In recent months academic economists, market commentators and investors have debated what the appropriate path of U.S. monetary policy should be this year, given where we reside in the economic cycle. Although two coherent camps have emerged from this debate — both making some arguments with which we have a degree of sympathy — each side has also made the mistake of underappreciating the importance of secular forces, such as technological innovation, that we have identified as holding a powerful disinflationary influence.
More specifically, a dovish camp is highly concerned about the economy’s ability to withstand even modest policy tightening, suggesting that such action might be akin to the situation the Federal Reserve faced in 1937, when premature tightening led to an extreme equity market sell-off and a setback in Depression-era recovery. This camp contends that if a central bank moves toward policy tightening and then has to reverse itself in short order because of economic deterioration, it would be much worse for its credibility than if policymakers were merely to begin hiking a little late. That is particularly the case today, or so the argument goes, when the current inflation rate is below target. Finally, on inflation, since the Fed has come close to achieving most of its labor market goals, this camp argues that the central bank should not begin policy tightening until inflation is nearer to the Fed’s 2 percent target goal. Supporters of this view even evoke the martial call ostensibly used at the Battle of Bunker Hill in their argument, suggesting that the Fed not tighten until it “sees the whites of inflation’s eyes.”
In contrast to this view, another — hawkish — camp is more concerned about the unintended consequences of unconventional policy measures, arguing that we should not dismiss out of hand the risk of rampant future inflation. This group tends to suggest that when judging the balance of risks between growth and inflation, the prudent thing for the Fed to do today would be at least a modest lift-off from the zero-bound Fed funds rate, which would be a more balanced approach than the extreme position of maintaining excessively low policy rates for too long. This group reminds us that the Fed’s credibility issue can cut both ways, in that the central bank could tighten too quickly or, just as possible, too slowly — as it did in the mid-2000s — risking both credibility and economic stability.
Based on our reading of the evidence, we share the hawkish camp’s concern of unintended consequences, but unlike many in that group, we are not worried about rampant inflation. Rather, we are more concerned about how excessively easy monetary policy has resulted in some questionable capital allocation decisions and financial asset price distortions that could eventually put the Fed’s broader goals at risk. We are living through a period in which extraordinary technological innovations and demographic shifts are combining to create a disinflationary environment. That structural disinflation is largely positive for U.S. households, as it aids in bolstering real disposable income gains at a time when nominal gains have been lacking. Although this dynamic helps all consumers, it should be a particular relief to those lower-to-middle-income households that have suffered the most in recent years.
This has led to a situation in which the Fed appears to be afraid of its own shadow when it comes to normalizing rates. We at BlackRock think the Fed currently has a window of opportunity to move, with stable markets, payroll growth at extremely high levels and foreign central banks — notably, the European Central Bank and the Bank of Japan — taking the reins of policy accommodation. As a case in point, the U.S. labor market continues to power ahead, creating 2 million new jobs in the past seven months. The last time that 12-month job growth was as strong as it is today, the Fed’s policy rate stood at 6 percent, compared with the near-zero rate now. The labor market is also tighter now than it was in 2006, with stronger positive momentum and more job openings.
Of course, the dovish rejoinder might concern the lack of appreciable wage growth seen in this economic cycle, as well as the contention that with inflation running low, there are few risks to continuing current levels of accommodation. Still, we would suggest that a good deal of evidence implies that wage growth is coming. The two-, three- and four-quarter change in the U.S. Department of Labor employment cost index shows solid wage growth in recent quarters, which should gain momentum as labor markets tighten further (see chart).
As Stanley Fischer, vice chair of the Federal Reserve Board, has suggested in recent comments, although the Fed expects to raise rates sometime this year, the central bank would merely be moving from ultra-stimulative to extremely stimulative policy. Effectively, this is taking the first step toward neutral, then slightly positive, real rates. At this stage of the economic recovery, this is hardly a radical policy prescription. In fact, Fed policy today is penalizing savers and holders of cash and instead benefiting borrowers. The maintenance of that dynamic, however, could place the credibility of policy at risk, as well as financial stability. The proximate cause of the past two recessions in the U.S. was asset bubble inflation that led to capital misallocations and eventual collapse. This concerns us.
We strongly suggest that Fed rate normalization not only will be borne well by the economy but also may actually have a positive impact. Conversely, keeping rates excessively accommodative almost certainly holds an increased risk for markets. Based on our interpretation of recent economic data, it is clear to us that a zero or negative real Fed funds rate is the wrong number relative to present growth levels. The great irony here is that whichever camp you ally yourself with — or if you agree with our view — the investment implication that follows is much the same: a fairly broad-based derisking of portfolios and elevated cash holdings related to your respective worry.
Rick Rieder, managing director, is chief investment officer of fundamental fixed income and co-head of Americas fixed income for BlackRock in New York.
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