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Equity market turmoil continued throughout last week, raising fresh questions about the Fed’s policy path. I don’t believe that Powell & Co. will panic just yet. I suspect they will take a broad view of incoming data and financial indicators and conclude they have little reason to alter their policy path. This will obviously be somewhat disconcerting for already rattled investors.

Start with the GDP report. It was generally upbeat with second quarter growth coming in at 3.5%, ahead of expectations for a 3.3% gain. Consumer spending grew at a solid 4% pace. No wonder we are seeing strong confidence numbers. Nothing makes Americans happier than spending, and when they can, they do – in three of the last four quarters, spending growth has registered at 3.8% or higher. With such a sustained, solid pace, I think the Fed would interpret any consumption slowing in the fourth quarter as temporary.

Inventory build contributed 2.1 percentage points to growth, while net exports subtracted 1.78 percentage points. I think we have two things going on here. First, there may have been some inventory building to get ahead of expected tariffs. That would be offsetting – counting as a plus via inventories and a negative via imports. These factors would likely fade out in the fourth quarter. But there was also a -0.45 percentage point contribution from exports, arguably attributable to some mixture slower global growth, retaliatory tariffs, and a stronger dollar. We may be waiting on the fourth quarter to see how all of these factors play out.

A more worrisome aspect in the report was the soft read on nonresidential investment, which contributed a meager 0.12 percentage points, the worst result since the final quarter of 2016. Couple that with the fading core manufacturing orders and you can tell a story that the Trump tax cut boom is fading which – especially when combined with uncertainty created by President Trump’s trade policy – suggests that maybe the capital equipment resurgence is coming to an end. 

This is an important space to watch as it cuts two ways for central bankers. On one hand you have a typical demand side story – is this a sign of slowing growth, and, if so, is growth slowing sufficiently to alleviate the inflationary pressures the Fed fears are building? On the other hand, with some central bankers talking up the supply side of the economy as reason to hold rates on the low side, has there been too much supply side optimism?

Housing investment was soft. I don’t have much to add here. It isn’t new – housing hasn’t been a steady contributor to growth for over a year. For those worried about a repeat of the last housing bust, note that the relative lack of substantial rebound in the sector makes for a weak comparison of the two cycles.

Some notable Fedspeak occurred during the past week. Federal Reserve Vice Chairman Richard Clarida presented his outlook and, more importantly, his current economic framework. A few takeaways: First, Clarida sees the risks as balanced and not skewed to the downside as earlier in the cycle. Second, Clarida wants to revive the greatness of the 5-year, 5-year forward inflation guide, an indicator that has been generally downplayed by the Fed in recent years as a measure of inflation compensation, not expectations. Third, Clarida retains his faith in estimates of the neutral interest rates as a policy guide. This places him at odds with other officials such as New York Federal Reserve President John Williams who are downplaying the r-star estimates. Fourth, Clarida sees policy as accommodative and supports further gradual rate hikes. The tone of the speech was on the dovish side in my opinion; barring more significant inflationary pressures, Clarida currently appears likely to resist pushing past his estimates of neutral.

Atlanta Federal Reserve President Raphael Bostic continued to lean hawkish with concerns about what he considers to be a high-pressure economy. He note that high-pressure economies tend to end badly as the Fed tends to follow such periods with a more “muscular” policy stance. Moreover, he worries about the durability of any gains to workers during a high-pressure period, with the implication being that the Fed shouldn’t allow unemployment to fall so much that a disruptive crash is inevitable. More resilient, longer-run gains come not from exceptionally low unemployment, but consistently low unemployment. The upshot for Bostic is that rates need to keep moving higher. 

One specific point from Bostic:

Costs are the one area where I have picked up a potential impact from changes in trade policy. Firms in my district are describing an upward shift in their cost structure. However, we have not yet seen a significant pass-through of higher costs into the final consumer space. Inflation remains stable, hovering around the FOMC’s 2 percent objective.

Still, the potential for changes in trade policy to affect the costs of production—through either direct tariffs, supply-chain disruptions, or firms switching to higher-cost routes to import supplies—remains a risk to my inflation outlook.

This matches what we are hearing from firms in earnings reports and is also evident in the Beige Book. There does appear to be substantial cost pressures in the background, and how these pressures evolve is particularly important at this juncture. If they emerge in such a way that the Fed believes they have been too optimistic on inflation, what we are looking at will be fairly typical late cycle dynamic where the Fed feels need to defend their inflation target. 

On the chaos in financial markets, we aren’t getting much sympathy from the Fed. I don’t think this should be a surprise. My sense is that central bankers are of course watching the situation, but are nowhere near reacting. I think it is instructive to look at measures of financial pressure in the 2015-16 era. I think the Fed will look at similar indicators and conclude that oil is rising not falling, the dollar is not strengthening as quickly, inflation expectations are not collapsing, and bond spreads remain tight. The general conclusion will be that equity markets got ahead of themselves, and some cooling off is expected and arguably, a good thing for sustaining the expansion.

Treasuries did catch a flight to safety bid. I found it interesting that the long bond, however, held most of the yield gains of recent weeks. That was a bit more resilient that I would have expected if growth concerns were mounting.

Bottom Line: The economy continued to power forward in the third quarter on the back of household spending Flagging investment activity, however, raises some red flags. Overall though nothing to dissuade the Fed from hiking rates. Watch how price pressure evolve in the coming months. If they break higher, a slowing economy will not deter the Fed from hiking rates, at least until it slows enough that Powell & Co. believe the pressure is off – this may require higher unemployment rates. That’s where you need to start more aggressively pricing in the end of the cycle.

Housing hit an air pocket in September as new home sales slid, falling along with deterioration in existing home sales. So it’s decision time once again for market participants. Given the well known pattern of “housing is the economy,” should you begin to price in the end of the cycle? Or is that premature given the dearth of other worrisome indicators? I believe it remains too early to price in the end of the cycle.

New home sales came in under expectations, falling low of 553,000 (SAAR), the lowest since December 2016. Inventories climbed to 7.1 months. To be sure, new home sales are volatile. This could simply be a  reaction as potential buyers took a breather to see if mortgage rates would tick back down. Or it could mean that the higher ends of the housing market have finally been saturated and builders need to shift downward to lower ends of the market. Or, more generally, prices finally reached a point where buyers pushed back. Such issues should be expected as the housing recovery matures, even if demographics remain a generally supportive factor.

To be sure, memories of the housing crash and subsequent financial crisis run deep. I don’t think we are likely to see a repeat of that experience. The housing recovery is not built on the same shaky financial ground as we saw in the 2000s; underwriting conditions are more stringent. Moreover, there is clearly less room to fall on the new construction side. And as far as housing’s contribution to the economy, it has been already been choppy and fairly weak in recent quarters. It hasn’t, on average, been driving the economy.

If you want to make the bet that this is the beginning of the end, I would caution you to remember that there remains a wide-range of indictors that still point toward continued economic growth. For example, manufacturing activity remains strong:

Initial unemployment claims still cling to record-low levels:

Temporary employment still grows:

And the yield curve has yet to invert.

Recessions are not single-indicator events. Remember the recession calls in 2016 when manufacturing rolled over? The thinking was that every time industrial production falls by 2%, a recession followed, and this time would be no different. But it was different. Those calls did not play out because the shock was largely contained to that sector; recessions stems from shocks that hit the entire economy. And even if a recession could be boiled down to a single indicator, I would pick the yield curve over housing.

I suspect the Fed will have a similar view to mine. Powell & Co. will tend to discount softening in housing in light of overall broad-based economic strength. That said, it is reasonable to tell a story in which housing softness is part of a cooling trend in 2019 that gives the Fed room to pause in the first half of the year rather then the second half. Assuming, of course, the inflation remains contained.

The upshot is that I am not terribly concerned about the housing situation. My primary focus currently is on the increasing margin pressures faced by firms. Labor and material costs, and of course tariffs, are weighing on the bottom line. Do firms respond with higher productivity, enduring persistently lower margins, or can they push off the cost increases on consumers? Inflation data suggests the last has yet to be an option, which gives the Fed a lot more room to shift policy in a dovish direction should a more broad-based slowdown materialize. Should inflation start to perk up, then they would feel compelled to stick with a more hawkish policy stance. Watch carefully the inflation data around the end of the year. Firms tend to raise prices once a year in a low inflation environment, so we might see the delayed reaction to all of these cost pressures in the December and January inflation reports.

Bottom Line: Recency bias is strong, which means it is easy to get lost in the housing data and miss the rest of the economy. That said, it is reasonable to wonder if the housing slowdown foreshadows softer growth ahead. Of course, such softer growth is already in the Fed’s forecast, so it is not clear that it will induce the Fed to change course. The Fed will be more likely to change course if inflation remains tepid.

Still getting caught up after a busy last week!

Last week Federal Reserve Vice Chair for Supervision Randall Quarles channelled former Fed Chair Alan Greenspan in a rare speech on the economy. Notably, Quarles offered considerable optimism, particularly with respect to the supply side of the economy. He sees room for further expansion of the labor force and, I suspect more importantly, reasons to think that productivity growth will soon accelerate. His optimism on productivity growth stems from recent gains in capital spending and his self-described techno-enthusiasm. In addition, he views favorable the “let the economy run hot” theory in which tight labor markets induce firms to make labor-saving improvements to their operations.

The policy implication:

The more the economy’s potential growth increases, the more gradual we can be in our removal of monetary policy accommodation. Thus, an assessment of the pace of potential growth will be an important input into what I view as the appropriate path of policy to achieve our objectives of maximum sustainable employment and price stability.

In Q&A, he expands further (via Bloomberg):

In a dovish signal, Quarles said that his “preferred path for policy is more gradual than I think many other people’s because of my optimistic assessment.”

To be sure, Quarles still anticipates continued gradual rate hikes. He hypothesizes that sticky inflation expectations may be hiding building inflationary pressures that could eventually emerge. While not a primary risk, it is sufficient risk to justify edging rates higher. That said, Quarles is on the low side of the dots.

Quarles sounds like he wants to walk in Greenspan’s footsteps. Recall that Greenspan famously delayed rate hikes in the late 1990s, believing that accelerating productivity growth justified a more dovish policy path. The difference is that Greenspan had firmer reasons to believe that productivity growth was accelerating. Quarles appears to be operating more on hope than data; note that the median longer run growth forecast presented in the Summary of Economic Projections has been stuck at 1.8% since being downgraded in 2016. His colleagues clearly don’t appear to be so optimistic.

Quarles’s speech, which included a supply-side wink to the tax cuts, must have been music to the ears of President Donald Trump. Trump looks to be having a bit of buyer’s remorse with respect to his selection of Federal Reserve Chair Jerome Powell. Last week he called the Fed his “biggest threat” while seeming to regret his choice of Powell (via CNBC):

“I’m not blaming anybody, I put him there,” Trump said of Powell. “And maybe it’s right, maybe it’s wrong. But I put him there.”

Will anything come of Trump’s ire? Well, maybe. Note that it looks like Nellie Liang’s nomination is in trouble. Liang, a Democrat and supporter of bank regulation, might not even make it out of committee. Indeed, given the apparrent opposition, one wonders how Liang even received the nomination in this political environment. (My answer: Too many people still expect the Fed to exit the Trump years unscathed).

Suppose Liang doesn’t make it out of committee. Further suppose that Trump’s ire at the Fed’s policy path means he doesn’t defer to Powell on the replacement nominee. Trump would be free to find a Quarles-like nominee. Moreover, Trump could pull the nomination of Martin Goodfriend, which is languishing in the Senate, and again find a more ideologically-minded replacement. Trump could have remade the Fed; he might now be realizing the lost opportunity and not want to dig his hole any deeper. Ironically, he could probably reach across the aisle and call the Fed Up staff for recommendations.

On the data front, there is nothing to stop that December rate hike. Unemployment claims remain low and show no signs of labor market deterioration:

The JOLTS numbers confirm the strength of the current American jobs machine. Job openings in August climbed to another record high. And confident workers are quitting their jobs at a pace not seen since 2000:

The nation’s factories are churning out product in September:

Housing is a bit of a week spot, with flattish single family starts for much of this year and evidence that multi-family housing is off its peak:

Moreover, existing home sales have clearly softened in recent months. I think that demographics still support the housing market over the medium term, but also think that high prices, higher mortgage rates, and slowing rent growth are all sapping some of the demand from housing. The keys question is how much of a drag will this become? It is worth noting that housing has not been a consistent contributor to GDP growth for awhile- and contributed negatively the last two quarters:

Hence the downside might be fairly limited. That said, this could become part of a moderation in activity that forces the Fed to rethink their policy path.

Bottom Line: Fed on path to hike rates in December, and the data is no obstacle. I don’t think that Powell will start setting the stage for an imminent pause to please Trump. But Trump could vent his frustrating with his choice of future nominees to the Federal Reserve Board.

Sorry for the limited Fed watching this week. I needed to shift gears to my Portland event, the Oregon Economic Forum, for a few days. That said, I still managed to write for Bloomberg this week:

The minutes of the September Federal Open Market Committee meeting confirmed speculation that Federal Reserve policy makers are leaning toward pushing interest rates above levels considered to be neutral, which neither stimulate nor restrain the economy. That sounds ominous, but it is important not to worry too much yet over the prospect of restrictive policy.

Fed forecasts are a projection, not a promise. If the economy stumbles, odds are the Fed will react appropriately and ease policy. There, however, is an important exception to this rule. If inflation looks to be stirring, the Fed will likely tighten down the clamps. That’s when the real worrying should start, but the Fed does not appear near that point yet.

Continued here at Bloomberg Opinion.

I should be back into the swing of things next week. Have a great weekend!

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The CPI report for September revealed that inflationary pressures remain muted. To date, weak inflation numbers have not deterred the Fed from hiking rates, but instead moderated the pace of rate hikes to gradual. I expect this will continue to be the case. Does this mean the Fed has gone crazy?

Core CPI inflation was again soft in September; the annualized one month gain was just 1.4%. The annual change remains above 2% (remember that PCE not CPI is the Fed proffered price gauge; in, recent year PCE inflation has been running below CPI inflation) but will roll over further if these soft monthly numbers continue. Shelter inflation appears to be moderating again: The pickup earlier this year was a bit of a surprise to me given reports that rent growth was slowing across many major metro areas. Consequently, I have been anticipating that the gains would not hold. Excluding shelter, service sector inflation firmed in September after a string of meager gains: What I find most interesting is that goods inflation has been very soft in the past two months despite tariffs and higher labor costs: This of course runs counter to the narrative that tariffs will become an excuse to push through higher prices to consumers. What’s going on here? Higher labor costs and higher material costs have to show up somewhere. If firms can’t push those costs through to final prices, then they show up in faster productivity growth or softer margins. This tweet from CNBC reporter Joumanna Bercetche:

Fascinating chart from @MorganStanley : The street is expecting margin expansion in every single US sector in 2019.This at a time of rising labor costs (wages) &raw materials (see PPG earlier this wk) No wonder we’re seeing #equities re-rating as more companies cite cost pressure pic.twitter.com/qYkUUFlOuW

— Joumanna Bercetche (@CNBCJou) October 11, 2018

suggests that analysts anticipate firms will be able to manage cost pressures through with a mix of the first two options (pushing through costs or higher productivity). But if the Fed continues to take a hard line on inflationary pressures, then it has to be productivity or margins. And if underlying productivity growth remains mired at roughly 1% give-or-take, then the cost pressures will reveal themselves in softer margins.

I think the Fed would be broadly happy with such an outcome. Optimally of course, they would like faster productivity growth. But the second best outcome is margin compression over inflation, which has the added benefit of tempering equity price gains. Enough pressure to keep inflation in check and ease the pace of job growth, but not enough to tip the economy into recession. Kind of a sweet spot for the Fed.

But should the Fed be raising rates at all given the weak inflation numbers? Shouldn’t they be rapidly lowering estimates of the natural rate of unemployment instead? Has the Fed gone “crazy” as President Donald Trump claims? Jared Bernstein noted that I dodged that question in yesterday’s post:

That’s all well and good, but just answer the question: has the Fed gone crazy or not?! (that’s snark, in case it wasn’t clear…I actually think there’s a great, albeit wonky, SNL skit in there somewhere–“Crazy Fed goes crazy!!”)

— Jared Bernstein (@econjared) October 11, 2018

Yes, I did dodge that question. I try, although not always successfully, to contain my work to “what will the Fed do” rather than “what should the Fed do.” I think I am more effective at the former if I divorce it from the latter. And if you are a market participant, you are probably looking for the former not the latter.

That said, I do have an opinion on this. My suspicion is that in the absence of rate hikes, inflation would be higher now and potentially high enough to be a threat to price stability. I don’t think you can use low inflation now as a reason to argue that the Fed should stop hiking rates because those rate hikes probably contained inflation. I think we are now too far along in the cycle to have not raised rates.

Moreover, I see room to raise rates further. Earlier this year I was worried that the Fed would deliberately invert the yield curve in their campaign to hike rates. I would view such an action as a policy error. Since then, however, the long end of the curve has sold off producing a bit of a bear steepening. This strikes me as an indication that the economy can indeed sustain the Fed’s rate path.

Finally, I am somewhat nervous that even in a low inflation environment the Fed appears fairly resistant to the idea that they should pause at something close to neutral to take a look around and wait for a bit more of the lagged impact of past rate hikes to work their way through the economy.

Speaking of crazy, Trump doubled-down on his Fed criticism today, saying the Fed is “out of control.” Trump did add that he didn’t expect to fire Federal Reserve Chairman Jerome Powell, but of course that threat is now out there (although the Fed Chair supposedly can only be fired for cause).

I do not think that this criticism will induce Powell to hike just to prove a point; Powell is going to be the adult in the room. Trump is looking to lay the blame for any slowdown in activity on the Fed, and has made itself a sitting target for such a game. The Fed’s forecasts very clearly show that central bankers intend to guide the economy into a slower growth trajectory. Now yes, we all know they believe such a policy path reduces inflationary pressures and actually extends the life of the expansion, but such nuance will be lost when the economy does slow.

Moreover, don’t forget that Trump knows how to work the press. This story gets him the attention he craves. So he will keep at it.

Bottom Line: Inflation remains low. Does this mean the Fed’s plan is crazy, or that it is successful? Looks more like success than craziness in my opinion. Regardless of that opinion, the Fed looks likely to keep following the path they laid out – gradual rate hikes until the economy looks likely to revert back to what they think is a sustainable pace of growth.

A bit of an unpleasant day in the stock market. Not unpleasant enough, however, to send much of a panic among Federal Reserve policy makers. In fact, quite the opposite – my sense is that Powell & Co. will be happier if the pace of equity gains moderated. Indeed, I would say that this is a lesser-mentioned goal of the tightening campaign. From their perspective, taking some of the steam off the stock market occasionally reduces the risk that financial instabilities grow and become a potential economic threat.

I wouldn’t panic yet either; I don’t think this is the beginning of the end for this bull market.  What would be the beginning of the end? When the Fed starts to believe they can’t cut rates in the face of economic weakness due to inflationary pressures. We aren’t there yet. 

Both the Dow and the S&P500 were down more than 3% Tuesday. The story floating around the press was that this was a risk-off day as equity traders processed the implications of evolving Fed policy. In contrast, Treasury bonds barely budged; long bonds even fell a notch, lifting long rates. My interpretation is that fixed income traders had already processed the shifting policy environment; equity traders were a bit late to the party.

What is that changing environment? Well, as I have documented over the past several weeks, the Fed has been slowly phasing out forward guidance, leaving market participants a bit more uncertain about the path of rates going forward. I think the Fed views this uncertainty as a policy feature, not a bug. Recall the criticism the Bernanke’s Fed contributed to market complacency by laying out so clearly the rate path. Powell may very well share that criticism (a good question for the December press conference).

The Fed has focused attention away from r-star estimates (and forward guidance in general) to their forecasts instead. And therein lies the problem for market participants. The incoming data appears to confirm the forecast, policy makers appear to agree that the data confirms the forecast. That rate forecast is hawkish relative to market expectations that the Fed would soon pause in their rate hike campaign. Worst, that forecast suggests they keep hiking even after the impact of fiscal stimulus starts to wane. The upshot is that we need to incorporate both a higher path of rates and additional uncertainty about the path of rates into prices. On net, that should sap the equity markets of some strength.

The Fed is not going to ride to the rescue here. There is no Powell-put for a 3% decline. Or even an extended decline like earlier this year. And Bloomberg caught this from New York Federal Reserve President John Williams last night:

“The primary driver of us raising interest rates is just the fact that the U.S. economy is doing so well in terms of our goals,” Williams said Wednesday in a reply to questions after a speech in Bali, where the annual meetings of the International Monetary Fund and World Bank are taking place. “But I would also add that the normalization of monetary policy in terms of interest rates does have an added benefit in terms of financial risks.”

“A very-low interest-rate environment for a long time does, at least in some dimension, probably add to financial risks, or risk-taking, reach for yield, things like that,” he said. “Normalization of the monetary policy, I think, has the added benefit of reducing somewhat, on the margin, some of the risk of imbalances in financial markets.”

This is not new. Federal Reserve Chairman Jerome Powell has made similar statements. There is a widespread concern that persistently low interest rates would become a problem not for price inflation, but for financial stability. Reducing financial accommodation to minimize those risks is clearly a policy goal here.

To add some additional drama to the day, President Donald Trump tossed in his two cents on monetary policy:

“The Fed is making a mistake,” he told reporters on Wednesday as he arrived in Pennsylvania for a campaign rally. “They’re so tight. I think the Fed has gone crazy.”

Trump is setting the stage to blame the Fed should the economy tank. Luckily, I don’t think that’s about to happen. It is important to remember that the Fed’s rate forecast will only hold in a solid economic environment that is generally supportive of equities. If the economy tilts downward more quickly than expected, the Fed will reel back on those rate forecasts. They might hem and haw before they shift, but most likely they will shift. If the economy faces a clear economic challenge, the Powell put will become a reality.

There are, however, two caveats to this prediction. One is just straight-up policy error, misreading the data. The second caveat, which is what concerns me, is that the Fed reaches a point where they don’t think they can ease due to inflationary pressures. As a general rule, central bankers think that inflation expectations are sufficiently well contained that they can maintain a gradual path of rate hikes. I think this also means that they will be react to a substantial change in the economic outlook – a greater slowdown than they anticipate – with a shift toward a more dovish policy path. But there of course is a chance that inflationary pressures emerge such that they think they need to defend their inflation target. In my opinion, in such a circumstance they will choose recession over inflation.

Bottom Line: Don’t panic. Yet. The Fed’s rate path might be higher and more uncertain than anticipated, but this largely reflects a more positive economic outlook. That’s ultimately a good thing. Watch the inflation numbers. Inflation is what could sour the Fed’s plan and its willingness to respond to a substantial deterioration in the outlook.

Recent speeches by Federal Reserve policy makers make clear that they have reduced their reliance on estimates of the long run neutral level of interest rates as a guide for monetary policy. Going forward, market participants will need to more closely scrutinize the central bank’s Summary of Economic Projections for clues as to where rates may be headed.

Those forecasts currently point to a fairly hawkish path for monetary path. Not only do they indicate policy will eventually turn restrictive, but they also suggest policy will remain restrictive even as economic growth slows. In other words, the Fed doesn’t anticipate turning tail on their policy path even if the economy dips next year.

Continued at Bloomberg Opinion…

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The labor market retained sufficient strength to convince Powell & Co. to stick with the current policy path. Expect more rates hikes in the months ahead as the early reads on the third quarter, primarily October survey data, indicate that the economic momentum continues. There is little reason at this point for the Fed to abandon its forecast toward the dovish side. That said, watch for signs that policy makers will be rethinking their unemployment forecast while doubling down on the natural rate forecast. The combination would play out in a hawkish direction.

Job growth defied growing expectations for a blow-out number and instead came in below consensus with a 134k gain. The headline print was likely weighed down by Hurricane Florence; previous months were revised higher. The net impact is that job growth continues at a monthly pace of roughly 200k, well above the roughly 100k policy makers generally expect to be consistent with a non-inflationary economy after the cyclical pull on labor force participation wanes.

Indeed, the jobs report gives hints that the surprise burst of labor force growth over the past year has reached a conclusion. Labor force participation overall and for prime ages workers have flat-lined, and labor force growth slowed markedly, helping to push the unemployment rate to 3.7%, a 48-year low. Recall that policymakers recently edged up their year-end unemployment forecast at the September FOMC meeting with the median policymaker expected 3.7% rather than 3.6%. In other words, the economy is at the Fed’s target well ahead of schedule and the pace of labor force growth versus job growth looks likely to push the unemployment rate down below their target.

Another way to think about this is that the Fed’s September forecast of faster growth and higher unemployment spoke to a growing conviction in a supply side growth story. The September jobs report weakens that narrative.

Central bankers might have waved off additional unemployment declines had wage growth continued to stagnate, but the wage data is starting to tell a different story. To be sure, year-over-year growth edged down from 2.9% to 2.8%, but the annualized pace over the last three months has been a healthier 3.76%. Supposed the labor market sustains that pace and do that math here: If we assume as the Fed does roughly 1% productivity growth and a 2% inflation target, you get an additional .76 percentage points of wage growth. That additional wage growth needs to show up somewhere. 

The Fed can hope that in the short-run the additional wage growth shows up as narrowing profit margins and real wage gains for labor. Indeed, I think that the Fed will risk this scenario as long as possible and not accelerate the pace of tightening – as long as inflation stays low. But obviously if inflation instead looks to be heading above 2.5% on a sustainable basis, they will be looking to engineer a slower economy via a faster pace of rate hikes or via signaling that they anticipate a higher terminal rate.

Keep an eye on the forward-looking indicators employment – they suggest the labor market isn’t loosening momentum anytime soon. Not only are initial unemployment claims holding at ultra-low levels, but temporary employment continues to rise. Both suggest job growth will hold strong.

Separately, Atlanta Federal Reserve President Raphael Bostic made a hawkish turn last week: 

The incoming economic data on the real side of the economy have come in stronger than I had been expecting earlier this year. So much stronger, in fact, that the central question in my mind is whether the apparent strength in GDP and job growth is a signal that I have materially underestimated the underlying momentum of aggregate demand. If that’s the case, the potential for overheating would require a higher path for rates than what I had been thinking.

And from business contacts:

…there was a marked uptick in the reported ability of firms to pass on cost increases. This was especially true for firms subject to tariff- and freight-related cost increases. Those firms reported little to no pushback when passing along rising costs to their customers. But I get the sense that the phenomenon is becoming more widespread. It’s a development that I will continue to watch closely.

Bostic concludes:

Current conditions suggest, to me, that we ought to get to a policy stance where our foot is neither on the gas pedal—what we call an accommodative policy—nor on the brakes—what we call a restrictive policy. Such a neutral policy position would allow the economy to stand on its own.

It is unclear if Bostic means moving faster to neutral than expected, or that neutral is higher than he excepted, or both. A “higher rate path” could be interpreted in any of these ways. But, at a minimum, it suggests upward drift of low dots toward the median, or, in other words, a growing confidence in the median rate hike projection.

Also note Bostic’s perception that firms can more easily push through prices to customers. If these concerns grow, it sounds likely he could be easily pushed into thinking that rates need not only to get to neutral, but beyond to restrictive.

Bottom Line: Incoming data continues to support the Fed’s basic forecast that rates need to climb higher. I think the data increasingly supports the case that rates need to move in a restrictive zone before the Fed can breathe easier, but much depends on the evolution of the inflation data. A hint that inflation could be sustainable higher than 2.5% would probably embolden central bankers to take more aggressive action.

This is just quick note to consider how Fed speak might evolve. Basically, I realize that given my recent push to highlight the hawkish aspects of Fed policy, I might be exposing myself to the risk of seemingly dovish Fed speak. This is a good time to reflect on what we might see from Fed communications in the coming months.

I see this Reuters story wondering if the Fed will react to the rise in long term yields. So far, it is just noise, at least according to Cleveland Federal Reserve Bank President Loretta Mester:

“The fact that interest rates moved on one day is not a concerning thing. Markets are volatile,” Cleveland Fed President Loretta Mester said, adding that strong payroll data and perhaps this week’s U.S.-Mexico-Canada trade agreement provided a boost to bond yields. “It is still appropriate for us to be moving interest rates up gradually,” she said.

That sounds right; the magnitude of recent Treasury moves should not be considered disconcerting, particularly if they reflect a more optimistic growth scenario. That said, the exit from forward guidance poses a communications challenge not only for Fed watchers and market participants, but also for central bankers. One benefit of explicit forward guidance is that it directly communicates the policy stance, thereby reducing the odds crossed wires between financial markets and the Fed. The intended effect of adding uncertainty into the picture by pulling forward guidance has the consequence that the Fed may have difficulty communicating their message.

The upshot is that we might see apparently conflicting messages if the Fed feels that the market has drifted too far away from the central story. It will be different than the “cacophony of voices” problem; this will be evident possibly from even a single voice. Note already how easily New York Federal Reserve President John Williams pivoted away from r-star. And I keep hearing complaints that Federal Reserve Chair Jerome Powell is “all over the place,” seemingly hawkish on one day and dovish the next. These transitions might appear more stark if, for instance, the Fed feels they need to rein in rate hike expectations.

Another way to think about this: In my view, Powell & Co. currently spend something like 50% of their time living in the 1970’s, 40% living in 1994-95, and 10% in the Great Recession. So most of the time they will be bouncing between worries that need to keep enough pressure on rates to ensure inflation remains contained and worries that the long end of the bond market shoots higher due to excessive rate hike expectations. The message might thus bounce back and forth accordingly.

Personally, I am looking forward to the post-forward guidance era. I think it will be much more fun and interesting. But I understand that not everyone will share that opinion.

Bottom Line: My approach to the post-forward guidance era centers on paying extra close attention to handicapping the Fed’s forecasts in light of how incoming information impacts those forecasts.  For instance, look at the initial unemployment claims numbers, a forward looking indicator that provides no hint of a shift in the labor market. That’s hawkish in that it confirms the forecast (which is more aggressive than market implied forecasts). Think of the Fed speak as trying to push us back to that approach. It might seem clumsy at times, but that is just what you need to expect in the absence of a more explicit communication strategy.

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We are coming up on jobs day – the months just fly by, don’t they? Expectations are high that the numbers will easily suffice to keep the Fed hiking, and Wednesday’s data raise the risk of substantial upside surprise. How high will rates go? The answer is of course data dependent, but Powell dropped a hint today by letting everyone know that he thinks the end point is still many months away.

Two numbers today stood out. ADP estimates 230k private sector jobs were created in September. The ISM non-manufacturing report measure of employment jumped to 62.4, up from 56.7 in August. Both indicators suggest the consensus forecast of a 180k NFP gain is on the low side. Be wary of an upside surprise, plus possible upward revisions in the August numbers (a month revised upwards in six of the last seven years). My model anticipates a a whopping 312k payroll gain, which seems crazy strong; my takeaway is simply that the risk to the consensus forecast is on the high side. 

Of course, it’s not all about the payrolls number. Watch also the unemployment rate. The consensus is that it dips a bit to 3.8%. This is particularly interesting because the median estimate of central bankers for the year end unemployment rate edged up from 3.6% to 3.7%. If it dips lower than 3.8% I expect the Fed will become a bit more nervous that they are underestimating the strength of the economy. Also keep an eye on wage growth – it was high enough in August to convince central bankers that their estimates of the natural rate of unemployment can’t be terribly wrong, but low enough not to kindle concerns of imminent inflationary pressures. Some will reassess the latter position is wage growth continues to climb.

Meanwhile, Federal Reserve Chairman Jerome Powell did a Q&A today. I was not surprised that he maintained the continued “gradual rate hike” mantra. I was surprised when he said “we’re a long way from neutral, probably.” That seemed like it was a bit of a slip. And a hawkish one at that. What seems remarkable to me is that I keep hearing a dovish interpretation of the Fed’s recent disavowal of r-star and the related demise of forward guidance. But what Powell let slip is that he clearly still has an estimate of neutral and we are nowhere near it. That’s hawkish.

Powell also added that “we may go past neutral.” In this sense, he is arguably a bit more dovish than colleagues such as Chicago Federal Reserve President Charles Evans, who reiterated toady his expectation that rates turn restrictive. Still, I see Powell as edging toward admitting what the forecasts reveal. Remember, you don’t have r-star as a guide anymore, but you still have the rate forecasts. You might say that there is a wide variation in the rate forecasts. But it looks like there is a common element – no matter where a central banker thinks neutral is, the majority if not all (not counting St. Louis Federal Reserve President James Bullard), expect rates will climb above their estimate of neutral. In other words, they all see policy as becoming restrictive.

Take the forecasts seriously. Handicap the data against the forecasts. Right now, the forecasts tell a hawkish story, especially if you let go of the r-star anchor. And the data doesn’t give reason to think otherwise. 

Finally, bond bears get their day in the sun as the long end of the yield curve lets go of its anchor. Something had to give in the face of ongoing rate hikes. Either the yield curve would soon invert, raising the prospect of recession, or it would start shifting upward on the back of some mix of stronger growth, firmer inflation expectations, and a rising term premium. The latter story currently has the upper hand. That is about as good a story as the Fed could hope for.

Bottom Line: You know the bottom line. The US economy is on a roll, and that will induce the Fed to keep adding pressure – gradually – to the brakes.