An Inflation Targeting Central Bank Should Be Careful Here

The Fed has an inflation problem. How they deal, or don’t, with that problem remains an open question. In the context of weak or even mediocre growth, the Fed’s response would be straightforwardly dovish. In the context of solid or even strong growth, however, the Fed might ultimately be unwilling to maintain a dovish policy stance. Figuring out how the Fed responds to the latter situation is our current challenge. If the Fed is serious about needing to see actual inflation before hiking rates, then the answer is that they are on hold for the foreseeable future. If the Fed is serious about the inflation target, then the odds favor a rate cut over a rate hike. Realistically though, the Fed has talked dovish about low inflation yet taken a relatively hawkish stance with respect to inflation, tightening policy even though inflation consistently falls below the Fed’s target. It’s tough to say this time will be any different.

The GDP report has been throughly dissected at this point, so I will cover the highlights quickly. The nation’s economy grew at a faster than expected 3.2% pace in the first quarter:

And at first blush the growth might look fairly balanced:

But investment was driven by inventories:

After subtracting for that and net exports the underlying pace of activity, domestic final sales, grew at an anemic 1.4% pace. That said, this was also the quarter of the government shut down and some traditional residual seasonality that depresses the headline number. On that note, today we learned that consumer spending bounce back in March:

The consumer spending data stumbled in the first quarters of 2017 and 2018 as well, leaving the underlying pace of spending growth hovering around 3%. I don’t think that has changed; I think we are looking at a rebound in consumer spending on a quarterly basis going forward. Firming durable goods order suggest a good chance the same will happen to investment.

How will the Fed read this report? They will see through the headline number to the softer domestic demand component and use that to justify holding policy steady. Still, they won’t discount the possibility that the softness is less persistent than they expect. But justifying the pause is all they really need right now; they don’t have to commit to anything else until later in the year. We will see how things look in three months when the second quarter data is all available.

The real action is in the inflation story. Some weak, very weak numbers on the inflation front:

Core inflation, annualized, for the first quarter was just 0.7%. The Fed’s not going to reach its 2% inflation target this way, is it? Arguably, these numbers justify a rate cut. To be sure, the Fed’s not there yet and will instead view the numbers as most likely temporary given the growth forecast. They can’t hold that position forever though. If inflation doesn’t rebound toward target, it would be hard for the Fed to hold the line on rates even if growth remains reasonably solid. Hard but not impossible. As I said, this remains a policy gray area. They just haven’t committed sufficiently to the inflation target to lead us to believe they will take action to defend that target in the future.

Bottom Line: Incoming data supports the Fed’s patient policy stance. They will reiterate that policy at the conclusion of this week’s meeting. The weak inflation numbers pose a very real dillema for the Fed. An inflation targeting central bank should be seriously considering a rate cut. The Fed claims to be an inflation targeting central bank. But are they? We still don’t really know.

The Fed Might Have Drawn Markets Into a ‘Dove Trap’

Note: Today’s Bloomberg Opinion piece is the media-friendly, market-implications version of my research note from last week, Some Thoughts on New Policy Strategies.

The Federal Reserve’s monetary policy meeting this week won’t yield any fundamental changes. The Fed’s near-term path remains holding interest rates steady and keeping its balance-sheet assets from shrinking further. But what about later in the year? We should remain open to the possibility that the Fed has pulled us into a “dove trap” and will reverse policy in a hawkish direction.

Continued at Bloomberg Opinion…

Durable Goods On The Rise

The Fed is in blackout ahead of next week’s FOMC meeting, so it’s a bit quiet in monetary policy-land. On the non-recession watch, core durable goods orders rose in March:


That’s another ding to the recession story. And, to be fair, a ding to the slowdown story as well. So far, this isn’t even shaping up to 2015-16 standards, raising the question of whether the soft landing story is really in play yet? That’s something I am watching closely; stable monetary policy assumes economic deceleration in the months ahead. Stronger-than-expected growth would cause us to question that outlook.

Initial unemployment claims popped this week:

That’s not something to worry about as there are two suspected culprits to account for the surge. Easter came late – the timing of holidays poses challenges for seasonal adjustment of weekly data. Also, a grocery strike likely impacted the data. Overall, nothing to see here, folks, move along.

Tomorrow is first quarter GDP. The Atlanta Fed is looking for 2.7%, which would be a pretty good number considering that the low estimate was just 0.2% in early March and the first quarter has been on the soft side in recent years. The Fed will be particularly interested in the internals of the report, in particular underlying domestic demand, and looking for that slowdown noted above. The inflation component is of course important, but is expected to remain sufficiently soft to support the Fed’s patient policy stance.

Bottom Line: That recession just isn’t happening. Even the degree of slowing could arguably be in doubt. Nothing though yet sufficiently definitive to push the Fed to change rates in either direction.

Housing, Fed Nominees, Bubbles

Some quick updates tonight. First and foremost, the new home sales data is the latest to cut against the recessionistas. Housing continues to rebound from the dip at the end of last year:

A good story going into the back half of 2018 was that rising housing prices, both new and used, would eventually kill off some demand. Higher interest rates, less generous tax deductions, and a bit of economic uncertainty added to the stress on the sector and sales fell. Builders, now realizing they have likely sated the higher end of the market, appear to have turned their attention to lower-priced product:

Lower prices help lure buyers back into the market. Note though that a housing rebound does not necessarily rule out a recession. See, for example, the 2001 recession, during which housing played no real part. Still, if the housing downturn was an important component of your recession call, you should rethink that call.

As far as nominees to the Board of Governors are concerned, one down, one to go. Hermain Cain withdrew his name from consideration, apparently realizing that it was actually a job you were expected to take seriously, so you weren’t allowed to run side businesses or give paid speeches. And apparently he didn’t realize the pay wasn’t all that great relative to the prestige. Of course, there is also the issue that he would his name would be dragged through the mud again on those sexual misconduct claims.

Speaking of being dragged through the mud, Trump’s other nominee, Stephen Moore, is seeing his past catch up to him. Sam Bell, who apparently spends most of his days cataloguing Moore’s past, caught Moore saying this today:

Of course, with Moore there are tapes. Like of him being a goldbug. And actual writings that revealed, surprise, surprise, a strong misogynistic streak; see also Jim Tankersly at the New York Times. No one should feel sorry for Moore. Still, we can’t count him out just yet; Republicans in the Senate may have a hard time deep-sixing a chief proponent for their economic agenda. Can’t really say he is sufficiently qualified to guide your economic agenda but not be part of the Federal Reserve, right?

On a final note, stocks rallied to a record high Tuesday. Is this good news or a bad omen? Rich Miller at Bloomberg senses concern that history may repeat itself:

Some Federal Reserve policy makers seem resigned to running a heightened risk of asset bubbles and other financial excesses as they seek to keep the economic expansion going.

I tend to think such concerns reflect too much recency-bias in our analysis. The last two cycles ended with asset bubbles, so this one must as well, right? My response is that Japan suffered through joint property and equity bubbles and has found it hard to recreate that dynamic despite years of ultra-low interest rates. We should be open to the possibility that we experience occasional mini-bubbles like oil shale and cryptocurrencies that have some sector specific impacts but are not economy-wide shocks.  Some bubbles just aren’t big enough to worry about from a macro perspective. The next cycle might just be a dirt-dull mild downturn like 1990.

Also on bubbles, I find it interesting that the path of equities still follows the pattern that followed past rate hikes:

Doesn’t look like a late 90’s type of surge. Looks pretty average instead.

That’s it for now.

Some Thoughts On New Policy Strategies

Note: This is a longer think-piece that I hope to continue developing in the months ahead. Comments welcome.

The Federal Reserve quickly switched gears between December 2018 and March 2019 as policy became “patient” and the two rate hikes projected for 2019 fell to zero. The backdrop for the shift was stumbling markets, softer growth data, and falling inflation. Fed officials find the turnaround of inflation particularly worrisome. Since adopting an inflation target in 2012, the Fed, in the words of Chairman Jerome Powell, has not “convincingly achieved our 2 percent mandate in a symmetrical way.”

The failure of the Fed to meet its self-defined inflation objective yields a number of both short- and long-term negative outcomes. At a most basic level, the continuing suboptimal inflation outcomes suggest policy has been too tight throughout the expansion that followed the Great Recession. Unemployment could have been reduced more quickly and could possibly still be held sustainably lower than current Federal Reserve forecasts anticipate. Another concern is that persistently low inflation is eroding inflation expectations which, though little understood (see Tarullo (2017)), anchor the Fed’s inflation forecast. The Fed would need to provide even easier policy should they want to firm up those expectations.

Over the longer-run, policy makers increasingly focus on how they should respond to the next recession. In addition to lower interest rates, quantitative easing, and forward guidance, Fed speakers also increasingly anticipate tweaking the policy framework to make up past inflation shortfalls. A version of such a policy is the temporary price-level targeting scheme suggested by former Federal Reserve Chairman Ben Bernanke.

Taken together, the above suggests a high likelihood that policy will at least err on the dovish side. In reality, I think the Fed should not just err on the dovish side, but should instead pursue an explicitly dovish strategy. Arguably it would be foolish if not downright irresponsible to enter the next recession without at least convincingly anchoring inflation expectations at 2%; an effort to do so might entail not just accepting above 2% inflation ahead of the next recession, but actually targeting a higher level to ensure that average inflation prior to the next recession is 2%.

As I think about these topics ahead of the Fed’s much-anticipated Chicago conference on strategy and communications, I become concerned that the Fed won’t follow through with their current dovish inclinations. Can they credibly pursue a dovish strategy approach? Optimally, they need to establish such credibility ahead of the next recession, but I wonder if they will get cold feet when push comes to shove. In other words, could the Fed’s rhetoric lead us into a dove trap?

Continued here as a PDF…

Soft Landing In Sight?

I was pulled away by jury duty this week, so postings have been light. Still, a couple of points to note. First, I am very, very glad that I did not go all recessionista on the back of that rise in initial unemployment claims at the end of last year. That indicator has turned around, and turned around hard:

So once again we are back to the story that if you are looking for signs of recession in the initial claims data, you are looking in the wrong place. Likewise for consumer spending. Retail sales perked up in March while previous months were revised higher:

Looks like the real story is not about impending recession, but a less-worrisome deceleration. Industrial production is a bit off:

Manufacturing may again be the odd man out in an otherwise solid economy. This has the feeling of 2015-16, though less severe.

The data has a soft-landing feeling, which I discussed in my Bloomberg Opinion article this week:

The Federal Reserve seems to be achieving the fabled soft landing. With growth likely to transition down toward the longer-term trend in 2019, expect monetary policy to remain on hold for the foreseeable future. If the Fed were to move, the odds still favor an interest rate cut over an increase. We are likely at the peak of this rate hiking cycle.

With regards to the policy outlook, the Fed appears to be setting the stage to pursue a dovish policy stance going forward. I discussed that in the above article, and Bloomberg’s Rich Miller and Craig Torres explore this theme as well:

Federal Reserve Chairman Jerome Powell and his colleagues have made an important shift in their strategy for dealing with inflation in a prelude to what could be a more radical change next year.

The central bank has backed off the interest-rate hikes it had been delivering to avoid a potentially dangerous rise in inflation that economic theory says could result from the hot jobs market. Instead, Powell & Co. have put policy on hold until sub-par inflation rises convincingly.

I have been puzzling on this issue this week. I think the conclusion that the Fed wants to see more conclusive evidence of inflation before hiking is correct. That’s the way the Fed is moving. That said, I fear they may be inadvertently setting a trap for market participants. It’s that nasty time-consistency policy problem bouncing around in the back of my head. I am not confident that what they will ultimately think is convincing evidence of inflation’s return will actually be convincing evidence of inflation’s return. Teaser alert: I am working on a longer note on this issue, which should be complete early next week.

A Hint of Weakness in the Employment Report?

The employment report came in above expectations, rebounding from an upwardly-revised but still weak February payrolls gain of 33k to a solid 196k in March. In short, the American jobs machine continues to roll forward:

That kind of strength will leave the Fed felling confident that they do not need to cut rates in the near-term. Moreover, the continued stability of the unemployment rate means they don’t have to hike rates either.

Hence, their strategy of remaining patient still holds.

On a monthly basis, wage growth pulled back, but on an annualized basis is holding in the range of 3 to 3.5%:

That translates into real wage growth hovering around 1 to 1.5%, assuming 2% inflation, right about the range experienced just before the recession:

On the surface, this is another “Goldilocks” report – strong job growth, low and steady unemployment and nothing in the wage data to support inflation concerns. A hint of weakness, however, is visible in the temporary help numbers:

The slowdown in temporary help hiring is consistent with other periods of decelerating growth, most recently the 2015-16 episode. To be sure, it could arguably also be a precursor to recession, but I think the current environment is still best described as “slowdown not recession.” That certainly is the story from the most recent initial unemployment claims report:

Nothing there yet to suggest that a deeper slowdown of activity is underway. That said, I have been a long supporter of temporary help employment as a leading indicator, and I would be remiss in my analysis if I didn’t identify it as something to keep an eye on. One can also look toward softness over the part two months in manufacturing and retail trade as signs that activity is slowing underneath the surface of the numbers.

Bottom Line: The employment report gives little reason for the Fed to exit its “patient” policy stance. Keep an eye on the temporary employment numbers. It’s a leading indicator in the report; recent declines are notable.

Assault on the Fed Continues

The Federal Reserve’s independence is under attack. I think this was inevitable once the Fed made it clear they intended a monetary offset against Trump’s fiscal stimulus. Now it is the reality. Can this genie be put back into the bottle? I am not particularly confident it ends here. If President Trump is successful at packing the Fed with political partisans, there may be nothing to stop the next president from doing the same.

If the potential nomination of Stephen Moore wasn’t bad enough, now we have to contend with the potential nomination of former presidential candidate Herman Cain. Cain is yet another candidate who appeals to the hawkish elements of the right wing. This short summary from Bloomberg is all you need to know:

He advocated for the U.S. to return to the gold standard during his presidential campaign and as recently as December 2017 defended higher interest rates, a position that contrasts with Trump’s repeated criticisms of the Fed last year.

Of course, Cain’s hard money advocacy will likely prove to be like Moore’s, simply a politically play to capture far right wing voters:

Trump’s recent nominees reflect his displeasure of the Fed’s rate hike campaign. That displeasure reached a peak in December as the Fed continued hiking rates while markets were tumbling. Since then the Fed has backed away from future rate hikes and in the process helping (hopefully) to keep the expansion alive. The political damage, however, was already done. Trump won’t trust the Fed going forward, nor will he trust those who gave him the names of those the Fed governors he already appointed.

For what it’s worth, the Fed itself shares some of the blame for this mess. The December rate hike aside, the Fed needs to come to grips with the reality that they have been fighting an inflation ghost for years. They haven’t treated their 2% target as a symmetric objective, but as a ceiling. Any central bank that fails to follow through on their mandate will come under fire eventually.

To be sure, perhaps neither Moore nor Cain make it through the Senate. Senator Mitt Romney, for example, appeared less than thrilled about the idea. That, however, doesn’t mean the institution walks away unscathed. The idea that Fed governors should be political partisans is now out in the open. Would a President Sanders follow Trump’s lead? Maybe those don’t get through the Senate as well, but then the Fed continues to operate with less than a full allotment of governors. That then shifts more power to the regional presidents, which changes the nature of the institution as well.

Of course, the ultimate concern is that the Fed shifts from a technocratic institution to a purely political one. One possible outcome is that the net result is a Fed that invites a repeat of the 1970s through excessively easy policy. Another is a Fed that works to ensure the dominance of one political party. Would Moore or Cain suddenly turn hawkish again if a Democrat were in the White House? 

Bottom Line: Maybe if the Fed fends off these assaults and the process reverts to credible, technocratic nominees, the Fed can walk away a stronger, more independent institution. Right now though I am not feeling so hopeful. That said, these are more long- than near-term concerns.

Employment Report On The Way

What data breaks the Fed out of its current “patient” stance? Given the persistence of low inflation, it appears to me most likely that the next move is down. Fed officials, however, are resisting any such moves just yet, requiring instead that the data break at least gently to the downside in the months ahead. And so we wait as the data rolls in.

The ISM nonmanufacturing report came in a little lower in March compared to the previous month, but I am not seeing any fundamental shift in the underlying pace of activity. Looks instead like typical noise in the series:

Softness was more evident in the 2015-16 slowdown than today. Good news for the economy; bad news for the recessionistas.

More interesting was the ADP employment report. That came in on the soft side with a 129k gain in private sector employees. Incorporating that information drags down my forecast to a 150k gain in March:

This forecast is on the soft side of consensus, which is currently expecting a rebound in job growth t0 170k with a 3.8% unemployment rate and a 0.2% wage gain. Given the noise in this data, the Fed would likely see little difference in any number in the mid-100’s. The Fed would probably view anything in that sort of range as consistent with relatively stable unemployment and continued upward pressure on wages. A good place to remain patient.

More interesting would something on either side of the mid-100s. If job growth came in closer to 100k or so, the Fed would start to get a bit nervous that maybe the February weakness wasn’t the one-off they believe it was. Any anxiety would step up a notch if the unemployment rate edged higher as well. That kind of pattern, if sustained for the next few months would likely prompt Powell & Co. to more seriously consider lower rates mid-year.

That said, betting against this job market hasn’t worked out very well yet. If we see job growth sticking closer to 200k a month, central bankers will start to think that they maybe became a little too dovish in March.

Bottom Line: We are stuck in a waiting game for the moment while we try to assess the degree to which the US economy is slowing. 

There Will Be A Recession At Some Point, But It Won’t Be Soon

Incoming data reveals that the recessionistas were again too early with their warnings in the waning days of 2018. Initial unemployment claims have leveled out:

New home sales have rebounded:

Manufacturing is keeping it together:

On the soft side though consumer spending looks weak:

Should we worry about consumer spending? I think it will slow this year relative to last, but I would not anticipate a sustained and substantial downturn absent a sharp deterioration of the job market. We get the employment numbers at the end of this week; the initial claims numbers have yet to give us much to worry about.

So are we out of the woods as far as a recession is concerned? For what it’s worth, the case of an imminent recession was never very strong and still isn’t despite the recent yield curve inversion. It is always forgotten that the yield curve is a very long leading indicator; an inversion might happen a year or even two ahead of a recession. Hence, what you should expect for some time after an inversion is that incoming data remains consistent with steady if not solid economic growth.

Nor does the inversion itself guarantee recession. My view is that the Fed still has time to prevent a recession even after an inversion (the worst risk is that the Fed keeps hiking after inversion) and the Fed has gone a long way toward holding the expansion together by shifting to a more dovish stance in recent months. I still believe, however, that they still need to be wary about a recession and be prepared to cut rates ahead of a downturn in the data – see my Bloomberg Opinion piece today. That takes something of a leap of faith on the part of policymakers, a leap of faith they are not always willing to take.

Bottom Line: Recession calls were again too early. The economy retains momentum into 2019 even if the pace of growth eases as expected. The Fed’s dovish shift should greatly increase the probability that the expansion continues. More easing may still be needed.