Newsletter version here…

Central bankers will meet this week, but only to sign off on the existing policy stance. Although it pains this fedwatcher to admit, the FOMC meeting is arguably the least important event of the week. It competes with a slew of critical data, including the employment report for October, to be released Friday. Plus, we should learn President Trump’s pick to lead the Fed when Yellen’s term expires next February. An FOMC meeting widely expected to yield no change in policy and likely little in the accompanying statement simply can’t compete with this week’s news flow.

The Fed continues to follow its well-defined strategy of setting policy via balancing solid employment against weak inflation as the economy settles into full employment. This strategy relies on a basic Phillips curve framework that anticipates intensifying inflationary pressures as the unemployment rate falls below its longer run rate. The Fed will see this as a tried and true strategy; they hesitate to abandon it on the basis of what they view as short-term inflation shortfalls.

Following this strategy, I anticipate the Fed will continue to pursue the current projected path of policy as long as job growth remains strong enough to push unemployment lower. In other words, they are likely to continue to turn their attention away from the disappointment of low inflation in favor of the excitement of labor market gains.

In practical terms, this means that emphasis on rate hikes will remain as long as the economy looks set to support job growth of more than 100k a month. The third quarter GDP report will confirm their suspicions that this continues to be the case. GDP gained at a 3.0% rate in the second quarter after gaining at a 3.1% rate the previous quarter. This is the strongest back-to-back growth since 2014. Compared to a year ago, the growth was more subdued at a 2.3% gain, albeit still sustaining a trend of steady improvement.

Digging into the numbers, the contributions from investment and net exports rose, while the gains attributable to consumption softened. The Fed will be particularly happy with the investment gains (similarly, they will like the story told by the strong durable goods orders report last week). Investment was a significant factor in the slowdown of 2015 and 2016, and the Fed will be relieved that this wound is healing nicely.

A look at averages over the last four quarters (noise in the quarterly numbers tends to hide underlying trends) reveals that while investment has begun to rebound from the 2015 decline, consumer spending has not. Nor I think should we expect a substantial acceleration in consumer spending at this point in the cycle. More likely is that while wage growth should rise further, the gains will compete with slower overall job growth to constrain spending growth. In other words, these numbers might be about what you might expect as the economy reaches full employment.

The trend in net exports is only a small drag on GDP growth, but this is due to a particularly large negative hit in the third quarter of 2016. Net exports have made a positive contribution in five of the last six quarters. I would have expected a more negative contribution given the acceleration in investment activity, but apparently we need to see a more rapid growth in domestic activity such as from late-2014 to mid-2015 to drive a greater drag from the external sector. And then at least small contribution from government spending supported domestic growth; the government spending contribution has fallen to basically nothing (a small negative in recent quarters).

Note the negative contributions from residential investment the last two quarters. With the multifamily sector likely over its peak for the current cycle, we need more single-family construction to support investment numbers in this sector. And although the trajectory for single-family is in the right direction, the pace of gains remains subdued.

Overall these are numbers that will continue to add jobs at a pace sufficient to push down unemployment. Indeed, the pace of growth remains too rapid given current projections of productivity and labor force growth. Consequently, the Fed anticipates that growth needs to slow to maintain balance in the economy, and will be focused on tightening policy further to ensure that slower growth emerges. This is an environment that looks ripe for an acceleration in the pace of rate hikes should fiscal policymakers push through a substantial tax cut that stimulates domestic demand.

As an aside, I can’t shake the feeling that the current pattern of growth remains very finely balanced, almost too balanced, as if it were ripe for a change. 

The selection of the next Fed chair devolved into a reality TV show. Even the losers are announced first; supposedly Gary Cohn is out of the running. So too are current chair Janet Yellen and former Federal Reserve Governor Kevin Warsh, at least according to the Washington Post. I never held out much hope for a Yellen reappointment on the basis of the politics, but still will be disappointed if she is not retained.

That leaves current Federal Reserve Governor Jerome Powell and Standard economist John Taylor vying for the top spot. Trump reportedly leans toward Powell. This is the smart choice if Trump wants to keep the party going; Powell is likely to retain much of the current policy framework that has worked well. At best I would anticipate a only more slightly hawkish policy lean under Powell, and that would be fully data dependent. A choice of Taylor, however, would likely be more popular with Congressional Republicans. And Trump was reported to be impressed with Taylor.

I don’t think we can rule out the possibility that this season has a surprise ending – a dual nomination of Powell for the chair and Taylor for the vice-chair. To be continued after this commercial break.

On the data side of the story, the week begins with the personal income and outlays report and with it the inflation numbers. Expectations are for a meager 0.1% read on core-PCE inflation. Tuesday brings us the employment cost index, the Case-Shiller home price index, and the beginning of the FOMC meeting. Wednesday brings the ADP job numbers, the ISM manufacturing index, construction spending numbers, and the conclusion of the FOMC meeting. Thursday is third quarter productivity numbers and jobless claims. And Friday are reports on employment, international trade, and the ISM service index. The consensus expects a rebound in nonfarm payroll growth to a whopping 323k after last month’s hurricane-induced negative print.

Bottom Line: A nonstop week from beginning to end. Stage set for lots of excitement outside the FOMC meeting, none in the FOMC meeting. A December rate hike is virtually certain at this point.  

Let’s revisit this from San Francisco Federal Reserve Resident John Williams:

If you look until 2015 or so, the inflation data basically followed our models, emphasizing the role of weakness in the economy. Where this mystery has happened is really in the last year or two. I view both inflation picking up faster than expected in early 2017 and now the pullback as just part of the variability that’s going to happen. I don’t see any signs that somehow the inflation process is fundamentally changed.

I’ve been doing this a long time, and the Phillips curve has been declared dead far more times than Mark Twain.

This is representative of the conventional wisdom at the Fed, summed up succinctly as adherence to a basic expectations-augmented Phillips curve as a primary policy guide. As unemployment falls toward and below full employment, capacity constraints in the economy tighten and eventually create inflationary pressures. The central bank needs to offset these pressures via tighter policy to contain inflation and maintain inflation expectations, the center of gravity for actual inflation over time.

Continued as newsletter….

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If we ignore inflation, then nothing is really standing in the way of a rate hike in December. Of course, given that arguably the primary job of a central bank is to meet its definition of price stability, the Fed shouldn’t really ignore inflation. Policymakers, however, would counter that they are not ignoring inflation. They are simply favoring the inflation forecast over actual inflation. And they would further argue they have good cause – with the economy chugging along, it is only a matter of time before resource constraints become evident and price pressures rise. That’s their story, and they are sticking to it.

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The Federal Reserve remains committed to a December rate hike, persistent low inflation not withstanding. With unemployment below Fed estimates of its longer-run natural rate, most FOMC participants do not need evidence of stronger inflation to justify further rate hikes. Ongoing solid job growth will be sufficient cause for tighter policy, especially in what they perceive to be an environment of loosening financial conditions. The main risk from this scenario is that the US economy enters the next recession with diminished inflation expectations, which could further hobble central bankers already facing the prospect of returning to the effective lower bound in the next cycle.

Continued here as a newsletter…

Federal Reserve policy makers tend to believe temporary shocks account for the persistent undershooting of the inflation target. But there’s a more disturbing possibility: Central bankers might just be using a broken model of inflation. Given that risk, they should pay attention to actual inflation and lean toward passing on a December rate hike. Nonetheless, they are prepared to move forward. The dismissal of actual data given these very real concerns about the forecasting accuracy of the Fed’s models could place us in a more dangerous stage of the business cycle.

Continued here on Bloomberg View…

Newly minted Nobel laureate Richard Thaler weighed in on equities today. Via Bloomberg:

A buoyant and complacent stock market is worrying Richard H. Thaler, the University of Chicago professor who this week won the Nobel Prize in economics.

“We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping,” Thaler said, speaking by phone on Bloomberg TV. “I admit to not understanding it.”…

…“I don’t know about you, but I’m nervous, and it seems like when investors are nervous, they’re prone to being spooked,” Thaler said, “Nothing seems to spook the market” and if the gains are based on tax-reform expectations, “surely investors should have lost confidence that that was going to happen.”

Riskiest moments of our lives, hmm. At a now seemingly long ago meeting of the Oregon Council of Economic Advisors, a more experienced member quipped that there is no more uncertainty than there has ever been. That individual  remembered, for example, the 60’s and the Cuban Missile Crisis. So while this is a risky moment to be sure, we have had other risky, and perhaps riskier, times to contend with.

Also, note the results of a quick Google search of Thalyer’s fellow Nobel laureate, Robert Shiller:

Think about that record, and think about the fact that Shiller is a noted expert in bubbles.

None of this should is meant to any way meant to diminish the accomplishments of Thaler and Shiller. Winning the Nobel prize in economics is something I am fairly certain I will not achieve. It’s just to say that before you act on the market advise of a Nobel laureate, it is worth considering if they can really forecast any better than the rest of us.

Scott Sumner is perplexed by Fed chair candidate Kevin Warsh. He reads the 2010 FOMC transcripts and finds Warsh explaining:

First, my views on policy. As I said when we met by videoconference, my views are increasingly out of step with the views of most people around this table. The path that you’re leading us to, Mr. Chairman, is not my preferred path forward. I think we are removing much of the burden from those that could actually help reach these objectives, particular the growth and employment objectives, and we are putting that onus strangely on ourselves rather than letting it rest where it should lie. We are too accepting of dangerous policies from others that have been long in the making, and we should put the burden on them.

I can think, Mr. Chairman, of a tough weekend that the Europeans had, particularly your counterpart at the ECB, in the spring or summer, when we all knew that the European Central Bank, rightly or wrongly, was going to take action. But Jean-Claude Trichet did not take action until very late that Sunday night, until the fiscal authorities did their part. He thought that if on Friday night he were to say all of the things he’d be willing to do, he’d be taking the burden off the fiscal authorities. He chose to wait. I think we would be far better off waiting. If we proceed on this path, as I suspect we will, I would still encourage you to put the burden where it rightly belongs, which is on other policymakers here in Washington, and to do so in a way that is respectful of different lines of responsibility.

Sumner is understandably scratching his head, trying to figure out what Warsh is getting at:

His reasoning process is poor and he lacks good communication skills.  He has very poor judgment when interpreting data.  I really don’t know what he’s trying to say here, but the reference to Trichet is interesting.  Trichet was trying to encourage fiscal authorities to adopt more contractionary fiscal policies, not expansionary policies.  Trichet did not want to “bail out” expansionary policies with ultra-low interest rates, and Warsh seems to be endorsing Trichet’s approach.  And given Warsh’s reputation as a conservative, and the massive deficits being run by Obama back in 2010, I find it odd that Warsh would be advocating fiscal stimulus, as Brannon suggests.  But again, the passage is so garbled that I could easily be wrong.

I don’t think Warsh was advocating for more fiscal stimulus at this meeting. Warsh is a Very Serious Person, and all Very Serious People know that deficits are bad. I believe that Warsh was at this juncture advocating a Trichet-style approach to the crisis, using the independence of the central bank to force the fiscal authorities to rein in those bad deficits, because of course everything wrong in the economy can be tied back to deficit spending. All Very Serious People know this. Of course, Trichet’s approach proved to be disastrous, which is why Sumner is rightfully puzzled when hearing a Fed governor suggest the same.

Sadly, Warsh was not the only Fed official who advocated such an approach. Warsh is apparently cut from the same cloth as the person I believe was the worst regional bank president in recent memory. Recall when the FOMC statement contained this sort of reference:

Household spending and business fixed investment advanced, and the housing sector has strengthened further, but fiscal policy is restraining economic growth.

Of course, if you bothered to know what the FOMC was saying, you knew the complaint was that they believed monetary policy had reached its limits to stimulate the economy, and that faster growth required a more stimulative monetary policy.

Then Dallas Federal Reserve President Richard Fisher either didn’t understand what the FOMC said, or deliberately misinterpreted the FOMC. In a 2013 speech, Fisher says:

Even if we at the Dallas Fed are right and the overall outlook for the economy is better than the current dashboard or the conventional prognostications of economists, there exists a formidable brake on growth. It was referred to point-blank in the last statement issued by the FOMC: “…fiscal policy is restraining economic growth.”

Fiscal policy is inhibiting the transmission of monetary policy into robust job creation…

…The propensity of members of Congress has been to spend in excess of revenues to give pleasure to their constituents and garner their affection…Until the Congress and the president provide a clear road map as to how fiscal rectitude will be implemented, this lack of credible details for limiting the debt-to-GDP ratio and reengineering fiscal policy to stimulate rather than constrain growth is creating undue uncertainty about future tax rates, future government purchases, future retiree benefits and all manner of factors that impact employment and economic growth. Meanwhile, the divisive nature and petty posturing of those who must determine the fiscal path of the nation is further undermining confidence and limiting the effectiveness of monetary policy…

…I argue that the Fed has no hope of moving the economy to full employment unless our fiscal authorities get their act together…Until then, I argue that the Fed is, at best, pushing on a string and, at worst, building up kindling for a massive shipboard fire of eventual inflation.

These aren’t the kind of people you want in charge of monetary policy. We need policymakers that understand their role is not to withhold monetary stimulus to force fiscal authorities to pursue countercyclical policy simply because Very Serious People know that deficit spending is always bad and cutting deficits is the solution to every problem. Monetary policy is about independently assessing the economy and enacting the policy necessary to maintain full employment and price stability. And oftentimes that means taking fiscal policy as an exogenous factor.

What is particularly discouraging is that neither Warsh nor Fisher appears to understand that during a recession, at a minimum automatic stabilizers themselves will swell the deficit. Taking aim at the deficit in such times is naive at best, deliberately spiteful at worst.

My concern remains that a Fed with someone like Kevin Warsh at the helm would prove to be disastrous for Wall Street and Main Street alike when the next recession hits. Neither group needs a central banker that believes a recession is an opportunity to inflict more pain.

The headline figure on nonfarm payrolls report came in well below already withered expectations, but the disappointment was more than compensated for in the details of both the establishment and household survey. The Fed is looking for data that allows them to overlook the weak inflation data. This was just that sort of data.

The employment report for September will be released this morning. It is widely expected to disappoint as it comes in the wake of a tough hurricane season. But those weak numbers are not expected to dissuade the Fed from hiking in December. And unexpectedly strong numbers would only help prod along those officials getting cold feet from the weak inflation data.

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The ISM manufacturing report for September came in stronger than expected. To be sure, hurricane impacts accounted for some of the boost, particularly in supplier deliveries and prices; anecdotal responses made this clear. But it isn’t all hurricanes. Manufacturing has been gaining steam since last year. The sector continues to throw off the 2015/2016 weakness associated with the oil price decline and rise in the dollar. I often feel this improvement has been overlooked.

Continued here….