Prologue

In an earlier piece I documented the Federal Reserve’s failure to consistently hit their 2 percent inflation target and suggest a corrective policy change. Here I explore some of the confusion around the current framework and consider how the Fed can be pursuing a symmetric inflation target yet not see symmetric policy outcomes.

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Introduction

The Federal Reserve’s much anticipated conference on strategy, tools, and communication will soon be upon us. Will the conference yield any groundbreaking changes in the Fed’s policy approach? Probably not. Federal Reserve Chair Jerome Powell set a low barfor the outcomes of this year’s strategy review, stressing the likely results would be “evolution not revolution.”

This of course doesn’t mean the Fed will not make meaningful progress. One place where progress should be obtainable is an improvement in the communication of its inflation target. The messaging around inflation and the inflation target has been muddled.

Specifically, the Fed does not appear to be properly communicating its interpretation of the “symmetric” inflation target. The operational meaning of “symmetry” has become confused. The Fed should more clearly differentiate between policy actions and policy outcomes when describing its symmetric target. Under the current framework, symmetric policy responses to inflation deviations do not necessarily imply symmetric policy outcomes in which observed inflation is equally distributed around 2 percent, particularly in the short-run.

Market participants, however, appear to believe that properly executing a symmetric inflation target should yield outcomes of 2 percent average inflation. Fed officials appear to believe this as well. Upon reflection, I don’t think this is necessarily true; persistent deviations from 2 percent are acceptable and possibly even likely within the context of the Fed’s current strategy. The Fed needs to either clearly explain that a symmetric inflation target should not be equated with 2 percent average inflation outcomes or change something about its strategy to bring about 2 percent average inflation outcomes.

The latter option could be achieved with a shift to an “average inflation target” that is version of price level targeting. This may be a bridge too far for the Federal Reserve; this would be more revolution than evolution.

The Original Meaning of Symmetry

Commenting on the December 19, 2018 FOMC meeting, St. Louis Federal Reserve Economist David Andolfatto observed:

…it occurred to be that people might be mixing up the notion of a symmetric inflation target with a price-level target.

If the Fed were to generate symmetric inflation outcomes around a 2% target, those outcomes would be operationally equivalent to a price level target. Andolfatto explains, however, that a symmetric inflation target refers not to the outcomes, but instead “implies the Fed should feel equally bad about inflation being 50bp above or below target.” Then Vice Chair Stanley Fischer noted in the January 2016 FOMC meeting, the time at which the Fed added “symmetry” to the inflation target, that this definition of symmetry was consistent with the understanding of Fed officials:

The proposed revisions would clarify that the Committee viewed its 2 percent inflation goal as symmetric. In presenting the revised statement on behalf of the subcommittee on communications, Governor Fischer pointed out that, in a discussion of the statement in October 2014, participants had expressed widespread agreement that inflation moderately above the Committee’s 2 percent goal and inflation the same amount below that level were equally costly. He noted that the proposed language was intended to encompass situations in which deviations from the Committee’s inflation objective were expected to continue for a time and had the potential to affect longer-term inflation expectations.

Operationally, the symmetry is in the Fed’s response when faced with deviations from target – they treat positive and negative moderate shocks of equal magnitudes with equal but opposite policy responses.In this framework, a 20 basis point shortfall of inflation relative to target will prompt a policy easing of equal magnitude to the policy tightening triggered by a 20 basis point excess of inflation relative to target.

Importantly, symmetry does not imply an effort on the part of the Fed to overshoot or undershoot the target to compensate for past errors. The Chair Janet Yellen made this clear at the March 2016 press conference:

SAM FLEMING. Sam Fleming from the Financial Times. Can I just follow up on this inflation point? Because the numbers have been ticking up, as you said—somewhat, at least. And we’re also, as you said, also at a point where we have quite close to full employment. Is there a risk that we’re heading for an overshoot in inflation, and is there, given the greater symmetry the Fed has been flagging up, in terms of its inflation target, a greater tolerance for a modest overshoot, especially given the long period of undershoots that we’ve been through?

CHAIR YELLEN. So I want to make clear that our inflation objective is 2 percent, and we are projecting a move back to 2 percent. And we are not trying to engineer an overshoot of inflation, not to compensate for past undershoots, so 2 percent is our objective. But it is a symmetric objective, and we certainly don’t seek to overshoot our objective. But some undershoots and overshoots are part of how the economy operates, and our tolerance for those is symmetric with respect to under- and overshoots.

Stepping back to 2016, the Fed’s intentions look fairly clear. Symmetry had a very specific meaning regarding the Fed’s reaction to overshooting or undershooting the inflation target. It simply meant they cared, or would react to such deviations in an equal manner. At no point did they intend that they would deliberately overshoot or undershoot the target to make up for past deviations.

Importantly, this should have comforted market participants that the Fed would not overreact to a shock that pushed inflation above target. But then something happened that the Fed probably didn’t expect – there was no such positive shock. The shocks were all negative. That outcome set the stage for the increasing confusion about the meaning of the symmetric inflation target and what it meant for Fed policy.

It’s Not About Inflation, It’s About the Inflation Forecast

Since the Fed created the inflation target in 2012, inflation has remained on average below inflation. This gave rise to the view that the 2 percent target was really a ceiling. The Fed sought to lessen this concern with the emphasis on the inflation target being symmetrical. Participants in the January 2016 FOMC meetingwere fairly optimistic regarding the gains from symmetry:

…they judged that the revisions were important because they would clarify the symmetry of the Committee’s 2 percent inflation objective and communicate to the public that the objective was not a ceiling. Participants also noted that the proposed new language indicating that the Committee would “be concerned if inflation were running persistently above or below” its 2 percent objective would not require that participants hold similar views about inflation dynamics; in addition, the proposed language would not specify the stance of monetary policy in such circumstances but would afford the Committee appropriate flexibility in tailoring a policy response to persistent deviations from the inflation objective. Moreover, participants generally agreed that the proposed new language should be interpreted as applying to situations in which inflation was seen as likely to remain below or above 2 percent for a sustained period.

St. Louis Federal Reserve President James Bullard, however, saw a potential problem:

…one participant judged that the proposed language could be read as referring to current and past deviations from the inflation objective, and argued that the statement should more clearly indicate that the Committee’s policy decisions were based on expected future inflation.

Bullard felt he needed to dissent on the revised language:

Although Mr. Bullard supported the statement without the changes and agreed that the Committee’s inflation goal is symmetric, he dissented because he judged that the amended language was not sufficiently focused on expected future deviations of inflation from the 2 percent objective. In addition, because the Committee’s past behavior had demonstrated the emphasis it places on expected future inflation, Mr. Bullard viewed the amended language as potentially confusing to the public.

Bullard’s concerns about inflation outcomes versus inflation forecasts now look prescient. Looking at inflation outcomes, the Fed has not met its inflation target in a symmetric fashion; outcomes have tended to fall on the low side of the Fed’s inflation target. This of course has not gone unnoticed. In late 2017,for example, Chicago Federal Reserve President Charles Evans said:

Indeed, actual inflation outcomes in the U.S. have been far from symmetric. As I noted earlier, core PCE inflation has come close to 2 percent only a couple of times since the recession ended in mid-2009, and these periods were far too short to be consistent with symmetry. This performance could easily be confused with a purposeful strategy in which 2 percent is a ceiling.

More recently, Boston Federal Reserve President Eric Rosengren said this about the outcomes:

In hindsight, it appears that the 2 percent inflation goal has essentially acted more like a ceiling, rather than a symmetric target around which inflation fluctuates. If the target were symmetric, we would expect to see a more balanced distribution, with a roughly equal number of observations above and below 2 percent. This frequency distribution and its skewing below 2 percent illustrates one of the key reasons to hold interest rates steady at present, as members of the Federal Open Market Committee (FOMC) await stronger evidence that we can consistently and symmetrically attain a 2 percent symmetric inflation target, a goal that has clearly been elusive over the past 20 years.

The addition of symmetry with respect to the Fed’s inflation target did not lessen concerns that 2 percent was a ceiling because the outcomes continued to suggest that 2 percent was a ceiling. Moreover, I think the focus on outcomes rather than the forecast has led observers both within and outside the Fed to conclude that the Fed has not effectively met its symmetric inflation target. Evans and Rosengren above both think they outcomes are not consistent with the symmetry. Nor does Powell, at least as of the December 2019 press conference:

BINYAMIN APPELBAUM. Binya Appelbaum, the New York Times. You’re about to undershoot your inflation target for the seventh straight year. Your new forecasts say that you’re going to undershoot it for the eighth straight year. Should we interpret the dot plot as suggesting that some members of your Committee believe that policy should be in a restrictive range by the end of next year? If so, can you help us to understand why people would be advocating restrictive monetary policy at a time of persistent inflation undershoots?

CHAIRMAN POWELL. Well, we—as a Committee, we do not desire inflation undershoots. And you’re right, inflation has continued to surprise to the downside—not by a lot, though. I think we’re very close to 2 percent, and, you know, we do believe it’s a symmetric goal for us. Inflation is symmetric around 2 percent, and that’s how we’re going to look at it. We’re not trying to be under 2 percent. We’re trying to be symmetrically around 2 percent. And I don’t—you know, I’ve never said that I feel like we’ve achieved that goal yet. The only way to achieve inflation symmetrically around 2 percent is to have inflation symmetrically around
2 percent, and we’ve been close to that but we haven’t gotten there yet, and we have not declared victory on that. So that remains to be accomplished.

And I don’t feel that we have kind of convincingly achieved our 2 percent mandate in a symmetrical way. Now, what do we mean by “symmetrical”? What we really mean is that we would look at—we know that inflation will move around on both sides of the target, and what we say is that we would be equally concerned with inflation persistently above as persistently below the target.

This exchange is fairly revealing. Powell believes that the Fed has not hit convincingly hit its mandate because inflation outcomes have not been symmetrical around 2 percent. But then he shifts gears and interprets the symmetric objective not about past outcomes, but instead about policy reactions (equally concerned) which hinge on the inflation forecast (inflation persistently above as persistently below). So which is it? Outcomes or forecast?

This is an important distinction because a symmetric objective with regards to the inflation forecast does not necessarily imply that the actual outcomes will be symmetric around the target yet some Fed officials, including Powell appear to believe that the persistently low inflation implies they are not meeting their objective. This in turn leads to a great deal of confusion. If they all agree they have not met the objective, then why hasn’t policy shifted accordingly? Shouldn’t the Fed be pursuing a more dovish strategy?

A Symmetric Target Does Not Necessarily Imply Symmetric Outcomes

I think the predominant view of Fed officials and market participants is that given the Fed’s stated symmetric inflation target, the actual inflation outcomes should be symmetric around the target. Yet it seems to be that this outcome is almost really a special case. If inflation was at 2 percent and future shocks were distributed equally around 2 percent, and the Fed responded equally to those shocks such that inflation would return to 2 percent, then the actual future outcomes would be symmetric around 2 percent.

But what if the starting point was below the 2 percent target, as was the case when the Fed formalized the inflation target?  In that case, the path of inflation would approach target from below, and the shocks to inflation would be equally distributed above and below that path. If the Fed did not attempt to overshoot the target, as is the case in the inflation targeting framework and was the intention described by Yellen even after the addition of symmetry, the resulting outcomes would be distributed below 2 percent. To be sure, the distribution would approach 2 percent over time. Moreover, presumably after reaching 2 percent then future outcomes will be symmetric. Still, you need to get to 2 percent first. We should have realized that if the Fed was approaching the target from below, the actual outcomes would likely be below target for a possibly long time.

Hence, the fact that the inflation outcomes have not yet been distributed symmetrically around 2 percent does not necessarily mean the Fed has not adequately pursued their stated policy. They meet this objective if they consistently followed a systematic policy with regards to the inflation forecast, which means that they adjust policy in a symmetric fashion as the forecast changes.

Under the current framework, the Fed would not be pursuing their strategy if they did not react to inflation above target as they have reacted to inflation below target. The lack of above target inflation, however, has made it difficult to prove that this is the case. Still, Fed officials have said they would react symmetrically if inflation was above target. Federal Reserve Governor Lael Brainard recently said:

Of course, it is not entirely clear how to move underlying trend inflation smoothly to our target on a sustained basis in the presence of a very flat Phillips curve. One possibility we might refer to as “opportunistic reflation” would be to take advantage of a modest increase in actual inflation to demonstrate to the public our commitment to our inflation goal on a symmetric basis.For example, suppose that an unexpected increase in core import price inflation drove overall inflation modestly above 2 percent for a couple of years. The Federal Reserve could use that opportunity to communicate that a mild overshooting of inflation is consistent with our goals and to align policy with that statement. Such an approach could help demonstrate to the public that the Committee is serious about achieving its 2 percent inflation objective on a sustained basis.

Brainard is suggesting that a persistent overshoot is consistent with the symmetric inflation target. If a shock were to push inflation above 2 percent, it is reasonable to believe that the future outcomes of inflation would be symmetric above 2 percent as inflation returns to 2 percent from above. The Fed would thus be meeting its objective yet inflation in that instance would be persistently above 2 percent. Unfortunately, the Fed has not yet had an opportunity to prove that this is how they would in fact behave.

It thus appears that outside of the special case where inflation starts at 2 percent and is subsequently subject to symmetric shocks, the Fed is unlikely to experience symmetric outcomes even if they are pursuing their symmetric inflation objectives. To achieve symmetric outcomes regularly, they would need to define the relevant time horizon and be willing to engineer compensating overshoots and undershoots relative to the target. In other words, something along the lines of my recent suggestion:

The Federal Open Market Committee reaffirms its symmetric inflation target of 2%. In practice, the FOMC believes that it will have met its target if over the past five years the distribution of inflation outcomes is evenly distributed around 2%. Operationally, if the distribution of outcomes during the past two and a half years falls below 2%, the FOMC will adopt a policy stance intended to generate offsetting inflation outcomes over the next two and a half years to achieve its 2% target. The normal range of inflation outcomes is expected to be 1.5-2.5%.

This though is effectively a price level target, not an inflation target. In other words, if they want outcomes that are symmetric around 2 percent, they need a fundamentally different policy strategy.

From this perspective, Fed officials create a substantial amount of confusion when they emphasize they are not meeting their symmetric inflation target in a convincing fashion. I think they lack a policy framework to actually produce that outcome in any convincing fashion. If they want that outcome, they need a different policy framework. Until then, they shouldn’t complain about the outcomes because it suggests they are willing to make policy that is not consistent with their current framework.

Lack of Symmetric Outcomes a Potential Policy Error

The persistent undershooting of inflation that I think is a consequence of the Fed’s symmetric policy when inflation begins from below target is creating not just a communications challenge but also possibly a more substantial economic challenge. The Fed believes that sustained deviations from the inflation target will eventually impact inflation expectations. Moreover, some believe this is already the case. For example, back to Evans:

Why might inflation expectations have drifted down? The FOMC’s 2 percent inflation target is a symmetric one—that is, the Committee is concerned about inflation running either persistently above or persistently below 2 percent. One concern I have is that the public instead thinks the Fed views 2 percent as a ceiling that it aims to keep inflation under.

Also Brainard:

There is no single highly reliable measure of that underlying trend or the closely associated notion of longer-run inflation expectations. Nonetheless, a variety of measures suggest underlying trend inflation may currently be lower than it was before the crisis, contributing to the ongoing shortfall of inflation from our objective.

And Powell:

GREG ROBB. I just wanted to press a little bit about, what is the story the Committee— you know, when you get in the discussion today and yesterday about inflation, what kind of is the story that emerges?

CHAIR POWELL. So there are a bunch of different stories. There’s no real easy answer. One of them is just that the natural rate of unemployment is lower than people think. That’s one way to think about it, that there’s still more slack in the economy. Another is that expectations play a very—inflation expectations play a very key role in our framework and other frameworks, and, you know, there is the possibility that some people discuss of expectations being anchored but below 2 percent. And so, either way, inflation itself has kind of bounced around a little below 2 percent…

If persistently low inflation is eroding inflation expectations, re-anchoring those expectations at 2 probably will be difficult if the Fed’s framework is likely to yield persistently below 2 percent inflation when approaching the inflation target from below. The Fed needs an overshooting outcome to stabilize inflation expectations, but such an outcome is not possible within the current framework. Instead they seem to be waiting for a positive shock of significant size and persistence to prove they have a symmetric objective.

This creates another communications challenge. When Fed officials lament about the possible of falling inflation expectations, they imply a willingness to change policy accordingly. But they don’t have a policy strategy that allows for such change. The existing policy strategy is met as long as the inflation forecast anticipates achieving 2 percent inflation over the medium term. Remember, the Fed can’t have a forecast above 2 percent in the medium term because that implies deliberate overshooting that is not possible within the Fed’s current framework.

Conclusions

The proper interpretation of the Fed’s inflation symmetric inflation target is that it refers to the Fed’s reaction to inflation deviations. The Fed’s reaction function is the same for equal deviations above and below target. Policy will be set to achieve 2% inflation from above or below in an identical timeframe. This does not mean that the actual outcomes will be symmetric around 2 percent. The distribution of outcomes will depend on the timeframe and the whether the Fed is starting from below or above target.

The fact that we have not experienced symmetric outcomes around 2 percent, however, has been a great source of angst and confusion even if the framework was not designed to guarantee such outcomes. To guarantee such outcomes, the Fed would need to define the time horizon and actively seek inflation overshoots or undershoots as needed. Neither element currently exists and hence symmetric outcomes are likely special case and the lack of such outcomes does not by itself prove the Fed is not pursuing it inflation target in a symmetric fashion.

From a communications standpoint, the Fed should clean up its inflation story by acknowledging that in the absence of deliberate overshooting, the current framework may be successfully implemented and yet the outcomes are not symmetric. To be successfully implemented, the Fed needs only to symmetrically react to deviations from target. The lack of above target outcomes leaves them unable to prove that they are reacting in a symmetric fashion.

Currently, some Fed officials lament the failure of inflation outcomes to be symmetric around target. This in turn raises expectations that the Fed will change policy to yield different outcomes. But such a policy change would not be consistent within the Fed’s interpretation of its symmetric policy objectives. Bullard early on recognized the potential for this problem.

There is reason to believe, however, that the current framework does not exclude the persistent deviations from target than may destabilize inflation expectations. If this is a concern, then the Fed will need to move toward a price level targeting framework. Such a framework, however, requires deliberate overshooting and undershooting. It is not clear the Fed is ready to accept such a policy shift.

In short, either the Fed needs to improve its inflation story to be consistent with the policy framework or change the policy framework to match the inflation story. If inflation expectations are in fact still anchored at 2 percent, they probably should continue to emphasize the inflation forecast while deemphasizing the fact that inflation outcomes are not symmetric. Indeed, they should acknowledge that depending on the timeframe and starting point, the outcomes are not likely to be symmetric. This would help keep the inflation story consistent with the policy framework. Alternatively, if inflation expectations are slipping, they need to revise the policy framework accordingly.

One way or another, President Trump is going to drag the Fed into his trade wars.

Tonight Trump announced via Twitter that imports from Mexico would face a 5% beginning June 10. The tariff could rise as high as 25% unless Mexico acts to stem the flow of refugees from Central America. It’s not clear that the legal authority exists to take such action, but, you know, details, details. And the White House is trying to argue that these tariff threats are separate from the USMCA trade deal that is currently a legislative priority. I guess this is like telling your wife that your mistress doesn’t have anything to do with your marriage.

You really can’t make this stuff up anymore.

A couple of points jump to mind here. First, this obviously threatens to disrupt North American supply chains. The auto industry in particular is likely to suffer as the industry accounts for a large share of the imports from Mexico. This can’t come at a much worse time given the US auto sales are on the downhill side of the post-Recession recovery.

Second, it doesn’t bode well for a trade deal with China. Chinese leaders will see what happens when you enter into a good faith deal with the U.S with this administration. It is reasonable to think China’s play here is to stretch this out until after 2020 elections and hope they have someone more reasonable to deal with.

Third, this weaponized uncertainty isn’t good for U.S. business confidence. Business leaders are already nervous about the sustainability of the expansion given it will soon be a record-breaker. The trade wars with China had them on further edge. An expansion of that war Mexico could undermine confidence further and discourage investment. We don’t know what straw will break the camel’s back here, but Trump is looking like he wants to try to find out.

Unsurprisingly, stock future fell while U.S. treasuries rallied, the latter only intensifying the inversion in the belly of the yield curve:

The story here is that market participants anticipate the Fed will need to cut rates to maintain the expansion. The Fed has so far resisted this story, but the odds favor them moving in this direction. The simple fact is that the Fed reacts systematically to a changing forecast. Financial markets are signaling the the growth forecast will worsen enough, or that the risks to the growth forecast will become sufficiently one-sided, that the Fed will have to act. The Fed isn’t there yet, but they will not be able to resist forever.

Bottom Line: Trump will get the Fed to back his trade wars, but only threatening to damage the U.S. economy first.

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Recent Data

A few notable data points from last week. First, initial claims continue to hover around cycle lows. Recent data has been volatile; I think the best explanation for this volatility is the odd timing of holidays throwing off the seasonable adjustment factors. Looking through the volatility, claims have leveled since the second half of 2018 while the dispersion of incidence of rising claims across the U.S. has risen a notch. Feels like a repeat of the patterns of the data around 2015-6.

The 2015-16 weakness was concentrated in the manufacturing sector. We are seeing something of a repeat now, although less disconcerting at this point. To be sure, core durable goods orders disappointed with a slight decrease. To date though, the overall pattern has been one of general flatlining of orders.Clearly, the current weakness does not compare to 2015-6 let alone to a recessionary-type decline. A caveat of course is that the April data preceded the recent intensification of trade tensions. If those tensions are weighing heavily on business confidence, we would expect more substantial declines in the months ahead.

 A classic indicator, housing, has bounced back from declines at the end of last year with the March number being revised up to a new cycle high.Typically, substantial, sustained downturns in housing activity precede recessions. This historical pattern suggests that we should take comfort in the housing numbers. That said, the 2001 recession did not have a large housing component; housing even rebounded in the year ahead of the recession. Hence, we should be open to the possibility of a non-housing related recession. On the other hand, the data also matches the 1994-95 pattern. If we are experiencing a repeat of that episode, we should be looking for housing to be modestly supportive of growth this year (although this may just cancel out the modest weakness anticipated from the auto sector).

The Atlanta Federal Reserve’s GDP Now measure currently estimates Q2 growth at a paltry 1.3%. Inventories, however, are a substantial drag on the headline growth numbers. In contrast, final sales to private domestic purchasers are estimated to rise 2.7% compared with a 1.3% gain in the first quarter. The Fed will be watching this number; if underlying domestic demand rebounds substantially relative to the first quarter, Fed policymakers will discount weakness in the headline number.

Federal Reserve Minutes

The minutes of the April/May FOMC meetingrevealed that participants were generally comfortable maintaining the “patient” policy stance initiated in January. While some policymakers recognized that special factors boosted the first quarter growth numbers, the mood was fairly optimistic:

For this year as a whole, a number of participants mentioned that they had marked up their projections for real GDP growth, reflecting, in part, the strong first-quarter reading. Participants cited continuing strength in labor market conditions, improvements in consumer confidence and in financial conditions, or diminished downside risks both domestically and abroad, as factors likely to support solid growth over the remainder of the year.

Looking forward:

Some participants observed that, in part because of the waning impetus from fiscal policy and past removal of monetary policy accommodation, they expected real GDP growth to slow over the medium term, moving back toward their estimates of trend output growth.

It’s interesting that only “some” participants believed growth would slow toward trend. Presumably, another, larger group anticipated a more moderate slowing of activity (and there isn’t a group anticipating excessive slowing). At that time though the Fed was somewhat optimistic about risks to the forecast:

A number of participants observed that some of the risks and uncertainties that had surrounded their outlooks earlier in the year had moderated, including those related to the global economic outlook, Brexit, and trade negotiations. That said, these and other sources of uncertainty remained.

As noted above, rising trade tensions have since clouded the outlook, so the Fed will likely not be quite so optimistic at the June meeting. As far as inflation was concerned, policymakers generally supported the conclusion that recent declines were transitory:

Consistent with the view that recent lower inflation readings could be temporary, a number of participants mentioned the trimmed mean measure of PCE price inflation, produced by the Federal Reserve Bank of Dallas, which removes the influence of unusually large changes in the prices of individual items in either direction; these participants observed that the trimmed mean measure had been stable at or close to 2 percent over recent months.

Concerns about falling inflation expectations remain contained to a minority. That said, that contingent will grow if inflation doesn’t pick back up soon:

Several participants commented that if inflation did not show signs of moving up over coming quarters, there was a risk that inflation expectations could become anchored at levels below those consistent with the Committee’s symmetric 2 percent objective—a development that could make it more difficult to achieve the 2 percent inflation objective on a sustainable basis over the longer run.

In the end, the FOMC concluded they would be best served by continuing along the current path:

Members observed that a patient approach to determining future adjustments to the target range for the federal funds rate would likely remain appropriate for some time, especially in an environment of moderate economic growth and muted inflation pressures, even if global economic and financial conditions continued to improve.

That last line implies that even if conditions improve relative to their current expectations, they will not easily raise their rate forecasts. In other words, the bar to a hawkish shift appears fairly high.

Fed Speak

As a general rule, Fed officials are sticking with the story that the economy is in a “good place” and that rate hikes and cuts are equally likely. San Francisco Federal Reserve President John Williams said:

I don’t see any strong argument today, based on what we have seen in the data or other information, to move interest rates one way or the other…

Although trade tensions simmer in the background, Boston Federal Reserve President Eric Rosengren believes the outlook has brightened in recent weeks:

Setting aside recent trade-related concerns, the broader U.S. economy seems to be displaying a sounder footing than it was at the beginning of this year.

He does of course recognize the risk that the U.S. – China dispute may drag on for longer than he anticipates and adversely impact the outlook. Ultimately, he sees no “no clarion call to alter current policy in the near term.”

Atlanta Federal Reserve President Raphael Bostic doesn’t see the casefor a rate cut over a rate hike. Instead, he believes: “the policy course we have done has been exactly on point.” In contrast, St. Louis Federal Reserve President thinks policy might be a notch too tight:

I am concerned we may have slightly overdone it with our December rate hike but I was pleased that the committee pivoted.

He doesn’t think, however, the situation justifies an immediate rate hike. He also argues that the tariff battle would need to continue for six months before it impacted monetary policy.

Cleveland Federal Reserve President Loretta Mester also dismissed calls for rate cuts, arguing that boosting inflation back to target requires only a continued patient policy stance. Kansas City Federal Reserve President Esther George opposes rate cutson the grounds that lower rates might induce a fresh round of asset bubbles.

In short, no one is clamoring for a policy change right now.

Upcoming Data

Although a holiday-shortened week, there is still plenty of data to chew on.Tuesday, the Case-Shiller home price measures will be released, providing insight into the strength of the housing market. Thursday brings us an additional read on that sector with the pending home sales index. Also Thursday is initial jobless claims, a revision of the first quarter GDP numbers, and the monthly international trade report. Fridays ramps up further with the personal income and outlays report for April. Included in the report is the PCE price index, which will be intensely examined as to the mix of transitory versus persistent factors pushing the inflation numbers. We also get readings on consumer sentiment and the Chicago PMI; with the latter, we gain some insight into the next week’s ISM manufacturing report.

Discussion

Bond markets continue to signal that the Fed’s next move is a rate cut while the Fed continues to push back on that idea.The story here is relatively straightforward. The Fed anticipates the economy will slow throughout 2019 to something more consistent with what they view as a sustainable pace. At this point, they are not particularly apocalyptic regarding the outlook. Quite the opposite – they are relieved that the late-2018 fears of imminent recession failed to materialize. Recall from above that FOMC participants have generally upgraded their growth assessments compared to their March meeting. Moreover, those growth forecasts need to be taken in the context of an economy with a 3.6% unemployment rate, well below what most central bankers believe is consistent with price stability over time. They hesitate to consider a rate cut under such circumstances.

Arguably, the fact they signal a continued “patient” policy stance is something of a small miracle. Remember, they see the downward pressure on inflation as only transitory. In the context of their models, when those transitory factors dissipate and inflation reverts to target, they will face upward pressure on inflation (remember, low unemployment relative to estimates of the natural rate). Typically, they would retain a tightening bias under such circumstances. From their view, signal policy stability and a willingness to accept inflation overshooting is already a fairly substantial concession to the bearish concerns percolating throughout the financial markets.

Trade tensions rattle financial market participants more than they concern the Fed.To be sure, the Fed remains wary of downside risks, but when they plug tariffs into their models, they do not see big impacts. In the words of John Williams via Bloomberg:

It probably will boost inflation by a few tenths over the next year. It affects demand a bit and growth in the short run. But also its negative effects on the value chains and how our economic system works.

A little inflation, a little slower growth, a reorganization of supply chains, but nothing that in their mind justifies the need for a rate cut. Overall, from the Fed’s perspective growth is solid, unemployment low, inflation likely to revert to trend, and threats to the outlook manageable. This leaves Fed officials hawkish relative to market expectations.

Bottom Line: Market expectations of a rate cut are well founded. Despite the Fed’s resistance, I still think the odds favor a rate cut over a hike. I think the situation is less equally weighted than the Fed believes. This is a fairly challenging time in the cycle. The yield curve suggests that the path of activity will require a rate cut sooner than later, but the yield curve is a long leading indicator. It’s typically well ahead of the data. At the current time, the data itself has yet to give the Fed much room to shift to a more dovish stance. For now, the Fed requires greater evidence of slowing activity, particularly in the employment data, to cut rates. Remember, the Fed’s typical pattern ahead of a rate cut is to resist, resist, resist, and then move quickly. And note that we don’t need to see a recession in the data to justify a rate cut; given the lack of inflation, the Fed only needs to see a substantial risk that growth will fall below estimate of the longer-run sustainable rate.

Although Fed officials continue to resist the notion that rates will shift either up or down in this year, I think the odds still favor a cut over a hike. To be sure, Fed officials remain optimistic, especially considering the economy did not fall off a cliff in the first half of 2019 as some feared after the financial turmoil of late last year. Incoming data, however, suggest that activity is slowing as expected. Ultimately, with inflation still quiescent, I don’t think it would take much additional slowing to prompt the Fed to ease policy a notch to help sustain the expansion. On the other side of the coin, low inflation means the Fed won’t jump at a rate hike even if data rolls in stronger than expected.

Industrial production softened in April, tumbling 0.5% on the month while the dispersion of weakness rose:

This data has the feeling of past mid-cycle slowdowns. A decline in vehicle production contributed to the weakness:

Realistically, auto sales already peaked for this cycle and hence there is little reason to expected a sustained pick-up in this data anytime soon. Weak auto sales also weighed on overall retail sales while the underlying trend remained softer relative to 2018:

Consumer activity looks to be settling into something closer to the 2016 pace – not recessionary to be sure but still supportive of the story that growth will ease toward trend this year.

Core inflation remained soft in April:

Which is interesting considering that shelter costs accelerated:

Obviously then there was offsetting weakness elsewhere in the numbers. Services excluding shelter inflation decelerated:

And outright deflation returned for a second month in core-goods:

Used cars (not unrelated obviously to the overall weakness in the auto sector) and apparel helped drive the declines. The Fed believes the recent weakness of inflation is temporary and as such is resistant to cutting rates without a compelling story on the growth side of the equation. Continued weakness in the inflation numbers into the back half of the year, however, would lower the bar to a rate cut.

Meanwhile, renewed trade war concerns supported a fresh inversion of the yield curve:

Market participants are looking for a rate cut that the Fed isn’t ready to give.  The Fed’s resistance shouldn’t be a surprise. The yield curve is a long leading indicator; it will invert well before enough data turns to catch the Fed’s attention. Still, the fact that the Fed has already backed away from rate hikes, as well as the low inflation environment, leaves the Fed better positioned to shift gears ahead of a recession compared to most cycles.

Bottom Line: The Fed will retain its “patient” policy stance until the tone of the data shifts meaningfully relative to their forecast. That hasn’t happened yet. My bet is that when the shift happens, it is more likely to support a rate cut than a hike.

A little late here with some labor report highlights. It’s just not a good sign when it’s only Tuesday and you already feel as if you are falling behind for the week! If the broad outlines of this report hold going forward, the Fed will face a few interesting questions this year.

The headline number revealed a strong payroll gain of 263k for April. The three-month moving average dipped due to the weak February report, but the twelve- month moving average remains above 200k. That’s the number to watch right now, and it doesn’t show signs of slowing.

The forward-looking temporary services sector rebounded, alleviating concerns of an emerging broader trend toward slower job growth:

It seems likely that recent hiccups in this data were largely attributable to weakness in manufacturing.

Overall, I don’t think there is much evidence here that the anticipated economic slowdown this year is having much of an impact on hiring yet. In fact, the unemployment rate fell as labor force growth slowed:

The unemployment rate of 3.6% is below the Fed’s 3.7% median projection for year end 2019. A drop in labor force participation is of particular note:

At least as far as the overall participation rate is concerned, there is little evidence of a sustained rise. It has held near 63% since 2014. Assuming this continues, the Fed will once again question the limits of strong job growth and start thinking the unemployment rate might fall more dramatically than they anticipate. Remember, the demographics always lurk in the background. The Fed anticipates that labor force participation will slide as the population ages. At that point, the unemployment rate can be stabilized with job growth around 100k, or less than half the current rate.

That said, it is not clear when unemployment falls low enough that we should be concerned about capacity constraints. The unemployment rate has been at or below Fed estimates of the natural rate of unemployment for, well, literally years without any disconcerting inflationary pressures:

The Fed’s explanation for low inflation is that inflation shocks are always conveniently one-sided, so the years of suboptimal inflation outcomes don’t really mean the Fed has missed its target or overestimated the natural rate of unemployment. Despite this convenient framing, the Fed will have a hard time holding the line on this position if the inflation data continues to disappoint. The Fed will have to again consider lowering it estimates of the natural rate.  Such a dovish shift would help offset any hawkish lowering of unemployment projections for 2019.

Wage growth looks to be decelerating:

Still, real wage growth remains on an upward trajectory, rising as unemployment falls:

In real terms, wage growth has rebounded to its pre-recession pace, an under-appreciated event in my opinion. Assuming this continues, the Fed will start to wonder if this implies costs pressures on firms will soon rise to a level in which they can no longer avoid pushing through higher costs to consumers.

Separately, Federal Reserve Vice Chair Richard Clarida backed up Chair Jerome Powell’s claim that the recent inflation shortfall is transitory. He also threw cold water on the idea that the Fed would make substantial changes to its operation procedure. Via Bloomberg:

He noted that while some of the proposals look great in theory, “there are some important implementation challenges that we would have to look at seriously before we would move away from our existing framework, which has served us well.”

If you want to see some really crazy stuff, watch this interview with Dallas Federal Reserve President Robert Kaplan. He repeats the story that the inflation shortfall is transitory and reiterates his position that structural factors are weighing on inflation. The reporter rightly challenges him by pointing out that the structural factors story means that the inflation shortfall is in fact persistent not transitory. Kaplan responds that the Fed can’t do anything about disinflation caused by structural factors:

“We are just going to have to monitor this very carefully but I am not inclined at this point to lower the Fed funds rate to address it,” said Kaplan, who doesn’t vote on monetary policy this year. “I think that is more effective dealing with the cyclical elements of inflation, I am less convinced that it deals that effectively with the structural elements.”

This is  just classic. The inflation story is evolving from “we have a symmetric inflation target” to “any shortfalls of inflation relative to target are transitory” to “we can’t do anything about inflation shortfalls because although they are persistent, they are structural in nature.”

Here’s the problem. Suppose the Fed ignores low inflation as structural as Kaplan suggests. Then, within the Fed’s framework, they will essentially be accepting a drop of inflation expectations because they are proving they do not intend to lean against weak inflation. By extension then the Fed undermines its position going into the next recession both because they face lower inflation expectations and any plan to raise inflation is automatically deemed lacking any credibility.

Bottom Line: Below target inflation when unemployment is low and job growth is strong puts the Fed in an uncomfortable position. If the situation continues, by the end of the year Fed will need to pull together a more coherent policy framework. 

With a single word — “transitory” — Federal Reserve Chair Jerome Powell has sprung the “dove trap,” leaving market participants wondering if the central bank will ever commit to its 2 percent inflation target.

Continued at Bloomberg Opinion….

Tough to keep up with this week’s news, and more is on the way. We still have the jobs report ahead of us!  In the interest of time, I am going to move through this quickly:

1.) The Fed held rates steady yesterday. The basic policy outcome was not a surprise. Federal Reserve Chairman Jerome Powell’s sanguine view of low inflation, including the claim that “transitory” factors were driving low inflation, was a surprise. Powell gave little reason to think the Fed was particularly concerned about the seven years of sub-par inflation outcomes since the Fed adopted its mandate. It doesn’t seem like the Fed is updating its view of inflation in light of the past history of data. This wouldn’t be so confusing if the Fed hadn’t been leading market participants to think that low inflation was a significant concern and could prompt a rate cut. The Fed’s basic story is that any inflation at or above 2% is always defined as persistent while any inflation below 2% is always defined as transitory. I am having trouble squaring this conclusion with the claims that they have a symmetric inflation target; it looks like that claim is all talk.

2.) The Fed lowered the interest rate on excess reserves. There appears to be some angst over this move as if it indicates the Fed can’t control rates. I don’t think this is the case; the angst appears to stem from the fact that IOER rates have tended to be ceiling on the federal funds rates in recent years. I always thought this was more likely than not a temporary situation. I have had this from New York Fed’s Simon Potter in the back of my head for years:

As a result, as the level of reserves declines during normalization, marginal balance sheet costs should fall, competitive frictions should lessen, and the demand for additional reserves from individual banks should increase.  These factors should strengthen the magnetic attraction of IOER and pull the fed funds rate and other market rates up toward—and at some point equal to or above—the IOER rate.

I don’t think we should be surprised if the IOER rate continues to fall toward the bottom of the Fed’s target range for the federal funds rate.

3.) Productivity growth is surging and labor cost growth holds at low levels. Continued acceleration in productivity growth would clearly be good news as it suggests a higher speed limit for the economy; it would also help make up for some lost ground from the expected slowing of the labor force. In addition, low unit labor cost growth justifies the Fed’s continued “patient” policy stance. High wage growth doesn’t automatically translate into inflation, but it’s tough to have inflation concerns when unit labor costs are low. Two points to note: As low productivity is often cited as a reason for low neutral interest rates, persistently higher productivity growth should translate into higher neutral interest rates, which should over time put upward pressure on the yield curve. Second, Ernie Tedeschi cautions us that the fall in unit labor costs might be related to the impact of the tax cuts. That said, even if unit labor cost was running at the rate seen prior to the tax cut, it wouldn’t be worrisome.

4.) Manufacturing indicators came in on the soft side. The ISM measure was weak in April, but not recessionary or even as weak as the 2015-16 era. Consistent with a softer pace of manufacturing activity and further justifying the Fed’s pause, but not particularly worrisome. Also note that even if manufacturing were sliding more deeply, a lesson from 2015-16 is that manufacturing is less important to the overall economic cycle than in the past.

5.) Initial unemployment claims remain high for a second week. Best story here is that the later Easter holiday is playing havoc with the seasonal adjustment process. In addition, maybe a little more dispersion of rate increases across states still evident, but again, like ISM, nothing particularly worrisome.

6.) High expectations for the job market. Wall Street, in part responding to a solid ADP employment report that showed a 275k in private sector employees, expects the BLS to say the economy added 217k workers in April. Strong job growth will keep the Fed wary that they moved too far to the dovish side in March and leave them less concerned about low inflation numbers.

7.) Moore is less.  This morning, Stephen Moore told Bloomberg News:

“My biggest ally is the president,” he said. “He’s full speed ahead.”

About ninety minutes later, President Trump announced that Moore pulled out of consideration for the job. So this ugly chapter in Federal Reserve history is over. It’s back to the rubber chicken circuit for Moore; Republicans trust him enough to feed the base, but not enough to go to bat for him for a top job at the Fed.

That’s it for now.