Fedspeak Reiterates Gradual Path

Fed speakers continue to reiterate that policy remains on a gradual path of tightening. So far, the inflation data and brightening economy has more emboldened their commitment to gradual rate hikes than a faster pace of hikes. What about fiscal policy? That train has left the station, but central bankers don’t seem too concerned – yet.

Federal Reserve Governor and Vice Chairman for Supervision Randal Quarles today gave a short speech on the economic outlook and associated policy implications. He praises low unemployment:

After peaking at 10 percent in October 2009, the unemployment rate fell rather steadily to 4.1 percent in January–the lowest level, outside of a period from 1999 to 2000, since the 1960s. Job gains in recent months have continued at a pace that would be pushing the unemployment rate even lower if the labor participation rate had not stabilized in recent years, a welcome development and a sign that the strength of the labor market is pulling in or retaining workers who might otherwise be on the sidelines. 

This is a fairly optimistic take – as long as the economy continues to draw in workers at a faster than expected pace, unemployment can stay low despite solid job growth and without inflationary pressure. This is dovish; the Fed doesn’t need to accelerate the pace of rate hikes in this environment. Still, Quarles views activity as close to full employment:

Broader measures of labor market slack–for example, those that include individuals who are out of the labor force but say they want a job as well as those working with a part-time job but who would like to work full time–have largely returned to pre-crisis levels.

The economy is thus running near full employment but with enough new labor supply coming online to prevent overheating. This is something of a Goldilocks scenario. As far the broader economy is concerned:

While the labor market has shown steady improvement over the past decade, the post-crisis performance of gross domestic product (GDP) growth has been more disappointing, averaging just 2 percent per year over the past seven years.

Yes, it has been disappointing. That said, I think this overstates the disappointment. It was sufficient, for example, to push the economy into a place where the Fed could begin normalizing policy. And to drive those labor market gains praised by Quarles. And there were some pretty good periods within that ten years. Still, that is history. For Quarles, all is good now:

However, beginning with the second quarter of last year, growth has shown some momentum. Over the past three quarters of 2017, real GDP increased at an average rate of almost 3 percent. While headline growth stepped back a bit in the fourth quarter, largely on account of increased drag from higher imports and lower inventories, underlying final private domestic demand–which is a better indicator of economic momentum–grew at its fastest pace in more than three years.

Well, is this growth sustainable? Quarles says yes, it is:

The tax and fiscal packages passed in recent months could help sustain the economy’s momentum in part by increasing demand, and also possibly by boosting the potential capacity of the economy by encouraging investment and supporting labor force participation.

Notice the modifiers – the fiscal stimulus “could” help sustain the momentum. That suggests an unwillingness to commit to a sizable boost in the forecast. And even if there is a demand boost, that might be matched with a supply side boost.

This is a “run the economy hot” story. Interestingly, he goes a step further:

Regardless, given the importance of productivity growth for the long-run potential of the economy and living standards, it is vitally important that policymakers pursue policies aimed at boosting the growth rate of productivity.

That isn’t just a job for fiscal policymakers, it is for all policymakers. So here is one way to read this: Fiscal policymakers have done their part with tax cuts for corporations. Monetary policymakers need to do their part by not undercutting growth too quickly. Hence, policy can remain on the current path:

Against this economic backdrop, with a strong labor market and likely only temporary softness in inflation, I view it as appropriate that monetary policy should continue to be gradually normalized. 

I think this is not a bad experiment to run. If the Fed wants to see what happens if you run the economy hot, best to give it a try in a low inflation, well-anchored inflation expectations environment. If the economy overheats and sends inflation to 3 percent, it wouldn’t be something the Fed couldn’t control. I am willing to endorse that experiment.

That said, I do find it interesting that Trump’s appointee quickly lands on a story that just happens to undermine the monetary offset story. If you want to run a late-cycle fiscal stimulus, you need a Fed that is on board with that policy. If this is an indicator, Trump’s appointees will lean to the dovish side of policy. 

As usual, his outlook is data dependent.

Atlanta Federal Reserve President Raphael Bostic also struck a dovish tone:

Should the recent data unfold in a manner similar to my outlook, I am comfortable continuing with a slow removal of policy accommodation. However, I would caution that that doesn’t necessarily mean as many as three or four moves per year.

Recent evidence suggests that the interest rate that would prevail when GDP and inflation are back on target could be close to 2 percent at the moment, and may rise only modestly over the medium term.

If this is right, then the current stance of monetary policy is still somewhat accommodative but is approaching a more neutral stance. Finally, it is important to remember that the Fed is also removing accommodation by shrinking its balance sheet.

Bostic is emphasizing that “gradual” isn’t just three or four hikes this year; it could be less, citing a low level of neutral interest rates. And that sounds like the direction he is leaning. In my opinion, he may not be placing sufficient weight on the risk that the neutral rate is already moving higher. But his opinion is of course the more important one – he is the FOMC voter this year.

St. Louis Federal Reserve President James Bullard threw cold water on expectations for four rate hikes:

Hiking rates by a total of 1 percent this year, which would signal four increases of the typical 0.25 percent, would be “priced for perfection,” Bullard said.

“The idea that we need to go 100 basis points in 2018, that seems like a lot to me,” he said. “Everything would have to go just right. The economy would have to surprise on the upside a bunch of times during the year. I’m not sure that’s a good way to think about 2018.”

I am wary of placing too much weight on Bullard’s sentiment. The St. Louis Fed’s economic model colors Bullard’s outlook. That model is an outlier approach within the Fed, hence not particular insightful for understanding the likely direction of monetary policy. Basically, everyone is more hawkish than Bullard. That said, he obviously isn’t trying to pull the FOMC to a more aggressive rate path.

Bottom Line: Fed speakers continue to show no urgency to accelerate the pace of rate hikes despite firming inflation data and budget-busting fiscal stimulus. Also, keep an eye out for the possibility that Trump’s appointees reveal themselves to be doves in hawks’ clothing. 

First Impressions of the January FOMC Minutes

The minutes of the January FOMC meeting revealed increasing confidence in the economic outlook. That translated into increased confidence that gradual rate hikes remains the appropriate policy path. Does that mean the central bankers stand poised to raise their “dots” such that the median rate hike projection rises to four hikes? I don’t think so. I read the minutes as wiping away lingering concerns about the inflation outlook and allowing policymakers to coalesce around the existing three hike projection. The risk remains, of course, that conditions remain sufficiently buoyant to raise the rate projection in June or September. More important to me at this juncture is I see clear hints that the projections beyond 2018 are vulnerable to upward revisions.

Remember that the December rate hike was met with two dissentions. That suggests caution among central bankers. Moreover, there were six “dots” below the median projection of three hikes, compared to four above. Again, an indication of overall caution. That caution stemmed from the inflation disappointment in 2017. But this is how participants viewed the economic environment in January:

…A number of participants indicated that they had marked up their forecasts for economic growth in the near term relative to those made for the December meeting in light of the strength of recent data on economic activity in the United States and abroad, continued accommodative financial conditions, and information suggesting that the effects of recently enacted tax changes–while still uncertain–might be somewhat larger in the near term than previously thought. Several others suggested that the upside risks to the near-term outlook for economic activity may have increased. A majority of participants noted that a stronger outlook for economic growth raised the likelihood that further gradual policy firming would be appropriate…

Firming confidence in the pace of economic activity translated directly into confidence in the inflation forecast:

Almost all participants continued to anticipate that inflation would move up to the Committee’s 2 percent objective over the medium term as economic growth remained above trend and the labor market stayed strong; several commented that recent developments had increased their confidence in the outlook for further progress toward the Committee’s 2 percent inflation objective. A couple noted that a step-up in the pace of economic growth could tighten labor market conditions even more than they currently anticipated, posing risks to inflation and financial stability associated with substantially overshooting full employment. However, some participants saw an appreciable risk that inflation would continue to fall short of the Committee’s objective. 

For the most part, incoming data strengthened the likelihood that the inflation forecast will be met in 2018. Not exceeded, but met. Of the participants on either side of that bet, the doves (some) appeared to outweigh the hawks (a couple). Hence arguably some caution remains. Still, the overall story is that in January the Fed was ready to declare that gradual rates hikes would indeed continue in 2018:

Members expected that economic conditions would evolve in a manner that would warrant further gradual increases in the federal funds rate. They judged that a gradual approach to raising the target range would sustain the economic expansion and balance the risks to the outlook for inflation and unemployment. Members agreed that the strengthening in the near-term economic outlook increased the likelihood that a gradual upward trajectory of the federal funds rate would be appropriate. They therefore agreed to update the characterization of their expectation for the evolution of the federal funds rate in the postmeeting statement to point to “further gradual increases” while maintaining the target range at the current meeting.

I think there may have been another motivation to add the modifier “further.” The Fed had spent much of 2017 trying to reinforce the three rate hike scenario, a matter made more difficult by the focus of some members on the weak inflation numbers. Taking a modestly firmer stance in January could be interpreted as putting market participants in notice to not underestimate the Fed in 2018.

What has changed since January? Two particularly important events. First is the wage and inflation data. Maybe though that isn’t too important yet – policymakers like San Francisco Fed’s John Williams, Minneapolis Fed’s Neil Kashkari, and Cleveland Fed’s Loretta Mester have all tried to tamp down expectations that the Fed will over react to higher inflation. Remember that last year was a model for how to handle inflation surprises: Keep a focus on the medium term.

The second event is the new fiscal spending plans. Note that participants were already expressing concern that the tax cuts would have a larger impact than they expected. It seems then policy makers will almost certainly see greater upside risk from the additional spending. Where does that fit into the forecast? They have a choice – they can accelerate the pace of gradual by adding a fourth hike in 2018, or up the 2019 forecast from a two-plus-some to a full third hike. I think they go for that latter.

Why put the extra hike in 2019? A few reasons. First, by 2019 the economy will be hit with the full force of the spending, so it seems natural to tighten up a bit more then. Second, I think they will be wary of deviating too much from the “three hikes is gradual story” just yet. Fixed income markets are already primed to over react to any sign the Fed is changing course. It appears central bankers are working to quell such concerns. It will be hard to do so if “gradual” suddenly becomes “faster.” That has taper-tantrum written all over it. Three, it would be the Fed at odds with the White House after Powell’s very first press conference. Equities would take a hit and every financial headline would read something like “Fed Squashes Trump’s Growth Agenda With Faster Rate Hikes.” I think the Fed really needs to be sure about what they are doing before they head down that road. I know, the Fed isn’t supposed to worry about such things. Except in the real world they do.

And one more reason: The Fed could be raising its estimate of the neutral rate. Back to the minutes:

Some participants also commented on the likely evolution of the neutral federal funds rate. By most estimates, the neutral level of the federal funds rate had been very low in recent years, but it was expected to rise slowly over time toward its longer-run level. However, the outlook for the neutral rate was uncertain and would depend on the interplay of a number of forces. For example, the neutral rate, which appeared to have fallen sharply during the Global Financial Crisis when financial headwinds had restrained demand, might move up more than anticipated as the global economy strengthened. Alternatively, the longer-run level of the neutral rate might remain low in the absence of fundamental shifts in trends in productivity, demographics, or the demand for safe assets.

You can view the relative buoyancy of financial conditions – the past few weeks notwithstanding – as an indication that the neutral rate is rising as the wounds of the financial crisis heal. And perhaps more importantly, although the demand for safe assets might still be high, the combined tax cuts and spending increases seem certain to increase the supply of safe assets. This too should put upward pressure on the neutral rate.

If the estimate of the neutral rate rises, then expected policy rates will need to rise as well to ease the unemployment rate back to the Fed’s longer run estimate. I think the Fed would slide this into the 2019 and 2020 forecasts. This preserves the current gradual part, important because they fear that accelerating the current path raises the risk of recession. In this scenario, the fiscal stimulus extends the tightening cycle, raises the terminal rate, raises the neutral rate, and pushes out the timing of the next recession.

Bottom Line: The Fed is more confident than any time in the past nine months that they will hit their inflation target under the current set of rate projections. Doves in particular had the farthest to move; centrists and hawks already saw the 2017 inflation shortfall as temporary. The risk is that the Fed finds a fourth rate hike in 2018 necessary, but I don’t think they will want to move there until they have more data, maybe by June. But the great fiscal stimulus and larger budget deficit should show up somewhere. I am thinking that is in 2019 and 2020 rate projections and the neutral rate estimates. Given the Fed-speak to date, that seems more likely to me to happen in March than an acceleration of the pace of hikes.

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.