An Easy Benchmark to Reduce the Fed Debate Pain
Over the past three years, commentary from and about the Fed’s interest rate policies has consisted of a mixed bag of messages and directions. Much of this time has been focused on an objective of normalizing interest rates. While this was needed, the process lacked a coherent definition of normal and lacked in coherent messaging. Examples include wide estimates in the number of needed rate increases as well as dot charts that proved to be inaccurate. As time passed and after several rate increases, we experienced what was the final in a string of quarter-point hikes in December, 2019 along with language to expect further rate increases. Within a few short weeks, the Fed changed direction to a policy of no rate changes for 2019. Lastly and in another reversal of thought, the overnight rate was cut in August. It is hard to look at our current situation with confidence.
Setting the interest rate portion of monetary policy is not always easy but I believe there is a need to make greater sense and structure to this important function. For rate setting, I think there is a need for a benchmark that makes simple and directional sense. When considering the important price stability portion of the Fed’s mandates, I believe there is one indicator that should play a major role in setting the overnight rate. This indicator is the expected rate of inflation derived from US Treasury markets as described in the following Federal Reserve definition: The breakeven inflation rate represents a measure of expected inflation derived from 10-Year Treasury Constant Maturity Securities (BC_10YEAR) and 10-Year Treasury Inflation-Indexed Constant Maturity Securities (TC_10YEAR). The latest value implies what market participants expect inflation to be in the next 10 years, on average. Though this definition states 10-years, breakeven inflation rates can be calculated for a multitude of maturities. This definition is used as the 10-year Treasury yield frequently serves as a key rate monitored by many. With the 10-year expected breakeven inflation rate currently at 1.60% (9/10/19), I believe a case for this as an overnight rate benchmark for the Fed can be illustrated in the following comments and questions:
- Treasury markets are very liquid and open for investors to position and arbitrage expected inflation levels. Though no forward indicator is perfect, it is hard to imagine a better indicator than one that includes input from many motivated contributors.
- Under current conditions, an overnight rate at or around 1.60% is fair in my mind.
- During the rate normalization process (2016 – 2018), it would have been helpful for the Fed to put this concept on display as, at least, an initial target. During this period, the expected breakeven inflation rate was in a general range of 1.5% to 2.0%. I think normalization guidance to an initial target within this range would have been accepted as reasonable verses the foggy messaging as described earlier.
- During the decision process regarding the last rate increase in December, it would have been helpful to recognize that the overnight rate range (before the increase) of 2-2.25% already exceeded the expected breakeven inflation rate at around 1.9%.
- I think this benchmark tool would allow the current Fed to lower interest rates without sending an overly implicit message of weak economic conditions.
- None of this prevents the Fed from setting rates over or under the breakeven level as needed. It would require the Fed to make an effective case for significant differentials while facilitating productive discussions and communications to the public.