Q:

I do not understand the last sentence of your post: We suggest: there is no contradiction in hiking rates while growth is slowing, provided that financial stability is at stake.

Is there a ‘not’ missing, or am I missing it ?

A:

I hope my English did not betray me…
Let’s find out.

This post is about systemic convergence: the assumption that central banks are (or will be) forced to normalize their unconventional monetary policy in order to avoid systemic or financial stability risks.

Think of banks, insurances, pension schemes, asset valuation, etc … If rates stay too low for too long – which I believe has already been the case – monetary policy is more a problem than a solution. To take Bernanke’s words: the cost/benefit ratio of unconventional monetary policy turns negative.

Back to the post. The Fed has been driving the short end of the curve quite aggressively of late: in a matter of weeks, the probability of a March hike went from less that 50% to 100%. Why such a hurry? Is growth or inflation exploding ? I doubt that. My best guess would be that the Fed is making use of the Trump effect – i.e. a fierce set of growth and inflation expectations – as a way to ‘finance’ its normalization.

To figure out, one should focus on the gap between expectations and current economic conditions. That’s precisely what the GDPNow model is supposed to do :

1. If the model is valid – and I believe it is – then the Fed should not be in a hurry to hike rates. In other words: a rate hike would be contradictory (your understanding I guess) ;

2. but if QEternity puts financial stability at risk, then the benefits of a hike would dominate the cost of a status quo (my reading).

Of course, the GDPNow model can be misleading. Interestingly enough however, the decision of the Fed yesterday was felt as a ‘dovish hike’.

Best regards,
Jacques