Ever since the financial crisis, the Federal Reserve has had a strong asymmetric bias towards easy monetary policy.1 Initially, with an economy in a liquidity trap, a severely impaired banking sector, a weak labor market, and prices flirting with deflation, emergency settings were justifiable even under a traditional monetary policy framework.2 Eventually as the recovery progressed, the banking sector healed, the labor market improved, and the probability of deflation subsided. And yet the U.S. Federal Reserve continued to ease policy further with QE2, QE3 and Operation Twist. These actions clearly reflected the Fed’s asymmetric bias.

The big question today is whether this regime is about to change. For the first time in more than ten years, the Fed will likely do more tightening in 2017 than the market expected at the beginning of the year. In December 2016, the market expected two rate hikes in 2017. Today the Fed appears on track to hike rates three times this year, and has begun balance sheet reduction this month. Further, according to the latest FOMC “dot plot” released on September 20th, the Fed intends to raise rates three more times in 2018, bringing the fed funds rate to 2.00-2.25%. Do these moves signal a shift in the Fed’s reaction function? And if so, what would the implications of such a shift be?

In this letter, we argue that recent Fed communications do, in fact, represent a subtle reaction function change, but that the impact on markets should be moderate in the next 6-12 months. As inflation converges to the Fed’s 2% target, a more decisive shift could occur, with potentially major implications for asset markets globally.

SOLUTIONS & MULTI-ASSET  |  GLOBAL MULTI-ASSET TEAM  |  MACRO INSIGHT  |  SEPTEMBER 2017

Global Multi-Asset ViewpointThe Fed’s Shifting Reaction Function

Display 1: Fed Policy to NormalizeFed Funds vs. Unemployment Rate

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FOMC DotsFed Funds Rate

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Forecasts/estimates are based on current market conditions, subject to change, and may not necessarily come to pass.

Source: MSIM Global Multi-Asset (GMA) Team analysis; Haver Analytics. Data as of September 30, 2017.

SERGEI PARMENOVPortfolio ManagerGlobal Multi-Asset TeamManaging Director

CYRIL MOULLÉ-BERTEAUXPortfolio ManagerHead of Global Multi-Asset TeamManaging Director

AUTHORS

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Display 2: Past Hike Delays Have Depressed Future Expectations Historical Expectations vs. Reality for Fed Hikes

2014 2019F2018F2017F201620150

20

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Basis Points

GMA Team Forecast

Rate Hikes Expected at Beginning of Year

Actual Rate Hikes

GMA Forecast for Rate Hikes

“Rate Hikes Expected” are implied by futures market pricing.

Forecasts/estimates are based on current market conditions, subject to change, and may not necessarily come to pass.

Source: MSIM Global Multi-Asset (GMA) Team analysis; U.S. Federal Reserve Board; Haver Analytics. Data as of September 30, 2017.

Following the Global Financial Crisis, the Fed exhibited a dovish bias, with Janet Yellen even introducing a new theory of policy setting, labelled Optimal Control. In order to ensure that inflation would recover to target, the approach supported easier-than-traditionally-justified policy, even if it called for tighter policy later. Initially, the argument for such loose policy focused on “hidden slack” in the labor market, causing Fed watchers to begin furiously tracking secondary labor market indicators in the hopes of anticipating Chair Yellen’s views. The Fed’s own staff developed new labor market indicators (the Labor Market Conditions Index, or LMCI) to help support the new approach.

As the economy healed further and credit growth recovered to a normal pace, the Fed slowly began taking steps to remove some of the excessive accommodation. But frequent financial market wobbles along the way delayed implementation. The taper tantrum (2013 bond yield backup of roughly 120 basis points) delayed Fed tapering by three months.3 The first rate hike was delayed from 2014 to 2015 due to uncertainties about the global economy and geopolitical concerns (including the Crimea/Ukraine invasion and a 50% decline in oil prices in the second half of the year). The second hike was delayed nearly a year due to a global (though not U.S.) equity bear market precipitated by Chinese devaluation fears, a further oil price collapse, and the Brexit vote. Each time markets wobbled, the Fed delayed removal of accommodation, even as the economy improved and traditional fundamental justifications for emergency policy settings diminished (Display 2).

What had started as the “Greenspan Put” in the late 1980s, evolved into the Bernanke Put in the 2000s and 2010s, and has become now the Yellen Put. In some ways, this was the logical outcome of a policy that had sought to use rates and the Fed’s balance sheet to increase asset prices in order to generate a “wealth effect” (higher wealth leading to lower savings and higher consumption). Financial markets have been huge beneficiaries of this monetary largesse: stock market investors have enjoyed the combination of strong economic growth, leading to record profits, and supported by the easiest monetary conditions ever (plentiful liquidity with record-low bond yields due a negative term premium). Market participants also appear to believe the Yellen put is still operating, with OIS swaps only implying one rate hike per year over the next three years, vs. 2-3 hikes according to the Fed’s dot plot.4

There are a few reasons why we believe the Fed’s reaction function is shifting away from this dovish bias and back to a more balanced reaction function:

1) For the first time since the Global Financial Crisis, the Fed is not slowing its tightening path despite the fact that progress to one of its targets (2% inflation) has stalled. In prior years, the Fed would have used recent inflation disappointments to justify holding off on further hikes or balance sheet reduction.

2) Fed commentary has subtly shifted to reflect a change in the Fed’s thinking. More members of the FOMC are citing “financial stability” as a factor in their decision-making. In June, outgoing Fed Vice Chair Stanley Fischer gave a speech detailing the Fed’s framework on financial stability which included financial and non-financial sector leverage, liquidity/maturity transformation, and asset valuation pressures. While he did conclude that today’s vulnerabilities were moderate compared to history, he also warned against complacency. Since then, the emphasis on financial stability has increasingly come into focus.5 In a speech on September 26th, Chair Yellen discussed how “persistently easy monetary policy” may not only raise overheating risks but “might also eventually lead to increased leverage and other developments, with adverse implications for financial stability”.6 This is clearly a shift from 2014, when Chair Yellen stated she did “not presently see a need for monetary policy to deviate from a primary focus on attaining price stability and maximum employment, in order to address financial stability concerns”.7 Boston Fed President Rosengren also advocated on September 27th, 2017 that the Fed should continue to raise rates in a gradual manner, even with currently low inflation, to prevent risks of overheating or of “higher asset prices”.8

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credit, which have significantly outperformed less risky assets, would have to reprice to take this double whammy (of tighter policy and slower growth) into account.

However, our assessment is that the Fed is still early in its reaction function shift and that the impact on markets should still be moderate in the next 6-12 months. The Fed will continue to steadily raise rates and wind down its balance sheet. It is willing to accept some modest tightening in financial conditions (higher yields, wider spreads, lower stocks and stronger dollar), but only a modest tightening that would not threaten its forecast of two more years of 2%+ economic growth with an eventual convergence to the 2% inflation target.

The critical threshold to monitor is inflation reaching 2%. This will likely be presaged by wages rising above 3%—the kink in the Phillips wage curve (Display 3). The Fed will then be unable to respond as quickly to any downshifts in growth (the lifeblood of stocks and other risky assets). This eventual combination of slower growth and tighter (or at least not loose) monetary policy could cause a wholesale repricing of risk in financial markets. In the meantime, we observe that the trade-off between growth and policy has just begun to become marginally less favorable: from strong growth and easy money to strong growth and slightly less easy money is a moderate concern. Weak growth and tight money are still a ways off.

Display 3: U.S. Wage Phillips Curve: Watch the KinkWage Growth vs. Unemployment Rate Deviation from NAIRU*

Wage Growth (%)

U6 NAIRU Gap, Lagged 7 months (%)

In 7 Months

Today

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-2 2 640

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*U6 NAIRU Gap; Wage Growth: GMA estimate of trend from principal component of 5 wage measures.

Source: MSIM Global Multi-Asset Team Analysis, Haver Analytics. Data as of October 9, 2017. Based on 2003-2007.

It can be argued that these recent actions and comments do not constitute a change in the Fed’s reaction function, but rather a recalibration given the current economic reality. As the Fed has now achieved its maximum employment goal (with unemployment below NAIRU and at 2006-07 levels) and Fed projections show core inflation reaching 2% within its 3-year forecast horizon, the Fed can now broaden its focus to the impact that its policy has on a broader range of factors, which naturally includes financial stability.9

It could also be argued that the Fed’s assessment of risks has shifted. Three years ago, the risk of deflation, a persistent output gap, and vulnerabilities to global fragilities tilted the balance towards caution. Today, given the roughly one-year lag between monetary policy and its economic impact,10 and inflation itself being the single most lagging variable, the risks of overheating could be judged to be greater than the risks of “secular stagnation” or persistently low inflation.

Another interpretation, however, could be that we are at the beginning of an even greater reaction function change. In fact, the Fed may have come to a realization that, if over the last 7 years, the economy has been able to grow at an above-trend pace and generate an average of nearly 200,000 net new jobs per month, then maybe low consumer price inflation is less of a risk than previously perceived. After all, historically, many countries, including the U.S., have had deflationary booms (e.g. nearly 30 years of 6% real GDP growth in the US with -1% inflation in the late 1800’s). In this case, the true risk is not consumer price deflation but rather asset price deflation. It is the latter that impairs the banking/financial system with declines in the value of collateral and subsequent ballooning of bad debts. And recent research has shown that the best predictors of asset price deflation are the busts that follow bubbles.11 The Fed could be beginning to distinguish between these two types of deflation, realizing that asset price deflation is potentially riskier than consumer price deflation. Such a radical shift in the Fed’s thinking is unlikely but it could be incorporating some of these considerations.

Whatever the reason for the Fed’s shift in tone and actions in the past year, we believe the Fed has indeed subtly shifted its reaction function.

A full shift in focus to financial stability could have a very negative impact on financial markets, as the Fed might continue to tighten policy even as growth begins to slow. This would be a radical shift from the current environment of strong growth and asymmetrically easy monetary policy. Equities and

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1 The Board of Governors of the Federal Reserve System is referred to as the “Federal Reserve” or “Fed” throughout.2 According to the Federal Reserve Bank of St. Louis, a Liquidity Trap refers to a situation in which increases in the money supply do not generate inflation (as would typically be expected), because investors hoard cash rather than spend it when interest rates, or the opportunity cost of holding cash, are at zero.3 MSIM GMA Team analysis; Bloomberg; Board of Governors of the Federal Reserve System.4 Ibid.5 Fischer, Stanley. “An Assessment of Financial Stability in the United States.” IMF Workshop on Financial Surveillance and Communication: Best Practices from Latin America, the Caribbean, and Advanced Economies, 27 Jun 2017, Washington, D.C.

6 Yellen, Janet L. “Inflation, Uncertainty, and Monetary Policy.” Prospects for Growth: Reassessing the Fundamentals, 59th Annual Meeting of the National Association for Business Economics, 26 Sep 2017, Cleveland, Ohio.7 Yellen, Janet L. “Monetary Policy and Financial Stability.” 2014 Michel Camdessus Central Banking Lecture, International Monetary Fund, 2 Jul 2014, Washington, D.C.8 Rosengren, Eric. “Trends and Transitory Shocks.” Money Marketeers of New York University, 27 Sep 2017, New York, New York.9 MSIM GMA Team analysis; Bloomberg; Board of Governors of the Federal Reserve System.10 Ibid11 Borio, Claudio; Erdem, Magdalena; Filardo, Andrew; and Hofman, Boris. “The Costs of Deflations: a Historical Perspective” BIS Quarterly Review March 2015.

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