Fed lowers its estimate of the long-run rate to 3.75%

Outlook:

The world outlook is one of divergence, especially in growth, inflation and central bank policies. The FT calls it “disjointed.” China is clearly worried by growth and by distorted sectors, including overbuilt housing that can’t turn into a burst bubble because markets are not free, but a major worry all the same. Not to mention appalling pollution and contaminated exports. For its part, Japan continues to push on string, as capex shows.

But even as Europe begins QE this month, we are seeing the seeds of recovery, if not exactly green shoots and not everywhere. The cyclical bottom could have already been reached… with one important caveat: oil can’t fall any further and “shock” consumer spending and inflation expectations. The ECB is skating on thin ice but as of today, there is a distinct possibility that the QE program could be ended ear-ly without going all the way to end-2016, as planned.

We get the usual first Friday payrolls this week, with wage growth the more important component. But no matter what the data brings, the overriding sentiment may easily become that of Fed Vice-Chairman Fischer, who told the University of Chicago econ-fest that Fed stimulus is just starting to get a full grip in Q1 and Q2 this year, and inflation will follow in 2016. Fischer also warned that market expectations might move and might move abruptly when the Fed starts raising rates. The First Rate Hike “will add to the credibility of what we’re saying.” In other words, the market is wrong to doubt the Fed. This is not about exact timing, but rather about the excellence of the Fed’s forecasting capabilities and the Fed’s resolve. Get out of the way, he is saying, or get on board.

The WSJ defines how the market has it wrong, noting that “nine of 17 policy makers see the central bank’s benchmark interest rate—the federal funds rate—at 1.13% or higher by year-end. The median estimates—meaning half are above and half below—reach 2.5% for the end of 2016 and 3.63% for the end of 2017. On the other hand, in fed funds futures markets, where traders buy and sell contracts based on expected rates, the expected fed funds rate is 0.50% on average in December 2015, 1.35% in Decem-ber 2016 and 1.84% in December 2017.”

The WSJ also gets into the long-run “natural” or equilibrium rate of return. This is the one that Summers has said is now permanently lower due to secular stagnation. To be sure, the Fed has lowered its estimate of the long-run rate from 4.25% in 2012 to 3.75% today, or 1.75% return on invest-ment and 2% for inflation. The Fed sees the equilibrium rate being met by end-2017. One paper pre-sented in Chicago rebuts the Summers view and pushes the idea that “the economy has been held back by temporary headwinds and not a permanent reduction in its potential growth rate.”

We are with the anti-Summers crowd. We’d be happier if we had an engine of growth like railroads, electric light and automobiles as in years past. Facebook and Twitter do not have the same growth-promoting multiplier effects. But if Elon Musk can get us a real long-lasting battery or alternative energy gets a genuine foothold (from the too-low levels today), maybe we are on the cusp on a similar growth revolution. Growth in 2014 was 2.4% y/y, after 2.2% y/y in 2013. That’s something… and vindicates the long-held view (from Rogoff and Reinhart) that a big recession takes 8 years to recover. Well, if we date the recession from 2008, that’s 2016.

The obstacle is the bond market. We find it really interesting that the cautious NY Fed chief Dudley said at the same conference on Friday that it’s more dangerous to move too early than too late. But he also said, according to the FT, “if unusually low market rates do not react when the Fed decides to boost the policy rate, the central bank could be forced to choose a more ‘aggressive’ path of monetary policy.” In other words, the Fed could poke the bond bear with a stick.

We have to wait for Friday to get payrolls and wages, but before then we may get news about the ECB bond-buying plan. Weinberg at High Frequency Economics told Market News he expects the ECB is "’prepared to buy at least €10 billion worth of sovereign bonds each week for at least the next year or two.’ Of the ECB purchase total, 25.6% of the paper will be Bunds, he said, reminding that ‘the whole market is only €679 billion and the ECB could buy up to one quarter of that under its QE program. It is a total no-brainer for investors to pile into Bunds of all maturities with the ECB stepping up to the market with a mandate to buy €2.7 billion of them each week for the next two years,’ Weinberg said.”

Yikes! It would be perverse indeed for the euro to rise on such an outlook. It would imply that all this is already priced in, but we doubt it. If the US bond market can’t listen to what its central bank is saying, why would we think the European bond market is any more responsive? What is “disjointed” is the Eu-ropean bond market. They don’t know what is about to hit them.