Two Fed Narratives

There are two Fed narratives developing in the background, one that favors a flatter yield curve and another that favors a steeper curve. As of now, it appears that the flat curve scenario dominates the conventional wisdom while the steeper curve is the risk. I think it is worth reviewing the basics of the two scenarios so we can keep an eye on which unfolds in the coming months.

The flat curve scenario is fairly straightforward and quite logical. I say logical because I have defended that scenario multiple times in the past, so it must be logical, right? Here, for example, where I discuss yield curve control and here where I discuss the Fed’s reaction to rising long term yields. The Fed’s update policy strategy and enhanced forward guidance appear generally consistent with this view. The Fed foresees long-term disinflationary pressures as a result of a protracted period of high unemployment. Under the new strategy, the Fed expects to long rates at zero until the inflation reaches 2% to encourage above target inflation and firm up inflation expectations. This was the message delivered in most recent statement and confirmed in the Summary of Economic Projections.

The Fed’s stance appears to favor further policy action to accelerate inflation. As a group, the Fed has steadfastly downplayed positive economic data in favor of a laser-like focus on downside risks to the outlook. Moreover, the median Fed meeting participant does not anticipate inflation exceeding during the forecast horizon that now extends to the end of 2023. That implies the Fed will continue to be pressured to do more to accelerate inflation and the only reason it has yet to do more is lack of time to build an internal consensus on next moves. The easiest, lowest cost next move is yield curve control although the Fed has downplayed that option. The next move is to shift asset purchases to the long end of the yield curve. The threat of these two potential outcomes maintains downward pressure on long term yields.

If the baseline is a flat yield curve, the risk is a steeper yield curve. How do you get there? You get there by recognizing that the Fed’s current policy stance remains dependent on the forecast. The Fed can choose to ignore any potential upside risk to the economy and promise to maintain deeply negative policy rates for the time being, but the rest of us can’t ignore the risk that the Fed gets caught on the wrong side of that bet.

The Fed has gone all in on fighting the last battle. I sense this remains the consensus view as well. The key features of the last battle were a slow recovery, a protracted period of high unemployment, weak wage growth, and persistently below-target inflation. The conventional wisdom and the Fed are deeply attached to that view despite a considerable amount of positive data flow. The Fed’s attachment remains despite the fact that it dramatically upgraded its own forecasts! The dynamics of this recession are very much not like the last and I think it is a mistake to continue to force your forecast into that framework.

Given where the Fed is now, how do we get from here to a steeper yield curve? One path would likely be gradual. Assume the data continues to generally surprise on the upside. That would take the pressure off the Fed to build a consensus to loosen policy further or even make that consensus more difficult to find. The Fed would instead take a policy of benign neglect toward the yield curve. The Fed in this scenario would not deviate from its policy rate strategy but also not step in the way of higher long-term interest rates. If this scenario where to unfold, we would expect Fed speakers to say things like “rising long-term rates reflect an improving growth outlook.” (If instead they say something like “the rise in long-term rates is not consistent with our policy intentions” then they will act to reduce long-term yields. This latter scenario though seems more likely driven by premature expectations of a tapering of asset purchases rather than a data-driven event.)

Another path to a steeper curve could be more abrupt. I focused on this scenario in my FOMC review. The Fed has so deeply embraced the downside risks dominate/this is a repeat of the last recovery framework that they abruptly pivot in a hawkish direction when the weight of evidence to the contrary becomes impossible to ignore. This could mean reducing asset purchases or bringing forward expected rate hikes. Rapid shifts in the outlook are not unprecedented; for instance, the Fed typically dismisses negative economic news prior to a dovish shift.

The key point in all of this is that the Fed’s ultimate policy path will be determined by the forecast. That forecast can change. I think there is a heightened danger that it changes abruptly because the Fed has committed to the pessimistic outlook.

Bottom Line: The baseline scenario is that conditions and Fed policy mesh such that the yield curve remains flat. This is arguably the message from the Fed’s last policy meeting in which the Fed operationalized the new framework. Continued better than expected outcomes are a threat to this scenario. I am sensitive to this risk given that the economy has outperformed my expectations such that it seems clear that this recession does not follow the dynamics of the last.