MBS Day Ahead: Fed Hints at Brave New World... Maybe

There is no question that the Fed hinted at a brave new world for global interest rates in yesterday's Minutes release, but for most market participants, there is too big a question as to whether we ever see it.  For me personally, it's vindication for my decision to increasingly go out on an analytical limb this year.  Said limb is my thesis about longer-term endgame for rates being a global race to zero due to a confluence of factors including aging populations, declining birth rates, declining productivity, an absence of growth exponentiators (like the industrial revolution, globalization, or the proliferation of internet and ecommerce). 

Inconveniently, I don't know how quickly the race to zero will unfold (clearly Europe is already modeling the behavior, and Japan has been its poster child for decades).  So this is not an endorsement or recommendation to make riskier lock/float decisions in the near term.  It could take years before we can be sure it's playing out.  Or it could happen by the end of 2016--not necessarily hitting zero rates, but starting on that path.

What I do know is that the Fed is thinking about this too, and over the past 7 days, they've chosen to share that fact with the rest of the world.  This began like many avant garde Fed ideas began: by sending out St. Louis Fed Pres. Bullard to say something seemingly crazy.  Last Thursday's wires were interesting to say the least.

• RTRS - BULLARD SAYS "REALISTIC POSSIBILITY" THAT INDUSTRIALIZED COUNTRIES COULD FACE RATES STUCK NEAR ZERO
• RTRS - BULLARD SAYS STILL PREFERS TO RAISE RATES, WORRIES ABOUT INFLATION, BUT 7 YEARS AT ZERO LOWER BOUND MAY CHALLENGE FUNDAMENTAL ASSUMPTIONS ABOUT U.S. MONETARY POLICY
• RTRS - BULLARD - ZERO POLICY RATE AND LOW EXPECTATIONS MAY HAVE ANCHORED INFLATION AT PERMANENTLY LOW LEVELS

He's totally missing the point about monetary policy creating the issue.  Or maybe I am.  The important part is the thoughts on "stuck near zero."  Then yesterday, the Fed Minutes conveyed similar thoughts

"With respect to longer-run trends, the staff noted that multiyear averages of short-term real interest rates had been declining not only in the United States, but also in many other large economies for the past quarter-century and stood near zero in most of those economies. Moreover, economic theory indicates that the equilibrium level of short-term real interest rates would likely remain low relative to estimates of its level before the financial crisis if trend growth of total factor productivity does not pick up and if demographic projections for slow growth in working-age populations are borne out.

Moreover, it was noted that the longer-run downward trend in real interest rates suggested that short-run r* would likely remain below levels that were normal during previous business cycle expansions, and that the longer-run normal level to which the nominal federal funds rate might be expected to converge in the absence of further shocks to the economy--that is, the level that would be consistent, in the long run, with maximum employment and 2 percent inflation--would likely be lower than was the case in previous decades."

Sounds very much like my ax-grinding (aging populations, productivity, global race to zero).  R* refers to the "natural" Fed Funds Rates, by the way.  That's that magical equilibrium rate that neither promotes or dissuades changes in unemployment or inflation.

Long story short, the Fed is increasingly coming to terms with "lower for longer." They're increasingly realizing their economic models will have to be adapted or scrapped in order to be relevant to a brave new world they're gradually discovering.  This is probably the most fascinating shift in thinking at the Fed that we've seen.  I think the reason it didn't hit financial markets yesterday (except maybe the boost for stocks), is that it still feels so far away or so improbable to many of the markets' older dogs. 

Additionally, it really doesn't do us much good in the short term except inasmuch as it promotes dreaming and perhaps helps us keep short term pain in perspective.  In other words, rates very well could rise in the short term.  They could even still be higher 2-3 years from now.  But ultimately, I have been saying/thinking that there's some very bright light at the end of that tunnel, and now the Fed is starting to see it as well.