Looking Backward, Looking Forward

The game right now is all about tracking the magnitude of the expected slowdown in US economic activity as Federal Reserve policymakers lay down markers about what the outlook means for rate policy. San Francisco Federal Reserve President Mary Daly, for instance, said she is anticipating 2% growth this year, setting the stage for the Fed to stay on the sidelines until 2020. Via the Wall Street Journal:

“If the economy evolves as I just said I expect it to—2% growth, 1.9% inflation, no sense that [price pressures are] going up, no sense that we have any acceleration—then I think the case for a rate increase isn’t there”

The median forecast for longer-term economic growth in the Summary of Economic projections is 1.9%, so 2% growth is pretty much at trend hence no need for hikes absent any inflationary pressures. In contrast, Atlanta Federal Reserve President Raphael Bostic thinks the economy will support another rate hike in 2019 while Philadelphia Federal Reserve President Patrick Harker expects a rate hike in each of 2019 and 2020.

Although on net central bankers thus appear on average to hold neutral to ever so slightly hawkish expectations for rate hikes this year, I imagine at this point this risk is that the outlook could turn darker than officials anticipate and hence the Fed cuts rates before the end of the year. That likely requires the threat of below trend growth. The challenge of course is, as I explained last week, that it is very difficult to identify the extent of a slowdown early in the process.

For example, the industrial production report revealed a sharp decline, placing it at odds with the most recent ISM report (although the situation was reversed in December). The magnitude was non-trivial, but we would be looking for a string of weakness similar to that of 2015-6 to become very concerned that the economy was slowing to something below trend:

The impact was largely attributable to manufacturing:

Which in turn was driven in large part by weakness in the automative sector:

Truck assemblies have been all over the place this year so I am wary of concluding that the industry is at the front end of a 2008 kind of slide. That said, it seems likely that auto sales have peaked for the cycle and are likely to move sideways to modestly down going forward. That though differs from recessionary dynamics. Overall, industrial production still looks solid compared to last year:

A typically good recession indicator, initial unemployment claims, has also been all over the map in recent weeks but still track at very low levels:

The dispersion of claims has picked up a bit, similar to that seen in 2015-16. That should make us a bit cautious about over-interpreting this signal as here again we need to be careful. Initial claims can provide a false recession signal:

A familiar story – the data is moving as one might expect with the economy slowing but as in the past, this is not yet different than other slowdowns that did not evolve into recessions.

Coming up this week we get a few bits of data to chew on. Wednesday the Fed releases the minutes of the January FOMC meeting. Of particular interest will be the discussion on the balance sheet. Last week Federal Reserve Governor Lael Brainard said that she favors ending the balance sheet reduction later this year; my suspicion is that she will find support among her colleagues and that it won’t be long before the Fed signals more clearly that they are getting close to ending quantitative tightening. Thursday promises a flurry of activity with durable goods, Philly Fed, Markit manufacturing and services, initial unemployment claims, and existing home sales set for release. Friday should be fun with Randal Quarles, John Williams, Mary Daly, James Bullard, and Patrick Harker all participating in the University of Chicago 2019 US Monetary Policy Forum. The conference begins with the report Prospects for Inflation with a High-Pressure Economy, which sadly is a topic that may have been overtaken by recent events.

Bottom Line: The economy is set to slow in 2019 and such an outlook is supported by early indicators. Slowing is not recession. While officials have said the next move could be up or down, I tend to think the median FOMC member would still believe flat to up more likely. That said,  I think flat to cut is more likely; the events of December appear to have been a wake up call for central bankers who had fallen too far into love with the idea of hiking rates deeper into the range of estimates of neutral. That change on the part of the Fed will likely prove critical to sustaining the expansion. 

Consumer Sentiment and the Totality of Data

If you were still worried about the weak December retail sales numbers, the rebound in consumer sentiment in February should help ease your mind.

Recall that last week I questioned the relevancy of the retail sales decline given the magnitude of the decline is recessionary in nature and the economy was clearly not in recession in December. If in recession, the jobs numbers would have fallen off a cliff.

What about data besides the employment report? Consumer spending had declined sharply in January before partially rebounding in February. Is there a story here?

First off, the January decline was greater than one standard deviation, but that is not an uncommon event even outside of recessions:

There is still a well known relationship between consumer sentiment and spending that we should acknowledge:

On quick visual inspection, the decline in January, especially coupled with the February rebound, don’t suggest much reason for concern about consumer spending. That said, the two-axis graph is anathema to respectable economic and financial analysis as it can be manipulated to suggest stronger relationships than actually exist. I find it preferable to at a bare minimum convert the graph to a scatter plot and add the results of a liner regression:

The implication in this chart is that the surge in confidence after Trump’s election did not translate into a surge of consumer spending; spending had persistently fallen short of what would have been expected given the confidence numbers. Spending should be higher if the boost in confidence reflected real improvement in household financial conditions associated with Trump’s election. Consequently, the January decline by itself was also likely not meaningful for the underlying pace of spending.

This regression, however, isn’t really my favorite; the two-axis, two-variable format limits the analysis. At a minimum, we can add a lag of spending to the regression (the resulting three-variable equation though doesn’t fit neatly on a scatter plot, hence I dropped the fitted line):

Now the predicted values dragged up modestly (to the top of the pink dots) by the high levels of confidence but still hold fairly constant due to the persistent impact of the lagged spending variable.

In reality, the December spending number is likely to be depressed below these forecasts, an artifact of the weak retail sales report. Still, the fact that consumer sentiment has not fallen off a cliff in December or thereafter suggests that this is a short term impact. At the same time, note that consumer sentiment is probably overstating the strength of actually spending, so even a decline in sentiment would have to be quite significant to be consistent with deteriorating household spending. That kind of situation is typically associated with substantial deterioration in the jobs market, which so far has not occurred.

Bottom Line: Consumer sentiment is another variable indicating that near term recession concerns are misplaced. The decline in January’s sentiment itself wasn’t reason for concern, and the rebound in February backs this up. Also, if your favorite pundit has a penchant for two-axis charts, request at a minimum conversion to a scatterplot with a regression. 

Beware of a Recessionary Bias Among Analysts

With the economy widely expected to slow in 2019, we should anticipate softer data in the months ahead. Softer data forces us to think hard about the possibility of recession simply because we don’t know how soft the data will become. Every recession begins with a softening of the data, but so too does every weak patch in the economy. Each weak piece of data that comes through the door needs to be eyed suspiciously for signs of recession. At the same time, however, we need to ensure that the expected slowdown itself is not biasing that analysis. It is important to remember to assess the totality of the data, not just the bits and pieces we want to see.

Today is a good day to think about these issues considering the exceptionally weak retail sales report for December:

Shocking though it might be, can you really take this result at face value? To be sure, if you have a pessimistic bias, you will jump all over such a number as signs that a recession is at hand if not already underway. Consider though that the decline in retail sales was at the same pace as during the depths of the Great Recession. Now ask yourself, do you really believe the economy sank into another Great Recession in December?

Think of the magnitude of job losses experienced 2008 compared to the most recent months:

Consumers simply are not going to make a massive retrenchment of spending as seen in December on a sustained basis absent a substantial collapse in jobs. And that collapse didn’t happen in December. If anything, the JOLTS report was a reminder on the strength of the job market:

Moreover, as we all know, a job collapse didn’t happen in January. Nor is the leading indication of temporary employment signaling a slowdown in job growth is upon us:

It’s simply fair unrealistic to think that we should take the December retail sales report at face value. As long as there is job growth, there will be spending growth.

I would also caution against this type of analysis:

You can’t analyze the decline in restaurant sales in the absence of the unusual burst of sales midyear:

It’s fairly evident the data is reverting to trend after an unusual bounce. Moreover, the National Restaurant Association found “positive sales and traffic levels” in December (hat tip to Bloomberg’s Matt Boesler).  That midyear acceleration isn’t in their surveys either. A reminder that we need to look toward understanding the totality of the data rather than just the bits and pieces. What fits and what doesn’t?

As for the claim that restaurant sales are a leading indicator, well look at the long series:

Doesn’t even look like sales took much of a hit in the 2001 recession so you would have missed that episode with this signal. Also, sales look more like a coincident to a lagging indicator in the 2007-09 recession than a leading indicator.

Bottom Line: The anticipated economic slowdown in the months ahead will make for some interesting analysis as it will be easy to see a recession in every soft indicator. It is much more difficult to weigh the totality of the data flow, both good and bad. We should see an increase in “bad” data as the economy slows. Otherwise, the economy wouldn’t be slowing! We should also be careful to acknowledge our internal biases when making that that analysis. If you are a regular reader, you know I don’t traffic in fear and anger (particularly anger about monetary policy). I am not going to be the one calling for recession at every drop of the hat hoping to be right once every decade. My bias is pretty clear. Growth is the norm, recession is the rarity, deep recessions like the most recent even more rare. 

Fed to Markets: Economy is Solid, Rates on Hold

The Fed is out of the picture through at least the first half of this year as central bankers work to understand the path of economic activity going forward. Of course, we will all be doing the same. As it currently stands, there is a widespread expectation that grow slows in 2019. The ultimate degree of slowing, however, remains the key question. Enough to keep the Fed from thinking they need to snug up policy a little tighter? Or enough to prompt a rate cut? Still unknown, but with inflation failing to live up to expectations it does seem that the Fed has a fairly high bar to a rate hike and a low bar to a cut.

In general, policymakers remain upbeat on the economy. Federal Reserve Chairman Jerome Powell views the economy as in a “good place” with both low unemployment and low inflation. St. Louis Federal Reserve President James Bullard believes the Fed is now set up for “very good couple of years.” Dallas Federal Reserve President Robert Kaplan said he believes:

…it would be prudent for the Fed to exercise patience and refrain from taking further action on the federal funds rate until the economic outlook becomes somewhat clearer. I expect we will get some further clarity during the first half of 2019…the Fed has the luxury of being patient over the next several months.

Vice Chair Randal Quarles also sees the outlook and solid, and notes that he will be closely watching global risks over the “next six months.” Cleveland Federal Reserve President Loretta Mester thinks that monetary policy is just about right and “does not appear to be far behind or far ahead of the curve.” Still, Mester remains a tad hawkish and expects rates to move a bit higher if her forecast holds.

The takeaway is that the Fed is sending a very coordinated message that they are on hold through the first half of the year. Now that policy rates are near the estimates of neutral while inflation remains unexpectedly low, central bankers are content to slow down and review their handiwork.There is no pressing reason to raise rates given the external threats of slowing growth, Brexit, and trade policy challenges and the internal threats of Trumpian policy uncertainty, fading fiscal stimulus, and impact of past interest rate hikes. Better to sit back and wait to see how it all plays out before taking further action.

To be sure, the past few months feel very much like the late-2015, early-2016 period. In December of 2015 the Fed pushed forward with the first rate hike of the cycle despite lack of inflation, turbulent financial markets, and slowing growth. Ultimately, the decision to hike rates at that point appeared more model dependent than data dependent. The December 2018 rate hike had the same feel. But in 2016 the Fed was forced to accept reality and, like now, pushed by the incoming inflation to quickly put additional rate hikes on hold.

Like then, the decision to sharply shift gears could be key factor is sustaining this expansion. I have said that the December 2018 rate hike was an error, but a recoverable error. The Fed’s dovish shift reinforces my view that the error is likely recoverable. Like 2015-2016, fears of recession are growing. Paul Krugman frets about recession in this interview with Bloomberg. I agree with Krugman on this point:

The headwinds facing the economy prompted the Federal Reserve this month to halt its interest-rate hiking cycle, which Krugman said was never “grounded in the data” to begin with. “Continuing to raise rates was really looking like a bad idea,” he added.

Krugman sees “better than even” odds of a recession in the next two year, saying that “[t]here seems to be an accumulation of smaller problems and the underlying backdrop is that we have no good policy response.” Krugman notes that the Fed doesn’t have much room to cut rates and he doubts that the White House has the leadership capacity to mount a fiscal crisis.

On the second point, I agree that the leadership is lacking. That said, I suspect that Trump and the Republicans would have a huge incentive to use fiscal policy to prevent a 2020 recession.

On the first point, yes, the Fed lacks the normal degree of maneuverability in its interest rate tool to respond to a full-blown recession. What I think is forgotten is that the Fed has now 225 basis points of room to prevent a recession, and that is not trivial. The Fed responded to the Asian Financial Crisis with 75bp. It also responded to the 1995 slowdown with 75bp. The key is a willingness to act before a recession gets underway, and low inflation creates a willingness to act.

Separately, San Francisco Federal Reserve President said that discussions were underway use the balance sheet as a more regular policy tool. Via Bloomberg:

“You could imagine executing policy with your interest rate as your primary tool, and the balance sheet as a secondary tool, but one that you would use more readily,” Daly said. “That’s not decided yet.”

This compares to the most recent statement on policy normalization:

The Committee continues to view changes in the target range for the federal funds rate as its primary means of adjusting the stance of monetary policy. The Committee is prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments. Moreover, the Committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.

The normalization statement implies that as of now, the expectation is that the balance sheet is a tool to be used when interest rate policy is by itself not enough to ease financial conditions. Presumably, that would occur when the economy has returned to the zero-lower bound. Daly offers up the possibility that the balance sheet could be used on a more regular basis.

Daly’s statements open a number of questions, the first of which jumps to mind is that if this is true, then is the current reduction of the balance sheet contractionary as many market participants believe? Is it really neutral as the Fed believes when Daly is signaling that the balance sheet could be used as a secondary tool? If that’s the case, then the Fed believes they are indeed still reducing financial accommodation by reducing the balance sheet, but just want you to believe something else.

My next question is what would be the objective of using the balance sheet? To influence the slope of the yield curve while pegging the near end? Does that mean regularly altering the mix of assets to influence the yield curve? Couldn’t this be done via signaling about the path of interest rates? Is the balance sheet about target specific aspects of the money markets? What aspects? Why do this outside of a crisis?

More questions: What is the transmission mechanism from the balance sheet to the economy? Is this mechanism different in a boom? A bust? Does the Fed believe they can fine tune the economy via balance sheet manipulation? That seems to be a leap for me; it’s not clear they can fine tune the economy with rates.

You see the point. The genie is out of the bottle; quantitative easing is a thing and it is not going away. Using it as even a secondary tool outside of the zero bound, however, raises lots and lots of questions. Hence I would be wary about reading too much into these conversations just yet. Many details need to be worked out to bring quantitative easing into regular play outside of the zero-bound.

Bottom Line: With policy rates near neutral, low inflation, and questions swirling around the economic outlook, the Fed is content to take a pause through at least midyear before changing rate policy. If the Fed were to move before midyear, I suspect that it would only happen in response to negative news that forced a rate cut. I believe the likely willingness of the Fed to cut rates should the outlook sour limits the odds that they economy slips into a recession; I would be more worried if inflationary concerns kept the Fed focused on rate hikes. While we wait for new information on the path of rates, the Fed will be updating its balance sheet policy. The next step in the process will be a slowing of the balance sheet run off with the expectation that at some point the balance sheet hangs in the background during normal times and is manipulated only as needed to support rate policy. It might be too early to speculate on the use of the balance sheet as an active tool during normal times; lots of messy questions there.

The Fed ‘Put’ Applies to Both the Economy and Markets

The stock market isn’t the economy, but it is sufficiently connected with the economy that it can’t be ignored by the Federal Reserve. Eventually, central bankers must respond to protracted turmoil in financial markets. That means it will be very difficult – if not impossible – to differentiate between a “Fed put” on the economy versus on the stock market. Rather than complaining about the “Fed put,” market participants should embrace it – or at least not bet against it.

Continued at Bloomberg Opinion…


Incoming data give little reason for serious concern about the economy. The labor market held strong while manufacturing sentiment strengthened in January. The housing downtrend might be less than feared. And the Fed has taken rate hikes off the table for now and will break the quarterly rate hike cycle by taking a pass on a March hike. At this point, fears of recession seem overblown. While I expect the Fed to hold rates steady through at least mid-year, it is worth wondering if the economy in fact slows down sufficiently to keep the Fed in a dovish mood past March.

Nonfarm payroll growth came in well above expectations with a 304k gain for January. The twelve-month moving is at 240k and remains on an uptrend. Note though that the previous month’s original 300K+ gain was revised sharply lower, leaving me a bit wary that the January number will follow suit. That said, there is little doubt the economy continues to enjoy strong job growth as the expansion approaches a record length this summer, well beyond the point many anticipated the labor market would hit supply side constraints.

Indeed, the labor market appears to be easily meeting the demand for workers, with rising labor force participation and sufficient labor force growth to hold unemployment fairly steady over the past year. The unemployment rate rose to 4.0% compared to 4.1% last January, although this month the number was likely inflated somewhat due to the temporary government shut down. The rise in labor force participation among prime age workers is particularly encouraging. It appears that persistently low unemployment and faster wage growth has elicited a supply-side response from the labor market.

Wage growth took a breather after the acceleration in final two months of the year, annualize wage growth remains at 3.2% and near the pre-recession pace:

A combination of low unemployment, strong job growth, and firmer wage growth will help support consumer spending in the months ahead.

Temporary help payrolls, a forward-looking indicator, continue to rise, suggesting that the strong of job gains will continue in the months ahead. The pace of temp help growth, however, is fairly subdued. I think this has less to do with any weakness in the economy and more to do with a preference for permanent jobs. In other words, the availability of jobs may be pulling workers out of this sector.

In something of a surprise, the ISM manufacturing number partially rebounded from the weak December report. Notably, the new orders index bounced off the break-even point; it may be that pessimism emanating from turbulent financial markets weighed on confidence and hence orders during December. The gain speaks well for the strength of the economy as 2019 begins.

New home sales rebounded in November, gaining 16.9% with a bounce in new homes sold but not started. Sales prices fell, with the median price down 11.9% from last year. This suggests that the primary problem in housing was that the higher end of the market was finally sated and builders needed to move to a lower priced product to sustain sales. It also suggests that fears of a housing slowdown may be excessive. Still, with December pending sales down, the jury is still out on that topic. We will need a few more months of data to gain some clarity on the topic.

The Fed took itself out of the game last week with a particularly dovish shift at the conclusion of the January FOMC meeting; see my take here. I admit that I am a bit wary that the Fed has overshot. It is not in my nature to say the Fed is out of play when job growth is accelerating, but I find the case easier to make when unemployment is holding steady and inflation remains well behaved. That said, I wish we had more clarity on the magnitude of any shift in the dot-plot in January. Presumably, the dots shifted to make the possibility of rate cuts and hikes nearly equally likely. That, however, is typically not how the Fed’s models work if there has not been a major forecast revision (note that Federal Reserve Chairman Jerome Powell claimed the forecast did not shift substantially).

Moreover, I am made a bit nervous by Dallas Federal Reserve President Robert Kaplan claiming that rate hikes were on hold for “certainly at least the first couple of quarters.” To be sure, a pause through the first half of the year is my base case. But I am uncomfortable with Kaplan engaging in date-based forward guidance rather than data-based forward guidance. Has the FOMC committed to a pause through mid-year? Because that seems the only way the Kaplan can make such a promise. It’s those kinds of promises that come back to haunt the Fed. Does “patient” mean the next meeting, so just near-term forward guidance? Or does “patient” mean the next six months, so longer-term forward guidance?

Bottom Line: Strong job growth, rising wages, and low inflation is pretty much a Goldilocks economy. Moreover, the Fed moving to the sidelines improves the odds that this expansion continues through next year; low inflation is key to restraining any hawkish impulses that central bankers harbor when presented with persistently low unemployment. I am less worried about recession than the possibility the Fed has a change of heart sooner than I anticipate.

Setting The Doves Free

The Fed gave markets participants all they could really hope for at the conclusion of the first FOMC meeting of 2019. Notably, the Fed shifted their guidance from further rates increases to patience, enshrining the recent Fedspeak in the FOMC statement and making clear that they Fed was in no rush to change policy and the next policy shift could be up or down. And if that alone were not enough, the Fed announced that they would likely be winding down the balance sheet run-off sooner than expected. Federal Reserve Chairman Jerome Powell came prepared avoid the missteps of the December FOMC meeting and markets rewarded him with a solid rally in stocks and bonds.

Where to next? The Fed is not committed to any particular policy path and will react as needed as incoming data impacts the forecast. Still, this feels like we are near the top of the rate hike cycle assuming the economy slows as anticipated.  

Interestingly, the Fed’s basic outlook remains fairly optimistic as I expected:

Information received since the Federal Open Market Committee met in December indicates that the labor market has continued to strengthen and that economic activity has been rising at a solid rate. Job gains have been strong, on average, in recent months, and the unemployment rate has remained low. Household spending has continued to grow strongly, while growth of business fixed investment has moderated from its rapid pace earlier last year.

Powell reiterated this point in the opening comments to his press conference:

This change was not driven by a major shift in the baseline outlook for the economy.

That’s interesting in that it suggests that the Fed’s SEP forecasts were fairly unchanged, possibly including the dot plot of rate projections. Luckily, however, since the SEP was not released this time, the statement and Powell’s press conference could be dot plot free and hence, more dovish overall (the dot plot is inherently hawkish, and it’s going to be a mess in March if the dot plot projections have not come down).

If the forecast didn’t change, what did? A number of factors, kind of a “lions, tigers, and bears” situation: Slowing global growth, Brexit, the partial government shutdown in the US, trade policy, tighter financial conditions, and weaker inflation expectations. Basically everything that has been weighing on financial markets throughout the final quarter of 2018 finally caught up to the Fed and caused them to be less certain in their forecast for higher interest rates.

The assortment of fears induce central bankers to drop their assessment that risks were balanced. That said, Powell’s opening statement sounded as if the risks were balanced to the downside. Specifially: “…the cross-currents I mentioned suggest the risk of a less-favorable outlook. As a consequence, the Fed no longer judges that further tightening will be required and instead:

In light of global economic and financial developments and muted inflation pressures, the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate to support these outcomes.

“Patient” means that the Fed doesn’t need to commit to a decision on rates anytime soon. The Fed would argue that they have eliminated forward guidance; I would say the “patient” is forward guidance for the near term. A “patient” Fed isn’t going to return to the quarterly 25bp rate hikes at the March meeting.

In short, the statement was more dovish than I anticipated; I did not think they would want to take rate hikes off the table to this degree. I forgot that the Fed often turns their story later than I think they should, but when they turn, they turn quickly.

If that wasn’t enough, the Fed also updated their policy normalization guidance. They now expect to control short term interest rates via a floor system in a world with abundant reserves. The consequence of that decision is that the Fed believes they will maintain a larger than expected balance sheet, which in turn means the asset run-off will end sooner than expected. Powell took care to note that the balance sheet is not expected to be an active policy tool under normal economic conditions. The active policy tool is short-term interest rates. Still, many market participants were clamoring for the Fed to end the balance sheet run off sooner than expected. They got their wish.

As far as the future is concern, is this the end of the cycle? The bar for raising rates seems high now and apparently hinges on the inflation boogeyman to finally show his face. Powell said “I would want to see a need for further rate increases, and for me a big part of that would be inflation.” So they really need to see actual inflation, or very strong growth that pushes the unemployment rate substantially lower, to justify a rate hike. This appears much more stringent that the story implied by the last dot plot of interest rate projections.

To me, this sounds like the rate hike cycle is over – or largely over – as long as the economy eases as expected. The lack of inflation is keeping the Fed on the sideline now that rates are near their estimates of neutral. Going forward, the Fed may do some nips and tucks here and there to keep the economy stable which means that barring a sharp change in the outlook, we could be entering a period of fairly stable rate policy. I would add that a fairly flat yield curve suggests that market participants see the case for fairly stable policy as well.

Bottom Line: The Fed made a dovish shift, declaring that they are on the sidelines for the time being. Given that they seem to believe the downside risks are more prevalent, it is reasonable to think the bar to easing in the near term is much lower than the bar to hiking. Importantly, it looks to me that the Fed has shifted gears well ahead of any recession; then did not invert the 10-2 spread and then keep hiking as typically occurs ahead of a recession. A flexible Fed and the lack of inflation was always a saving grace for the economy. The Fed may have just pushed back the next recession. If so, expect everyone who expects an imminent recession to “blame the Fed” when that recession fails to emerge.

Fed Holding Steady For Now

The Federal Reserve will leave interest rates unchanged at the conclusion of this week’s FOMC meeting. Any excitement that the meeting might bring will be contained in the statement and the press conference. The balance sheet will be of particular interest to market participants. The Fed’s challenge on that front will be communicating that should they slow the pace of balance sheet reduction, they will do so for technical reasons rather than as a shift in their underlying policy stance.

There is no question that the Fed will hold rates steady this week. Central bankers have made this abundantly clear by repeatedly stating that the Fed can afford to be “patient” when considering future policy changes. Now that policy rates are near the lower bound of neutral, the Fed believes they can slow the pace of rate hikes as they assess the impact of past policy actions. Policy thus has shifted to a more data dependent mode.

The statement will be searched for signs of dovishness with a focus on the Fed’s description of the economy and any expectations for the path of policy in the months ahead. The data flow of course was crippled by the now-concluded government shutdown. That said, I suspect the Fed will retain a fairly optimistic view of the economy.

Recall that the month began with an unquestionably positive jobs report. Moreover, initial unemployment claims provide no reason to think the labor market cracked in the first month of the year. Claims dropped to 199k, the lowest level since 1969 and pulling the four-week moving average down to 215k:

I am old enough to remember the recessionistas claiming that the uptick in claims in the final weeks of 2018 was of dire concern. Good times.

Industrial production has a strong showing in December despite the drop in the earlier reported ISM manufacturing report:

That said, regional surveys have on average suggested some ongoing malaise in the manufacturing sector while the Markit PMI measure firmed in January. Something of a mixed bag but I suspect the Fed will place the more weight on the industrial production report rather than the survey data.

The consumer sector of the economy is likely holding up despite the government shutdown. Consumer confidence slipped, but in my opinion that number had been elevated relative to actual spending since it jumped in the wake of Trump’s election. While we don’t have updated retail sales data yet, Redbook retail sales held strong with a solid year-over-year gain of 6.7% in the last week’s release. Also, Neil Dutta of Renaissance Macro, using Google search data, estimates that retail sales growth accelerated in December.

Housing remains something of a red flag that bears continued watching. Existing home sales dipped in December, likely weighed down by high prices, an earlier rise in mortgage rates, and increased uncertainty related to the stock market turbulence. That said, I suspect that slower price appreciation will allow time for income growth to improve affordability. In addition, mortgage rates have pulled back from their highs. On net then I don’t think that housing enters a deep, sustained downtrend in the months ahead. At a very basic level the lack of a substantial upswing in construction activity after the bubble-related collapse last decade means that the potential downside to the sector is relatively limited.

I think the Fed will on net conclude that there exists reason to believe that the economy will slow in 2019 relative to 2018 but the degree of slowing remains uncertain and not clearly sufficient to relieve inflationary pressures. As such, I doubt that the Fed will drop its internal bias toward further tightening before 2019 ends. That bias is clearly evident externally in the Fed’s Summary of Economic Projections. It is also evident in the statement with this sentence:

The Committee judges that some further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term.

Will the Fed drop this sentence and end explicit forward guidance in the statement? I think the problem for the Fed is that dropping this language will be seen as a signal that the Fed is done raising rates for the cycle. In other words, lack of explicit forward guidance in the statement will be taken as explicit forward guidance nonetheless. I don’t think the Fed wants to send a signal that they are done hiking for the cycle and hence will need to retain some language that implies a tightening bias even if only implicitly. I also think the Fed is naïve to believe they can stop giving forward guidance. They can stop making promises about policy long into the future, but they will always find themselves providing at least near-term forward guidance.

Reporters will certainly pepper Federal Reserve Chairman Jerome Powell with questions about the Fed’s balance sheet. And just as certainly Powell will come more prepared for those questions compared to the December press conference. I suspect that he will have more clearly defined talking points on the topic. Indeed, I would anticipate a less “off-the-cuff” feeling in general for this presser.

The balance sheet is a tricky issue for the Fed. It is fairly clear that the don’t see the balance sheet reduction as a cause of recent market turbulence. They tend to think the decline in the balance sheet is a background technical issue. Hence central bankers don’t see the size of the run-off as particularly relevant for stance of monetary policy and focus instead on short-term policy rates.

That said, it is unfortunate that Powell was forced to admit that the Fed would of course change that pace of balance sheet reduction should the economy require such action. Very unfortunate really given that the Fed was already contemplating slowing the pace of the run-off for technical reasons related to the ability of the Fed to maintain effective control over short-term interest rates. From the December minutes:

Reducing reserves close to the lowest level that still corresponded to the flat portion of the reserve demand curve would be one approach consistent with the Committee’s previously stated intention, in the Policy Normalization Principles and Plans that it issued in 2014, to “hold no more securities than necessary to implement monetary policy efficiently and effectively.” However, reducing reserves to a point very close to the level at which the reserve demand curve begins to slope upward could lead to a significant increase in the volatility in short-term interest rates and require frequent sizable open market operations or new ceiling facilities to maintain effective interest rate control. These considerations suggested that it might be appropriate to instead provide a buffer of reserves sufficient to ensure that the Federal Reserve operates consistently on the flat portion of the reserve demand curve so as to promote the efficient and effective implementation of monetary policy.

Participants discussed options for maintaining control of interest rates should upward pressures on money market rates emerge during the transition to a regime with lower excess reserves…Some participants commented on the possibility of slowing the pace of the decline in reserves in approaching the longer-run level of reserves. Standard temporary open market operations could be used for this purpose. In addition, participants discussed options such as ending portfolio redemptions with a relatively high level of reserves still in the system and then either maintaining that level of reserves or allowing growth in nonreserve liabilities to very gradually reduce reserves further.

The communications challenge however, is this:

Several participants, however, expressed concern that a slowing of redemptions could be misinterpreted as a signal about the stance of monetary policy.

The idea of slowing the balance sheet run-off has only gained traction since the December FOMC meeting. See Nick Timiraos in the WSJand Victoria Guida at Politico. The ground has been laid.

My expectation then is that upon questioning Powell will open the door to slowing the balance sheet run-off as more than a theoretical possibility but will emphasize, or attempt to emphasize, that changes to the balance sheet policy do not indicate a change in the stance of monetary policy overall. Good luck with that though; I suspect that any indication that the Fed is winding down quantitative easing will be read as a dovish signal. Moreover, the Fed will come under fire for supposedly bowing to markets. I don’t think this is true, but that will be the perception.

Bottom Line:  The Fed will hold steady this week. I anticipate that barring any evident inflationary pressures, the Fed will be content to stay on the sidelines through at least the middle of the year. I think the underlying data will still prove too strong for central bankers to signal that they are at the end of the rate cycle. They will though want to communicate that regardless of their expectations, actual policy will be made with patience and flexibility. They will also want to communicate that the ultimate size of the balance sheet remains a technical issue at this point.

Fed Positioned to Slow Pace of Rate Hikes – Assuming the Data Cooperates

The Federal Reserve has positioned itself to sharply slow the pace of rate hikes this year. There even exists a scenario in which the December 2018 rate hike was the last of the cycle. That said, the Fed still anticipates the economy will need some additional tightening to reach their goals of low inflation and maximum sustainable employment over the medium term. Ultimately the path of rate hikes is data dependent, and that data yet to lead central bankers to the conclusion that rate hikes are now off the table.

With the December rate hike, policy rates at 2.25% to 2.5% now touch the bottom end of the 2.5% to 3.5% range of neutral rate estimates. Hence, policy may now be neither accommodative nor restrictive. Because of the imprecision of neutral rate estimates, however, policy makers do not know exactly the level of accommodation their policy provides. Consequently, they will need to rely even more heavily on the data flow as a guide to the appropriate policy stance.

Indeed, Federal Reserve speakers have made it clear that they will be very sensitive to incoming data in the months ahead. Last week, Chairman Jerome Powell reassured market participants that he recognized the downside risks reflected in recent equity price declines and, perhaps more importantly, that with inflation still low the Fed can afford to be patient before implementing further rate hikes.

What does this mean for the path of policy going forward? The ability for the Fed to remain patient means that in the near term there is no longer an immediate need to hike rates. While the Fed’s interest rate forecasts still anticipate another two 25 basis point hikes this year, those hikes do not need to be front loaded. The Fed can sit back and review its handiwork, waiting for the lagged impact of past rate hikes to filter through to the economy before taking further action.

That said, the data will still be relevant. The mix of data that keeps the Fed from hiking while retaining a bias to hike is best described as a combination signaling that growth will decelerate relative to the rapid pace of 2018, labor market outcomes point to fairly steady unemployment, and inflation remains low.

Recent data may be consistent with this story. The Institute of Supply Management index of manufacturing data slid in December, indicating that the sector still grows but at a slower pace than earlier in the year. The new orders index took a particularly large hit:

That said, the its non-manufacturing sibling revealed a much smaller decline while new orders held at high levels:

Countering the ISM manufacturing weakness, the employment report revealed a strong job market with a blowout gain of 312,000 employees for the month.

The temporary help component showed no reason to expect the job gains will end anytime soon:

And wage growth looks to now be sustainably higher:

I have to admit I am uncomfortable expecting the Fed to delay a rate hike until the middle of the year when employment growth remains on an upward trend. The only saving grace is that the economy delivered the workers necessary to keep pace with such growth.The unemployment rate actually ticked up to 3.9%, leaving it effectively unchanged over the past six months. In turn, continued stable unemployment will reduce the chances that the economy is overheating. Inflation is thus likely to remain in check.

Assuming December job growth is an outlier and will pull back in the following two months, the data flow will likely be sufficiently softer to keep the Fed from hiking in March – but they would retain a tightening bias and would likely hike again mid-year. This would be consistent with the forecasts presented in their Summary of Economic Projections. They will fear that eventually job growth that consistently exceeds 100,000 each month would eat up enough upward slack in the labor market to push unemployment sharply lower. They would be inclined to snug up a policy a notch to prevent that outcome.

If conditions arise that slows job growth toward 150,000, they will push any rate hike back further in the year. If the economy slows more than expected and job growth heads for 100,000, the Fed will move off the stage entirely.

Remember, these scenarios assume inflation remains contained. My general rule is this: The Fed will choose recession over inflation, but as long as inflation looks to hold sustainably near the Fed’s target, there will be a “Powell put” on the economy. That’s something to remember when wrestling with the recession calls that have grown louder in recent months. If you aren’t recognizing that absent inflation the Fed has the ability and willingness to cushion the economy against shocks that could threaten to send growth sharply lower than expected, you are doing it wrong.

Bottom Line: Low inflation means the Fed can move patiently. They don’t feel compelled to maintain the pace of quarterly rate hikes. Still, that doesn’t mean they won’t. My baseline expectation is that the data flow remains sufficiently soft and economic uncertainty sufficiently high to keep the Fed on the sidelines until at least mid-year. There is a chance of course that the correction in equity markets has left us all too pessimistic about the outlook for growth and inflation this year. If so, Fed commentary might turn hawkish again sooner than I anticipate.

State of Play, December 26, 2018

It’s Christmas, and Mrs. Fedwatch isn’t really keen on me typing away on the computer. Hence, I will need to keep this brief and to the point, at least as much as I can. With that in mind:

Fed ends the year with a questionable rate hike. The Fed acted as expected and hiked rates last week. The data drove the decision; even with growth slowing, the pace of activity is expected to remain above the rate of potential growth, stoking inflationary pressures. In simple terms, the economy retains too much momentum heading into the economy for the Fed to hold back from pushing closer to their estimate of neutral.

What makes the hike questionable (in my opinion, an error) was that it felt like a model-driven decision much like the December 2015 hike. Both occurred despite market turmoil that had continued too long to be ignored. And both occurred in the context of low inflation. There was no pressing reason for a rate hike other than they insist on defining policy on the back of long-run forecasts and feel compelled to follow-through with that policy.

That said, if the hike was an error, it was a recoverable error. I think the Fed will follow the 2016 script and step off the stage for at least the first half of the year if not longer. They now have the yield curve flat as a pancake; continuing to hike rates threatens to invite an outright inversion. Why tempt fate when you can sit back and wait for the lagged impact of rate hikes to make itself evident? They can stop now, stand ready to ease if necessary, and still keep the expansion alive. There is simply nothing in the data that says a recession is right on top of us.

Trump’s war with the Fed was inevitable. We all knew how the Fed would react to a fiscal stimulus shock. A monetary offset was always coming down the pipeline. The Fed never fully embraced the story that tax cuts would induce a supply-side response (a story that looks at odds with the decline in very long-term bond yield back down to 3%), something very clear in the Fed’s forecasts. That monetary offset was destined to anger President Trump.

The Fed isn’t the only thing weighing on markets. I don’t think the Fed is helping with the December rate hike while the forecasts of an intention to tighten policy into the restrictive range only adds insult to injury. That said, equities prices are under stress from a variety of directions: The expected fading of fiscal stimulus (including losing the impact on profits from tax cuts last year), expected slowing growth, tighter profit margins due to tariffs and labor costs, external political factors (Brexit), the US government slowdown, and general Trumpian uncertainty about almost every aspect of US policy. FWIW, it’s reasonable to argue that a bear market without a recession is a buying opportunity.

Trump’s ire with Powell creates a dangerous situation. Trump has reportedly discussed firing Powell as well as Mnuchin, who he blames for hiring Powell in the first place. Even aside from central bank independence issues, it is obviously bad precedent for the President to fire his economic team at the first hint of trouble. What does this say about the reaction of the President to a recession or a real financial crisis? What does this say about the ability of the government to manage the economy in such an event? Nothing good – it says that Trump stands ready to let it all burn down unintentionally because he does not understand policy. It is unquestionably now a real risk for market participants.

I feel we need to place nontrivial odds on the possibility that Trump fires, or at least attempts to fire, Powell. Mnuchin too. Yes, Trump did say nice things about both Powell and Mnuchin on Christmas day. How long is that good will going to last if markets keep slipping? A day? And note Trump’smodus operandi.Threaten to fire repeatedly, say nice things after the news leaks of the threatened firing, and then fire by tweet. Trump never accepts fault for anything, if there is a problem it is always caused by someone else, and that someone needs to be fired. Needless to say, firing Powell would rattle markets.

We don’t know how the Fed would react to an effort by Trump to fire Powell. There is a widely held belief that the President can’t “fire” Powell; at most he can demote Powell from Chairman back to governor. But then Powell’s colleagues could just vote to retain Powell in his role as head of the policy making FOMC. Trump would go ballistic of course and want Powell gone. The Fed could send the whole issue to the courts to be sorted out and, in theory, should they be victorious, enhance the Fed’s independence. But it would come at the cost of protracted uncertainty as the court battle rages.

Trump’s war on the Fed is already damaging the Fed. The Fed will deny vociferously that politics plays any roles in its policy making decisions. That said, central bankers are humans and it seems unlikely to me that they can truly make decisions that are not impacted in some way, even if just subconsciously, by politics. We will never know if Trump prodded the Fed into last week’s rate hike subconsciously; pushing back on Trump would be at least icing on the cake. And if the Fed is forced to cut rates going in the months ahead, they will be accused of caving to Trump even if the data or a Trump-induced market meltdown drives the decision.

Trump is placing the Fed in a no-win situation. I understand that my belief that the Fed has substantial exposure here is someone controversial. I don’t think the Fed can escape the Trump years unscathed. When I say this, the response is that Trump can’t fire the Chair or that he can’t influence the voting FOMC members or that the Chair can just make nice with the Senate.

First, I don’t think Trump cares that he “can’t” fire the Fed Chair. In Trump-world, he hired Powell and can fire Powell. Second, the Senate hasn’t shown much backbone when it comes to standing up to Trump. Third, what wasn’t entirely expected is that Trump can make the Fed do his bidding by creating a crisis that forces a Fed response. Exerting Fed independence in such a situation only puts the economy at risk. Heads they win, tails you lose.

Bottom Line: I not naturally prone to hyperbole, but this whole episode has a distinctly emerging market feel. I of course could be wrong here, but I don’t think that Trump-induced volatility is going to end anytime soon. It will arguably only get worse when a Democratic House of Representatives starts issuing subpoenas. We appear to be caught in a doom loop at the moment with each drop in the stock market bringing about a Trump response that induces another drop in the market. That can’t happen forever of course, but it is not clear that anyone wants to catch the falling knife just yet. We don’t know how long Wall Street can remain under pressure before it bleeds over into Main Street. The Fed can’t stand back and watch that happen; ultimately, they will need to cushion Trumpian uncertainty.

Related reading:

Trump Has Likely Done Lasting Damage to the Fed

The Fed Needs a Little Push From the Data for a Pause