The markets are always one move ahead of everyone else

In recent weeks we’ve been treated to an almost non-stop set of finance news headlines, indicating stocks either rose or fell on rumors of when the Fed will scale back its bond purchases.  How can this possibly be important?  After all, the Fed is simply swapping one highly liquid federal government liability for another.  I can only guess, but my hunch is that the markets are thinking one move the head of us economists, and everyone else as well.

Let’s start with a couple possible long run equilibria, and then work backwards to today.  I’d guess that markets expect NGDP to rise somewhere between 34% and 55% over the next 10 years (those figures correspond to annual growth rates of 3% to 4.5%.)  For all sorts of reasons, equity prices today would be much higher if markets expected 55% NGDP growth by 2023, as compared to 34% total growth.  So it’s no surprise that markets would react strongly to rumors that provided useful information about the likely future path of NGDP.  But why are current Fed purchases of securities so important?  After all, we are at the zero bound.

Most economists agree that the Fed steers NGDP when we are not at the zero bound, presumably through a policy regime roughly approximated by the Taylor Rule.  Let’s also assume that rates are likely to stay near the zero bound for another 3 to 6 years, and then rise gradually.  That assumption seems consistent with the yield curve.  In that case, post-zero bound Fed policy will obviously have a big effect on the total 10 year growth rate of NGDP.

But it’s also important to recognize that the Fed doesn’t like sudden shifts.  Thus even if they’d prefer 55% total growth, if they are far short of that path 6 years from now then they are unlikely to do a sudden push to catch up over the final 4 years.  Thus it matters a lot where the economy is when the zero bound period ends.

The Fed’s big decision will be how fast to adjust its various policy instruments in the face of nominal economic growth data.  Thus they might keep rates at 0% for two consecutive years of 5% NGDP growth, or they might begin ratcheting them upward after just two quarters of such growth.  We simply don’t know–despite the so-called “Evans Rule.”

Here’s why I think the markets care so much about the possible phase out of QE:

1.  Before the Fed begins actually raising interest rates, it will offer hints that it plans to raise rates at a series of FOMC meetings.

2.  Before the Fed offers hints that it is thinking about raising rates, it will end QE3 (or QE4.)

3.  Before the Fed ends QE3, it will offer hints that it plans to end QE3 at a series of FOMC meetings.

4.  Before it offers hints that it is considering ending QE3, it will scale back QE3.

5.  Before it scales back QE3, it will offer hints that it plans to scale back QE3.

You could argue that we have already reached step 5.  The speed at which we move from one step to another, and more importantly the condition of the economy (NGDP growth) as we move from one step to the next, will largely determine whether NGDP ends up 34% higher in 2023, or 55% higher.

You might wonder why the Evans Rule didn’t make all this transparent.  The basic problem is that the Evan’s rule is not a series of precise targets, but rather a sort of “guardrail” preventing excessive monetary stimulus, but also preventing premature tightening.  It also ignores QE, the policy du jour, and describes those guardrails solely in terms on the decision to raise interest rates.  Thus the Evans Rule might well be consistent with either 34% or 55% NGDP growth over 10 years.  Indeed the Japanese have come close to adhering to the Evans Rule for 2 decades (assuming a lower natural unemployment rate in Japan), and have seen less than 0% NGDP growth over 20 years.

You can see this most clearly in the mixed signals coming out of the Fed.  Top Fed officials have complained about the effects of fiscal austerity.  Top Fed officials have also indicated that they are considering a tightening of monetary policy.  These statements seem contradictory–does the Fed want faster NGDP growth, or not?

No wonder the markets are confused–the policymakers they are trying to read are equally confused.  But give the markets credit; at least they understand that monetary policy is the key right now.  Any hint as to more or less monetary stimulus should have a major impact on asset prices.  And it does.

PS.  Another gem from Nick Rowe . . . and bonus points to Nick for keeping his composure this time.





16 Responses to “The markets are always one move ahead of everyone else”

  1. Gravatar of Scott N Scott N
    5. June 2013 at 07:34

    The Fed is feeling the heat because the stock market has gone up substantially since they started QE3. From what I can tell, I think they are worried that additional QE will inflate some kind of asset bubble. In the meantime, employment data has shown slight improvement. And, the Fed apparently no longer cares what inflation does. Add all that up and the Fed is feeling pressure to tighten monetary policy.

    This is beyond frustrating. I thought employment targets were only bad in an inflationary environment like the 70s, but I can see that they are equally as bad in a deflationary environment like now. The Fed seems content with zero percent inflation as long as everyone has a job. I think there was another central bank who thought the same. That’s right, it was the Bank of Japan circa 1990-2012.

  2. Gravatar of Doug M Doug M
    5. June 2013 at 08:00

    The Fed wants faster NGDP growth now. The Fed is non-committal for 2014 and 2015.

  3. Gravatar of Geoff Geoff
    5. June 2013 at 09:24

    “The markets are always one move ahead of everyone else…

    …except the Europeans…concerning inflation and monetary policy…then markets are stupid and must bow down to the infinite wisdom of market monetarists.”

  4. Gravatar of Nick Nick
    5. June 2013 at 09:27

    Does this analysis apply to Japan? It seems not to, as Japan seems about as far away from step 5 as they could be. But if not, what is going on with the Yen and Nikkei? (Yes, never reason from a price change…but inquiring minds want to know)

  5. Gravatar of Nick Rowe Nick Rowe
    5. June 2013 at 09:39

    Thanks Scott. It was hard. But maybe because I did keep my composure, nobody else seems to have noticed.

  6. Gravatar of kebko kebko
    5. June 2013 at 09:39

    Interest rate futures currently are priced for an expected initial increase in March 2015 with a 22bp rise per quarter after that.

  7. Gravatar of Sean Sean
    5. June 2013 at 09:57

    I was discussing with my boss what the NGDP target of the FED is right now? Which I think they are roughly doing some kind of NGDP targeting right now even if they don’t know it.

    I said 4.5%. He said it was too high and closer to 4%. Based on the tapering talk right now I think you must concluse its in this rain.

    I posed a follow up question would the FED have different NGDP targets for QE and for lifting rates from 0%?

    I think they are far more comfortable doing interest rate targeting than QE (Though I obviously believes its their forecasts that matters more).

    So the question is would the FED begin tapering QE at roughly 4.3% NGDP growth, but remain comfortable at 0% inflation if NGDP growth was say 6% with inflation still below 2%.

  8. Gravatar of ssumner ssumner
    5. June 2013 at 10:26

    Scott, If they are worried about overheating, then why the complaints about austerity?

    Doug, Possibly, but I don’t really see the point in that policy stance.

    Nick, I did a post on that a few weeks back. There are rumors the BOJ is less than committed to the 2% target.

    Nick Rowe, Unfortunately, the crude and simplistic bloggers get most of the attention.

    I admit to having to read it twice, the first time it went right over my head. Upward sloping AD curves make my hair hurt.

    Thanks Kebko.

    Sean, It’s hard to say, as the Taylor Rule is maddeningly vague.

  9. Gravatar of TheMoneyIllusion » Never reason from a price change, example #397 TheMoneyIllusion » Never reason from a price change, example #397
    5. June 2013 at 10:39

    […] right now.  Either reserves and T-securities are not perfect substitute, or else the Fed is sending signals about future Fed policy, when reserves and T-securities will no longer be prefect substitutes.   […]

  10. Gravatar of Saturos Saturos
    5. June 2013 at 12:04

    This is a great post.

    Do you think that the exit from the ZLB in five years will come because of nominal wage adjustment, or for other reasons?

  11. Gravatar of Nick Rowe Nick Rowe
    5. June 2013 at 13:52

    Scott: “Let’s start with a couple possible long run equilibria, and then work backwards to today.”

    That is very much the key point. It forces you to bring expectations into the analysis. All games are solved backwards, in exactly this way. It is so easy to make the mistake of doing exactly the opposite.

  12. Gravatar of Bill Ellis Bill Ellis
    5. June 2013 at 14:12

    2008-9 market was telling us that there would be no/negative growth ten years out.

    There is a 6 year overlap between the ten year spans of 2009-19 and 2013-23.

    Soylent Green is People !… I mean, Markets are people.

  13. Gravatar of ssumner ssumner
    5. June 2013 at 14:50

    Saturos, Mostly wage adjustments, unfortunately (it takes a long time that way.)

    Thanks Nick.

    Bill, I honestly have no idea what you mean. Does anyone else?

  14. Gravatar of Benjamin Cole Benjamin Cole
    5. June 2013 at 20:13

    The problems of Fed vicissitudes and indirection, compounded by ranting of various FOMC members, all of which jangle the markets and create uncertainty, and confuse voters—really, does anyone think the Fed is properly constituted now?

    How is this either an effective policy-making arrangement, or good governance?

    Seems to me that Reagan’s Treasury Secretary Don Regan had it right: Put the Fed into the Treasury Department, and have it take orders from the President.

    Now, we voters have some accountability, and what course our monetary policy will take should be defined clearly by the President. The markets might not be assured—but if they react very badly, that will put pressure on the President to change his policy.

    The FOMC feels no pressure. They are not up for a vote.

  15. Gravatar of The markets are always one move ahead of everyone else | Fifth Estate The markets are always one move ahead of everyone else | Fifth Estate
    6. June 2013 at 05:21

    […] See full story on […]

  16. Gravatar of ssumner ssumner
    6. June 2013 at 06:47

    Ben, I agree.

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