Monday Morning Notes: The Rate Hikes Keep Coming

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

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

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

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

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

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

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

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

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

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

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

Entering the Danger Zone

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

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

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

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

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

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

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

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

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

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

Kaplan Looks Toward The Pause

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

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

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

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

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

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

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

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

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

Bostic Throws Down the Gauntlet

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

Bostic, via Bloomberg:

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

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

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

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

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

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

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

Data Flow Continues To Support The Fed’s Narrative

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

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

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

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

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

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

A Policy Pause Is Still Some Time Away

The U.S. economy performed about as well as might be expected in the first half of 2018, growing at an average pace of 3.15% in a “new normal” world where the longer-term speed limit might be just 1.8%. Indeed, in an otherwise fairly unchanged statement, the Fed hailed the results as a “strong” pace of growth at the conclusion of this week’s FOMC meeting, an upgrade from last meeting’s “solid.”

But that is all in the rearview mirror now. As we all plunge deeper into the second half of 2018, the focus is on a potential slowdown in the wake of trade wars, higher labor and material prices, a moderation in the housing market, and the lagged impact of rate hikes. Will those factors be sufficient to give the Fed room to pause as central bankers approach their estimates of the neutral policy rate? At this juncture, it still looks likely that the Fed delivers rate hikes in September and December and probably into March of next year before they will entertain the notion of an extended pause. Their willingness to entertain that notion, however, will of course be data dependent.

The July data begins to trickle in this week, starting yesterday with the ISM manufacturing report. The headline number slipped a notch from 60.2 to still strong 58.1. Considering the monthly volatility in the report, the takeaway is that manufacturing holds strong as the second half begins. The anecdotal comments in the report, however, are rife with concerns over tariffs. There is no guarantee these concerns dissipate quickly. While the conflict with Europe appears to be on the back burner for now, the Trump administration is reportedly poised to ratchet up the stakes with China. Manufacturers can only hope that calmer voices prevail.

Disruption in manufacturing, however, may lead to only limited impacts on the rest of the economy. As we learned during the oil price collapse of 2015, a sector specific shock is not necessarily an economy wide shock. One place to look for an early warning signal is initial unemployment claims. Cases of tariff-related layoffs are emerging, but none seem significant enough to put much if any of a dent in the US economy. If the impact is great and spreading we should start to see a substantial increase of initial unemployment claims. So far, that has yet to happen; we will see another round of claims data this morning. 

There are some jitters that the housing market is slowing down. See this from Bloomberg and this from Calculated Risk. Given his track record, I would not bet against the more sanguine views from Calculated Risk. My take is that in many markets sellers became a little too aggressive on pricing given higher mortgage rates. The result was some pushback from buyers. That said, I don’t think weakness in new home sales will persist. I suspect that the underlying fundamentals (solid job growth and demographic trends) will still push single family starts steadily higher, but that multifamily has peaked for the cycle. The net result may be some softening in the aggregate numbers going forward, which would in turn weigh on economic growth. 

Still, you can imagine that the net impact of tariffs and manufacturing and housing and higher input prices, not to mention tighter monetary policy, all come together to materially slow the economy as 2019 approaches. This isn’t a recession warning, to be sure. Just a notice that although the economy retains substantial momentum, one can tell a reasonable story by which grow eases back enough to give the Fed room to pause in the early part of next year.

Moreover, incoming wage and inflation data do not prevent the Fed from pausing if growth slows materially (likewise, they don’t give the Fed room to accelerate the pace of rate hikes). The employment costs index continues to make steady headway despite quarterly ups and downs but also remains at a level below that of recent cycles. In other words, nothing to suggest an overheating of activity is imminent. Similar story for inflation. Core-PCE inflation, used by the Fed to monitor underlying inflation pressures, slowed in June to a 1.3% annualized rate and remains a notch below the Fed’s target on an annual basis. Talk of overshooting remains premature. 




To be sure, this slowdown that allows the Fed to pause is an almost perfect soft landing where growth eases back to a sustainable long-term pace before the economy overheats or the Fed pushes policy rates too high. That story is of course not yet in the data itself. For example, Wall Street expects the July employment report will show job growth of 190k (close to my forecast of 198k), well above the 100k level the Fed anticipates needed to hold unemployment steady over time. I continue to find it hard to believe the Fed would be content to pause if job growth of this magnitude was expected to continue. In other words, until a slowdown emerges, the Fed will be hard-pressed to change course.

Bottom Line: For now, the economy continues to grow at a pace that allows the Fed to stick with the path of gradual rate increases. Powell & Co. would like to see evidence that the economy is stabilizing at a more moderate pace of growth before entering into a period of extended pause. That evidence has not yet materialized, but we can tell a story in which it does materialize by the end of this year or early next year. Until it does, expect the Fed to keep the pressure on the breaks.

The Flat Yield Curve Is Flagging a Strong U.S. Economy

Given all the attention it has gotten in recent months, most everyone seems to know that the bond market’s yield curve is dangerously close to inverting, an event that has reliably predicted U.S. recessions in the past. The recent firming of economic growth, however, is a reminder that the shrinking difference between short- and long-term Treasury yields by itself does not indicate economic weakness ahead.

Continued at Bloomberg Opinion…