What Can We Learn From The New York Fed’s Underlying Inflation Gauge?

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Working on examples for a class, I stumbled upon one with implications for market participants. Specifically, what has the New York Federal Reserve’s Underlying Inflation Gauge (UIG) been telling us? The answer is somewhat surprising. It does provide new information about the path of core-inflation. Still, even at its height it wasn’t predictive of any worrisome inflation. There are two interpretations. One is that you ignore the UIG, the other is that you embrace the predictions of low inflation. I pick the latter interpretation.

The New York Fed UIG is an effort to capture the underlying trend in inflation. An attractive feature of the UIG is that its construction utilizes a wide array of financial and economic variables; The “full-data-set” version is based on 346 monthly, weekly, and daily series. This allows it to capture a number of factors such as, for example, tighter labor markets that may influence the path of core inflation. The objective is to add information to our traditional measures of core-inflation as those measures arguably exclude important information that might shape our inflation forecast.

Last year the UIG created angst within some quarters of the investment community as it rose to highs last seen prior to the Great Recession. Examples can be found in the news here, here, here, and here. Neil Dutta of Renaissance Macro Research, however, argued prior to the highs in the UIG that “…if loose financial conditions and stronger growth do little to move price inflation, perhaps the premise of those who rely on UIG to claim inflation will turn up is flawed.”

With this in mind, I set out to understand a bit more about the dynamics between the UIG and inflation. While the UIG is presented along with year-over-year core CPI inflation, I focus on year-over-year core PCE inflation because the latter is the Fed’s preferred inflation measure (technically, the Fed targets headline inflation but use core as a predictor of the likely path of headline inflation). I also use the “full-data-set” version of the UIG as it received the most press last year and I am interested in the importance of the wider range of variables in predicting inflation.

Visually, the turning points of the UIG correspond to turning points of core-inflation. Moreover, high values of the UIG have corresponded to inflation rates in excess of the Fed’s 2% target. This is more easily seen in a scatterplot.

What I want to know is a.) does a change in the UIG predict a change in core-inflation and b.) what does the UIG say about the inflation forecast? To get at these issues I set up a simple two-variable vector autoregression with six lags. The Granger causality tests indicate that the UIG and inflation both have an impact on inflation but inflation does not have an impact on the UIG. That suggests a shock to the UIG will have an impact on inflation but not vice-versa, which is what the impulse response function show.


Roughly, a 0.07 percentage point shock to the UIG will be translated into an equal shock to core-inflation after three months (right hand charts). Moreover, the impact on core-inflation is fairly persistent (upper right chart). Shocks to core-inflation are not persistent and dissipate over the next twelve months (upper left chart) while having very little impact on the UIG (lower left chart). These basic results are not very sensitive to the choice of lag length, but lag lengths beyond 12 months tend to result in models where the cycles overrun each other and are not particularly instructive. 

I find these results reassuring in that they suggest the UIG does capture factors that have a persistent impact on core-inflation. That said, has the magnitude of shocks been sufficient to heighten inflation concerns? To get at that question, I compute the 24-month inflation forecasts from the model for each month beginning with 2017:1 and ending 2018:11 (using recursive regressions that re-estimate the model each month). Those forecasts  all point toward inflation settling into a range of 1.7-1.8%. In other words, adding the UIG to the inflation forecast has indicated for the past two year that inflation will fall short of the Fed’s target. 

I think these results point toward the strength of the mean reverting properties of inflation in recent years as inflation expectations have become more entrenched and the Phillips curve less pronounced.

Bottom Line: The New York Fed UIG appears to provide new information about the direction of inflation but that information for the past two years has indicated inflation below the Fed’s target.

Backwards Looking Data Likely To Justify Fed Patience

We have a big week of data ahead, but with a twist: Because of the government shutdown, the incoming data is an even deeper look into the past than normal. How much of it will really be new news at this point when market participants already appear to have discounted a weak fourth quarter and are looking forward to the future? Which leaves me thinking this week could be one of those “bad news is good news” situations when soft data reinforces expectations that the Fed is done hiking for this cycle.

The durable goods report for December came in on the soft side:

But note that the degree of softening so far is more noise than a substantial decline:

Of course, that is December data and hence fairly backward looking. More timely data though has followed a similar pattern. Regional manufacturing surveys have generally been on the weak side, with the latest example being the Philly Fed measure coming in weak. Consequently, we should anticipate some weakness in the national ISM report to be released this upcoming Friday.

Still, when I am looking at the manufacturing data, I am wondering if any weakness in that sector remains fairly well contained. Note that while the preliminary Markit PMI for manufacturing for February was a bit softer than expected, the services measure came in better than expected. That might be particularly important given that the service sector dominates the US economy. We may again experience a repeat of the 2015-16 episode when the manufacturing sector diverged from the service sector with the net result being that the economy slowed but did not slip into recession.

Last week saw another soft reading on existing home sales; high prices and higher mortgage rates turned the tide on what had been fairly hot markets in many metros. We get more December housing data Tuesday with building starts and permits along with Case-Shiller home prices. And on Wednesday we get pending home sales for January. I don’t think may are expecting any big positive surprises in the data and instead anticipate it will further justify the Fed’s decision to hold rates steady in January and beyond.

Thursday brings the delayed fourth quarter GDP report. Expectations are low; the Atlanta Fed GDP tracker anticipates a growth rate of just 1.4%. The December retail sales report, regardless of whether or not you believe it to be just a blip, will take a large piece out of growth for the quarter. Again, not only do we have low expectations, it is very backwards looking data at this point.

More forward looking is the initial claims report. Last week brought a decline in claims, but it really has been all over the place in recent weeks. Still, on average the trend is a notch higher, and the dispersion of rising claims across states a little wider:

Definitely an indicator that we need to keep our eyes on, but also one that has made false recession calls in the past.

Friday brings the December personal income and outlays report and with it an inflation reading. Again, weakness is anticipated and will be largely anticipated by the results of the previously released GDP report of this week. Also, as noted earlier, we also get ISM and Market PMIs. In additional, a final February reading on consumer sentiment from the University of Michigan.

Plenty of Fedspeak for the week, including a trip by Federal Reserve Chairman Jerome Powell to the Senate (Tuesday) and House (Wednesday) for the semiannual monetary policy report. Vice Chair Richard Clarida will deliver an economic outlook Thursday morning. That evening, Powell has a speech titled Recent Economic Developments and Longer-Term Challenges. Between the two we should get some insight on the expected path of policy. That said, I anticipate it will largely be confirmation of what we already know: The Fed is on the sidelines for the time being and I suspect the bar to a rate cut is lower than the bar to a hike.

One thing to note is that the Fed has effectively eased policy by shifting down the expected path of short-term rates. This pulls down interest rates across the curve, for example on the shorter end here:

At least for now, equity markets have responded and retraced their December loses:

The important point to remember here is that if you are sitting around waiting for the Fed to move, you already missed it.They did move and set the stage to move further if needed.

Finally, in case you missed it, it is worth your time to review the action at last week’s monetary policy forum, paper here, comments by New York Federal Reserve President John Williams here, and comments by Richard Clarida here. A takeaway is that the Fed is preparing for the next downturn with the expectation that new tools need to be ready to address another trip to the effective lower bound. Importantly, the Fed will be looking for tools to prevent downward drift on inflation expectations by, for instance, policies such as makeup strategies that allow for higher inflation to make of for periods of low inflation. I think a result of this work will likely be a more aggressive monetary policy in the wake of the next downturn.

Bottom Line: Plenty of delayed data, mostly backwards looking, will be released this week. Expect it to justify the Fed’s shift to a “patient’ policy stance. Expect Fedspeak to reinforce this point. Keep in mind that the Fed has already eased policy and done so fairly early in a soft patch. That’s bullish for the economy.

January 2019 FOMC Minutes: Shifting Gears

As is often the case, one could linger for hours over the minutes of the Fed meetings, pulling out interesting bits and pieces to chew on. This one is no exception, but the short story in the January minutes is that the Fed was concerned enough about the outlook to shift to its current “patient” stance, but not so worried that they were contemplating a rate cut in the year ahead. They are also closer to ending the balance sheet reduction; I expect they will slow the pace they are reducing the balance sheet within the next two meetings with an eye toward ending entirely by the end of the year.

The operating procedures and balance sheet discussion came early in the meeting. Recall that the Fed announced in January they had decided to manage short-term rates in a system with ample reserves. With that in mind, the Fed sees that the end of “quantitative tightening” is upon us:

Almost all participants thought that it would be desirable to announce before too long a plan to stop reducing the Federal Reserve’s asset holdings later this year.

They also noted the implications of their plan on the mix of their asset holdings:

Participants commented that, in light of the Committee’s longstanding plan to hold primarily Treasury securities in the long run, it would be appropriate once asset redemptions end to reinvest most, if not all, principal payments received from agency MBS in Treasury securities.

In other words, they will eventually find themselves once again buying Treasuries to offset continued reduction in their mortgage holdings as they work to exit the housing business.

Participants were generally upbeat about the economy:

Participants agreed that over the intermeeting period the labor market had continued to strengthen and that economic activity had been rising at a solid rate

Still, they saw growth slowing in 2019 more than anticipated in December:

Participants generally continued to expect the growth rate of real GDP in 2019 to step down somewhat from the pace seen over 2018 to a rate closer to their estimates of longer-run growth, with a few participants commenting that waning fiscal stimulus was expected to contribute to the step-down. Several participants commented that they had nudged down their outlooks for output growth since the December meeting…

Recall that in December the median 2019 growth forecast was 2.3%. The above suggests that by January it had fallen to something closer to 2% (the Fed’s median estimate for longer-run growth was 1.9%). A particular concern was the investment outlook:

Participants noted that growth of business fixed investment had moderated from its rapid pace earlier last year.

With regards to inflation, hope springs eternal:

 Participants continued to view inflation near the Committee’s symmetric 2 percent objective as the most likely outcome.

Despite the reality:

Some participants noted that some factors, such as the decline in oil prices, slower growth and softer inflation abroad, or appreciation of the dollar last year, had held down some recent inflation readings and may continue to do so this year. In addition, many participants commented that upward pressures on inflation appeared to be more muted than they appeared to be last year despite strengthening labor market conditions and rising input costs for some industries.

They took a fairly benign view of falling market-based measures of inflation compensation, favoring the interpretation that this was less about falling inflation expectations and more about declining risk premiums and a greater risk of downside to the inflation forecast. Stable survey measures of inflation expectations supported this view. Since then, however, the University of Michigan longer-run inflation measure slipped to 2.3%. Most interesting is that series has not begun to edge higher despite a period of unemployment that is supposedly persistently below its natural rate.

Not unexpectedly, the Fed worried about the financial markets:

Among those participants who commented on financial stability, a number expressed concerns about the elevated financial market volatility and the apparent decline in investors’ willingness to bear risk that occurred toward the end of last year.

These concerns played into their policy decision:

Participants observed that since then, the economic outlook had become more uncertain. Financial market volatility had remained elevated over the intermeeting period, and, despite some easing since the December FOMC meeting, overall financial conditions had tightened since September. In addition, the global economy had continued to record slower growth, and consumer and business sentiment had deteriorated. The government policy environment, including trade negotiations and the recent partial federal government shutdown, was also seen as a factor contributing to uncertainty about the economic outlook.

They subsequently concluded that they should hold rates constant and signal they would be patient with respect to future policy changes. Interestingly, I would argue that most of these factors were present at the December policy meeting, which would explain why markets puked in the wake of that decision to hike rates and signal more rate hikes to come. The Fed was then less willing to see what everyone else saw.

Policymakers on average retain a hawkish bias with respect to the likely direction of rates:

Many participants suggested that it was not yet clear what adjustments to the target range for the federal funds rate may be appropriate later this year; several of these participants argued that rate increases might prove necessary only if inflation outcomes were higher than in their baseline outlook. Several other participants indicated that, if the economy evolved as they expected, they would view it as appropriate to raise the target range for the federal funds rate later this year.

Note that they seemed focused on the possibility of additional rate hikes and not focused at all on cuts. Also, the Fed made clear that they will dump “patient” before any rate hike:

Many participants observed that if uncertainty abated, the Committee would need to reassess the characterization of monetary policy as “patient” and might then use different statement language.

This on the dot plot is interesting:

A few participants expressed concerns that in the current environment of increased uncertainty, the policy rate projections prepared as part of the Summary of Economic Projections (SEP) do not accurately convey the Committee’s policy outlook. These participants were concerned that, although the individual participants’ projections for the federal funds rate in the SEP reflect their individual views of the appropriate path for the policy rate conditional on the evolution of the economic outlook, at times the public had misinterpreted the median or central tendency of those projections as representing the consensus view of the Committee or as suggesting that policy was on a preset course. However, some other participants noted that the policy rate projections in the SEP are a valuable component of the overall information provided about the monetary policy outlook.

The ongoing debate at the Fed. Does the dot plot help or hurt? The Fed is having a hard time convincing market participants that the dot plot median is not a consensus forecast and that any of the individual forecasts are much more uncertain than commonly believed. This was particularly an issue in December when the median dot anticipated another two rate hikes in 2019 after the Fed pushed through what market participants already considered an ill-advised rate hike at that meeting. The Fed argues that was a forecast, not a promise. This and similar dynamics have been an ongoing issue. In my opinion, the Fed’s models make the dot plot inherently hawkish, which arguably sets expectations such that policy is less accommodative than the Fed believes.

All that said, many FOMC participants still find value in the dot plot in that it conveys the Fed’s reaction function. The challenge is finding a new version of the dot plot that retains this communications element while losing the problematic elements.

Bottom Line: Policy on hold through mid-year at least, the Fed still retains a modestly hawkish internal bias, the balance sheet reduction will soon be over, and the Fed still doesn’t know exactly what to do with the dot plot.

Looking Backward, Looking Forward

The game right now is all about tracking the magnitude of the expected slowdown in US economic activity as Federal Reserve policymakers lay down markers about what the outlook means for rate policy. San Francisco Federal Reserve President Mary Daly, for instance, said she is anticipating 2% growth this year, setting the stage for the Fed to stay on the sidelines until 2020. Via the Wall Street Journal:

“If the economy evolves as I just said I expect it to—2% growth, 1.9% inflation, no sense that [price pressures are] going up, no sense that we have any acceleration—then I think the case for a rate increase isn’t there”

The median forecast for longer-term economic growth in the Summary of Economic projections is 1.9%, so 2% growth is pretty much at trend hence no need for hikes absent any inflationary pressures. In contrast, Atlanta Federal Reserve President Raphael Bostic thinks the economy will support another rate hike in 2019 while Philadelphia Federal Reserve President Patrick Harker expects a rate hike in each of 2019 and 2020.

Although on net central bankers thus appear on average to hold neutral to ever so slightly hawkish expectations for rate hikes this year, I imagine at this point this risk is that the outlook could turn darker than officials anticipate and hence the Fed cuts rates before the end of the year. That likely requires the threat of below trend growth. The challenge of course is, as I explained last week, that it is very difficult to identify the extent of a slowdown early in the process.

For example, the industrial production report revealed a sharp decline, placing it at odds with the most recent ISM report (although the situation was reversed in December). The magnitude was non-trivial, but we would be looking for a string of weakness similar to that of 2015-6 to become very concerned that the economy was slowing to something below trend:

The impact was largely attributable to manufacturing:

Which in turn was driven in large part by weakness in the automative sector:

Truck assemblies have been all over the place this year so I am wary of concluding that the industry is at the front end of a 2008 kind of slide. That said, it seems likely that auto sales have peaked for the cycle and are likely to move sideways to modestly down going forward. That though differs from recessionary dynamics. Overall, industrial production still looks solid compared to last year:

A typically good recession indicator, initial unemployment claims, has also been all over the map in recent weeks but still track at very low levels:

The dispersion of claims has picked up a bit, similar to that seen in 2015-16. That should make us a bit cautious about over-interpreting this signal as here again we need to be careful. Initial claims can provide a false recession signal:

A familiar story – the data is moving as one might expect with the economy slowing but as in the past, this is not yet different than other slowdowns that did not evolve into recessions.

Coming up this week we get a few bits of data to chew on. Wednesday the Fed releases the minutes of the January FOMC meeting. Of particular interest will be the discussion on the balance sheet. Last week Federal Reserve Governor Lael Brainard said that she favors ending the balance sheet reduction later this year; my suspicion is that she will find support among her colleagues and that it won’t be long before the Fed signals more clearly that they are getting close to ending quantitative tightening. Thursday promises a flurry of activity with durable goods, Philly Fed, Markit manufacturing and services, initial unemployment claims, and existing home sales set for release. Friday should be fun with Randal Quarles, John Williams, Mary Daly, James Bullard, and Patrick Harker all participating in the University of Chicago 2019 US Monetary Policy Forum. The conference begins with the report Prospects for Inflation with a High-Pressure Economy, which sadly is a topic that may have been overtaken by recent events.

Bottom Line: The economy is set to slow in 2019 and such an outlook is supported by early indicators. Slowing is not recession. While officials have said the next move could be up or down, I tend to think the median FOMC member would still believe flat to up more likely. That said,  I think flat to cut is more likely; the events of December appear to have been a wake up call for central bankers who had fallen too far into love with the idea of hiking rates deeper into the range of estimates of neutral. That change on the part of the Fed will likely prove critical to sustaining the expansion. 

Consumer Sentiment and the Totality of Data

If you were still worried about the weak December retail sales numbers, the rebound in consumer sentiment in February should help ease your mind.

Recall that last week I questioned the relevancy of the retail sales decline given the magnitude of the decline is recessionary in nature and the economy was clearly not in recession in December. If in recession, the jobs numbers would have fallen off a cliff.

What about data besides the employment report? Consumer spending had declined sharply in January before partially rebounding in February. Is there a story here?

First off, the January decline was greater than one standard deviation, but that is not an uncommon event even outside of recessions:

There is still a well known relationship between consumer sentiment and spending that we should acknowledge:

On quick visual inspection, the decline in January, especially coupled with the February rebound, don’t suggest much reason for concern about consumer spending. That said, the two-axis graph is anathema to respectable economic and financial analysis as it can be manipulated to suggest stronger relationships than actually exist. I find it preferable to at a bare minimum convert the graph to a scatter plot and add the results of a liner regression:

The implication in this chart is that the surge in confidence after Trump’s election did not translate into a surge of consumer spending; spending had persistently fallen short of what would have been expected given the confidence numbers. Spending should be higher if the boost in confidence reflected real improvement in household financial conditions associated with Trump’s election. Consequently, the January decline by itself was also likely not meaningful for the underlying pace of spending.

This regression, however, isn’t really my favorite; the two-axis, two-variable format limits the analysis. At a minimum, we can add a lag of spending to the regression (the resulting three-variable equation though doesn’t fit neatly on a scatter plot, hence I dropped the fitted line):

Now the predicted values dragged up modestly (to the top of the pink dots) by the high levels of confidence but still hold fairly constant due to the persistent impact of the lagged spending variable.

In reality, the December spending number is likely to be depressed below these forecasts, an artifact of the weak retail sales report. Still, the fact that consumer sentiment has not fallen off a cliff in December or thereafter suggests that this is a short term impact. At the same time, note that consumer sentiment is probably overstating the strength of actually spending, so even a decline in sentiment would have to be quite significant to be consistent with deteriorating household spending. That kind of situation is typically associated with substantial deterioration in the jobs market, which so far has not occurred.

Bottom Line: Consumer sentiment is another variable indicating that near term recession concerns are misplaced. The decline in January’s sentiment itself wasn’t reason for concern, and the rebound in February backs this up. Also, if your favorite pundit has a penchant for two-axis charts, request at a minimum conversion to a scatterplot with a regression. 

Beware of a Recessionary Bias Among Analysts

With the economy widely expected to slow in 2019, we should anticipate softer data in the months ahead. Softer data forces us to think hard about the possibility of recession simply because we don’t know how soft the data will become. Every recession begins with a softening of the data, but so too does every weak patch in the economy. Each weak piece of data that comes through the door needs to be eyed suspiciously for signs of recession. At the same time, however, we need to ensure that the expected slowdown itself is not biasing that analysis. It is important to remember to assess the totality of the data, not just the bits and pieces we want to see.

Today is a good day to think about these issues considering the exceptionally weak retail sales report for December:

Shocking though it might be, can you really take this result at face value? To be sure, if you have a pessimistic bias, you will jump all over such a number as signs that a recession is at hand if not already underway. Consider though that the decline in retail sales was at the same pace as during the depths of the Great Recession. Now ask yourself, do you really believe the economy sank into another Great Recession in December?

Think of the magnitude of job losses experienced 2008 compared to the most recent months:

Consumers simply are not going to make a massive retrenchment of spending as seen in December on a sustained basis absent a substantial collapse in jobs. And that collapse didn’t happen in December. If anything, the JOLTS report was a reminder on the strength of the job market:

Moreover, as we all know, a job collapse didn’t happen in January. Nor is the leading indication of temporary employment signaling a slowdown in job growth is upon us:

It’s simply fair unrealistic to think that we should take the December retail sales report at face value. As long as there is job growth, there will be spending growth.

I would also caution against this type of analysis:

You can’t analyze the decline in restaurant sales in the absence of the unusual burst of sales midyear:

It’s fairly evident the data is reverting to trend after an unusual bounce. Moreover, the National Restaurant Association found “positive sales and traffic levels” in December (hat tip to Bloomberg’s Matt Boesler).  That midyear acceleration isn’t in their surveys either. A reminder that we need to look toward understanding the totality of the data rather than just the bits and pieces. What fits and what doesn’t?

As for the claim that restaurant sales are a leading indicator, well look at the long series:

Doesn’t even look like sales took much of a hit in the 2001 recession so you would have missed that episode with this signal. Also, sales look more like a coincident to a lagging indicator in the 2007-09 recession than a leading indicator.

Bottom Line: The anticipated economic slowdown in the months ahead will make for some interesting analysis as it will be easy to see a recession in every soft indicator. It is much more difficult to weigh the totality of the data flow, both good and bad. We should see an increase in “bad” data as the economy slows. Otherwise, the economy wouldn’t be slowing! We should also be careful to acknowledge our internal biases when making that that analysis. If you are a regular reader, you know I don’t traffic in fear and anger (particularly anger about monetary policy). I am not going to be the one calling for recession at every drop of the hat hoping to be right once every decade. My bias is pretty clear. Growth is the norm, recession is the rarity, deep recessions like the most recent even more rare. 

Fed to Markets: Economy is Solid, Rates on Hold

The Fed is out of the picture through at least the first half of this year as central bankers work to understand the path of economic activity going forward. Of course, we will all be doing the same. As it currently stands, there is a widespread expectation that grow slows in 2019. The ultimate degree of slowing, however, remains the key question. Enough to keep the Fed from thinking they need to snug up policy a little tighter? Or enough to prompt a rate cut? Still unknown, but with inflation failing to live up to expectations it does seem that the Fed has a fairly high bar to a rate hike and a low bar to a cut.

In general, policymakers remain upbeat on the economy. Federal Reserve Chairman Jerome Powell views the economy as in a “good place” with both low unemployment and low inflation. St. Louis Federal Reserve President James Bullard believes the Fed is now set up for “very good couple of years.” Dallas Federal Reserve President Robert Kaplan said he believes:

…it would be prudent for the Fed to exercise patience and refrain from taking further action on the federal funds rate until the economic outlook becomes somewhat clearer. I expect we will get some further clarity during the first half of 2019…the Fed has the luxury of being patient over the next several months.

Vice Chair Randal Quarles also sees the outlook and solid, and notes that he will be closely watching global risks over the “next six months.” Cleveland Federal Reserve President Loretta Mester thinks that monetary policy is just about right and “does not appear to be far behind or far ahead of the curve.” Still, Mester remains a tad hawkish and expects rates to move a bit higher if her forecast holds.

The takeaway is that the Fed is sending a very coordinated message that they are on hold through the first half of the year. Now that policy rates are near the estimates of neutral while inflation remains unexpectedly low, central bankers are content to slow down and review their handiwork.There is no pressing reason to raise rates given the external threats of slowing growth, Brexit, and trade policy challenges and the internal threats of Trumpian policy uncertainty, fading fiscal stimulus, and impact of past interest rate hikes. Better to sit back and wait to see how it all plays out before taking further action.

To be sure, the past few months feel very much like the late-2015, early-2016 period. In December of 2015 the Fed pushed forward with the first rate hike of the cycle despite lack of inflation, turbulent financial markets, and slowing growth. Ultimately, the decision to hike rates at that point appeared more model dependent than data dependent. The December 2018 rate hike had the same feel. But in 2016 the Fed was forced to accept reality and, like now, pushed by the incoming inflation to quickly put additional rate hikes on hold.

Like then, the decision to sharply shift gears could be key factor is sustaining this expansion. I have said that the December 2018 rate hike was an error, but a recoverable error. The Fed’s dovish shift reinforces my view that the error is likely recoverable. Like 2015-2016, fears of recession are growing. Paul Krugman frets about recession in this interview with Bloomberg. I agree with Krugman on this point:

The headwinds facing the economy prompted the Federal Reserve this month to halt its interest-rate hiking cycle, which Krugman said was never “grounded in the data” to begin with. “Continuing to raise rates was really looking like a bad idea,” he added.

Krugman sees “better than even” odds of a recession in the next two year, saying that “[t]here seems to be an accumulation of smaller problems and the underlying backdrop is that we have no good policy response.” Krugman notes that the Fed doesn’t have much room to cut rates and he doubts that the White House has the leadership capacity to mount a fiscal crisis.

On the second point, I agree that the leadership is lacking. That said, I suspect that Trump and the Republicans would have a huge incentive to use fiscal policy to prevent a 2020 recession.

On the first point, yes, the Fed lacks the normal degree of maneuverability in its interest rate tool to respond to a full-blown recession. What I think is forgotten is that the Fed has now 225 basis points of room to prevent a recession, and that is not trivial. The Fed responded to the Asian Financial Crisis with 75bp. It also responded to the 1995 slowdown with 75bp. The key is a willingness to act before a recession gets underway, and low inflation creates a willingness to act.

Separately, San Francisco Federal Reserve President said that discussions were underway use the balance sheet as a more regular policy tool. Via Bloomberg:

“You could imagine executing policy with your interest rate as your primary tool, and the balance sheet as a secondary tool, but one that you would use more readily,” Daly said. “That’s not decided yet.”

This compares to the most recent statement on policy normalization:

The Committee continues to view changes in the target range for the federal funds rate as its primary means of adjusting the stance of monetary policy. The Committee is prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments. Moreover, the Committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.

The normalization statement implies that as of now, the expectation is that the balance sheet is a tool to be used when interest rate policy is by itself not enough to ease financial conditions. Presumably, that would occur when the economy has returned to the zero-lower bound. Daly offers up the possibility that the balance sheet could be used on a more regular basis.

Daly’s statements open a number of questions, the first of which jumps to mind is that if this is true, then is the current reduction of the balance sheet contractionary as many market participants believe? Is it really neutral as the Fed believes when Daly is signaling that the balance sheet could be used as a secondary tool? If that’s the case, then the Fed believes they are indeed still reducing financial accommodation by reducing the balance sheet, but just want you to believe something else.

My next question is what would be the objective of using the balance sheet? To influence the slope of the yield curve while pegging the near end? Does that mean regularly altering the mix of assets to influence the yield curve? Couldn’t this be done via signaling about the path of interest rates? Is the balance sheet about target specific aspects of the money markets? What aspects? Why do this outside of a crisis?

More questions: What is the transmission mechanism from the balance sheet to the economy? Is this mechanism different in a boom? A bust? Does the Fed believe they can fine tune the economy via balance sheet manipulation? That seems to be a leap for me; it’s not clear they can fine tune the economy with rates.

You see the point. The genie is out of the bottle; quantitative easing is a thing and it is not going away. Using it as even a secondary tool outside of the zero bound, however, raises lots and lots of questions. Hence I would be wary about reading too much into these conversations just yet. Many details need to be worked out to bring quantitative easing into regular play outside of the zero-bound.

Bottom Line: With policy rates near neutral, low inflation, and questions swirling around the economic outlook, the Fed is content to take a pause through at least midyear before changing rate policy. If the Fed were to move before midyear, I suspect that it would only happen in response to negative news that forced a rate cut. I believe the likely willingness of the Fed to cut rates should the outlook sour limits the odds that they economy slips into a recession; I would be more worried if inflationary concerns kept the Fed focused on rate hikes. While we wait for new information on the path of rates, the Fed will be updating its balance sheet policy. The next step in the process will be a slowing of the balance sheet run off with the expectation that at some point the balance sheet hangs in the background during normal times and is manipulated only as needed to support rate policy. It might be too early to speculate on the use of the balance sheet as an active tool during normal times; lots of messy questions there.

The Fed ‘Put’ Applies to Both the Economy and Markets

The stock market isn’t the economy, but it is sufficiently connected with the economy that it can’t be ignored by the Federal Reserve. Eventually, central bankers must respond to protracted turmoil in financial markets. That means it will be very difficult – if not impossible – to differentiate between a “Fed put” on the economy versus on the stock market. Rather than complaining about the “Fed put,” market participants should embrace it – or at least not bet against it.

Continued at Bloomberg Opinion…


Incoming data give little reason for serious concern about the economy. The labor market held strong while manufacturing sentiment strengthened in January. The housing downtrend might be less than feared. And the Fed has taken rate hikes off the table for now and will break the quarterly rate hike cycle by taking a pass on a March hike. At this point, fears of recession seem overblown. While I expect the Fed to hold rates steady through at least mid-year, it is worth wondering if the economy in fact slows down sufficiently to keep the Fed in a dovish mood past March.

Nonfarm payroll growth came in well above expectations with a 304k gain for January. The twelve-month moving is at 240k and remains on an uptrend. Note though that the previous month’s original 300K+ gain was revised sharply lower, leaving me a bit wary that the January number will follow suit. That said, there is little doubt the economy continues to enjoy strong job growth as the expansion approaches a record length this summer, well beyond the point many anticipated the labor market would hit supply side constraints.

Indeed, the labor market appears to be easily meeting the demand for workers, with rising labor force participation and sufficient labor force growth to hold unemployment fairly steady over the past year. The unemployment rate rose to 4.0% compared to 4.1% last January, although this month the number was likely inflated somewhat due to the temporary government shut down. The rise in labor force participation among prime age workers is particularly encouraging. It appears that persistently low unemployment and faster wage growth has elicited a supply-side response from the labor market.

Wage growth took a breather after the acceleration in final two months of the year, annualize wage growth remains at 3.2% and near the pre-recession pace:

A combination of low unemployment, strong job growth, and firmer wage growth will help support consumer spending in the months ahead.

Temporary help payrolls, a forward-looking indicator, continue to rise, suggesting that the strong of job gains will continue in the months ahead. The pace of temp help growth, however, is fairly subdued. I think this has less to do with any weakness in the economy and more to do with a preference for permanent jobs. In other words, the availability of jobs may be pulling workers out of this sector.

In something of a surprise, the ISM manufacturing number partially rebounded from the weak December report. Notably, the new orders index bounced off the break-even point; it may be that pessimism emanating from turbulent financial markets weighed on confidence and hence orders during December. The gain speaks well for the strength of the economy as 2019 begins.

New home sales rebounded in November, gaining 16.9% with a bounce in new homes sold but not started. Sales prices fell, with the median price down 11.9% from last year. This suggests that the primary problem in housing was that the higher end of the market was finally sated and builders needed to move to a lower priced product to sustain sales. It also suggests that fears of a housing slowdown may be excessive. Still, with December pending sales down, the jury is still out on that topic. We will need a few more months of data to gain some clarity on the topic.

The Fed took itself out of the game last week with a particularly dovish shift at the conclusion of the January FOMC meeting; see my take here. I admit that I am a bit wary that the Fed has overshot. It is not in my nature to say the Fed is out of play when job growth is accelerating, but I find the case easier to make when unemployment is holding steady and inflation remains well behaved. That said, I wish we had more clarity on the magnitude of any shift in the dot-plot in January. Presumably, the dots shifted to make the possibility of rate cuts and hikes nearly equally likely. That, however, is typically not how the Fed’s models work if there has not been a major forecast revision (note that Federal Reserve Chairman Jerome Powell claimed the forecast did not shift substantially).

Moreover, I am made a bit nervous by Dallas Federal Reserve President Robert Kaplan claiming that rate hikes were on hold for “certainly at least the first couple of quarters.” To be sure, a pause through the first half of the year is my base case. But I am uncomfortable with Kaplan engaging in date-based forward guidance rather than data-based forward guidance. Has the FOMC committed to a pause through mid-year? Because that seems the only way the Kaplan can make such a promise. It’s those kinds of promises that come back to haunt the Fed. Does “patient” mean the next meeting, so just near-term forward guidance? Or does “patient” mean the next six months, so longer-term forward guidance?

Bottom Line: Strong job growth, rising wages, and low inflation is pretty much a Goldilocks economy. Moreover, the Fed moving to the sidelines improves the odds that this expansion continues through next year; low inflation is key to restraining any hawkish impulses that central bankers harbor when presented with persistently low unemployment. I am less worried about recession than the possibility the Fed has a change of heart sooner than I anticipate.