Still On Track To Raise Rates

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Despite slowing growth, the Fed remains on track for a December rate hike. The reasoning is simple – even a substantial slowdown in growth from the pace of recent quarters leaves the US economy operating at a pace that exceeds the Fed’s estimates of potential growth. This means that inflationary pressures will continue to grow even if the pace of growth slows. It is not an environment in which the Fed is likely to call off rate hikes. Of course, if growth looks likely to slow more than anticipated, the Fed will react and adjust their expected policy path accordingly. Without more evidence that inflationary pressures are translating into higher actual inflation, the Fed will neither accelerate the pace of rate hikes nor hesitate to pause if the data turns sharply lower than expected.

Incoming data indicate the US economy continues to growth at a respectable pace. That said, fourth quarter growth will likely moderate from the pace of the previous two quarters. GDP tracking indicators from the Atlanta and New York Federal Reserve banks both currently stand at 2.7%. Indeed, it seems almost certain that the heat will come of the consumption numbers, which contributed 4 percentage points to growth in the third quarter; the retail sales numbers today pointed in that direction. That alone will likely temper the pace of growth.

Moreover, it is reasonable to expect that growth will slow further in 2019. Fiscal stimulus will wane if not given a fresh boost, housing has moderated and is not driving growth, the lagged impact of higher rates should be increasingly evident, and, if sustained, slower global activity will take a bite out of growth. Much of this should already be incorporated into the Fed’s economic forecasts, which explains why the median policymaker anticipates growth will slow from 3.1% in 2018 to 2.5% next year. Growth will continue to trend downward into the following year as well. Note that trending downward does not mean we need to go on recession watch; leading indicators overwhelming point toward continued economic expansion. See, for example, low initial unemployment claims.

Yet despite expectations of slowing growth, central bankers anticipate ongoing rate hikes. The next one will come in December; another likely in March 2019 as well. Why? Because the Fed will look at the pace of growth relative to expectations that potential growth is expanding at only 1.8% a year. Hence, the 2.5% growth rate forecast for 2019 remains sufficient to place downward pressure on unemployment and sustain inflationary pressures more generally. The Fed expects that further tightening will be required to ease growth down to a pace that those inflationary pressures wane.

To be sure, it is reasonable to point out that actual inflation does not look worrisome. Central bankers would also reasonably respond that this does not imply that rate hikes should come to an end; they will tend to see stable inflation as a consequence of past rate hikes. In other words, the lack of inflation despite rapid growth stands as evidence that their strategy of preemptive rate hikes was successful.

The lack of inflation is, of course, still very relevant. First, it dissuades the Fed from reacting to low unemployment (they can instead try to squeeze additional slack out of the labor market). Second, it will allow the Fed to move quickly should the economy falter more quickly than expected (but, as should be clear by now, they aren’t going to come to the stock market’s rescue without evidence of damage to the broader economy. Third, it will argue for further decreases in the Fed’s estimates of the natural rate of unemployment, which would in turn place downward pressure on the rate path.

The upshot is that we remain in a familiar place – the Fed is likely to continue hiking rates until they feel confident that they have removed a sufficient amount of financial accommodation to alleviate overheating concerns. If data starts tracking below the Fed’s forecasts, we can expect that the Fed will scale back on their rate hike path. If above, the opposite will occur (side note on this point – while the current expectation is for fiscal stimulus to wane, with the Democrats taking the House, the path of least resistance for Congress going forward may be more spending). 

This is a good place to be. It’s a place where the Fed can be nimble. Of course, during a tightening cycle there is always the risk that the Fed overshoots and plunges the economy into recession. And arguably the Fed’s forecasts highlight this risk as they clearly indicate a goal to restrain the pace of activity. But I don’t think we should worry too much yet absent evidence that inflation looks to be rising to 2.5% on a sustainable basis. Under such circumstances, the Fed would likely adopt a more hawkish and less flexible posture. We just aren’t there yet.

Bottom Line: Goldilocks 2.0 keeps the Fed on its basic policy path, gradually hiking rates but having sufficient room to maneuver such that they can change course if needed. 

Employment Report Keeps the Fed on Track for December and Beyond

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The US economy hit it out of the park in October. Rapid economic growth continues to fuel a labor market that delivers the enviable combination of job growth, labor force growth, and now faster wage growth. So far, this also continues in a low inflation environment. The Fed, however, doesn’t believe that situation will continue forever in the absence of tighter monetary policy. Expect the rate hikes to continue. Furthermore, I think you can make an argument that the labor market is close to the point where inflationary pressures will intensify. Something that everyone seems to think can’t happen anymore.

Nonfarm payrolls rose 250k, a solid above-consensus pace of job growth. Both the three- and twelve-month moving averages are above 200k. Fairly impressive growth for an expansion that is over nine years old. The pace still exceeds the Fed’s estimate of sustainable growth after the cyclical forces driving labor force growth give way to demographics.

That day, however, is not yet at hand. Labor force participation ticked up, which helped hold the unemployment rate at 3.7%. Remember, the Fed anticipates this rate to hold through the end of the year, a bet that looks better this month than last. At least in the near-term, central bankers are labor force optimists.

The labor market does not look likely to sputter anytime soon either. The leading indicator of temporary help employment maintains steady growth, and we all know that initial unemployment claims are not sending out any warnings.

Wages grew 3.1% over the past year; over the past three months, the pace of gains has been 3.4% annualized. It would seem that wage growth appears to be kicking in, albeit at a low unemployment rate than the previous expansion. 

In contrast, real wage growth has been trending sideways around 1% since the unemployment rate hit roughly 5.5%. This number is fairly consistent with productivity growth. Recall Federal Reserve Vice Chair Richard Clarida:

A sustained rise in inflation-adjusted, or “real,” wages at or above the pace of productivity growth is typical in an economy operating in the vicinity of full employment, and we are starting to see some evidence of this. I certainly hope it continues. Now, some might see a rise in wages as leading to upside inflationary pressures, but here, again, the experience of earlier cycles is instructive. In the past two U.S. expansions, gains in real wages in excess of productivity growth were not accompanied by a material rise in price inflation.

Of course, this time may be different, and as with growth, the job market could perform better or worse than the baseline outlook. However, for now, the increase in wages has been broadly consistent with the pickup in productivity growth that I have just discussed, and a rise in the still-low rate of labor force participation among the prime-age population provides scope for the job market to strengthen further without generating inflationary pressures.

Over the past year, nominal wage growth has been creeping up in tandem with underlying inflation to hold real wage growth around 1%. In other words, I think you can make an argument that we are at or beyond full employment with enough pressure on the economy that we see both faster wage growth and faster inflation. In other words, what I am seeing is that the world pretty much works out as you might expect.

If nominal wage growth continues to rise, the increase will need to be felt somewhere in the data – either faster inflation, faster productivity, or tighter profit margins. This is the space to watch. Obviously, the worst-case scenario is higher inflation, the best is higher productivity growth, and tighter profits margins fall somewhere in between depending on who you are in the economy. 

I don’t know yet how this will play out. What I do know is that central bankers are very comfortable with the flat Phillips Curve story, almost complacent. Essentially, they have been surprised so many times by how low they can push unemployment that they don’t really trust their ability to estimate the natural rate of unemployment and are now defaulting to a dovish scenario that allows them to maintain a gradual pace of rate hikes despite fairly hot growth. There don’t appear to be many skeptics left among central bankers. My experience is that when everyone believes the same story, it’s time to get a new story. 

Bottom Line: Jobs data gives no reason for the Fed to think their job is done; rate hikes will continue. 

Employment Report Up Next

Friday morning the BLS releases the October employment report. It will most likely leave expectations for a December Fed rate hike intact. We should focus on the unemployment rate and wages. Steady or even an uptick in the unemployment rate would help convince central bankers that they can squeeze more out of the labor market. That said, continued acceleration in wage growth would suggest that any lingering slack may be minimal.

The September payrolls gain was on the soft side; I anticipate upward revisions. The October report will likely be stronger. The consensus expectation is for a NFP gain of 190k in the range of 150k-231k. The ADP report released yesterday estimated a gain of 227k private sector employees, suggesting upside risk relative to the consensus. My model agrees that the risk is to the upside.

The unemployment rate ticked down to 3.7% in September. Wall Street expects it to hold steady; given the variance in labor force participation, anything in the 3.6%-3.8% range should not be a surprise. Whatever the number, we should compare it against the Fed’s current year end forecasts for 3.7% (median and central tendency) issued in September. Recall that this estimate nudged up from 3.6% in June, indicating more confidence that they could get more help from labor force expansion. So far, this bet has been wrong, but could be quickly right given the nature of the data. A downward tick in the unemployment rate would like increase overheating concerns.

Wages are expected to be up 3% (range 2.8%-3.2%) relative to year ago levels. Continued acceleration of wage growth would nudge Powell & Co. toward thinking that maybe they are approaching limits to what they can squeeze out of the labor market.

Bottom Line: It would take quite a dive in the data to stop the Fed from hiking in December. We won’t find that kind of dive int he next employment report. The Fed will tend toward hiking rates until they are confident that economic activity is likely to slow enough that concerns of overheating fade. We aren’t there yet.

Markets Rattling Investors, Fed Still Calm

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Equity market turmoil continued throughout last week, raising fresh questions about the Fed’s policy path. I don’t believe that Powell & Co. will panic just yet. I suspect they will take a broad view of incoming data and financial indicators and conclude they have little reason to alter their policy path. This will obviously be somewhat disconcerting for already rattled investors.

Start with the GDP report. It was generally upbeat with second quarter growth coming in at 3.5%, ahead of expectations for a 3.3% gain. Consumer spending grew at a solid 4% pace. No wonder we are seeing strong confidence numbers. Nothing makes Americans happier than spending, and when they can, they do – in three of the last four quarters, spending growth has registered at 3.8% or higher. With such a sustained, solid pace, I think the Fed would interpret any consumption slowing in the fourth quarter as temporary.

Inventory build contributed 2.1 percentage points to growth, while net exports subtracted 1.78 percentage points. I think we have two things going on here. First, there may have been some inventory building to get ahead of expected tariffs. That would be offsetting – counting as a plus via inventories and a negative via imports. These factors would likely fade out in the fourth quarter. But there was also a -0.45 percentage point contribution from exports, arguably attributable to some mixture slower global growth, retaliatory tariffs, and a stronger dollar. We may be waiting on the fourth quarter to see how all of these factors play out.

A more worrisome aspect in the report was the soft read on nonresidential investment, which contributed a meager 0.12 percentage points, the worst result since the final quarter of 2016. Couple that with the fading core manufacturing orders and you can tell a story that the Trump tax cut boom is fading which – especially when combined with uncertainty created by President Trump’s trade policy – suggests that maybe the capital equipment resurgence is coming to an end. 

This is an important space to watch as it cuts two ways for central bankers. On one hand you have a typical demand side story – is this a sign of slowing growth, and, if so, is growth slowing sufficiently to alleviate the inflationary pressures the Fed fears are building? On the other hand, with some central bankers talking up the supply side of the economy as reason to hold rates on the low side, has there been too much supply side optimism?

Housing investment was soft. I don’t have much to add here. It isn’t new – housing hasn’t been a steady contributor to growth for over a year. For those worried about a repeat of the last housing bust, note that the relative lack of substantial rebound in the sector makes for a weak comparison of the two cycles.

Some notable Fedspeak occurred during the past week. Federal Reserve Vice Chairman Richard Clarida presented his outlook and, more importantly, his current economic framework. A few takeaways: First, Clarida sees the risks as balanced and not skewed to the downside as earlier in the cycle. Second, Clarida wants to revive the greatness of the 5-year, 5-year forward inflation guide, an indicator that has been generally downplayed by the Fed in recent years as a measure of inflation compensation, not expectations. Third, Clarida retains his faith in estimates of the neutral interest rates as a policy guide. This places him at odds with other officials such as New York Federal Reserve President John Williams who are downplaying the r-star estimates. Fourth, Clarida sees policy as accommodative and supports further gradual rate hikes. The tone of the speech was on the dovish side in my opinion; barring more significant inflationary pressures, Clarida currently appears likely to resist pushing past his estimates of neutral.

Atlanta Federal Reserve President Raphael Bostic continued to lean hawkish with concerns about what he considers to be a high-pressure economy. He note that high-pressure economies tend to end badly as the Fed tends to follow such periods with a more “muscular” policy stance. Moreover, he worries about the durability of any gains to workers during a high-pressure period, with the implication being that the Fed shouldn’t allow unemployment to fall so much that a disruptive crash is inevitable. More resilient, longer-run gains come not from exceptionally low unemployment, but consistently low unemployment. The upshot for Bostic is that rates need to keep moving higher. 

One specific point from Bostic:

Costs are the one area where I have picked up a potential impact from changes in trade policy. Firms in my district are describing an upward shift in their cost structure. However, we have not yet seen a significant pass-through of higher costs into the final consumer space. Inflation remains stable, hovering around the FOMC’s 2 percent objective.

Still, the potential for changes in trade policy to affect the costs of production—through either direct tariffs, supply-chain disruptions, or firms switching to higher-cost routes to import supplies—remains a risk to my inflation outlook.

This matches what we are hearing from firms in earnings reports and is also evident in the Beige Book. There does appear to be substantial cost pressures in the background, and how these pressures evolve is particularly important at this juncture. If they emerge in such a way that the Fed believes they have been too optimistic on inflation, what we are looking at will be fairly typical late cycle dynamic where the Fed feels need to defend their inflation target. 

On the chaos in financial markets, we aren’t getting much sympathy from the Fed. I don’t think this should be a surprise. My sense is that central bankers are of course watching the situation, but are nowhere near reacting. I think it is instructive to look at measures of financial pressure in the 2015-16 era. I think the Fed will look at similar indicators and conclude that oil is rising not falling, the dollar is not strengthening as quickly, inflation expectations are not collapsing, and bond spreads remain tight. The general conclusion will be that equity markets got ahead of themselves, and some cooling off is expected and arguably, a good thing for sustaining the expansion.

Treasuries did catch a flight to safety bid. I found it interesting that the long bond, however, held most of the yield gains of recent weeks. That was a bit more resilient that I would have expected if growth concerns were mounting.

Bottom Line: The economy continued to power forward in the third quarter on the back of household spending Flagging investment activity, however, raises some red flags. Overall though nothing to dissuade the Fed from hiking rates. Watch how price pressure evolve in the coming months. If they break higher, a slowing economy will not deter the Fed from hiking rates, at least until it slows enough that Powell & Co. believe the pressure is off – this may require higher unemployment rates. That’s where you need to start more aggressively pricing in the end of the cycle.

Decision Time

Housing hit an air pocket in September as new home sales slid, falling along with deterioration in existing home sales. So it’s decision time once again for market participants. Given the well known pattern of “housing is the economy,” should you begin to price in the end of the cycle? Or is that premature given the dearth of other worrisome indicators? I believe it remains too early to price in the end of the cycle.

New home sales came in under expectations, falling low of 553,000 (SAAR), the lowest since December 2016. Inventories climbed to 7.1 months. To be sure, new home sales are volatile. This could simply be a  reaction as potential buyers took a breather to see if mortgage rates would tick back down. Or it could mean that the higher ends of the housing market have finally been saturated and builders need to shift downward to lower ends of the market. Or, more generally, prices finally reached a point where buyers pushed back. Such issues should be expected as the housing recovery matures, even if demographics remain a generally supportive factor.

To be sure, memories of the housing crash and subsequent financial crisis run deep. I don’t think we are likely to see a repeat of that experience. The housing recovery is not built on the same shaky financial ground as we saw in the 2000s; underwriting conditions are more stringent. Moreover, there is clearly less room to fall on the new construction side. And as far as housing’s contribution to the economy, it has been already been choppy and fairly weak in recent quarters. It hasn’t, on average, been driving the economy.

If you want to make the bet that this is the beginning of the end, I would caution you to remember that there remains a wide-range of indictors that still point toward continued economic growth. For example, manufacturing activity remains strong:

Initial unemployment claims still cling to record-low levels:

Temporary employment still grows:

And the yield curve has yet to invert.

Recessions are not single-indicator events. Remember the recession calls in 2016 when manufacturing rolled over? The thinking was that every time industrial production falls by 2%, a recession followed, and this time would be no different. But it was different. Those calls did not play out because the shock was largely contained to that sector; recessions stems from shocks that hit the entire economy. And even if a recession could be boiled down to a single indicator, I would pick the yield curve over housing.

I suspect the Fed will have a similar view to mine. Powell & Co. will tend to discount softening in housing in light of overall broad-based economic strength. That said, it is reasonable to tell a story in which housing softness is part of a cooling trend in 2019 that gives the Fed room to pause in the first half of the year rather then the second half. Assuming, of course, the inflation remains contained.

The upshot is that I am not terribly concerned about the housing situation. My primary focus currently is on the increasing margin pressures faced by firms. Labor and material costs, and of course tariffs, are weighing on the bottom line. Do firms respond with higher productivity, enduring persistently lower margins, or can they push off the cost increases on consumers? Inflation data suggests the last has yet to be an option, which gives the Fed a lot more room to shift policy in a dovish direction should a more broad-based slowdown materialize. Should inflation start to perk up, then they would feel compelled to stick with a more hawkish policy stance. Watch carefully the inflation data around the end of the year. Firms tend to raise prices once a year in a low inflation environment, so we might see the delayed reaction to all of these cost pressures in the December and January inflation reports.

Bottom Line: Recency bias is strong, which means it is easy to get lost in the housing data and miss the rest of the economy. That said, it is reasonable to wonder if the housing slowdown foreshadows softer growth ahead. Of course, such softer growth is already in the Fed’s forecast, so it is not clear that it will induce the Fed to change course. The Fed will be more likely to change course if inflation remains tepid.

Quarles, Trump Versus Powell, Data

Still getting caught up after a busy last week!

Last week Federal Reserve Vice Chair for Supervision Randall Quarles channelled former Fed Chair Alan Greenspan in a rare speech on the economy. Notably, Quarles offered considerable optimism, particularly with respect to the supply side of the economy. He sees room for further expansion of the labor force and, I suspect more importantly, reasons to think that productivity growth will soon accelerate. His optimism on productivity growth stems from recent gains in capital spending and his self-described techno-enthusiasm. In addition, he views favorable the “let the economy run hot” theory in which tight labor markets induce firms to make labor-saving improvements to their operations.

The policy implication:

The more the economy’s potential growth increases, the more gradual we can be in our removal of monetary policy accommodation. Thus, an assessment of the pace of potential growth will be an important input into what I view as the appropriate path of policy to achieve our objectives of maximum sustainable employment and price stability.

In Q&A, he expands further (via Bloomberg):

In a dovish signal, Quarles said that his “preferred path for policy is more gradual than I think many other people’s because of my optimistic assessment.”

To be sure, Quarles still anticipates continued gradual rate hikes. He hypothesizes that sticky inflation expectations may be hiding building inflationary pressures that could eventually emerge. While not a primary risk, it is sufficient risk to justify edging rates higher. That said, Quarles is on the low side of the dots.

Quarles sounds like he wants to walk in Greenspan’s footsteps. Recall that Greenspan famously delayed rate hikes in the late 1990s, believing that accelerating productivity growth justified a more dovish policy path. The difference is that Greenspan had firmer reasons to believe that productivity growth was accelerating. Quarles appears to be operating more on hope than data; note that the median longer run growth forecast presented in the Summary of Economic Projections has been stuck at 1.8% since being downgraded in 2016. His colleagues clearly don’t appear to be so optimistic.

Quarles’s speech, which included a supply-side wink to the tax cuts, must have been music to the ears of President Donald Trump. Trump looks to be having a bit of buyer’s remorse with respect to his selection of Federal Reserve Chair Jerome Powell. Last week he called the Fed his “biggest threat” while seeming to regret his choice of Powell (via CNBC):

“I’m not blaming anybody, I put him there,” Trump said of Powell. “And maybe it’s right, maybe it’s wrong. But I put him there.”

Will anything come of Trump’s ire? Well, maybe. Note that it looks like Nellie Liang’s nomination is in trouble. Liang, a Democrat and supporter of bank regulation, might not even make it out of committee. Indeed, given the apparrent opposition, one wonders how Liang even received the nomination in this political environment. (My answer: Too many people still expect the Fed to exit the Trump years unscathed).

Suppose Liang doesn’t make it out of committee. Further suppose that Trump’s ire at the Fed’s policy path means he doesn’t defer to Powell on the replacement nominee. Trump would be free to find a Quarles-like nominee. Moreover, Trump could pull the nomination of Martin Goodfriend, which is languishing in the Senate, and again find a more ideologically-minded replacement. Trump could have remade the Fed; he might now be realizing the lost opportunity and not want to dig his hole any deeper. Ironically, he could probably reach across the aisle and call the Fed Up staff for recommendations.

On the data front, there is nothing to stop that December rate hike. Unemployment claims remain low and show no signs of labor market deterioration:

The JOLTS numbers confirm the strength of the current American jobs machine. Job openings in August climbed to another record high. And confident workers are quitting their jobs at a pace not seen since 2000:

The nation’s factories are churning out product in September:

Housing is a bit of a week spot, with flattish single family starts for much of this year and evidence that multi-family housing is off its peak:

Moreover, existing home sales have clearly softened in recent months. I think that demographics still support the housing market over the medium term, but also think that high prices, higher mortgage rates, and slowing rent growth are all sapping some of the demand from housing. The keys question is how much of a drag will this become? It is worth noting that housing has not been a consistent contributor to GDP growth for awhile- and contributed negatively the last two quarters:

Hence the downside might be fairly limited. That said, this could become part of a moderation in activity that forces the Fed to rethink their policy path.

Bottom Line: Fed on path to hike rates in December, and the data is no obstacle. I don’t think that Powell will start setting the stage for an imminent pause to please Trump. But Trump could vent his frustrating with his choice of future nominees to the Federal Reserve Board.

Don’t Worry Too Much About The Prospect Of Restrictive Policy

Sorry for the limited Fed watching this week. I needed to shift gears to my Portland event, the Oregon Economic Forum, for a few days. That said, I still managed to write for Bloomberg this week:

The minutes of the September Federal Open Market Committee meeting confirmed speculation that Federal Reserve policy makers are leaning toward pushing interest rates above levels considered to be neutral, which neither stimulate nor restrain the economy. That sounds ominous, but it is important not to worry too much yet over the prospect of restrictive policy.

Fed forecasts are a projection, not a promise. If the economy stumbles, odds are the Fed will react appropriately and ease policy. There, however, is an important exception to this rule. If inflation looks to be stirring, the Fed will likely tighten down the clamps. That’s when the real worrying should start, but the Fed does not appear near that point yet.

Continued here at Bloomberg Opinion.

I should be back into the swing of things next week. Have a great weekend!

CPI Inflation Still Soft, Fed Not Yet Deterred

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The CPI report for September revealed that inflationary pressures remain muted. To date, weak inflation numbers have not deterred the Fed from hiking rates, but instead moderated the pace of rate hikes to gradual. I expect this will continue to be the case. Does this mean the Fed has gone crazy?

Core CPI inflation was again soft in September; the annualized one month gain was just 1.4%. The annual change remains above 2% (remember that PCE not CPI is the Fed proffered price gauge; in, recent year PCE inflation has been running below CPI inflation) but will roll over further if these soft monthly numbers continue. Shelter inflation appears to be moderating again: The pickup earlier this year was a bit of a surprise to me given reports that rent growth was slowing across many major metro areas. Consequently, I have been anticipating that the gains would not hold. Excluding shelter, service sector inflation firmed in September after a string of meager gains: What I find most interesting is that goods inflation has been very soft in the past two months despite tariffs and higher labor costs: This of course runs counter to the narrative that tariffs will become an excuse to push through higher prices to consumers. What’s going on here? Higher labor costs and higher material costs have to show up somewhere. If firms can’t push those costs through to final prices, then they show up in faster productivity growth or softer margins. This tweet from CNBC reporter Joumanna Bercetche:

suggests that analysts anticipate firms will be able to manage cost pressures through with a mix of the first two options (pushing through costs or higher productivity). But if the Fed continues to take a hard line on inflationary pressures, then it has to be productivity or margins. And if underlying productivity growth remains mired at roughly 1% give-or-take, then the cost pressures will reveal themselves in softer margins.

I think the Fed would be broadly happy with such an outcome. Optimally of course, they would like faster productivity growth. But the second best outcome is margin compression over inflation, which has the added benefit of tempering equity price gains. Enough pressure to keep inflation in check and ease the pace of job growth, but not enough to tip the economy into recession. Kind of a sweet spot for the Fed.

But should the Fed be raising rates at all given the weak inflation numbers? Shouldn’t they be rapidly lowering estimates of the natural rate of unemployment instead? Has the Fed gone “crazy” as President Donald Trump claims? Jared Bernstein noted that I dodged that question in yesterday’s post:

Yes, I did dodge that question. I try, although not always successfully, to contain my work to “what will the Fed do” rather than “what should the Fed do.” I think I am more effective at the former if I divorce it from the latter. And if you are a market participant, you are probably looking for the former not the latter.

That said, I do have an opinion on this. My suspicion is that in the absence of rate hikes, inflation would be higher now and potentially high enough to be a threat to price stability. I don’t think you can use low inflation now as a reason to argue that the Fed should stop hiking rates because those rate hikes probably contained inflation. I think we are now too far along in the cycle to have not raised rates.

Moreover, I see room to raise rates further. Earlier this year I was worried that the Fed would deliberately invert the yield curve in their campaign to hike rates. I would view such an action as a policy error. Since then, however, the long end of the curve has sold off producing a bit of a bear steepening. This strikes me as an indication that the economy can indeed sustain the Fed’s rate path.

Finally, I am somewhat nervous that even in a low inflation environment the Fed appears fairly resistant to the idea that they should pause at something close to neutral to take a look around and wait for a bit more of the lagged impact of past rate hikes to work their way through the economy.

Speaking of crazy, Trump doubled-down on his Fed criticism today, saying the Fed is “out of control.” Trump did add that he didn’t expect to fire Federal Reserve Chairman Jerome Powell, but of course that threat is now out there (although the Fed Chair supposedly can only be fired for cause).

I do not think that this criticism will induce Powell to hike just to prove a point; Powell is going to be the adult in the room. Trump is looking to lay the blame for any slowdown in activity on the Fed, and has made itself a sitting target for such a game. The Fed’s forecasts very clearly show that central bankers intend to guide the economy into a slower growth trajectory. Now yes, we all know they believe such a policy path reduces inflationary pressures and actually extends the life of the expansion, but such nuance will be lost when the economy does slow.

Moreover, don’t forget that Trump knows how to work the press. This story gets him the attention he craves. So he will keep at it.

Bottom Line: Inflation remains low. Does this mean the Fed’s plan is crazy, or that it is successful? Looks more like success than craziness in my opinion. Regardless of that opinion, the Fed looks likely to keep following the path they laid out – gradual rate hikes until the economy looks likely to revert back to what they think is a sustainable pace of growth.

Don’t Panic. Yet.

A bit of an unpleasant day in the stock market. Not unpleasant enough, however, to send much of a panic among Federal Reserve policy makers. In fact, quite the opposite – my sense is that Powell & Co. will be happier if the pace of equity gains moderated. Indeed, I would say that this is a lesser-mentioned goal of the tightening campaign. From their perspective, taking some of the steam off the stock market occasionally reduces the risk that financial instabilities grow and become a potential economic threat.

I wouldn’t panic yet either; I don’t think this is the beginning of the end for this bull market.  What would be the beginning of the end? When the Fed starts to believe they can’t cut rates in the face of economic weakness due to inflationary pressures. We aren’t there yet. 

Both the Dow and the S&P500 were down more than 3% Tuesday. The story floating around the press was that this was a risk-off day as equity traders processed the implications of evolving Fed policy. In contrast, Treasury bonds barely budged; long bonds even fell a notch, lifting long rates. My interpretation is that fixed income traders had already processed the shifting policy environment; equity traders were a bit late to the party.

What is that changing environment? Well, as I have documented over the past several weeks, the Fed has been slowly phasing out forward guidance, leaving market participants a bit more uncertain about the path of rates going forward. I think the Fed views this uncertainty as a policy feature, not a bug. Recall the criticism the Bernanke’s Fed contributed to market complacency by laying out so clearly the rate path. Powell may very well share that criticism (a good question for the December press conference).

The Fed has focused attention away from r-star estimates (and forward guidance in general) to their forecasts instead. And therein lies the problem for market participants. The incoming data appears to confirm the forecast, policy makers appear to agree that the data confirms the forecast. That rate forecast is hawkish relative to market expectations that the Fed would soon pause in their rate hike campaign. Worst, that forecast suggests they keep hiking even after the impact of fiscal stimulus starts to wane. The upshot is that we need to incorporate both a higher path of rates and additional uncertainty about the path of rates into prices. On net, that should sap the equity markets of some strength.

The Fed is not going to ride to the rescue here. There is no Powell-put for a 3% decline. Or even an extended decline like earlier this year. And Bloomberg caught this from New York Federal Reserve President John Williams last night:

“The primary driver of us raising interest rates is just the fact that the U.S. economy is doing so well in terms of our goals,” Williams said Wednesday in a reply to questions after a speech in Bali, where the annual meetings of the International Monetary Fund and World Bank are taking place. “But I would also add that the normalization of monetary policy in terms of interest rates does have an added benefit in terms of financial risks.”

“A very-low interest-rate environment for a long time does, at least in some dimension, probably add to financial risks, or risk-taking, reach for yield, things like that,” he said. “Normalization of the monetary policy, I think, has the added benefit of reducing somewhat, on the margin, some of the risk of imbalances in financial markets.”

This is not new. Federal Reserve Chairman Jerome Powell has made similar statements. There is a widespread concern that persistently low interest rates would become a problem not for price inflation, but for financial stability. Reducing financial accommodation to minimize those risks is clearly a policy goal here.

To add some additional drama to the day, President Donald Trump tossed in his two cents on monetary policy:

“The Fed is making a mistake,” he told reporters on Wednesday as he arrived in Pennsylvania for a campaign rally. “They’re so tight. I think the Fed has gone crazy.”

Trump is setting the stage to blame the Fed should the economy tank. Luckily, I don’t think that’s about to happen. It is important to remember that the Fed’s rate forecast will only hold in a solid economic environment that is generally supportive of equities. If the economy tilts downward more quickly than expected, the Fed will reel back on those rate forecasts. They might hem and haw before they shift, but most likely they will shift. If the economy faces a clear economic challenge, the Powell put will become a reality.

There are, however, two caveats to this prediction. One is just straight-up policy error, misreading the data. The second caveat, which is what concerns me, is that the Fed reaches a point where they don’t think they can ease due to inflationary pressures. As a general rule, central bankers think that inflation expectations are sufficiently well contained that they can maintain a gradual path of rate hikes. I think this also means that they will be react to a substantial change in the economic outlook – a greater slowdown than they anticipate – with a shift toward a more dovish policy path. But there of course is a chance that inflationary pressures emerge such that they think they need to defend their inflation target. In my opinion, in such a circumstance they will choose recession over inflation.

Bottom Line: Don’t panic. Yet. The Fed’s rate path might be higher and more uncertain than anticipated, but this largely reflects a more positive economic outlook. That’s ultimately a good thing. Watch the inflation numbers. Inflation is what could sour the Fed’s plan and its willingness to respond to a substantial deterioration in the outlook.