Transcript of Loyola University-Maryland’s College Fed ...

November 27, 2019

College Fed Challenge Finals Transcript

Transcript of Loyola University-Maryland's College Fed Challenge Finals Presentation November 27, 2019

ELIZABETH ABDOO: My name is Elizabeth Abdoo. MADDIE BRENNER: Hi, my name is Maddie Brenner. NICK SPURGEON: I'm Nick Spurgeon. SEAN MCDERMOTT: Hi, I'm Sean McDermott. MATTHEW PANICCIA: I'm Matthew Paniccia and on behalf of all of us and our team, we would like to thank you for having us today and putting this event together. ANTULIO BOMFIM: Thank you and welcome. My name is Antulio Bomfim. I am a Senior Advisor here at the board in the Division of Monetary Affairs. THOMAS LUBIK: Morning and welcome. My name is Thomas Lubik. I'm from the Richmond Fed. I'm a Senior Advisor to the President. TOM KLITGAARD: My name is Tom Klitgaard. I'm from the New York Fed. ELIZABETH ABDOO: Our presentation is called Mindfully Navigating Current Monetary Policy Decisions. Today we're going to take a look at economic indicators, the dual mandate of the Fed and how this affects the Philips curve, we'll take a look at global factors that will be influencing the Fed's decisions, we'll go into an in depth analysis of the yield curve, a Hawk and Dove argument and then finally we'll end with our policy recommendation. The first part of the dual mandate is to maximize sustainable employment. As we've seen through the U3 headline unemployment rate, that rate is sitting at 3.6 percent right now, and it is sitting around a 50-year low. While this indicator alone can indicate a strong and tight labor market, when we take a look further into unemployment, we can see that this remains true. You can see the difference between the green line and the blue line. That spread has been decreasing since the recession indicating that people are becoming more fully employed and

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November 27, 2019

College Fed Challenge Finals Transcript

reentering the labor market, and then I also want to draw your attention to the red line, which represents the black male unemployment rate. Janet Yellen has made the argument that towards the end of economic expansions, when the labor market is really strong, that's when low income and marginalized employees begin to feel the full effects of a tight labor market and we can see that in 2019, the black male unemployment rate has declined significantly.

The next unemployment factor we'll look at is the prime age labor force participation rate. We can see that that has been on the rise since 2014, which represents people are reentering the labor market after being discouraged, I also would like to point out that that rate is not at the point that it was before the recession which could indicate that there's still slack in the labor market.

The final unemployment indicator we'll look at is the quit rate. The quit rate is at a 12year high right now which indicates that people are confident that if they quit their jobs today, they'll be able to find another job. The next indicator we'll look at is GDP percent change. As we can see the recovery that the economy made after the 2008 recession and we can also see the positive GDP change in the most recent years, but we can also see that that rate is slowing, so we'll have to keep an eye on slowing GDP.

This slide takes us into a breakdown of real GDP quarterly. The first panel shows that we have had positive real GDP change in recent quarters and below that we can see that that's been driven by personal consumption which is sitting at 3 percent right now from quarter three data. When we take a look at the right side of the screen, that's where we see some concern in GDP growth. So as you can see, investment overall has been down 1.5 percent and then if we take a further look at that, it seems to be that business investment has the biggest drag on GDP growth at negative 3 percent.

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College Fed Challenge Finals Transcript

The next indicator we look at is productivity. We were hopeful in quarters one and two that productivity growth was going to be strong and steady, but when we recently received quarter three data, productivity growth was negative for the first time since 2015. This negative productivity paired with the rising unit labor costs increases the costs of production to firms which ultimately will have inflationary pressures on the economy, we believe.

MADDIE BRENNER: So our second side of the dual mandate is price stability. By this, the Fed aims to keep core inflation at about 2 percent per year. But as we can see, we've actually only hit this target two times over the last 10 years. Currently we are below target and core inflation is at 1.7 percent, so we are looking to see this continue to rise. Next, we're going to look at our long run inflation expectations and we see that these have been pretty well anchored at the 2 percent but recently, especially in the last year, they have drifted below the target and currently are at 1.74 percent for the five-year five-year forward, so this could indicate some concern for the Fed.

Now, we're going to look at the relationship between the inflation rate and the unemployment rate. So, historically we turn to the Phillips curve which shows an inverse relationship between these two variables and we see this because as the economy is growing, businesses are expanding, creating more jobs, then they face increased competition to retain and attract good labor. So as the unemployment rate goes down, inflation has tended to rise.

Then we first saw a breakdown in this relationship in the 1970s with stagflation that was very high inflation and high unemployment at the same time. So currently, we're about the opposite of stagflation, with inflation below the Fed's target and unemployment at almost 50year low. We see how flat this curve has been so we're not necessarily seeing the overheating relationship as much as we did in the past. So reasons for this flattening of the curve are the

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College Fed Challenge Finals Transcript

anchored inflation expectations without too much volatility, a strong dollar, which Matt will talk about later, but this can have downward pressure on inflation in the US economy. Then when wages are pushed up, employers now have increasingly more options to avoid paying these higher wages so they can automate jobs and globalize into economies with cheaper labor and input prices. Then that headline unemployment 3.6 percent, that doesn't necessarily capture the full scope of the labor market since it doesn't include the discouraged workers or the underemployed.

MATTHEW PANICCIA: So Maddie and Elizabeth just did a great job explaining the factors and data we're getting from the U.S. but obviously that's not the only thing the Fed needs to take into account when making monetary policy decisions, so we'll take a look at some global factors, the first of which being China, which is obviously an important player in the global economy and a major trade partner with most developed nations, and their quarter three year over year growth for GDP was about 6 percent, which is the slowest growth rate they've had since 1992, which is a major concern.

On top of that, we've had a trade war obviously, for the past few years between both parties, political powers and that's led to on the next slide we'll see a decline in exports which peeked really about in 2018 right before some of those tariffs were being talked about and put into effect. So we've seen slowdown in exports from the U.S. which leads us also into the next slide which we can see this possibly spilling over into other parts of the world, so the Eurozone has also had a decrease in exports starting at about the same time, a negative 3 percent growth rate there and going on to the next slide also, there are also other factors in Europe that need to be considered.

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College Fed Challenge Finals Transcript

There's been a three-year debate in British Parliament about Brexit and ECB policy also has affected this Mario Draghi in his last press conference stated that he was maintaining the ECB's policy of just under 2 percent inflation target and that rates will probably remain lower for longer and what this does is essentially will give-- Yeah, so the lower for longer rates will attract the U.S.-- the U.S. yields are higher than foreign countries, so that attracts large asset managers and money managers from abroad are seeking the yields on U.S. return so they're selling their currency, they're purchasing U.S. currency, buying these assets which is propping up the price of the dollar, which we see is downward pressure on inflation.

Also with all this political uncertainty, we also see that as a drag on business investment, because why would a business invest in fixed property plant equipment if in six to 12 months' time they're uncertain about the conditions they'll be operating in.

SEAN MCDERMOTT: This brings us to a discussion about the yield curve. The yield curve depicts interest rates on fixed securities over various years to maturity. The yield rates are composed of interest rate expectations as well as a term premium. Naturally, the yield curve is upward sloping as investors typically need to be more highly compensated for long-term generally more risky bonds.

However, the yield curve can invert when short-term rates are greater than long-term rates, which is important because the yield curve has inverted within the last month. Equally important the yield curve has inverted for long durations before each of the last three recessions. Now does this flattening or inversion of the yield curve indicate a recession? No the yield curve can invert due to lower expected short-term interest rates, which can pose a problem for the economy as the market has lower expectations for interest rates and it displays pessimistic expectations for the economy.

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College Fed Challenge Finals Transcript

However, the term premium, I mean, the yield curve can also invert due to a low or negative term premium, which is not necessarily a problem as businesses are able to borrow at cheaper rates and this reduces the accuracy that an inversion of the yield curve leads to recession. Low inflation coupled with a negative term premium can lead to a flatter yield curve than we have seen in the past and when we look at the data we can see the 10-year term premium is sitting at negative 1.01 percent. As Matt mentioned, one reason for this could be the negative rates on long-term European bonds which creates a higher demand for long-term US bonds as investors search for higher yielding alternatives.

The long-term decrease in the term premium that we have seen over the last 20 years can be attributed to greater transparency of Fed policy as well as lower inflation volatility and risk. The more recent decrease in the term premium that we've seen over the last year can be contributed to Europe's continuation of large scale asset purchases through their expanded asset purchase program, and recently we have discovered that long-term bonds have provided a great hedge against equity risk which increases the demand for these bonds.

Then when we look at the yield curve, today, we could see the inversion has reverted as a spread between the three month Treasury bill and the 10-year Treasury bond is increasing. When we look at the 10-year rate, it is currently sitting at 1.8 percent which includes the negative 1.01 percent term premium, when if the term premium were zero, this rate would be sitting at 2.8 percent, which is a very healthy indicator and displays great expectations for the economy in the future and the yield curve maintains its typical upward slope that we like to see which shows Fed policy is already taking effect.

NICK SPURGEON: So now that we've taken a look at all these different macroeconomic indicators, we have gone ahead and categorize them into the Hawk and Dove debates.

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College Fed Challenge Finals Transcript

Now, for the first major indicator for the Dove side of things, we see an upward trending labor participation rate sending out right about 82.6 percent. This ultimately suggests that we may now be at our long run aggregate supply and some form of expansionary policy might be necessary to get us to that potential GDP.

The next three points are really tied closely together. So inflation is well below the federal target rate of 2 percent, expected inflation has been decreasing in recent years due to stagnant inflation and then also the strong U.S. dollar is holding inflation down. So ultimately, these are all tied to that 2 percent target rate for the Fed and ultimate expansionary policy might be necessary to get us to that 2 percent level. On top of this, as Sean just mentioned, there has been the yield curve inversion but this is not of a major concern for our team as it has recently reverted since its inversion. Then lastly for the Dove side of things, we've seen investments down 1.5 percent which can suggest a pessimistic business outlook and ultimately expansionary policy might be able to help this number improve.

Now, for the hawk side of things, one major indicator is a strong labor market. We're sitting at a 50-year low which is sitting right about 3.6 percent. If we were to be currently be expansionary, this would suggest that we might be overheating or potentially being financially unstable. Also, as we mentioned before, the yield curve has reversed and ultimately there's a healthier outlook for the economy going forward. On top of this, global forces are keeping US rates down and ultimately there's some form of expansionary stimulus already coming from abroad markets. Lastly, the consumption is up 2.9 percent, government spending is up 2 percent and also consistent GDP growth of 1.9 percent are all signs of the healthy and improving economy. Then lastly, one thing if we were to be expansionary going forward, there's this deteriorating lending standards in a leveraged loan market. So with lower rates, there's

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College Fed Challenge Finals Transcript

ultimately riskier and more loans being taken and ultimately a bubble like the 2000 housing crisis could potentially develop. This ultimately leads us into the neutral rate analysis. So the FOMC currently estimates the real neutral rate to be at 0.5 percent, and if you add this to the core inflation of 1.7 percent, this puts us at 2.2 percent overall. If the federal funds target rate now is 1.5 to the 1.75 percent range, this puts the Fed at a slightly mildly expansionary position.

This ultimately gets into our team's recommendation. So overall, we agree with FOMC's current mildly expansionary position, and this is due to two main reasons. One, investment spending is decreased, it's down 1.5 percent and then also inflation is below the target sitting at 1.7 percent. It's slightly expansionary position would help improve these numbers. But going forward, we do not believe the Fed should be making any more cuts, that's due to a few reasons. One is that we've seen this reversal of recession indicators like the yield curve and on top of that we as a team believe that the benefits do not outweigh the weaknesses, the costs.

Overall, there's financial instability and excessive risk taking costs associated with cutting rates. The benefit, obviously, would be to increase the inflation and ultimately to increase the investment spending numbers as well. On top of this, there's outside factors that the Fed can influence, these are financial instability, the data lags, the global factors and slowing growth productivity. Ultimately, we as a team believe we should wait for the data lags and to monitor all these other outside factors before the Fed decides to cut in the near future and ultimately should refrain from cutting currently. Thank you.

ANTULIO BOMFIM: Thank you. So we'll start by asking you a couple questions and then we'll dig a little deeper into some of the really interesting issues that you all brought up. Okay? So, as you know, the Federal Reserve has been conducting a review of its monetary policy strategy, tools and the communication practices, and this has been going on throughout

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