Inflation, General Data Flow, Fiscal Stimulus, And Implications For Monetary Policy

The data flow remains supportive of the Fed’s forecast of sustained moderate growth. A spike in prices, however, drove core CPI inflation to the fastest monthly pace since 2005, again raising fears that the Fed will accelerate the pace of rate hikes. I still think this is premature. To be sure, the risk is that the Fed hikes rates more than the projected three times this year. But Powell & Co. will need more data to support a faster pace of rate hikes. They will not overreact to data that may prove to be nothing more than a flash in a pan. 

Continued here as a newsletter…

The gains in core-CPI inflation in January were impressive. Month-over-month inflation came in at an annualized of 4.27 percent, a rate unmatched since a 4.29 percent reading in March of 2005. Rising prices across a broad array of categories drove the gains, with apparel, transportation, used cars, and medical care services standing out among the major sectors.

The breadth of the gains is at first glance somewhat disconcerting and suggestive that maybe the dam has broken. Perhaps it was premature to declare the Phillips curve dead. I think though it remains too early to make that call. First, some of the gains, such as apparel, are almost certainly not likely to be sustained. Second, note that a major component of CPI inflation, shelter, remains off its peak. Continued restrained housing costs will weigh down the overall measure. And third, there may be some lingering seasonality issues as play. In a low inflation environment, the number of times firms raise their prices falls, and the timing of the remaining increases may be concentrated around the December and January. Also, firms may have a tendency to raise prices along with minimum wage increases, also January.

The Fed will of course be delighted that their forecast inflation rebound looks more likely to be true this year than last. But they will also be wary of reading too much into recent data. They have been fooled before; after such a long run of disappointing below-target inflation, they will not break out the champagne just yet.

More data will be needed to raise the Fed’s confidence in the sustainability of inflation. At this point, the inflation numbers justify maintenance of their existing forecast. They do not, however, justify raising the forecast. Assuming the Fed behaves like last year, they will not over-react to higher than expected inflation if they think it is transitory within the context of their forecast. Changing their rate hike plans requires that inflation will not revert to target over the projected medium-term policy conditions. It is too early to say that.

With this in mind, beware of reading too much hawkish intent into the minutes of the January meeting. We don’t want to confuse increased confidence of a rate hike in March with an intention to change the pace of rate hikes. Moreover, note also the meeting preceded the recent volatility in financial markets. Any concerns over excessively easy financial conditions have likely moderated since then.

The data flow last week included more than just CPI. Weaker than expected retail sales data suggest that consumer spending momentum faded in December and January. Recall that the consumer boosted GDP growth in the final quarter of 2017; this could be an indication that this strength will not carry forward into 2018. Which means be cautious with any 2018 forecast inflated by activity in the latter months of last year. The Fed is looking for a healthy (by recent standards) 2.5 percent growth this year. They will need the consumer to cooperate to hit that mark.

Industrial production fell 0.1 percent compared to December. The less volatile annual number has rebounded to the pace of activity experienced prior to the 2015 oil price shock. Given the strength and magnitude of the rebound, I would not be surprised if some of the cyclical momentum recedes in the coming months. Also watch the auto sector. Sales began moving sideways in late-2015 and were in a downtrend for much of last year. The sector was “saved” in some sense by hurricane damage sales, but that factor looks to be fading.

Housing starts continued to grow throughout 2017. Multifamily held up better than I expected, which is good news for both sustaining aggregate demand and constraining shelter inflation. Single family continues to make ground, albeit still well below pre-bubble levels. The ongoing aging of the millennial population should maintain upward pressure on single family construction even as multifamily activity levels off.

How does fiscal stimulus fit into the picture? As is well known at this point, the US economy is about to run an experiment with a late cycle fiscal stimulus. It is also widely believed that the US economy is already operating near full employment. It is also widely believed that the potential growth rate lies below expected growth for this year. And next year as well, even in the absence of the recent spending package. So arguably the stage is set for economic overheating by the middle of 2019 if not earlier.

The primary concern is that when the Fed realizes the magnitude of the overheating, central bankers will quickly hike interest rates and trigger a recession. While there is some talk that this recession will come as early as 2019, that seems too early to me. Given the lags in monetary policy, I think the Fed would need to hike rates over 100 bp in the by the middle of this year to push the economy into a mid-2019 recession (and if that happened, this will be the best timed fiscal stimulus in history).

In any event, you can find the worrisome story in many places, so I think maybe it is best for me to chart a less worrisome scenario. That scenario has four elements. The first is that the cyclical momentum of late last year will fade as the year progresses. Hence why comined with gradual tightening, the Fed’s 2019 forecast has growth slowing to 2.1 percent. Consequently, some of 2019’s fiscal boost is just offsetting that cyclical fade. Second, a substantial portion of the fiscal boost may be simply offshored in the form of a higher trade deficit. That relief valve helps prevent the US economy from overheating. Thus, while there might be a domestic demand boost, the stress on domestic capacity will be limited by the trade deficit expansion. Third, we don’t actually know how much capacity remains in the US labor market. Even a modest acceleration in wage growth might drive up labor force participation. Or increase labor saving investment, which would boost productivity. Either would raise potential growth.

Finally, we are running this fiscal policy environment in a very different monetary policy environment than the 1980’s. Inflation expectations are low and well anchored. Moreover, those expectations are reinforced by an explicit inflation target. It may be that the Fed does not have to hike interest rates aggressively to keep a lid on inflation pressures. In other words, no sharp slowing of the economy required. Gradual rate hikes will do the trick – although those hikes will continue into 2020.

Another possibility is that the persistent low interest rate environment signals that the US government should be running a higher structural budget deficit. This alleviates a global safe asset shortage driven by a surplus of global savings. Arguably, as the issuer of the global reserve currency, the US has a responsibility to creates these safe assets. And maybe that is what is necessary to “normalize” the term structure into a range that frees monetary policy from the zero bound problem. So maybe rates rise faster and or higher than expected, but in way that leaves the Fed simply chasing the long rate higher that returns policymakers to the more familiar, pre-Great Recession world.

Bottom Line: There are many, many moving pieces as the economy moves deeper into the economic cycle. It is a complex environment made only more so by the fiscal stimulus barreling down on the economy. My general takeaways: 1.) The data flow is generally supportive of the Fed’s forecast, 2.) the risk is that the Fed moves at a faster than anticipated rate of hikes 3.) that said, the Fed will not overreact to any one data point 4.) the Fed will adjust policy as necessary to maintain the inflation target over the medium run, 5.) the current policy operating environment of low and anchored inflation expectations leaves open the possibility that the Fed does not need to choke off fiscal stimulus even if it threatens to overheat the economy, 6.)  fiscal stimulus does not increase the risk of recession in 2019 as much as in subsequent years if it is revealed that the Fed fell behind the inflation curve, 7.) fiscal stimulus though makes the Fed’s 2019 and 2020 rate forecast more likely. 

Stick To The Forecast

“So far, I’d say this is small potatoes…”

New York Federal Reserve President William Dudley, February 8, 2018

“All that said, given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.”

Federal Reserve Chairman Ben Bernanke, May 17, 2007

Friday was yet another day of wild swings on Wall Street as market participants continue to digest the implications for stocks and bonds of this new stage of the business cycle. In short, there looks to be a painful repricing underway that involves a new equilibrium set of prices for bonds and stocks. For now, though the Fed doesn’t care about your pain. At least that’s the message from Fed officials. They want to keep the focus on the bigger picture. That bigger picture is the economic forecast – which continues to point to gradual rate hikes.

Continued here as a newsletter…

My position on Wall Street’s gyrations remains unchanged. Until late last year, the risk of higher interest rates was underappreciated. It wasn’t until the fall that the realization started to sink in that the Fed was nowhere near calling it quits. The economy was normalizing faster than anticipated. The wounds of the financial crisis were healing, leaving the stage set for the best economy since the late 1990s.

Stock prices, however, did not reflect this new reality. Even a partial normalization of interest rates would require a repricing of equities. The gains in stock prices in recent months were excessive. A correction was not unexpected. The spark for that correction appears to have been a solid employment report (although it is reasonable to say that we never really know why the psychology shifts).

I think that the shock to Wall Street is more likely than not to be contained to Wall Street. This looks more to me like 1987 than 2007. Indeed, I think this shock has a silver lining in that it might extend the length of this expansion.

Central bankers appear to feel similarly – the hit to stocks to date has yet to meaningfully impact their forecast. This is the message they want to push to sustain expectations that another rate hike is coming in March. See San Francisco Federal Reserve President John Williams, who I think lays this out nicely in this speech.

Logic would point us in the same direction even without policy maker guidance. Note that the Fed did not raise their rate hike expectations in light of the positive shock to equities over the past couple of months. An offsetting negative shock should then not cause a change in forecast either. We also know from the Fed minutes that some officials were concerned about the possibility of a drop of equity prices and the potential negative implications for the economy. These individuals will likely take comfort in some steam coming off of financial markets. Better a small hit than a 1987-like crash. Other officials saw high equity prices as reflective of very low neutral rates. They will see then see lower equity prices as a natural consequence of rising neutral rates – something that both looks to be happen and is consistent with their forecast.

Indeed, I would add higher long-term rates give greater credence to the Fed’s rate forecast for this year and next. Chasing the long end of the curve is exactly what is needed if policy rates are going to return to something much more “normal.” Watch the very long bond – the anchor of the 30-year yield is slipping.

All of that said, I am not sure I would, like Dudley in the quote above, dismiss the market move as “small potatoes.” A ten percent swing in prices is going to hurt someone. Someone is on the bad side of a leveraged trade. How big and how bad, I don’t know. What I do know is that small events can balloon into larger problems. I don’t think that is the case in this instance, but neither did then-Federal Reserve Chairman Ben Bernanke in 2007. The lesson from then should have been that policy makers are wise to approach this things with a bit more humility, at least in public.

The further the financial crisis fades into the past, the more lessons will be forgotten.

I suspect the challenge for the Fed will be to keep market participants focused on their medium-term forecast. If, as many believe, wage growth and inflation make an appearance this year, the Fed will have the opposite problem from 2017. Then they struggled to keep the focus on gradual rate hikes despite disappointing data. In retrospect, I think the dovish policymakers did us few favors last year, tamping down rate hike expectations that then were quickly reversed in recent weeks.

In 2018, we should be cautious of the opposite, of rising rate hike expectations (to four and beyond). To be sure, this is the risk to the forecast. But policymakers will likely send a message that they will not overreact to higher inflation just as they did not overreact to lower inflation in 2017. I don’t think anyone could be faulted for believing that two percent is a ceiling, not a target. This would be the opportunity for the Fed to disabuse us of that notion and prove that the inflation target is symmetric. I suspect this message would be well received by market participants fearful that the Fed is going to accelerate rate hikes at the slightest provocation.

Bottom Line: Gyrations on Wall Street look to be best described as a negative shock that simply reverses a recent positive shock. If the latter did not have time to feed through to the broader economy, then the former will have limited negative impact. Unless that situation changes, keep an eye on the economic forecast for signals on the likely path of monetary policy. In particular, watch for policy makers to emphasize the symmetric nature of their policy target. This is potentially the first time in a long time they can prove the target is indeed symmetric. They can maintain focus on the forecast and calm market jitters without glibly dismissing the possibility that last week proves to be the tip of an iceberg.

Not Over Yet

The equity market resumed its slide on Thursday, taking the Dow and S&P500 down by 4.2% and 3.8%, respectively. Since the downturn in equities began, Fed officials have largely stuck to the party line – more rate hikes are coming. This should not come as a surprise. The magnitude of the declines still falls well short of that necessary to induce the Fed to change course, especially in the context of the recent pace of gains. That means that until losses deepen, market participants are on their own.

Continued here as a newsletter…

My baseline interpretation of recent events: The US economic expansion not only continues unabated, but is currently riding a cyclical upturn. The momentum from that upturn looks to continue long enough for the Federal Reserve to realize its policy rate forecast for 2018 – and into 2019 as well. This message began to sink in last fall, showing up, for example, in a steady rise in 2 year yields. The reality of the situation set in more deeply after the solid January employment report with its surprise wage gain.

That alone should have been enough to encourage market participants to see that the economy was in some sense “normalizing” as the scars of the financial crisis healed, allowing the Fed to continue to raise interest rates. Adding to this environment is a tax cut and now a spending bill that look to widen the structural US deficit. Fiscal policy is thus set to add further fuel for an economy that is arguably already pushing up against full employment. The prospect of an overheated economy tilts the odds in favor an even more aggressive monetary policy stance.

In short, interest rates needed to adjust to this new outlook. Note that this has long been built into the Fed’s forecasts, which assumed that neutral rates would rise as the financial crisis moved further into the rearview mirror. This appears to be what is happening.

In the meantime, equity prices continued to rise relentlessly – the pace clearly had a frothy feel to it. A correction was likely to occur, and I argue that the sooner it occurred, the better off we will be in the long run. The employment report seemed to be the trigger for that correction.

Recent price action between bonds and equities suggests to me that market participants are incorporating all of this information and in the process grinding out a new equilibrium that takes longer-term interest rates up a notch and equity prices down a notch. This makes sense to me in the context of an economy that has shifted into a mature phase. As the US economy moves closer to full employment, the constellation of prices in the economy will shift. Wall Street is a place where that shift happens.

Within the context of this adjustment, however, lies a signal extraction problem. It is difficult to differentiate between a readjustment of pricing and a crash. Hence, there is a tendency to step aside until the dust settles. That tendency tends to exacerbate market turmoil. It takes some time for this kind of thing to sort itself out.

In the meantime, monetary policy makers appear to believe that they have already solved the signal extraction problem.  St. Louis Federal Reserve President James Bullard called this “the most predicted selloff of all time.” New York Federal Reserve President William Dudley – the man of “more” or “less” compelling fame, also sees the turmoil as a nonevent:

“This wasn’t that big a bump in the equity market,” Dudley said at a moderated question-and-answer session in New York on Wednesday. “The stock market had a remarkable rise over a very long time with extremely low volatility,” he said, adding: “My outlook hasn’t changed just because the stock market’s a little bit lower than it was a few days ago. It’s still up sharply from where it was a year ago.”

Dallas Federal Reserve President Robert Kaplan described the volatility as possibly a “healthy thing.” San Francisco Federal Reserve President John Williams reiterated his position on the economy:

I am optimistic about the economy, but I expect continued moderate growth, with no Herculean leap forward. So given that the economy’s performing almost exactly as expected, you can expect policymakers to do the same.

He added:

 For the moment, I don’t see signs of an economy going into overdrive or a bubble about to burst, so I have not adjusted my views of appropriate monetary policy. So my message to those concerned about a knee-jerk reaction from the Fed is that, as always, we’ll keep our focus on the dual mandate and let the data guide our decisions.

This is clearly intended to tamp down fears that the Fed will suddenly accelerate the pace of rate hikes. While I think the risk is weighted towards more than three hikes this year, I also think that such a policy shift requires some real change in the medium-term forecast. Changes in the near-term forecast did not affect the path of policy last year. The same seems likely to be the same this year. And if anything, the market turmoil enforces the current forecast and reduces the risk of a fourth hike.

Bottom Line: After many months of calm, we are now experiencing a painful readjustment. I think that pain is likely to continue until we sort out a new set of prices in the economy. The Federal Reserve looks set to allow that adjustment to continue unimpeded. They even seem to have expected the adjustment. For now, central bankers expect to maintain a gradual pace of rate hikes; it will take a much deeper correction – or evidence the correction to date is sufficient to trigger systemic damage in the financial markets – before they alter that that plan. 

Be Thankful for the Stock-Market Selloff

The meltdown on Wall Street in recent days might have an upside: It could help extend the length of the expansion.

I had three primary concerns about the extent of the equity rally of 2017 and the beginning of 2018. The first was that it could shift the Federal Reserve in a hawkish direction. The second was that it would extend beyond Wall Street to Main Street, heightening the risk that a market crash would spread through the broader economy. The third was that a selloff would derail the Fed’s interest-rate hike plans and even force it to cut rates. A more modest pace of gains would help ease these worries.

Continued here on Bloomberg...

Market Turmoil Isn’t Enough to Make the Fed Change Its Plans

In mid-January, well before the recent turmoil in financial markets, I wrote that although it is hard to bet against equities in the midst of an economic expansion, stock markets felt frothy, with excessive gains in recent months.

That would have been a good market-timing call. A period of steady, good economic news, including data on U.S. wages that raised fears of a more aggressive Federal Reserve in the months ahead, helped trigger a shift in market psychology. The sell-off that began Feb. 2 turned into a rout on Monday. Not a particularly welcome event for the new Fed Chair, Jerome Powell.

What’s next….?

Continued on Bloomberg Prophets….

Unpleasant, Not Unexpected

Well, that was unpleasant. But not completely unexpected.

Continued here as a newsletter…

I don’t think it is possible to examine Monday’s action on Wall Street without the context of the last few months of rapid and virtually uninterrupted gains. Equity prices were easily outpacing historical gains during tightening cycles. And we even lacked the productivity story of the late 1990’s that helped drive gains during that period. In short, markets felt frothy. A correction was waiting to happen.

As far as the exact cause is concerned for why the correction occurred Monday, there probably isn’t one. Leadership change at the Fed? Unexpectedly high wage growth? Political uncertainty? Perhaps none, or perhaps all contributed to the psychological shift that drove Monday’s wave of selling.

What I am fairly confident about is that the sell-off is more about correction for an overly fast pace of gains than a sign that the economy will likely turn the corner. Nor do I think the sell-off is of a magnitude that would materially change the outlook for the economy or monetary policy. This I think will be the message from Fed officials.

My baseline scenario is this: The January employment report suggests that the economy is operating close to or beyond full employment. Moreover, incoming data such as the recent ISM reports on the manufacturing and service sectors are consistent with an economy that maintains solid cyclical momentum. That momentum will receive an additional boost from tax cuts.

The implication for monetary policy is that the Fed is most likely to continue to raise interest rates. In the absence of deeper market declines, or the revelation that the declines are triggering systemic damage via leverage within the financial sector, the Fed will I suspect welcome the recent market declines. Taking the froth out of the markets early helps sustain the expansion will be the thinking. First, there is less likelihood the excess on Wall Street will spill over into Main Street as in the last two cycles. Second, policy makers will feel less pressure to raise rates to rein in financial markets. They can hold their attention to where it should be, the dual mandate.

A less ebullient equity market will thus help reduce the risk of a fourth rate hike this year. That fourth hike now seems “less compelling.” That said, I still don’t believe equity prices would have been the driving factor in any event. The aggressiveness of the Federal Reserve this year will depend more on inflation outlook. The Fed will tolerate higher wage growth; what they won’t tolerate is a forecast of persistent inflation in excess of their target.

Of course, getting policy right is easier said than done. The challenge facing newly minted Federal Reserve Chair Jerome Powell is navigating policy during a mature phase of the business cycle. Powell faces a mature economy that is closer to full employment than arguably any time since the last 90s. That is usually close to the tipping point in the business cycle. Typically, the Fed needs to continue to tighten policy to prevent overheating of the economy, but it is easy to over tighten and tip the economy into recession. Powell’s challenge will be to both keep snugging up on policy while both resisting calls to accelerate rate hikes late in the cycle and knowing when enough is enough – when to pull back from tightening. The last point is probably the most difficult due to lags in the policy process.

This is a challenging position for any Fed chair.

Bottom Line: Don’t panic just yet. Market declines do not appear tied to an earnings warning or recession threat (like 2015/206) nor are they sufficient to derail the expansion. In fact, you can argue that at this point they lengthen the expansion. What does it mean for monetary policy? It’s not a fun day to start his tenure leading the Fed, but it is still too early for Powell to be thinking about implementing the “Greenspan put.” Way too early. Fed officials will tell you they are watching financial markets but that the economic data still guides their policy decisions. Take them at their word. We need a couple of more days like this to change that story.

Moving Pieces

There are lots of moving pieces right now. So many that few wanted to step in front of last week’s selling on Wall Street. I am going to try to sort out some of these pieces here.

Continued here as a newsletter…

The employment report and, most notably, the pop in wages caught analysts off guard. If you were expecting the job market to slow down early this year, you continue to be on the wrong side of the story. Employers added 200k workers to payrolls in January, close to the three-month average of 192k. Curiously, the unemployment rate has held steady for four months in a row despite job growth well in excess of labor force growth. To be sure, those numbers come from different surveys, so they don’t need to match up month to month. Still, I think the household survey will eventually catch up and hence we should be prepared for a sharp lurch downward in the unemployment rate in the coming months.

Wage growth accelerated to 2.9 percent year over year, a sharp rebound. I think there are two stories to tell here. First, 2.9 percent by itself isn’t cause for concern that labor markets are overheating. If inflation were at 2 percent, then real wage growth would be 0.9 percent, which is pretty much in line with productivity growth. In other words, this isn’t an inflationary reading on wages. Moreover, hours worked slipped, setting the stage for a productivity boost in the first quarter. Higher productivity growth, even just 0.5 percentage points, would help support nominal wage acceleration in a continued low inflation environment.

The second story, however, is arguably more disconcerting for bond traders. Annualized wage growth in four of the last five months exceeded 3 percent. In two of those months the gain was more than 5 percent. The three-month moving average is a 4.1 percent gain. That marks the fastest three-month gain since 2008. This solid pace over the last several months suggests that the January number is more than just higher minimum wages. If this trend continues, the Fed will tend to see such numbers as evidence that the economy has pushed excessively past full employment.

To be sure, such wage growth doesn’t have to be inflationary – productivity could leap higher to above 2 percent, or profit margins squeezed. Or some combination of the two could come to pass. But any way you look at it screams caution in the near term until it all gets sorted out. Consider these possibilities:

  1. Wage growth acceleration indicates an overheating economy. The risk here is that the Fed turns hawkish and accelerates the pace of rate hikes. This puts upward pressure on the yield curve in the near term while in the medium term supports renewed flattening as the Fed tightens policy to restrain growth. The risks of a policy error rise, and with it the risk to corporate profits.
  2. Wage growth indicates productivity growth is accelerating. Under this circumstance, the neutral rate is likely moving higher and the Fed will feel compelled to chase that rate. That argues for an upward shift of the yield curve. Higher real rates would likely pressure asset valuations more broadly, weighing on equity prices.
  3. Wage growth acceleration eats into profit margins. This is a complicated space for the Fed. Margin compression would weigh on equity prices and financial conditions more broadly, which would tend to ease pressure on the Fed to hike. On the other hand, central bankers would be wary that eventually firms would be forced to pass on higher costs. In other words, margin compression would provide only temporary relief from the inflationary pressures of an overheated economy. The Fed would thus need to accelerate the pace of rate hikes.

Under any of these circumstances, I think Gavyn Davies at the Financial Times is correct that the end of deflationary bets means the term premium has moved higher as well. Altogether then what it looks like is that the economy is shifting into a new equilibrium and with it the constellation of prices (goods, assets, interest rates, exchange rates) are all shifting as well. And while that shift occurs there will be periods of uncertainty that will be negative for dollar assets. That uncertainty will remain until there is more clarity with regards to the path of economic activity.

If all of this wasn’t enough, market participants are also watching for an increased supply of US Treasury debt plus a simmering political crisis in the US that looks increasingly likely to boil over in the weeks ahead.

My sense is that much of the shifting is cyclical rather than secular and as such I don’t see ten-year yields jumping to 4 percent and instead expect much more resistance as 3 percent is crossed. That said, I can certainty understand where market participants are wary about reaching out to catch that falling knife.

Two central bankers spoke up during last Friday’s sell off. San Francisco Federal Reserve Bank President John Williams said that the economic forecast remains intact and hence the Fed should maintain the current plan of gradual rate hikes. He does not think the economy has “fundamentally shifted gear.” For what it is worth, it is my impression that Williams is slow to update his priors. His colleague Dallas Federal Reserve President Robert Kaplan also retains his base case of three rate hikes in 2018, but opened the door to more. My sense is that Kaplan is sensitive to the yield curve and will tend toward chasing the long end higher.

Also, if the economy is shifting gears, watch for St. Louis Federal Reserve President James Bullard to warn of an impending regime change in his model and with it a possible sharp upward adjustment of his dot in the Summary of Economic Projections.

Bottom Line: If as I suspect much of what we are seeing in the economy is a cyclical readjustment, then long term yields will likely reach more resistance soon while short term yields will continue to be pressured by Fed rate hikes this year and beyond. If the Fed turns hawkish here they will likely accelerate the inversion of the yield curve and the end of the expansion (this could be the ultimate impact of the tax cuts – a short run boost to a mature cycle that moves forward the recession). If a more secular realignment is underway, long (and short) rates have more room to rise. It is reasonable to be unable to differentiate between these two outcomes as this juncture.

Employment Report Preview

Big data day coming up with the monthly employment report. Most likely the report will not yield anything to prevent the Fed from raising rates. 

Continued here as newsletter…

What to expect from the report? Consensus expectations for payroll growth remains at 175k in a range of 150k to 205k. The ADP report suggests the consensus is too pessimistic. Of course, the same could be said of the last report as well. That said, my expectation is that the report is more likely to surprise on the upside rather than the downside. Note though that even a report that falls short of expectations like last month (payroll gain of 148k) remains sufficient to keep the Fed on track for further tightening.

Wall Street also expects the unemployment rate will hold constant at 4.1 percent. Here again I think the risk is weighted toward a better number. Job growth continues to run ahead of labor force growth; eventually this will translate into a lower unemployment rate. Remember that the unemployment rate is already just a small step away from the Fed’s year end estimate of 3.9 percent. A 0.2 percentage point move in a single month is not in any way outside the realm of possibilities. All else equal, such a move would place upward pressure on the Fed’s rate forecast.

Of course, all else is almost never equal. Continued tepid wage gains would likely induce further reductions in the Fed’s longer-run unemployment estimates. And tepid wage gains are expected to continue with Wall Street anticipating just 2.6 percent higher hourly earning relative to last year.

Part of the low earnings growth can be attributed to low inflation. Part can also be attributed to low productivity growth. Compared to a year ago, real output per worker in the final quarter of 2017 was up just 1.1 percent. Note that real hourly earnings growth for all employees was up just about the same amount at 0.96 percent. In short, real wage growth remains stuck at just where you might expect it to be given productivity growth and inflation.

Even with low productivity growth, in theory real wage growth could accelerate if labor markets remained sufficiently tight to drive up nominal wages but competitive pressures were sufficient to restrain inflation. The difference would come from profit margins, which would likely weigh on equity prices. Still, it is not yet clear that the Fed is willing to run that experiment.

Finally, note that the still low productivity numbers suggest the economy remains in a low r-star world. That suggests some caution is assuming the upward pressure on long yields can be maintained.

Bottom Line: Employment report will keep the Fed on track. Most likely it will entrench expectations of three rate hikes this year. Relative to consensus expectations, I see the risks as weighted toward raising the probabilities of more rather than less. 

Fed Stands Pat, But More Rate Hikes Are On The Way

As anticipated, the Fed left rates unchanged at the conclusion of yesterday’s FOMC meeting. The statement was little changed but the handful of revisions point to continuing rate hikes. The Fed remains on track for three 25bp rate hikes in 2018. For the most part, the turnover at the Fed combined with ongoing solid data has left the remaining doves sidelined. The low inflation warnings of last year were largely a head fake as the Fed was always positioned to continue raising rates as long as there looked to be continuing downward pressure on unemployment.

Continued here as a newsletter…

The FOMC statement was largely unchanged compared to December. The Fed dropped the hurricane references as they were no longer relevant for the outlook. The Fed revealed additional confidence in the inflation outlook by dropping the reference to low near-term inflation in place of an expectation that inflation will rise this year. The firming of recent inflation numbers likely influenced this change although it was evident in the Fed’s forecast from December.

Risks remain roughly balanced; they did not delete the “roughly.” They are still watching inflation developments, but note that this can cut both ways. Last year it arguably reflected the influence of doves worried about low inflation. Now it could be interpreted as the influence of hawks worried about high inflation. In either case, the Fed remains data dependent.

More curious was the addition of the word “further.” As in:

The Committee expects that, with further gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market conditions will remain strong. 

It would be nice to have had a press conference to see if there was any significance to this change. In my view, the reason for this change was to dissuade anyone from thinking the Fed was done hiking rates.

Arguably then you can say this statement is more consistent with the message of the SEP than the last statement. The message of the December SEP was that inflation will climb in 2018 and so too will rates. The December statement was arguably a bit mushy on both points. The January statement thus clarifies the likely path of policy.

So maybe we should read the January statement as an effort to make the statement more consistent with the forecast? And that this was easier to accomplish with some of the more dovish voices rotating off as voting members? Something to get some clarity on in the coming weeks.

In other news, the Fed also updated its “Statement on Longer-Run Goals and Monetary Policy Strategy.” The notable change was the Fed’s estimate of longer-run unemployment fell from 4.8 percent to 4.6 percent. This change makes the statement consistent with the December SEP. I sense a theme here. A bigger takeaway is that the Fed continues to show flexibility in revising their estimates of longer-run unemployment in response to tepid wage growth.

Oh, the FOMC also selected incoming Federal Reserve Chair Jerome Powell to be the chair of the FOMC. But you kind of saw that coming.

Meanwhile, we still have plenty of data coming up as the week winds down. Today the BLS released the Employment Cost Index for the final quarter of 2017. Total compensation costs for civilian workers was up just 2.6 percent compared to a year earlier. The direction of gains remains up, but the magnitude remains tepid. There is no reason here to believe that labor costs are rising at a rate suggestive that the economy has breached capacity constraints. That argues for continued policy gradualism.

Note that to the extent firms face rising labor costs, they may become increasingly interested in expanding or relocating in lower cost regions. This is another mechanism firms can control costs and keep an lid on inflation. See Pandora for example.

ADP reported private sector job growth of 234k for January. This may induce some upward revisions to consensus estimate – currently a 175k payrolls gain – for Friday’s employment report. (Although that bet didn’t work out too well for the December report). Of course, the current consensus, if realized, would already be sufficient to keep downward pressure on the unemployment rate. The Fed thinks they need to get to something closer to 100k to guide the economy to a sustainable place. I don’t see a reason to think we are getting there anytime soon, and that will keep pressure on central bankers to raise rates.

Bottom Line: The Fed is set to hike rates in March. I continue to believe that the hawkish tilt of the FOMC should entrench forecasts of three rate hikes in 2018 and that it is premature to conclude four or more. I don’t see reason yet to think the Fed is about to conclude they are behind the curve if they retain the current projected policy path.

Is The Fed Ready To Turn Hawkish?

The Fed begins its two-day FOMC meeting this morning. Conventional wisdom anticipates no change in rate policy. Conventional wisdom is correct in this instance. The Fed will stay on the sidelines for Chair Janet Yellen’s final meeting. The statement itself will likely be somewhat more upbeat relative to the December statement. With another quarter of solid economic growth and some firming of inflation in recent months, the risks to the outlook should shift from “roughly balanced” to just “balanced.” Overall, I expect the statement to leave little doubt that the Fed will return to rate hikes in March.

Continued here as a newsletter…

A March rate hike would be the first of the three anticipated in 2018 by the median FOMC policymaker according to the December Summary of Economic projections. Those three rate hikes remain a reasonable baseline. My expectation is that the hawkish tilt of both the voting rotation and the new leadership will dominate over the more dovish voices of last year. Solid data on the trajectory of the economy, including continued gains in the labor market, will almost certainly keep the Fed committed to rate hikes even if inflation again surprises on the weak side.

The strength of recent data on the back of a solid global cyclical upswing leads to the reasonable conclusion that the Fed could shift to a more aggressive pace of rate hikes. Easy financial conditions – arguably the easiest since the early 1990s – further supports this possibility. Indeed, it seems as if an FOMC with a more hawkish tilt would seize upon these factors to justify a fourth rate hike this year or even a surprise 50 basis point hike midyear.

But will the FOMC indeed turn hawkish? And under what conditions? And what are the market implications? With these questions in mind, I have been considering a variety of scenarios and the potential investment implications.

One concern is how the Fed would respond to a surprise jump in the inflation numbers. In theory, they should respond in the same way in which they responded to the surprise inflation shortfall in 2017. Rather than slowing the pace of rate hikes, they instead stayed the course on the planned three rate hikes and the initiation of balance sheet reduction.

If the Fed is treating its inflation target symmetrically, they should then respond to a positive inflation shock by again staying the course. In other words, they should remain focused on the medium-term forecast and not overreact to above target inflation. Moreover, the closer policy moves to the neutral rate, the greater the possibility that an overreaction to higher inflation turns policy too tight and triggers a recession. Consequently, extra caution is warranted and argues against an acceleration in the pace of rate hikes. Under this scenario, I would anticipate the yield curve to shift upward or steepen further in the near-term, essentially a continuation of recent trends.

Be wary, however, of the idea that this implies longer term yields will blow out. I don’t think that the fundamental factors (saving glut, investment shortage, demographics) holding down long-term rates have eased yet. Consequently, my expectation is that similar to recent run-ups in long rates, buyers will find opportunity as the yield on the 10 year exceeds three percent. Moreover, the long rate currently benefits from a global cyclical upturn. It will lose support when that upturn plays out later in the year. If this occurs, the cycle will shift back to yield curve flattening (assuming the Fed stays on track for another three hikes in 2019).

I think that if you are looking for even higher rates, you likely need more than just an inflation surprise, you need a sustained change to the inflation dynamic that the Fed does not seem inclined to get in front of. That would push up term premiums and create the kind of environment more supportive of higher rates. That said, I wouldn’t expect that out of the Yellen Fed, and certainly not out of a more hawkish leaning Powell Fed.

Arguably, this assumes too much patience on the part of the Fed. Historically, the Fed tends to overreact late in the cycle and forgets about those pesky long and variable lags in monetary policy. A more hawkish Fed would arguably be more prone to making this mistake. Under these circumstances, I would be very wary of shorting the long end of the curve. This scenario suggests instead a resumption of the yield curve flattening experienced for most of this cycle.

An arguably even more bullish scenario for longer-term yields would be a Fed that turns hawkish not due to inflation, but in response to frothy financial markets. My suspicion is that the Fed would break the economy in the process of trying to tame the behavioral forces carrying risk assets higher. In that case, the Fed would be holding policy tight while the economy and financial conditions rolled over. That would be bad.

Finally, another possibility you should have on your radar is a potential rate cut. A catalyst might come along that reverses the current psychology on Wall Street and sets in motion a price correction. My expectation is that the Fed would respond to a substantial correction by either delaying expected rate hikes or, if needed, even a rate cut. Yes, the Fed will face withering criticism that the it only continues the Greenspan put. But I don’t think that ultimately either Wall Street or Main Street would like a world in which the Fed doesn’t respond when needed.

Bottom Line: At this point, I don’t think we can be confident that a Powell Fed would be demonstrably more hawkish than a Yellen Fed. Indeed, I think you can argue that the Yellen Fed had a hawkish tilt by holding the line on policy despite low inflation. Consequently, a continuation of that policy in the face of inflation surprises would yield a dovish tilt to the Powell Fed. And that it seems to me remains the best bet in the absence of further policy guidance. As that guidance arrives, I will update my expectations accordingly.