Monday Morning Notes: Blackout Week

Data last week gave little reason to suspect that monetary policy would soon deviate from the current path of gradual rate increases. Tame inflation continues to hold the pace of rate hikes to “gradual.” Still, the Fed will resist ending rates hikes until they have good reason to expect growth will slow to a range they believe consistent with stable inflation. That will make for interesting debate if growth remains strong as the policy rate approaches 3%. Still that is a story for later. The immediate future holds yet another rate hike.

Industrial production told a familiar story – the nation’s factories hum a long, powered by solid underlying demand:

Retail sales were on the soft side in August, but prior months were revised higher:

Still, the upward trend of core sales is the best experienced during this cycle. Whenever you hear of a threat to household spending, it pays to remember that the U.S. consumer will not go quietly into the night.

Although the economy looks to be holding onto the momentum of the second quarter (the Atlanta Fed currently pegs growth at 4.4%), inflation remains under control. Core-CPI inflation plummeted on a monthly basis, pulling the year-over-year numbers lower:

It’s numbers like those that keeps the Fed locked into a gradual pace of rate hikes. The Fed might believe that the current pace of growth will eventually prove inflationary hence preemptive hikes remain necessary. But at the same time, inflation doesn’t provide a reason to step hard on the breaks. That said, the unusually weak goods inflation (apparel and medical goods commodities) pulled the overall August inflation number lower:

On the services side, medical care was a drag. I suspect this weakness will prove to be temporary. I would be wary of expecting a sustained downturn of inflation at this stage of the cycle and I am hesitant to expect a sustained declined in health services inflation. Still, whatever behavioral switch that triggers worrisome inflation dynamics appears to remain in the “off position.”

Fedspeak will be nonexistent this week, blacked out in advance of next week’s FOMC meeting. Sadly, only a few data releases will entertain between now and then. Most important will be housing data (starts and permits Wednesday, existing home sales on Thursday). We will be watching for indications that housing activity could be a moderating factor on economic activity. Enough such factors and the Fed could see the data that support a sustained policy pause in the first half of next year. But as I have said before, that is still more hope than reality.

Bottom Line: Quiet week as we await next week’s FOMC meeting.

Fed Debate on Neutral Rate Misses the Bigger Picture

First, “What’d You Miss” Bloomberg interview with Joe Weisenthal:

Link here if video not working.

Second, new Bloomberg column:

Federal Reserve policy makers are debating whether to stop tightening monetary policy when interest rates reach a neutral level that neither stimulates nor restricts growth. At this point, there is no easy answer, but central bankers should de-emphasize the level of rates at which they would pause and instead focus on the economic conditions that justify a pause.

Continue reading on Bloomberg Opinion.

Finally, recent data tells a familiar story with contained inflation and strong growth. Calculated Risk reports some recent estimates placing third quarter GDP growth in a range from a low (New York Fed) of 2.2% to a high (Atlanta Fed) of 4.4%. Assuming the reality splits the difference at 3.3%. That is a growth rate that easily keeps the Fed hiking, but the inflation numbers moderate the pace of hikes to the Fed’s gradual path. The status quo holds.

I will have more on the recent data flow Monday. Until then, have a great weekend!

Brainard To Markets: We Aren’t Stopping At What You Think Is Neutral

Federal Reserve Governor Lael Brainard delivered a clear message in her latest speech: The way things are going, the rate hikes are not going to stop anytime soon. In fact, you should be happy that we haven’t accelerated the pace of hikes. As I said earlier this week, the “pause” story is more about hope than reality. We can’t talk pause until we detect a significant change in the tone of the data.

The theme of Brainard’s speech is an explanation of the neutral policy rate with an eye toward policy implications. It is tempting to say that market participants are the intended audience. I sense this is too narrow. I think this is also a message for her colleagues at the regional banks who argue for a pause at neutral. She is telling them they don’t understand what neutral means. Or at least they need to be more careful about its meaning.

So what does neutral mean? Brainard:

Intuitively, I think of the nominal neutral interest rate as the level of the federal funds rate that keeps output growing around its potential rate in an environment of full employment and stable inflation.

Right – this would be a standard definition. But Brainard wants to emphasize the difference between the short- and the long-runs. First:

Focusing first on the “shorter-run” neutral rate, this does not stay fixed, but rather fluctuates along with important changes in economic conditions…In many circumstances, monetary policy can help keep the economy on its sustainable path at full employment by adjusting the policy rate to reflect movements in the shorter-run neutral rate. In this context, the appropriate reference for assessing the stance of monetary policy is the gap between the policy rate and the nominal shorter-run neutral rate.

Read that carefully. Brainard says that at a full employment economy (like now), the shorter-run neutral rate is the relevant indicator for determining the level of accommodation provided by a particular policy stance. By extension, in the current situation, the longer-run rate is not the relevant metric. In other words, policy might still be accommodative even when pegged at the longer-run neutral rate. Don’t look at the longer-run SEP rate estimates to assess the current policy stance.

We all know the estimates of the longer run rate, 2.5-3.5% as reported in the SEP. So what is the shorter-run neutral rate? Back to Brainard:

Turning to the shorter-run neutral rate, although the estimates are model dependent and uncertain, we can make some general inferences about its recent evolution that are largely independent of the details of specific models. Estimates suggest the shorter-run neutral rate tends to be cyclical, falling in recessions and rising during expansions, and our current expansion appears to be no exception.

Take a moment and appreciate Brainard’s intelligence and foresight. She doesn’t provide a number or even a range. Why not? She has estimates. She just said so. Brainard wisely does not provide that estimate because she knows we will lock onto that number and will not let go. She doesn’t want to lay down that marker because she knows it can change all too easily.

Brainard doesn’t give you a number, but she still gives guidance. That guidance is all about the data:

Last year, the unemployment rate returned to pre-crisis levels, which required real interest rates that were below zero for nearly 10 years. This year, the unemployment rate has fallen further, and job market gains have gathered strength, at the same time that the federal funds rate has increased. This combination suggests that the short-run neutral interest rate likely has also increased. If, instead, the neutral rate had remained constant as the federal funds rate increased, we would have expected to see labor market gains slow. That inference is consistent with the formal model estimates, which indicate that the shorter-run neutral rate has gone up as the expansion has advanced. This is also suggested by the observation that overall financial conditions, as measured by a variety of indexes, have remained quite accommodative during a period when the federal funds rate has been moving higher.

The Fed has been raising interest rates, but that “tightening” has yet to be felt in the economy. Au contraire, the job market has strengthen in recent months and financial conditions remain loose. So it must be that the short-run neutral rate has risen – and arguably risen more than policy rates, which would account for the stronger job market. This, by the way, is what I think the Fed should be doing – talking less about the neutral rate estimates and more about the data. It’s the future of forward guidance.

With some guidelines on the kinds of data we should be looking at, Brainard shift to a discussion of the outlook. It’s an optimistic forecast: “…it seems likely that growth will remain solid.” And while she also shows some mild optimism that there remains room for addition improvement in labor markets, Brainard is clearly concerned about the stability of the inflation outlook:

At 3.9 percent, the August unemployment rate was about 1/2 percentage point lower than the previous year. If unemployment continues to decline at the same rate as we have seen over the past year, we will soon see unemployment rates not seen since the 1960s. Historically, the few periods when resource utilization has been at similarly tight levels have tended to see elevated risks of either accelerating inflation or financial imbalances…So far, the data on inflation remain encouraging, providing little signal of an outbreak of inflation to the upside, on the one hand, and some reassurance that underlying trend inflation may be moving closer to 2 percent, on the other…The past few times unemployment fell to levels as low as those projected over the next year, signs of overheating showed up in financial-sector imbalances rather than in accelerating inflation. The Federal Reserve’s assessment suggests that financial vulnerabilities are building, which might be expected after a long period of economic expansion and very low interest rates.

She apparently takes little relief from the stable inflation numbers to date, instead fearing a reprise of inflation or financial instability episodes of the past. And arguably the latter are currently the more relevant concern! What that means for policy is that the rate hikes keep coming:

Over the next year or two, barring unexpected developments, continued gradual increases in the federal funds rate are likely to be appropriate to sustain full employment and inflation near its objective. With government stimulus in the pipeline providing tailwinds to demand over the next two years, it appears reasonable to expect the shorter-run neutral rate to rise somewhat higher than the longer-run neutral rate. Further out, the policy path will depend on how the economy evolves.

No reason to pause at the longer-run neutral rate because that will not be shorter-run neutral. So what about all those Fed regional presidents talking about pausing at the longer-run neutral rate? Maybe we shouldn’t be paying too much attention to them.

Brainard repeats her yield curve story. The summary is that yes, she is aware of the historical implications of the yield curve, but this time is different so it is not an impediment to raising rates. Brainard also throws in the obligatory “data dependence” caveat, but it is clearly biased in a hawkish direction:

While the information available to us today suggests that a gradual path is appropriate, we would not hesitate to act decisively if circumstances were to change. If, for example, underlying inflation were to move abruptly and unexpectedly higher, it might be appropriate to depart from the gradual path. Stable inflation expectations is one of the key achievements of central banks in the past several decades, and we would defend it vigorously.

As I keep saying, the Fed is going to pick recession over inflation. That isn’t changing.

Bottom Line: The rate hikes are going to keep coming until it becomes more evident that growth will ease to what the Fed believes is a more sustainable pace. Don’t count on an automatic pause as rates approach 3%. And don’t expect the Fed to care about the yield curve if the data continues along its recent path.

Monday Morning Potpourri

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First, an excerpt from my latest on Bloomberg Opinion:

The Federal Reserve this month is widely expected to raise interest rates for the eighth time in the current hiking cycle that began in December 2015. Get ready for tensions within the Fed to spill over into the public as monetary policy moves closer to estimates of the neutral rate.

The Fed staff will likely push harder for policy makers to follow a model-based approach with fairly hawkish implications that would result in rates rising beyond what is considered a neutral level. Although Fed Chairman Jerome Powell doesn’t look married to the Fed’s models, he hasn’t provided a great deal of alternative guidance. That means policy will become less predictable in 2019.

Second, that said, policy is pretty predictable for the rest of this year. The Fed will hike rates in September, they will most likely hike rates in December, and at the December meeting they will likely signal they are not yet ready to pause. The continued strength of the US economy provides the simple reason the Fed will push forward with rate hikes in the near term. Indeed, the August labor report provides more evidence that the economy continues to charge forward despite the uncertainties induced by the Trump Administration.

Firms added 201k employees to their payrolls in August, pretty much the same pace as the last three months and the last twelve months. The unemployment rate held steady at 3.9%; the number of unemployed fell but the number of persons in the labor force did as well. The labor force participation rate continues to hover in a familiar range. The Fed will see this as reason to believe that the pace of job growth remains sufficient to push the unemployment rate still lower, keeping fears of overheating alive.

Attention fell heavily on the wage number as average wages rose to a cycle high of 2.9% year-over-year. This extends the trend of slow but steady increases in wage growth and will provide the Fed reason to believe that the economy is working as it should.

Note that the wage gains shouldn’t really be a surprise – wages had to rise to keep pace with inflation. Using core-PCE as a deflator (which I think it more appropriate than headline because it likely more accurately reflects expectations and abstracts away from some wild swings in recent years), real wage growth is hovering around its pre-recession level, say 1%, probably not too far from trend productivity growth.

A baseline expectation is that in a normal labor market, wage growth will be in the vicinity of real wage growth plus inflation (on average, headline and core inflation are very close over time). Assuming trend productivity remains constant near 1%, further labor market tightness should yield one of two outcomes – either real wages rise at the expense of profits margins or nominal wages and inflation rise in a lockstep pattern. The Fed would likely welcome the first outcome but would be unhappy with the second.

Looking forward, temporary help payrolls guide us to anticipate continuing overall job growth. It ain’t over yet – and that’s what keeps the Fed hiking until they get closer to their estimates of neutral policy.

Third, a little Fedspeak last Friday. Dallas Federal Reserve President Robert Kaplan said the job report confirms what I just said above. Via Fox Business:

“That tells me that over the next nine to 12 months, we ought to be raising the Fed fund rates probably at least three more times, maybe three to four times, to get to that neutral rate,” Kaplan said during an exclusive interview with FOX Business’ Edward Lawrence. “Everything that’s in this job report today just causes me to reaffirm that view.”

Kaplan doesn’t think trade concerns are materially impacting the economy yet and thus doesn’t provide a reason to pause in the near term. He also says that the fiscal stimulus will fade over the next two years and that he is watching for how demographic shifts expected to weigh on labor force growth will impact the economy over the next two years. Note that Kaplan has in the past stated his preference for a neutral-then-pause strategy.

Separately, Cleveland Federal Reserve President Loretta Mester described the jobs report as strong and justifying continued gradual rate hikes to push policy to a neutral level (see Bloomberg here). She adds that the economy has more “underlying momentum” than she believed in June. Watch for the impact of stronger growth on the “dots.” While we are all looking for the pause, maybe some of the Fed anticipates more rate hikes than currently expected.

Chicago Federal Reserve President Charles Evans released a speech originally prepared for his cancelled appearance in Argentina (never waste good copy!). After describing the economy and policy as returning to something more normal, the dove turns to a hawk:

Given the outlook today, I believe this will entail moving policy first toward a neutral setting and then likely a bit beyond neutral to help transition the economy onto a long-run sustainable growth path with inflation at our symmetric 2 percent target.

Yep, this is what the models are telling them to do. This will be the crux of the debate next year as the models demand more tightening. What I find most interesting is the adherence to these models even though, as Evans says, they will sustain the economy in the zone where the zero lower bound is likely to be an issue once again. One would think the Fed would continue to adjust policy accordingly in a dovish direction but increasingly is looks like many policymakers intend to 1.) fall back on old models and 2.) accept the likelihood of a return to the zero bound and be ready to use unconventional policy as needed. That strikes me as hawkish – the Fed said policy normalization is underway, and they mean it.

Bottom Line: Expect the rate hikes to keep coming. No reason to pause this year. In some sense, expecting a pause even after policy rates hit neutral is more hope than anything else.

Employment Report Up Next

The August Employment situation report is set to be released Friday morning. Most likely it will make little difference for the September FOMC meeting. I am challenged to see an outcome from this report that, in the context of the rest of the data, would forestall a hike at that meeting. And given strong momentum the US economy continues to enjoy, it seems that a December hike remains the baseline case.

Incoming data suggests the labor market remains solid. Employment components in both the manufacturing and non-manufacturing ISM reports both rose in August. Initial unemployment claims remains on a downward trend, falling to a record low with the most recent data. There is no evidence in that number that the tariffs announced to date have materially affected the labor market despite sporadic anecdotal reports of layoffs.

The ADP report estimates private sector payrolls for August of 163k, a bit soft relative to expectations but still enough to push unemployment down further over time. Altogether, the numbers point me to expect an employment gain of 190k tomorrow, pretty much in line with the consensus expectation of 195k in a range of 150k-237k. Note though that Calculated Risk reminds us that August is often below consensus.

To be sure, the Fed will be looking deeper into the report than just the job gains. Unemployment is expected to edge back down to it’s current cycle-low of 3.8%. That is a number that will keep fears of overheating alive, which in turn means ongoing rate hikes. Central bankers will also have their eyes glued to the wage numbers. Weak wage growth remains a mystery for the Fed and that mystery helps keep the rate hikes gradual. I suspect that signs of faster wage growth would rattle the Fed, raising concerns that hey have pushed too far past full employment. The policy implication would be either a faster pace of hikes or a longer period of hikes before the Fed pauses. Still, this has long been a risk and it has long been unrealized.

Looking forward, it appears that the economy holds the momentum of the second quarter. The Atlanta Federal Reserve currently pegs third quarter growth a 4.4%, a figure well, well above the median policymaker’s estimate of long run growth. It would be hard for the Fed to pause in the face of such a number. Support for a pause will grow as policy rates move closer to neutral (current estimates centered on a range of 2.75-3.0%). Until then, policy remains somewhat straightforward, but at that point the tension among Fed policymakers and staff will grow as some push for rates to rise above neutral and others advocate patience.

In Fedspeak today we had New York Federal Reserve President John Williams sticking to a story that supports a gradual pace of rate hikes. He remains willing to invert the yield curve if needed. Via Bloomberg:

“We need to make the right decision based on our analysis of where the economy is, and where it’s heading, in terms of our dual mandate goals,” Williams said Thursday while speaking to reporters after an event in Buffalo, New York. “If that were to require us to move interest rates up to the point where the yield curve was flat or inverted, that would not be something I would find worrisome on its own.”

Reiterating my opinion, an inverted yield curve is almost certain to be the only warning sign when that inversion happens, hence why the Fed tends to ignore that sign. In contrast, St. Louis Federal Reserve President James Bullard places more faith in the recessionary signal of an inverted yield curve. Still, I suspect that he would be in the minority of voting members next year should the yield curve invert. My thinking is that absent an obvious slowdown in the economy or a clear tightening of financial conditions that made a slowdown more than likely, the Fed will tend toward the direction of pushing past neutral even if it threatened or caused an inversion of the yield curve. We don’t have much guidance from Federal Reserve Chair Powell on the conditions for a pause.

Separately, Minneapolis Federal Reserve President Neil Kashkari provides this insight on Fed psychology, via Marketwatch:

There’s scarring from the financial crisis, yes. But there’s scarring, bigger scarring from the inflation of the 1970s. And I think that that is persuading us more than anything else and why we’re so biased towards … you know we say that we are we have a symmetric view of inflation. We don’t mind if it’s 2.1  or 1.9 but in our practice, in what we actually do, we are much more worried about high inflation than we are low inflation. And I think that that is the scar from the 1970s.

Yep, that sounds about right. If there was no threat of the zero lower bound, I think the Fed would have set the inflation target lower at 1.75% compared to 2%. Somewhere deep inside the genetic makeup of you average central banker is a deep aversion to inflation. And that is arguably a desirable quality in a policy maker charged with maintaining price stability. But that same quality has in recent years tend to lead the Fed to tighten maybe just a little too hard and a little too long with the result being no real threat to price stability but two recessions.

Bottom Line: Fed still hasn’t found a reason to pause. The US data isn’t really giving one.  And don’t expect emerging market turmoil to factor much into the Fed’s decisions – until the problem threatens to wash up on US shores, it will fall into the general category of “risks we talk about but don’t act on.”

Monday Morning Notes: The Rate Hikes Keep Coming

Jackson Hole came and went with little reason to believe the Federal Reserve will do anything other than raise interest rates in September and again in December of this year.

Bloomberg has a quick rundown of the action hereMy quick summary to start the week is that the Fed potentially has two big decisions ahead of it in the upcoming months. The first is whether or not to deliberately invert the yield curve – already nearly flat with a 10-2 spread of just 20 basis points as of Sunday night. The battle lines on this issue are already well defined. Some, like St. Louis Federal Reserve President James Bullard see an inverted yield curve as a fairly clear warning of recession (via Reuters), while others like Cleveland Federal Reserve President Loretta Mester tends to fall into the “it’s different this time” camp.

Last week Atlanta Federal Reserve President Raphael Bostic appeared to take a firm stand on the issue, claiming that he would not vote for any policy action that would “knowingly” invert the yield curve. Apparently he thought that with that comment he was writing a check he couldn’t cash because he quickly followed up with a blog post on the topic in which he chooses his words more carefully:

I believe the yield curve gives us important and useful information about market participants’ forecasts. But it is only one signal among many that we use for the complex task of forecasting growth in the U.S. economy. As the economy evolves, I will be assessing the response of the yield curve to incoming data and policy decisions along the lines I’ve laid out here, incorporating market signals along with a constellation of other information to achieve the FOMC’s dual objectives of price stability and maximum employment.

This is where I think most central bankers will find themselves if the yield curve inverts in the near future. Absent a financial crisis, a 10-2 inversion would most likely happen well before a business cycle peak. It will be just one out of a “constellation of other information” that will look fairly solid if not downright frothy. It would be hard for the Fed to ignore everything else in favor of the yield curve.

The second issue facing the Fed is to pause or not when the Fed reaches estimates of the neutral interest rate. The idea is that once they hit neutral, they should assess the impact of past rate hikes before moving toward a restrictive policy stance.

Interestingly, the question of a pause at neutral is not unrelated to the first debate. Given the median policy maker estimate of the neutral rate is 2.9% and the 10 year Treasury is hovering around 3%, a neutral policy stance implies a flat yield curve.  So pushing past current estimate of neutral would be inverting the yield curve unless long rates suddenly begin to move higher (think quantitative tightening, fiscal deficits, rising term premium).

Powell’s contribution to the Jackson Hole conference did not give much guidance on this point. He basic point was that central bankers should not take estimates of such policy metrics as the neutral interest rate too seriously. Policy needs to be based on good analysis but also good judgement. My takeaway is that he isn’t putting much faith into the Fed’s estimates of the neutral rate. If they get to those estimates and the job market continues to churn away, Powell & Co. might reasonably conclude that their neutral rate estimate is too low – just as they concluded that their initial estimates of the natural rate of unemployment was too high.

That said, I think a reasonable baseline remains that the Fed hikes rates three maybe four more times and then the data gives them reason to pause. But if the data doesn’t give them reason, they will be hard pressed to pause simply because they have reached their estimates of neutral.

Speaking of data, manufacturing activity keeps cranking away according to the industrial production report and manufacturer’s survey:The Atlanta Fed currently estimates third quarter growth at a whopping 4.6%. To be sure, it is still early, but it is hard to see the Fed stopping if the numbers are even well below that at say 3%. Look this week for personal income and outlays report with its read on consumer spending and of course inflation.

Bottom Line: The rates hikes keep coming. It is hard for me to argue that December isn’t pretty much already a lock, as is of course a rate hike next month.

Entering the Danger Zone

As we wait for Federal Reserve Chair Jerome Powell to take the podium in Jackson Hole and impart some wisdom on the economy and hopefully provide policy guidance as well, it is worth considering that we may be soon be entering a dangerous period for monetary policy – the time when the lagged effects of previous rate hikes have yet to reveal themselves in the form of slowing growth while inflation numbers continue to firm.

It is in such an environment in which the Fed has to be willing to take a risk that their estimates of neutral policy are more right than wrong and pull back from rate hikes if they want to keep the expansion alive. But Powell & Co. take such a leap of faith?

The US economy continues to ride along on the momentum of the first quarter. Economists surveyed by Bloomberg expect 3.0% growth in the first quarter, down from a smoking hot 4.1% the first quarter but still well above the 1.8% growth rate the Fed believes sustainable over the longer run. The Atlanta Fed is currently looking for another 4+% growth quarter. Job growth has been running at a monthly rate of 224,000 the past three months while the forward-looking indicator of initial jobless claims has been pinned down at record lows, promising more job gains to come. Manufacturing activity remains solid as well.

Moreover, the economy holds strong despite the uncertainty of trade wars and an emerging market pullback that includes the threat of financial crisis in Turkey. Overall, most important is that the Fed’s monetary tightening to date has apparently done little to slow the pace of activity down toward something the Fed thinks will ultimate be sustainable and noninflationary.

While the economy chugs along, price pressures are firming as evidenced by the rise of core-CPI inflation in July to 2.4%. To be sure, the Fed will tolerate some overshooting of their inflation target – it’s a symmetric target, not a ceiling. They will not overreact and accelerate the pace of tightening unless the overshooting looks to be significant and persistent. The rebound of inflation coupled with solid growth prospects looks likely to keep the Fed hiking rates at least twice more this year and into next as well.

Presumably, the Fed will be looking for an opportunity to pause in early 2019 so they can see the impact of their work. But will the data cooperate? Central bankers need some of the momentum of recent quarters to fade as tighter monetary policy and higher resource costs straight to weigh on aggregate activity. For example, I am hearing anecdotal stories of slacking demand for commercial construction due to sticker shock. Additionally, they will be looking toward 2019 and the fading impact of fiscal stimulus on the economy.

Such an actual and expected slacking of demand, combined with contained inflation and an increase of risks from abroad, could give the Fed room to pause. I view this as a best-case scenario in which the Fed shifts to an extended policy pause before a slowdown becomes so deeply ingrained that it turns to recession.

Danger lurks, however, in this stage of the business cycle. Due to long and variable lags in monetary policy, activity might not slow sufficiently quickly to deter the Fed from hiking rates. Moreover, they may still be witnessing a lagged impact of higher inflation from prior economic strength. This combination could push the Fed to hold rates higher for longer than is appropriate for the economy. Indeed, this is an error I believe the Bernanke Fed made at the height of its tightening cycle.

My sense is that the Fed will resist pausing until the data suggests enough slowing to put the economy on a sustainable path. If true, this is where the risk of recession rises as policy transitions from “less accommodative” to “neutral” to “restrictive.” That said, should Powell’s comments at Jackson Hole be relevant for the near-term policy path, I am watching for signals that he is looking to raise policy rates another 50 or 75 basis points into the range of estimates of the neutral rate and then be willing to pause even if the data flow remains strong. This will take of a leap of faith on the part of the Fed that their estimates of neutral are more correct than not and that continuing strong data simply reflects a policy lag.

Bottom Line: In recent years, the Fed has tended to choose recession over the risk of higher inflation, with the result being recessions in 2001 and again in 2007-09 while inflation remains locked down to the point it drifted persistent below the Fed’s target in recent years. Powell’s relative dovishness on inflation – he is more concerned that inflation expectations may have drifted downward than that they are poised to shift higher – may turn out to be the key insight that allows the Fed to navigate the economy through the coming policy danger zone. But beware that the Fed often just can’t stop itself from hiking until the data turn (too much backcasting and too little forecasting), which will most likely be too late to stave off recession.

Kaplan Looks Toward The Pause

Dallas Federal Reserve President Robert Kaplan had this to say about the neutral interest rate:

My own view, informed by the work of my colleagues Evan Koenig at the Dallas Fed as well as John Williams of the New York Fed and Thomas Laubach at the Federal Reserve Board, is that the longer-run neutral real rate of interest is in a broad range around 0.50 to 0.75 percent, or a nominal rate of roughly 2.50 to 2.75 percent.

With the current fed funds rate at 1.75 to 2 percent, it would take approximately three or four more federal funds rate increases of a quarter of a percent to get into the range of this estimated neutral level.

What should the Fed do when the Fed hits estimates of neutral? Kaplan would like to see the Fed pause:

At this stage, I believe the Federal Reserve should be gradually raising the fed funds rate until we reach this neutral level. At that point, I would be inclined to step back and assess the outlook for the economy and look at a range of other factors—including the levels and shape of the Treasury yield curve—before deciding what further actions, if any, might be appropriate.

This is an entirely reasonable approach as it acknowledges the existence of policy lags. It is very much possible that when the Fed hits the neutral rate, the impact of past tightening has yet to filter through much to the overall economy. Continuing blindly forward might then be a critical policy error if they have already tightened policy enough to ease growth down to a more sustainable level.

But can the Fed resist pressing forward if the data flow, particularly the jobs numbers, still suggest downward pressure on unemployment? I think that Powell & Co. could justify an extended pause on the basis of contained inflation and, more importantly, soft inflation expectations plus uncertainty about the natural rate of unemployment. Of course, if six to nine months from now core-PCE inflation is pressing up on 2.5% and wage growth is higher, the Fed would have a hard time waiving off ongoing strong job numbers.

The cleanest outcome is that economic activity moderates over the next six to nine months as the higher rates and tighter resource constraints bite. Housing, for example, is showing signs of moderating, particularly multifamily housing. A clear slowing of activity would go a long way toward helping the Fed shift toward an extended pause in the cycle. It would be realistic to consider the rate cycle to have peaked after 3 or 4 more 25bp points.

Bottom Line: For now, the Fed will stick with the policy of gradual rate rate hikes, almost certainly two more this year and one next. But the time is coming when going forward or standing still will not be an easy choice. The more dovish policy makers and those most worried about the yield curve are laying down the rational for standing still. It would be nice for permanent voting members of the FOMC need to start weighing in more on this debate.

Bostic Throws Down the Gauntlet

Atlanta Federal Reserve President Raphael Bostic threw down the gauntlet today with a declaration to dissent any policy move that will invert the yield curve. He may get the chance to make good on that threat in December – his last meeting in his current rotation a voting member.

Bostic, via Bloomberg:

“I pledge to you I will not vote for anything that will knowingly invert the curve and I am hopeful that as we move forward I won’t be faced with that,’’ Bostic said Monday in Kingsport, Tennessee, in response to an audience question. “The market is going to do what the market does, and we have to pay attention and react.’’

Arguably, there is some wiggle room here – the criteria for dissension is that the policy must “knowingly” invert the yield curve. And I suppose he could abstain from voting rather than dissent.  Moreover, it is important to know what he views to be the relevant portion of the curve. Is it the 10-2 spread? Or the 10-Fed Funds spread? Inquiring minds want to know!

Still, Bostic reveals here a fairly strong conviction that the yield curve must be taken seriously as a warning sign that policy is in danger of turning too tight. His hopefulness that the Fed will not be faced with this decision, however, might be misplaced.

The 10-2 spread has narrowed to 24 basis points. Still not a recession indicator, or even an indicator of weakness in my opinion. What I am looking for is 10-2 inversion plus continued Fed tightening as a recession warning signal. But it is fairly easy to see how a Fed hike in September combined with expectations of continued gradual rate hikes into 2019 pushes the 10-2 spread close to inversion by the time the December meeting rolls around. It is also fairly easy to see that the US economy retains enough strength to justify a rate hike at that meeting. A rate hike at that point could reinforce future rate hike expectations and then push the curve into inversion. This would give Bostic the opportunity to follow through with his threat and dissent – if of course the 10-2 spread is the relevant spread.

Alternatively, if the 10-Fed Funds spread is his focus, his threat might be fairly meaningless as that inversion would not happen until much later. And probably by the time that happens a recession would be baked in the cake. In other words, his threat is only meaningful if he focuses on the long-leading indicator of the 10-2 spread.

And more importantly his threat means little to policy unless he can pull a significant portion of the voting FOMC members in his direction. While some Fed regional presidents are sympathetic to Bostic’s position, they still make up a minority of policy makers. Nor are they voting now. My guess is that given the 10-2 spread is such a long leading indicator, it will invert at a time when that data, from the Fed’s perspective, supports further rate hikes. Hence they are likely to hike through an inversion.

Bottom Line: My sense is that the majority of the Fed would find more reasons to ignore than embrace the signal from a 10-2 yield curve inversion. They will fall back on the basic theory that this time is different because the curve inverts at a lower level of rates than in previous inversions. If the yield curve doesn’t stop them from continuing rate hikes, what will? Certainly a clear slowdown in activity would do the trick. But that is obvious. Less obvious is the possibility that they pause after reaching their estimates of neutral even if the data remains consistent with above-trend growth. That would require something of a leap of faith by Powell & Co. that the lagged impacts of tightening had yet to materialize in a slower pace of activity.

Data Flow Continues To Support The Fed’s Narrative

The July employment report provides additional evidence to support the Fed’s campaign to tighten policy rates. At the same time, subdued wage growth indicates that despite anecdotal evidence of rising salaries amid hiring challenges, the labor market has yet to overheat. That lack overheating allows the Fed to continue to tighten gradually; they have little reason to justify accelerating the pace of hikes at this time.

Nonfarm payrolls grew by 157k in July, somewhat below consensus expectations. Previous months, however, were revised higher, leaving the three-month average at a healthy 224k. This rate of growth exceeds the rate the Fed believes is necessary over the longer-run to hold the unemployment rate constant over time, around 100k jobs per month. Still, this is not necessarily a speed limit in the near term when cyclical factors might dominate the demographic trends. Indeed, an uptick in labor force growth in recent months slowed the declines of the unemployment rate. That rate edged down to 3.9% in July, a bit higher than the cycle low of 3.8% in May.

Wage growth has been improving over the past few years, but that improvement occurs at a glacial pace. Mediocre wage growth indicates there remains room to squeeze labor markets further, hence the Fed will be in no rush to push policy rates to a neutral level, let along push rates even higher in an effort to slow economic activity. Steady as she goes at 25 basis points a quarter for this year and likely into next.

To be sure, the employment report is a backwards looking indicator. But continuing low levels of initial unemployment claims coupled with ongoing growth in temporary help payrolls gives us little reason to expect anything but continued job growth in the months ahead.

Powell & Co. will likely find they need to calibrate policy a bit more carefully before too much longer. They can afford to be on something like autopilot of hiking 25 basis points per quarter when policy rates are well below neural and the economy shows few signs of overheating. Once rates are closer to neutral, they will likely want to move a bit more cautiously (assuming inflationary pressures continued to remain subdued). To be sure, the economy might break on either side of the current Goldilocks dynamic, forcing central bankers to adjust policy accordingly. For now, however, the best bet remains that they will keep pushing rates higher with hikes in September, December, and probably March before economic conditions change markedly.

Bottom Line: As the economy heads deeper in the second half of the year, the employment report falls in line with the general data flow and points toward a continuation of the current path of monetary policy.