Data, Brainard, Yield Curve

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Thursday’s data told a familiar story – the US economy continues to chug along at a solid pace while inflation remains quiescent. This provides room for the Fed to continue their march toward a neutral rate, but little reason to push beyond that rate without careful thought. That said, at least one key policy maker has eyes set on exceeding the neutral rate, even at the expense of inverting the yield curve.

Consuming spending bounced back in the second quarter from a weak showing earlier in the year. The underlying trends remind us to remain wary of reading too much into the monthly or quarterly volatility. Real spending has been growing at a fairly steady pace of 2.5-3.0% for over two years now; any fears of a consumer slowdown continue to prove unfounded. That story probably won’t change until the labor market drops into a lower gear. We get a fresh employment report Friday morning; until then, we can take comfort in the initial claims numbers, which show no signs that the labor market has hit a wall.

Inflation appears to be firming around the Fed’s 2% target with the annualized one, three and twelve-month changes sitting at 1.9%, 2.0%, and 1.8%, respectively. The larger monthly gains of January and February have waned in subsequent months, leaving little worry that inflation will soon overshoot the Fed’s target. And even some overshooting won’t cause Powell & Co. to panic as they will tolerate inflation numbers modestly above target. My thinking is that they will let inflation drift as high at 2.5% as long as they can reasonably forecast a return to target assuming current rate projections. But if it looks like inflation is rising to that level on a sustained basis, they will step up the pace of rate hikes. Friday morning we also get a read on the manufacturing sector with the ISM report. That number should be solid, following the trend of recent regional reports. For example, Thursday’s Chicago PMI number for May came in above expectations. Of course, the ongoing trade frictions pose a risk for the manufacturing sector. Today the U.S. implemented steel tariffs on key allies; this kind of action will like disrupt already tight supply chains and, more importantly, creates uncertainty by setting the U.S. against the rest of the world.

Federal Reserve Governor Lael Brainard reads the tea leaves in this speech and concludes that further gradual rate hikes remains the appropriate policy path”

This outlook suggests a policy path that moves gradually from modestly accommodative today to neutral–and, after some time, modestly beyond neutral–against the backdrop of a longer-run neutral rate that is likely to remain low by historical standards.

Brainard does identify some fresh downside risks to the outlook – divergent monetary policy across major economies, an emerging markets pull back, and global trade tensions – these are still just risks. Moreover, they are offset by upside risks from fiscal policy.

Most interesting to me were Brainard’s comments on the yield curve. She acknowledged the flattening yield curve and the recessionary signal of past inversions. But she then argues the “this time is different” story, claiming that the yield curve may be sending a weaker signal than in the past due to factors depressing the term premium.

What does this mean for policy? Brainard:

In the median outlook in the FOMC’s Summary of Economic Projections (SEP), the federal funds rate is projected to reach its longer-run value by 2019 and exceed it in 2020. If the 10-year term premium were to stay very low, that path would likely imply a yield curve inversion. But for the reasons I just noted, if the term premium remains low by historical standards, there would probably be less adverse signal from any given yield curve spread.

It is important to emphasize that the flattening yield curve suggested by the SEP median is associated with a policy path calibrated to sustain full employment and inflation around target. So while I will keep a close watch on the yield curve as an important signal on how tight financial conditions are becoming, I consider it as just one among several important indicators. Yield curve movements will need to be interpreted within the broader context of financial conditions and the outlook and will be one of many considerations informing my assessment of appropriate policy.

This is a clear willingness to invert the yield curve. Remember, a yield curve inversion is a very long leading indicator, perhaps signaling a recession more than a year in the future. Thus, when the yield curve inverts the economy will still be well below the peak of the business cycle. In other words, all of the data the Fed uses to assess the outlook will be strong. There will be a strong tendency in such an environment to ignore the signal of the yield curve and keep hiking rates. This has been the story in the past.

Of course, it is worth noting that a sizable contingent of the Fed appears to be concerned with inverting the yield curve. But these concerns may be overruled by key leadership at the Board. This is a space to keep watching closely.

Bottom Line: A solid US economy keeps the Fed focused on raising interest rates. I think that they will become more cautious when they get closer to the neutral rate, but Brainard’s comments suggest policymakers will be less cautious than I have been thinking. I still anticipate rate hikes in June and September. December still fuzzy.

Employment Report Will Keep Fed On Track For June Hike

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The May employment report will likely follow in the path of recent data and support the Fed’s case for further gradual rate hikes. Central bankers will pull the trigger on another rate hike at their June meeting. I suspect they will do the same in September as well. By that point, they will be closing in on the bottom range of estimates for the neutral rate. They will proceed more cautiously thereafter.

Wall Street expects May payroll growth of 190k within a range of 155k to 220k. My model anticipates 167k, pretty much the same as April’s unrevised number. That said, instinct tell me that my model is coming in a little light (previous months were weighted down by weather, leaving room for a bounce in May). Consequently, I wouldn’t bet against the consensus this month. Most important though is that anything in the consensus range will confirm the Fed’s belief that the labor market holds strong even as the expansion approaches its nine-year anniversary. 

Per usual, watch the unemployment rate, which edged down to 3.9% last month. Employment growth has tended to outpace labor force growth, which should over time place further downward pressure on the unemployment rate. And according to the latest Beige book, labor conditions are getting very tight:

Labor market conditions remained tight across the country, and contacts continued to report difficulty filling positions across skill levels. Shortages of qualified workers were reported in various specialized trades and occupations, including truck drivers, sales personnel, carpenters, electricians, painters, and information technology professionals. Many firms responded to talent shortages by increasing wages as well as the generosity of their compensation packages. 

Still, it’s not tight until we see broad-based increases in wages, which remain elusive:

In the aggregate, however, wage increases remained modest in most Districts.

Hope springs eternal though:

Contacts in some Districts expected similar employment and wage gains in the coming months.

Wage growth is as important as the unemployment rate as the former will confirm or deny the latter’s proximity to full employment. Wage growth has been notoriously low, and is expected to remain to with a gain similar to April’s number. A faster gain (note that the Employment Cost Index has looked healthier in recent quarters) would help confirm the Fed’s estimate of the natural rate of unemployment (4.5%).

That said, wage growth acceleration alone will not prompt the Fed to take a more hawkish stance. They really need faster wages gains combined with more evidence that inflation will consistently overshoot target (by something greater than a modest overshoot) to justify accelerating the pace of rate hikes. The Beige Book again gives some hints that inflation might pick up in the months ahead:

Prices rose moderately in most Districts, while the remainder reported slight or modest increases. There were several reports of rising materials costs, notably for steel, aluminum, oil, oil derivatives, lumber, and cement. A few Districts noted that these reports of rising materials costs were becoming more common across contacts. Input cost increases, along with labor shortages in some sectors and strengthening demand, put upward pressure on prices in the transportation, construction, and manufacturing sectors. Some Districts also noted that their retail contacts were more able to pass along price increases to their customers than in the recent past.

But, again, anecdotes and data are two different things. The anecdotes will keep the Fed on the gradual path, but it will take data before the Fed shifts gears to something else.

The Beige Book upgraded the overall assessment of the economy from this in April:

Economic activity continued to expand at a modest to moderate pace across the 12 Federal Reserve Districts in March and early April. 

to this in May:

Economic activity expanded moderately in late April and early May with few shifts in the pattern of growth.

This fits with the story of the Atlanta Fed and New York Fed trackers, which are coming in at 4.0% and 3.0% respectively for the second quarter, which in either case would be an acceleration from the 2.2% growth of the first quarter.

Such a pace of growth would sustain concerns that the economy will overheat in the absence of further rate hikes. As long as those concerns are alive and well, the Fed error on the side of rate hikes until they approach a policy rate that is closer to neutral. They won’t want to be too far from neutral should the economy overheat; they won’t want to push past neutral and unnecessarily tip the economy into recession. I suspect they will only push past their estimate of neutral if inflation overshoots substantially (greater than 2.5%) and does not appear likely to return to target without a more aggressive policy stance.

What this means for policy is that assuming the current pace of growth can be sustained, the Fed will likely hike at the next two meetings to move to the bottom end of neutral estimates. To be sure if growth falters (or financial chaos spreads from Europe or emerging markets), they will reassess the timing of the next rate hike. But that is a risk at this point, not my baseline scenario.

Bottom Line: Expect incoming data to continue to support the case for gradual rates hikes, but watch for the Fed to shift gears to a slower pace of hikes after closing in a bit more on estimates of the neutral rate. That slowing in the pace of hikes assumes inflation remains contained. 

Bond Traders Are Too Quick to Doubt the Fed’s Resolve

Bond traders in the U.S. responded to the brewing crisis in Italy by sharply reducing their forecasts for how many times the Federal Reserve will raise interest rates this year. In reality, it’s too soon to make that call. The U.S. economy is in a very different place compared with previous rounds of the European debt crisis. To be sure, Fed policy makers will be watching the European situation closely for signs of contagion, but they will be watching the U.S economy even more closely.

Continued at @bopinion here….

Waiting For Something Different

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The April employment report lent further support to the Fed’s gradual approach to rate policy. There is little reason to doubt that central bankers will hike rates at their June meeting while indicating more will be coming in the second half of the year. The report deepened the mystery of low wage growth, putting the Fed in the familiar place of again being overly pessimistic with regards to the unemployment forecast. Meanwhile, central bankers continue to signal they will allow inflation to overshoot their target.

Nonfarm payrolls grew a below-consensus forecast 164k in April while the previous two months were revised up by 30k. The twelve-month pace is holding just below 200k and solid growth in temporary help numbers suggest these numbers are sustainable going forward.

The pace of job growth finally caught up to the unemployment rate. After months at 4.1 percent, the unemployment rate dropped to 3.9 percent, a level last seen in December 2000. The Fed was not expecting to see 3.9 percent until the end of this year; with the overall economy looking sufficiently strong to sustain this pace of job growth, they will almost certainly edged down their unemployment rate forecasts at the next FOMC meeting.

Even though unemployment pierced the 4 percent mark, wage growth continues to disappoint. The monthly gain annualize was just 1.8 percent, while the change from a year ago was 2.6 percent. With inflation rising back to the Fed’s 2 percent target, these numbers suggest real wage growth is decelerating. This strikes me as unsustainable in the face of already low and still falling unemployment rates. Consequently, I anticipate wage growth will tick up higher in the months ahead.

Still, just enough wage growth to match the combination of inflation and productivity growth, let’s say a combined 3 percent, doesn’t suggest the economy is overheating. By extension, the economy thus has not yet pushed past full employment. The Fed’s estimate of a 4.5 percent natural rate of unemployment thus still seems too high and likely to fall in line with downward revisions to the unemployment rate forecast next month. Alternatively, they can hold the longer run natural rate estimate steady with the explanation that it is temporarily depressed. Or they can hold the natural rate estimate steady and raise interest rate projections accordingly.

My current thinking is that they will not look to raise rate projections again just yet. They need to see stronger wage growth to confirm the economy is operating above full employment and to see such overheating reflected in higher inflation. And not just a few basis points of higher inflation, but something significantly more. Via Bloomberg, Atlanta Federal Reserve President Raphael Bostic told reporters:

“We’re fluctuating around the 2 percent target. I am comfortable with that. To the extent we have seen some upward pressure, we don’t have the ability to stop trends on a dime. Some overshoot is fine.’’

This will be the dominant thinking among central bankers for the time being. I think they will be comfortable allowing their near-term inflation forecasts drift higher if need be – up to as high as 2.5 percent even – if those forecasts revert back to target over the medium run under current rate projections. This gives also will give them quite a bit of leeway to accept lower unemployment. Given the flat Phillips curve, even very low unemployment doesn’t generate inflation worth getting upset about.

Bottom Line: Assuming the current path of activity continues and that the Phillip’s curve remains flat and doesn’t have a “hockey stick” moment, I expect the Fed to remain on kind of autopilot. They will tolerate modest overshooting of inflation and instead focus on their forecasts. Those forecasts suggest that the path of expected tightening will suffice to return inflation to target over the medium term. They need to see genuine threats to that forecast before deviating to a new policy path. They will likely raise rates once a quarter until the yield curve flattens out. At that point, policy becomes more complicated – especially if the lagged impact of monetary policy has yet to show up in slower economic activity.

Fed Holds Rates Steady

With incoming data largely supporting the Fed’s economic outlook, central bankers did as expected and left policy rates unchanged. There is little reason to expect the Fed to alter course from the predicted three or four rate hikes this year (barring any slowdown in the data or increase in risks to the outlook, four should be the baseline). The most important news from the FOMC statement was the hint that the Fed would not overreact with substantial policy changes in response to inflation readings modestly above 2 percent. As usual, watch the employment report for signal that the economy will overshoot full employment, but also note that the Fed already expected overshooting.

The Fed concluded their two-day meeting with a statement that was largely unchanged with the exception of updates in response to incoming data. Most notable was the addition of “symmetric” in this line:

Inflation on a 12-month basis is expected to run near the Committee’s symmetric 2 percent objective over the medium term.

Inflation is now very near the Fed’s target and it is reasonable to expect some overshooting of that target. Central bankers are reminding market participants that the inflation target is symmetric such that they will tolerate reasonable short-run deviations from target in the near term. In other words, don’t freak out if inflation exceeds 2 percent as that alone will not drive the Fed to change policy. The Fed is likely to stick to the present policy path unless inflation rises above 2.5 percent and looks like to stay high without a more aggressive policy stance.

The next major release is Friday’s employment report for April. Expect payroll growth to bounce back from a weak March reading; my forecast of a 207k gain is fairly close to the Wall Street consensus of a 190k gain. Job growth running at roughly 200k per month should eventually put downward pressure on unemployment. Or at least this is what the Fed expects as they foresee unemployment falling to a low of 3.6 percent by the end of next year.

That said, unemployment has remained stuck at 4.1 percent for months. This is good news as the labor market keeps kicking out supply to meet demand. The Fed fears this good news will eventually come to an end as the demographics factors eventually catch up to the cyclical forces pulling people into the labor market. Note that this is already build into the Fed forecast, so if it happens soon it should not dramatically alter the path of policy.

Likewise, tepid wage growth belies claims that the economy has surpassed full employment. If wage growth remains low, the Fed will likely continue their downward revisions of their estimates of the natural rate of unemployment. Faster wage growth would reinforce their current views, but again this is already build into the forecast.

Bottom Line: The Fed’s forecast already calls for faster inflation and some overshooting of the full employment objective. This is why central bankers anticipate that interest rates will need to rise above longer-term levels; returning the economy to a sustainably longer run equilibrium requires such tighter monetary conditions in their models. What gets us to a faster pace of rate hikes? Clear evidence that the economy has surpassed full employment in the form of sharply higher wage growth plus either much quicker than expected unemployment declines or evidence that inflation will be sustainably above 2.5 percent. Of course, also watch for the possibility that the Fed foregoes a fourth rate hike this year if the economic activity unexpectedly wanes.