Observations: Immaculate conception
A brief intermission in Veni, vidi, vocavi
A funny thing happened on the way to writing Part II of Veni, vidi, vocavi: the Fed held yet another triumph for me! The FOMC’s quarterly Summary of Economic Projections (SEP), released yesterday, supported my views from Part I: markets’ pricing of rates in the next few years was (and remains) far too low.
But, unfortunately for the FOMC, in their rush to crown me with yet another laurel, they released a confused and inconsistent SEP. The FOMC seem to assume that, like Jesus born of the Virgin Mary, higher rates in the next two years are a gift from heaven without earthly source (or apparent cost). This immaculate conception provides not only a wonderful teaching moment, but an opportunity to unleash slings and arrows at one of my favorite targets, the flawed Laubach-Williams model that appears to be at the heart of the FOMC’s confusion. Because the Fed has been so giving, I would like to be equally generous by making this short Observation freely available.
Did somebody forget a copy edit?
The Fed took a predictable pass this week and left rates on hold. They continue to project one more hike this year in the SEP, but having largely “caught up with the curve”, a pause to reassess and observe progress seems prudent. The surprise aspect of the meeting was the SEP’s predictions for the next few years: (1) GDP growth is revised higher by a cumulative 1.5 percentage points; (2) the unemployment rate is revised lower by 0.3 this year and 0.4 in 2024 and 2025; and (3) inflation forecasts are unchanged this year and next but – consistent with Thematic Markets’ Being is believing predictions – a tick higher in 2026; yet, (4) all of this “good news” occurs against a backdrop of rates that are 50bp higher in both 2025 and 2026!
While every aspect of the FOMC’s changed projections agrees with long-standing Thematic Markets’ views, there is one glaringly obvious inconsistency in the revised SEP: the FOMC’s implied r* – the real interest rate that stabilizes both growth and inflation – was held constant at 0.5%! The only way for a higher path of rates to be costless to growth, employment and inflation is if the “natural rate” of interest is higher, yet the FOMC do not project this. To be fair to the Committee, the SEP is not a coordinated forecast, it is a collection of the 18 FOMC members’ individual views, taken before the meeting without coordination (though it is easy to show its median values roughly center on the Federal Reserve staff’s forecast). But the omission of any shift in the Committee’s view of r* – particularly after debate on its level featured so prominently at this year’s Jackson Hole meetings – seems a quite serious error.1
Blame John Williams
What, or rather who, is responsible for the error? The clue is in the value of the FOMC’s median projection for r*: 0.5% (the difference of the longer-run projections for inflation, 2.0%, and Fed funds rate, 2.5%). This is precisely the estimated value of r* one obtains from the Laubach-Williams model, found on the New York Fed’s webpage,2 and detailed in academic papers co-authored by New York Fed President and FOMC Vice Chair, John Williams.
r* in theory and Fed reality
The “natural rate” of interest, or r*, is an economic concept to describe the real short-term policy rate that keeps an economy in equilibrium: running neither too hot, nor too cold. Landing policy rates exactly at r* amid stable inflation and full employment is the dream of every central banker, but since r* evolves with the economy and is unknown at any point in time, like the dreams of every serious athlete to win gold at the Olympics, it is possible but unlikely. Yet, the Fed (and other central banks by copying them) have made their job that much harder by determinedly looking for r* in the wrong place. The overwhelming preponderance of central bank discourse on r* relates to the highly flawed, one might even say completely-detached-from-theory, Laubach-Williams model.
The returns on all asset prices in an economy derive from the marginal product of capital (MPK): the incremental return to investment in one more dollar of capital. Differential rates of return among differing instruments – stocks, corporate bonds, government debt, and short-term interbank lending (like Federal funds) – are determined by the security of claims on them and risk preferences. But the underlying source of return is MPK.
This is as true of r* as any other interest rate: it covaries positively with MPK and risk preferences. Intuitively, demand for investment will be higher and the supply of savings lower in a rapidly growing economy with ample investment opportunities – i.e. one with a high MPK – meaning that economic stability will require a higher natural interest rate. The converse would be true in a low-growth, low-opportunity economy. Similarly, given that policy rates are at the lower end of the risk spectrum, r* will be lower in an economy with high risk aversion than in an economy with high risk tolerance.
This is why the revised FOMC’s projection of costless higher rates in 2024 and 2025 without an accompanying increase in their estimate of r* makes no sense! It violates basic economic theory.
Yet one can see how such an error can occur if policymakers are instead relying on the Laubach-Williams model, which makes no reference to capital, risk preferences, savings, or investment. Instead, it models r* solely as a function of inflation’s deviation from a stable Phillips Curve relationship (i.e. its tradeoff with unemployment or the “output gap”). The logic being that r* – all else equal – should keep inflation stable in an economy at full employment.3
But of course, all else is not equal. All three variables in the tidy little Laubach-Williams’ triangle – inflation, unemployment and real interest rates – have been buffeted by a range of shocks in recent decades. Thematic Markets readers know that Being is believing effects have been one of the key drivers of inflation, leading to both the Missingflation that befuddled economists and central bankers throughout the 2010s and the more recent surge in inflation (they likewise missed), that the shift from globalization and the $Bloc/Chinese co-prosperity sphere to Localization has radically changed relative labor demand, means of production, productivity, and (most importantly) MPK across economies, and that rising Global entropy, its Complexity cascades and resultant Uncertainty have altered the constellation of risk preferences.
Along with the false narrative of “secular stagnation”, overreliance on Laubach-Williams by both central banks4 and Street economists to provide a definitive “answer” to where r* lies may be the largest contributor to their collective shock at how much interest rates have had to rise in the last 18 months to contain both the surging US capex cycle and run-away Being is believing inflation effects. It would be too simplistic to suggest that a large, well resourced central bank like the Fed, staffed with many brilliant, experienced economists, relies solely on Laubach-Williams to estimate the natural interest rate, but it is clear from FOMC Minutes, speeches, SEPs, and policy choices that the model has anchored policy over the last decade and continues to. Consumers and investors are now paying a heavy price for that overreliance.
A sustainably higher r*
What is driving the higher r*? I have written extensively about the capital needs and productivity gains created by the most powerful force in today’s global economy: automated Localization.5 Shifting three or four decades of investment in globalized supply chains into more efficient, automated, Localized production is a massive capital expenditure that will put upward pressure on real interest rates and r* for years to come. But as I documented in Thematic Markets’ inaugural piece, Solved: Drivers of the dollar cycle, a year ago, the underlying source of Localization appears to be a US-led innovation cycle that also is raising total factor productivity growth, further contributing to a higher r*. (Renè Aninao at Corbū also ascribes the rise in r* to a productivity boom and has done a wonderful job of comparing the current boom to that of the 1990s, one that also largely was missed by the consensus and everyone at the Fed…except its then Chairman, Alan Greenspan.)
Neither the US innovation cycle nor its associated capex boom are showing any signs of slowing. As such, one should assume a significantly higher r* for the foreseeable future, and as I detailed in Part I, a substantial further bear steepening of the US yield curve.
Not everyone on the FOMC “mailed it in”. While it didn’t move the median, there was a shift higher in the distribution: one member shifted higher from 0.5% and two others shifted higher from 0.75%.
While I refer colloquially to the original “Laubach-Williams” model, the current FRBNY estimate of 0.5% comes from the revised Holston-Laubach-Williams model, but the discussion remains the same.
I am simplifying. The empirical model is derived from a sophisticated mathematical representation of a Neo-Keynesian sticky-price model, then estimated with a Kalman filter that includes a variety of control variables. The Holston-Laubach-Williams model adds some bells and whistles related to time-varying volatility and supply shocks, but ultimately it boils down to, and yields qualitatively and quantitatively similar results to, a linear transformation of the deviation of inflation from its Phillips Curve prediction.
This has been especially true of the Federal Reserve where the authors of the model have had an outsized voice in policy: John Williams was a staff economist at the Federal Reserve Board for years before becoming President of the San Francisco Fed, and more recently the New York Fed; Thomas Laubach, before his unfortunate early passing, was Director of Monetary Affairs, one of the three “Barons” directing research at the Federal Reserve Board.
Free subscribers can learn more in Can a tiger change its stripes in a typhoon; a more detailed description is presented for paid subscribers in Clash of the Themes.