Soft Landing In Sight?

I was pulled away by jury duty this week, so postings have been light. Still, a couple of points to note. First, I am very, very glad that I did not go all recessionista on the back of that rise in initial unemployment claims at the end of last year. That indicator has turned around, and turned around hard:

So once again we are back to the story that if you are looking for signs of recession in the initial claims data, you are looking in the wrong place. Likewise for consumer spending. Retail sales perked up in March while previous months were revised higher:

Looks like the real story is not about impending recession, but a less-worrisome deceleration. Industrial production is a bit off:

Manufacturing may again be the odd man out in an otherwise solid economy. This has the feeling of 2015-16, though less severe.

The data has a soft-landing feeling, which I discussed in my Bloomberg Opinion article this week:

The Federal Reserve seems to be achieving the fabled soft landing. With growth likely to transition down toward the longer-term trend in 2019, expect monetary policy to remain on hold for the foreseeable future. If the Fed were to move, the odds still favor an interest rate cut over an increase. We are likely at the peak of this rate hiking cycle.

With regards to the policy outlook, the Fed appears to be setting the stage to pursue a dovish policy stance going forward. I discussed that in the above article, and Bloomberg’s Rich Miller and Craig Torres explore this theme as well:

Federal Reserve Chairman Jerome Powell and his colleagues have made an important shift in their strategy for dealing with inflation in a prelude to what could be a more radical change next year.

The central bank has backed off the interest-rate hikes it had been delivering to avoid a potentially dangerous rise in inflation that economic theory says could result from the hot jobs market. Instead, Powell & Co. have put policy on hold until sub-par inflation rises convincingly.

I have been puzzling on this issue this week. I think the conclusion that the Fed wants to see more conclusive evidence of inflation before hiking is correct. That’s the way the Fed is moving. That said, I fear they may be inadvertently setting a trap for market participants. It’s that nasty time-consistency policy problem bouncing around in the back of my head. I am not confident that what they will ultimately think is convincing evidence of inflation’s return will actually be convincing evidence of inflation’s return. Teaser alert: I am working on a longer note on this issue, which should be complete early next week.

A Hint of Weakness in the Employment Report?

The employment report came in above expectations, rebounding from an upwardly-revised but still weak February payrolls gain of 33k to a solid 196k in March. In short, the American jobs machine continues to roll forward:

That kind of strength will leave the Fed felling confident that they do not need to cut rates in the near-term. Moreover, the continued stability of the unemployment rate means they don’t have to hike rates either.

Hence, their strategy of remaining patient still holds.

On a monthly basis, wage growth pulled back, but on an annualized basis is holding in the range of 3 to 3.5%:

That translates into real wage growth hovering around 1 to 1.5%, assuming 2% inflation, right about the range experienced just before the recession:

On the surface, this is another “Goldilocks” report – strong job growth, low and steady unemployment and nothing in the wage data to support inflation concerns. A hint of weakness, however, is visible in the temporary help numbers:

The slowdown in temporary help hiring is consistent with other periods of decelerating growth, most recently the 2015-16 episode. To be sure, it could arguably also be a precursor to recession, but I think the current environment is still best described as “slowdown not recession.” That certainly is the story from the most recent initial unemployment claims report:

Nothing there yet to suggest that a deeper slowdown of activity is underway. That said, I have been a long supporter of temporary help employment as a leading indicator, and I would be remiss in my analysis if I didn’t identify it as something to keep an eye on. One can also look toward softness over the part two months in manufacturing and retail trade as signs that activity is slowing underneath the surface of the numbers.

Bottom Line: The employment report gives little reason for the Fed to exit its “patient” policy stance. Keep an eye on the temporary employment numbers. It’s a leading indicator in the report; recent declines are notable.

Assault on the Fed Continues

The Federal Reserve’s independence is under attack. I think this was inevitable once the Fed made it clear they intended a monetary offset against Trump’s fiscal stimulus. Now it is the reality. Can this genie be put back into the bottle? I am not particularly confident it ends here. If President Trump is successful at packing the Fed with political partisans, there may be nothing to stop the next president from doing the same.

If the potential nomination of Stephen Moore wasn’t bad enough, now we have to contend with the potential nomination of former presidential candidate Herman Cain. Cain is yet another candidate who appeals to the hawkish elements of the right wing. This short summary from Bloomberg is all you need to know:

He advocated for the U.S. to return to the gold standard during his presidential campaign and as recently as December 2017 defended higher interest rates, a position that contrasts with Trump’s repeated criticisms of the Fed last year.

Of course, Cain’s hard money advocacy will likely prove to be like Moore’s, simply a politically play to capture far right wing voters:

Trump’s recent nominees reflect his displeasure of the Fed’s rate hike campaign. That displeasure reached a peak in December as the Fed continued hiking rates while markets were tumbling. Since then the Fed has backed away from future rate hikes and in the process helping (hopefully) to keep the expansion alive. The political damage, however, was already done. Trump won’t trust the Fed going forward, nor will he trust those who gave him the names of those the Fed governors he already appointed.

For what it’s worth, the Fed itself shares some of the blame for this mess. The December rate hike aside, the Fed needs to come to grips with the reality that they have been fighting an inflation ghost for years. They haven’t treated their 2% target as a symmetric objective, but as a ceiling. Any central bank that fails to follow through on their mandate will come under fire eventually.

To be sure, perhaps neither Moore nor Cain make it through the Senate. Senator Mitt Romney, for example, appeared less than thrilled about the idea. That, however, doesn’t mean the institution walks away unscathed. The idea that Fed governors should be political partisans is now out in the open. Would a President Sanders follow Trump’s lead? Maybe those don’t get through the Senate as well, but then the Fed continues to operate with less than a full allotment of governors. That then shifts more power to the regional presidents, which changes the nature of the institution as well.

Of course, the ultimate concern is that the Fed shifts from a technocratic institution to a purely political one. One possible outcome is that the net result is a Fed that invites a repeat of the 1970s through excessively easy policy. Another is a Fed that works to ensure the dominance of one political party. Would Moore or Cain suddenly turn hawkish again if a Democrat were in the White House? 

Bottom Line: Maybe if the Fed fends off these assaults and the process reverts to credible, technocratic nominees, the Fed can walk away a stronger, more independent institution. Right now though I am not feeling so hopeful. That said, these are more long- than near-term concerns.

Employment Report On The Way

What data breaks the Fed out of its current “patient” stance? Given the persistence of low inflation, it appears to me most likely that the next move is down. Fed officials, however, are resisting any such moves just yet, requiring instead that the data break at least gently to the downside in the months ahead. And so we wait as the data rolls in.

The ISM nonmanufacturing report came in a little lower in March compared to the previous month, but I am not seeing any fundamental shift in the underlying pace of activity. Looks instead like typical noise in the series:

Softness was more evident in the 2015-16 slowdown than today. Good news for the economy; bad news for the recessionistas.

More interesting was the ADP employment report. That came in on the soft side with a 129k gain in private sector employees. Incorporating that information drags down my forecast to a 150k gain in March:

This forecast is on the soft side of consensus, which is currently expecting a rebound in job growth t0 170k with a 3.8% unemployment rate and a 0.2% wage gain. Given the noise in this data, the Fed would likely see little difference in any number in the mid-100’s. The Fed would probably view anything in that sort of range as consistent with relatively stable unemployment and continued upward pressure on wages. A good place to remain patient.

More interesting would something on either side of the mid-100s. If job growth came in closer to 100k or so, the Fed would start to get a bit nervous that maybe the February weakness wasn’t the one-off they believe it was. Any anxiety would step up a notch if the unemployment rate edged higher as well. That kind of pattern, if sustained for the next few months would likely prompt Powell & Co. to more seriously consider lower rates mid-year.

That said, betting against this job market hasn’t worked out very well yet. If we see job growth sticking closer to 200k a month, central bankers will start to think that they maybe became a little too dovish in March.

Bottom Line: We are stuck in a waiting game for the moment while we try to assess the degree to which the US economy is slowing. 

There Will Be A Recession At Some Point, But It Won’t Be Soon

Incoming data reveals that the recessionistas were again too early with their warnings in the waning days of 2018. Initial unemployment claims have leveled out:

New home sales have rebounded:

Manufacturing is keeping it together:

On the soft side though consumer spending looks weak:

Should we worry about consumer spending? I think it will slow this year relative to last, but I would not anticipate a sustained and substantial downturn absent a sharp deterioration of the job market. We get the employment numbers at the end of this week; the initial claims numbers have yet to give us much to worry about.

So are we out of the woods as far as a recession is concerned? For what it’s worth, the case of an imminent recession was never very strong and still isn’t despite the recent yield curve inversion. It is always forgotten that the yield curve is a very long leading indicator; an inversion might happen a year or even two ahead of a recession. Hence, what you should expect for some time after an inversion is that incoming data remains consistent with steady if not solid economic growth.

Nor does the inversion itself guarantee recession. My view is that the Fed still has time to prevent a recession even after an inversion (the worst risk is that the Fed keeps hiking after inversion) and the Fed has gone a long way toward holding the expansion together by shifting to a more dovish stance in recent months. I still believe, however, that they still need to be wary about a recession and be prepared to cut rates ahead of a downturn in the data – see my Bloomberg Opinion piece today. That takes something of a leap of faith on the part of policymakers, a leap of faith they are not always willing to take.

Bottom Line: Recession calls were again too early. The economy retains momentum into 2019 even if the pace of growth eases as expected. The Fed’s dovish shift should greatly increase the probability that the expansion continues. More easing may still be needed. 

Fed Needs to Get With The Program

Where to begin?

Probably best to first step back to last week’s FOMC meeting. That event concluded with the scene of Powell & Co. running backwards as fast as is possible for central bankers to try to correct the error of the December rate hike. As expected, the Fed downgraded their assessment of the economy and held rates steady. Less expected was the sharp downward revision to the dot plot with now eleven of the seventeen participants anticipating no rate hikes in 2019. The median expectation is for another hike in 2020 and then that’s it for this cycle. Note the median rate path doesn’t even get rates up to neutral. In other words, the Fed no longer thinks containing inflation requires restrictive policy.

That last point resonates as a substantial change to the outlook. The Fed’s models typically don’t work that way. That call for restrictive policy comes from the need to push unemployment to its natural rate to contain inflationary pressures. Those inflationary pressures have apparently disappeared now that the rate forecast has flattened out despite unemployment remaining below its natural rate.

What’s going on here? The persistence of low inflation has finally become too much for the Fed to dismiss, especially now with the economy decelerating. They can’t justify it anymore as a transitory phenomenon so it must be attributable to excessively high estimates of the natural rate of unemployment (which came down again to a now 4.3%) or, more worrisomely, eroding inflation expectations. Powell emphasized inflation concerns in the press conference and acknowledged that the Fed had not met the symmetric inflation target in any convincing way. That’s something of an understatement; if anything, Fed policy has very clearly treated 2% as a ceiling in the actual application of policy.

This from Powell’s press conference is particularly telling:

It’s a major challenge. It’s one of the major challenges of our time, really, to have inflation, you know, downward pressure on inflation let’s say. It gives central banks less room to, you know, to respond to downturns, right. So, if inflation expectations are below two percent, they’re always going to be pulling inflation down, and we’re going to be paddling upstream and trying to, you know, keep inflation at two percent, which gives us some room to cut, you know, when it’s time to cut rates when the economy weakens. And, you know, that’s something that central banks face all over the world, and we certainly face that problem too. It’s one of the, one of the things we’re looking into is part of our strategic monetary policy review this year. The proximity to the zero lower bound calls for more creative thinking about ways we can, you know, uphold the credibility of our inflation target, and you know, we’re openminded about ways we can do that.

I see two big points here. The first is that the Fed suddenly remembered that policy rates remain mired near the zero lower bound. They seemed to forget this point over the last year, too excited by the prospect of raising rates to remember that even at the projected end of rate hikes they would lack the room to mount a traditional response to a full-blown recession. The second point is that fading inflation expectations mean a.) they are “paddling upstream” to hold inflation higher and b.) they have “room to cut” when the economy weakens. My interpretation of this new inflation realization is that the Fed has a fairly low bar for a rate cut; see my latest for Bloomberg Opinion.

Since that meeting, the yield curve continues to flatten and invert with the 10s3mo spread going negative last Friday. An inverted yield curve is a well-known recession indicator. As a market participant, you have a choice. Either embrace that relationship in your analysis or reject it on the basis that any signals from the term structure are hopelessly hidden by the massive injections of global quantitative easing over the last decade.

I am going to error on the side of caution and choose the former. Everyone has their pet recession indicator; many are probability models based on some combination of yield spreads and other leading indicators. Most will be raising red flags like this estimate of the probability of recession in six months based on the 10s2s and 10s3mo spreads and initial unemployment claims:

To be sure, the longer into the future, the fuzzier the forecast. If I add in temporary employment claims and narrow the forecast horizon to three months, I get:

In either case I get the same takeaway: The risk of recession has risen to levels that demand attention from the Federal Reserve. In the two cases of similar spikes in the 1990s, a recession was avoided by the rapid response of the Fed in the form of rate cuts. The times that response was lacking, a recession followed.

So now I switch from analyst to commentator: The above leads me to the conclusion that the Fed needs to get with the program and cut rates sooner than later if they want to extend this expansion. Given inflation weakness and proximity to the lower bound, the Fed should error on the side of caution and cut rates now. Take out the insurance policy. It’s cheap. There will be plenty of opportunity to tighten the economy into recession should inflation emerge down the road.

What would delay that rate cut? Data. A yield curve inversion is a long leading indicator. Sure, the data is softer. But soft enough to cut rates? Not necessarily from the Fed’s perspective. Moreover, cutting rates now means admitting the December rate hike was an obvious error. The Fed hates admitting error.

Speaking of errors, the December rate hike is turning into one for the books. Not just on the economic side, but also the political side. I can already hear the howls of the monetary policy community shouting me down with claims of Federal Reserve independence and how nothing has changed in the past two years and that of course the Fed will walk away from the Trump years unscathed. I think that hypothesis is a.) completely wrong and b.) already proven to be completely wrong.

Monetary policy independence is not a law of nature. There is no special 11thcommandment “Thou shalt not interfere with the central bank.” Independence only exists so long as a.) it is an established and followed norm and b.) the central bank continues to deliver results.

The second part is straightforward. The Fed hasn’t delivered on inflation as Powell admitted last week, which by itself is a problem. That problem would be compounded by delivering a recession in an effort to fight a nonexistent inflation problem. You want to stay independent, you have to do your job. After years of watching the Bank of Japan, you would think the Fed had picked up a thing or two on this topic.

On the first part, President Trump shattered the norms last year when he began haranguing the Fed. That didn’t work, or perhaps it even backfired. The Fed would never admit it, but it is hard not to conclude that one factor behind the December rate hike was a perceived need to establish independence. If so, that was a clear case of cutting off your nose to spite your face. On the economic side, there was no cost to taking a pass and coming back to the topic six weeks later. This would have had the political benefit of giving Trump what he wanted. Two birds with one stone, as they say.

Consider the current situation. The Fed is likely to be cutting rates anyways. And now the unimaginable has happened: Stephen Moore is nominated to a spot on the Federal Reserve Board. 

I don’t think I need to go into the history here, but if you are new to the game you can check out this by Jonathon Chait and this by Noah Smith. We might as well nominate my cat for that other open spot. And remember the Herman Cain thing? Two years ago, these people wouldn’t have been on the table. Now they are.

You might reasonably say that Moore won’t make it through vetting and the Senate. That’s kind of beside the point. The real issue is the openness with which this administration is willing to place a political operative into the Federal Reserve. Just like any other agency. You should also see it as a blow to Powell’s influence. I suspect that Powell initially had considerable say over the choice of governors. That is how you can explain the nomination of Nellie Liang who, qualified as she is, couldn’t make it out of committee. Now, does anyone think that Powell signed off on Moore? Anyone? Bueller?

My guess is that what happened here is Trump has torn up any agreement he had with Powell to allow the latter to decide on appointments to the Board. And Trump isn’t going to trust Mnuchin, who gave him Powell. So now Trump is going to do what Trump does, and that means nominating people he knows are “his guys.” And once the norms are shattered, can they be rebuilt? What will the next president do?

The game has changed on many fronts, but I am thinking the raw application of political influence is blindsiding the Fed. They should have seen this coming, but I suspect they were too shielded by the central banking community to see it coming.

Bottom Line: I am going to break this into three parts, all market relevant in various ways. First, what I think the Fed is going to do. They are scrambling to recover from the December rate hike and that scramble leaves the Fed positioned to cut rates. Second, what I think they should do. They should cut rates sooner than later; the cost of insurance is low. Third, what I think about the political climate and the Fed. The political climate has changed, and the Fed needs to change with it; don’t buy into the story that the Fed is independent and will walk away from this as the only agency smelling like roses. The failure to adapt is already having consequences, most obviously in who is now considered qualified to lead the central bank.

“Patience” To Make Its Way Into the SEP

Fed policymakers from around the nation once again descend upon Washington D.C. to ponder the path of monetary policy as the economy eases down from the fiscal-stimulus boosted pace of 2018 to something more consistent with what the Fed believes to be sustainable growth. The expectation is that the Fed will leave policy rates unchanged and will reiterate their intention to remain “patient” while awaiting the data that will guide their next move. Still, there will be plenty of excitement even if rates hold steady. More important will be the new set of forecasts, which will likely shift to reflect the “patient” stance adopted at the January FOMC meeting. In addition, I anticipate the Fed will announce a plan to wind down the balance sheet runoff.

Incoming data generally continues to support the Fed’s plans to hold rates steady. In my eyes, there are clear signs the economy continued to slow in the first quarter but the pace of the deceleration remains inconsistent with recession.  New orders for core-durable goods, for example, edged higher:

The gains did little to reverse the recent declines, but given the experience of the past two recessions, we would have expected a much sharper decline if the economy was decelerating rapidly. The same can be said for industrial production, which slid during in January and gained only a touch in February. The pace over the past year has decelerated:

In addition, the number of sectors contracting rose higher as would be expected in a slowing economy. Remember though that during a recession, typically the declines in industrial production are deeper and the dispersion across sectors is greater. We also should not ignore the lesson of 2015-16, during which a manufacturing shock remained fairly well contained. In short, the numbers again suggests softening, not recession.

Core retail sales rebounded from the dreary December number (again, as expected in a still growing economy):

My expectation at this point is that when the recent volatility passes, retail sales stabilize closer to the 2015-16 pace than the 2017-18 pace.

Initial unemployment claims edged down last week:

Here again, the modest rise in claims and widening of deterioration across states is consistent with a slowing economy, but the overall pace of worsening still remains short of recessionary.

Soft inflation numbers certainly caught the Fed’s attention:

I suspect the above data will support a downgrade in the median growth forecast for 2019 to something closer to 2%, close to the median longer run forecast of 1.9%. That would mean the economy would fall to its sustainable growth rate about a year ahead of what the Fed expected in December.

With growth downshifting, inflation soft, and rising concerns about deteriorating inflation expectations, the Fed has the opportunity to sharply pull down the expected path of rate hike and wipe out the two 2019 rate hikes expected at the December meeting.  This would be consistent with recent communications and I suspect that the Fed would not want to whipsaw markets with a set of projections that was markedly different from what the mantra of “patience” they have been chanting all up and down Wall Street and Main Street.

A shift downward in the dots is the expectation; the risk is that the gap between longer run unemployment and forecasted unemployment remains wide enough to keep a sufficiently large subset of FOMC participants thinking that they still need to snug rates higher that the median dot calls for another hike this year. More interesting to me, however, is the possibility that at least one dot anticipates a rate cut in 2019. I would not be surprised if one FOMC participant thought a slowing economy with already soft inflation numbers would more likely that not justify a rate cut by the end of the year.

Bottom Line: I expect the Fed will revise their projections to reflect the dramatically more dovish tone taken since the ill-fated December rate hike. Such a move also appears consistent with incoming data. Moreover, Fed speakers have given little reason to believe that market participants have taken an overly dovish view of policy. Altogether, that means the dots will reveal a marked downshift in the expected path of rate hikes. If we don’t see that, we will be pondering the cause of yet another communications divide between central bankers and market participants.

Payroll Growth Retreats

As expected, the broad trends in January’s employment report reversed in February. That said, growth in Nonfarm payrolls was a meager 20k. Per usual, you need to make a choice. Did you think the 300k+ number in January represented the true trend? Do you think the 20k February number represents the true trend? Or was February more likely just the occasional pothole that happens? I lean in the latter direction; I suspect the Fed will as well.

Nonfarm payrolls were revised up for the previous two months by 12k, but that was  cold comfort given the weak gains of February:

To be sure, “cold” likely contributed to the February softness. The three-month moving average is 186k, which is probably a lot closer to reality than the either the January or February numbers. Importantly, the leading indicator in the employment report of temporary help remains on a general uptrend:

This has been a good leading indicator in the past two cycles and I have no reason to think it won’t be again. My short story is to analyze the headline payroll number in context of the overall data flow. If temp helps was rolling over, if the ADP number was equally soft, if consumer confidence were plunging, I would be more concerned about the soft employment gain.

The unemployment rate pulled back to 3.8%. A decrease was expected due to the end of the federal shutdown. Less expected was the slowdown in labor force growth:

Solid labor force growth over the past year helped stabilize the unemployment rate and supported the hypothesis that the economy was not overheating. A sustained slowdown in labor force growth in the context of still upward pressure on labor demand would call that hypothesis into question. That said, one month does not make a trend.

Wage growth accelerated as expected:

The twelve-month change was at a cycle high of 3.4%. A solid number but not one that would rattle the Fed. They are most likely to see it as consistent with productivity growth.

Separately, new starts for single family housing jumped in January, reversing the downtrend in the final months of last year:

A couple of factors are likely at play. Primarily, mortgages rates are down and the panic that reverberated through the economy late last year subsided. What does this tell us? That the underlying dynamics in housing are probably still in play – demographics are likely a drag to multifamily but support single family as the Millennial generations ages. I suspect the net impact will relegate housing to fairly neutral to small drag on GDP. This would be a continuation of recent trends. Housing has been a small drag on GDP in 6 of the last 7 quarters:

Bottom Line: Looking through the noise, the labor market most likely retains its Goldilocks aspects of solid job growth, low unemployment, and improving wage growth. Note that we should anticipate some slowing of growth over the next year is the economy slows as expected. Housing looks to remain on fairly stable ground but don’t expect miracles as the sector is not likely to provide a large boost to growth at this point in the cycle.