of 1 January 2016 SOURCE: Federal Reserve Bank of New York, PIMCO MBS maturities are estimated by modeling prepayments on MBS currently held on the Fed s balance sheet. pg 2
A New Neutral Requires a Gradual Lift Off to a Lower Destination The equilibrium real federal funds rate is at present well below its historical average and is anticipated to rise only gradually over time as the various headwinds that have restrained the economic recovery continue to abate. If incoming data support such a forecast, the federal funds rate should be normalized, but at a gradual pace. - Chairman Janet Yellen speaking at the "The New Normal for Monetary Policy research conference at the Federal Reserve Bank of San Francisco, March 27, 2015 SOURCE: Federal Reserve pg 3
Evolution of Market Pricing of Short Term Interest Rates in December 2018 7.0 December 2018 Eurodollar Interest Rate Future Contract Implied Policy Rate 6.0 5.0 Percent (%) 4.0 Old Neutral = 4% Nominal Median Blue Dot 3.0 2.0 1.0 0.0 Jan-09 Jun-09 Nov-09 Apr-10 Sep-10 Feb-11 Jul-11 Dec-11 May-12 Oct-12 Mar-13 Aug-13 Jan-14 Jun-14 Nov-14 Apr-15 Sep-15 Feb-16 As of 29 February 2016 SOURCE: Bloomberg pg 4
Global growth converging to slowing trend trajectories Potential output growth and its components 2.5 Advanced Economies Potential employment growth Capital growth Total factor productivity growth 2.0 Percent (%) 1.5 1.0 0.5 0.0 2001 2007 2015 2020 8.0 Emerging Market Economies Potential employment growth Capital growth Total factor productivity growth Percent (%) 6.0 4.0 2.0 0.0 2001 2007 2015 2020 As of 15 April 2015 SOURCE: IMF World Economic Outlook pg 5
Neutral real interest rate, in theory, a weighted average of US and foreign potential output growth (Clarida, Gali, Gertler (2002)) Only in the special case of a closed economy is neutral real interest rate a function solely of home potential output growth. In general, CGG (2002) show that: rr t = ρ + β 1Et{ yt + 1} + β 2Et{ yt Potential Home GDP growth Potential Global GDP Growth * + 1 } What happens in Beijing and Brasilia is (almost) as important as what happens in Washington to US bond yields - in the front end as well as the long end! pg 6
US Bond Yields Reflect in Part the Value of Insurance in an Uncertain World Curiously, heightened risk and fears of further disruptions not just another financial crisis, but also geopolitical instability and pandemics do not seem to carry much weight in current policy discussions Though bonds are hardly a perfect hedge against such risks even relatively minor shifts in disaster risk say, a rise from a normal 2 3% to 3 4% can lead to a massive decline in global real interest rates, even taking them well into negative territory. This can be the case even if expected growth is strong Ken Rogoff, The Stock Bond Disconnect, Project Syndicate SOURCE: Atlantic Monthly pg 7
Total Return on a 30 Year US Treasury Bond in 2008 40%! 150 Price of a 4.75% 2/15/37 Treasury Bond in 2008 Price (US $) 140 130 120 Ceteris paribus, a 40 percent expected return on a 30 year Treasury with a 2 percent greater probability of a crisis lowers the expected return absent the crisis by about 70 basis points! 110 100 90 Jan '08 Feb '08 Mar '08 Apr '08 May '08 Jun '08 Jul '08 Aug '08 Sep '08 Oct '08 Nov '08 Dec '08 As of 1 January 2009 SOURCE: Bloomberg pg 8
Fed likely to continue to rely on communication to keep policy rate expectations anchored 3.5 3.0 5y 5y break-even inflation (BEI) The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected in the longer run. FOMC Statement 16 December 2015 QE 2 The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term. Fed Statement - 18 March 2015 Break Even Inflation Rate (%) 2.5 2.0 1.5 1.0 0.5 0.0 QE 1 To support continued progress the Committee anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015 Twist Fed Statement - 13 September 2012 Feb '08 Aug '08 Feb '09 Aug '09 Feb '10 Aug '10 Feb '11 Aug '11 Feb '12 Aug '12 Feb '13 Aug '13 Feb '14 Aug '14 Feb '15 Aug '15 Feb '16 QE3+4 This exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. Fed Statement - 12 December 2012 As of 29 February 2016 SOURCE: Bloomberg, Federal Reserve pg 9
As output gaps close in some major economies, and as central banks aim to run economies hot, is there upside risk to inflation that is not factored in to the consensus view? 20 A permanent hit to potential output? 19 18 9.8% 17 $ trn 16 15 14 13 12 2000 2002 2004 2006 2008 2010 2012 2014 2016 As of 25 January 2016 SOURCE: CBO, An Update to the Budget and Economic Outlook: 2015 to 2025 pg 10
US Price Level Since 1992 Time for a Price Level Target? 120 PCE Price Deflator Price level path consistent with 2 percent inflation 115 110 105 If the Fed were to aim for a Price Level Target, it would want inflation of almost 3% for next 3 years to make up for falling below the price level path consistent with 2 percent inflation objective. Fed formally adopts a 2% inflation target 3.3% Level 100 95 90 85 80 75 70 Dec '91 Dec '92 Dec '93 Dec '94 Dec '95 Dec '96 Dec '97 Dec '98 Dec '99 Dec '00 Dec '01 Dec '02 Dec '03 Dec '04 Dec '05 Dec '06 Dec '07 Dec '08 Dec '09 Dec '10 Dec '11 Dec '12 Dec '13 Dec '14 Dec '15 As of 31 December 2015 SOURCE: PIMCO, Haver Analytics pg 11