The Fed Increasingly Turns its Attention to Inequality

Matthew Boesler at Bloomberg brings us this:

Policy makers have acknowledged getting labor markets wrong in the recent past, and say they’ve learned from community outreach this year that many Americans haven’t felt the benefits of the economy’s long expansion.

All this rethinking has bolstered the case for keeping rates low at times when prices aren’t rising much — like the past quarter-century or so. And if the new ideas take hold, America’s next economic upswing may be overseen by a Fed that’s less inclined to raise rates in response.

This is an important development that has gained substantial traction this year. Indeed, it is likely already having a policy impact; I believe it was one reason for the Fed’s dramatic pivot this year. The Fed recognized the benefits of sustained low unemployment and were unwilling to risk losing those benefits to fight phantom inflation when the risks to the outlook were rising. Hence they lowered both interest rates and the expected path of rates. In comparison, in December of last year central bankers were still eyeing rate hikes for 2019 and beyond.

I have long argued that the Fed has a tendency to favor high unemployment over high inflation. Consequently, in the post-1995 period in particular the economic outcomes have been subpar, with unemployment unacceptably high during much of that period:

Realistically, since 1995 inflation has never been sufficiently high to cause concern. Moreover, the lower left-hand quadrant arguably doesn’t make any sense; if inflation is too low and unemployment too low, then more likely than not the estimated natural rate of unemployment is simply too high.

Persistently excessive unemployment has its costs. Not only does the period of low unemployment not extend long enough to spread its benefits to the most challenged sections of the labor market, but it also tips the scales toward employers when it comes to wage bargaining. Workers who are always fearful of losing their jobs have little incentive to derive a hard bargain for higher wages.

Boesler credits Minneapolis Fed President Neel Kashkari with leading the charge on this issue, arguing that the Fed policy does have a role in distribution outcomes. And he is not wrong; indeed, Kashkari tendency toward dovishness has proven more correct than not since he came on board. His concerns about inequality helped prompt him to launch the Minneapolis Fed’s Opportunity and Inclusive Growth Institute and has now found its new leader in the highly-respected economist Abigail Wozniak.

The implication for policy of a broad acceptance of idea that the Fed may have contributed to inequality in the past is that the Fed is likely to be much more cautious when raising rates and respond to economic weakness much more quickly. In other words, this adds another reason to expect rates will remain lower than what we might have thought the Fed’s reaction function would suggest.

There will be two immediate criticisms of such a more dovish direction. The first is that lower interest rates contribute to inequality by boosting asset prices. This I think is just a silly complaint. The ultimate inequality comes from not having a job or having a job with no bargaining position. The Fed should focus first on the employment situation and I don’t see the problem in the related positive impact on asset prices. Wouldn’t we expect higher asset prices if another percentage point or two of the labor force was consistently employed rather than being without a job and income or that the risk of recession was lower?

The second complaint is that lower rates will contribute to asset bubbles and financial instability. This I think is an overwrought concern. I think investor psychology has a greater role than interest rates in creating and sustaining asset bubbles and trying to pop a bubble likely requires recession-inducing levels of interest rates. In addition, note that literally decades of low interest rates has yet to recreate the property and equity asset bubbles that Japan experienced in the 1980’s. If it were so easy, Japan would have made it happen by now.

Bottom Line: The Fed edges more dovish with each year that passes without the inflation outbreak so-long feared. It’s another reason to expect that both interest rates will tend to surprise on the low side and, if the Fed increasing errs against recession, expect that equities will surprise on the high side.

Powell Continues to Lean in a Dovish Direction

I apologize for running a bit radio silent recently. University-related demands and a surge in requests to speak to local business and community groups have dominated my schedule in recent weeks. The fear of recession is apparently good for business in my world.

As for the Fed, monetary policy remains on hold for the time-being. In Congressional testimony today, Fed Chair Jerome Powell offered a fairly optimistic view of the economy despite some recent blemishes:

The U.S. economy is now in the 11th year of this expansion, and the baseline outlook remains favorable. Gross domestic product increased at an annual pace of 1.9 percent in the third quarter of this year after rising at around a 2.5 percent rate last year and in the first half of this year. The moderate third-quarter reading is partly due to the transitory effect of the United Auto Workers strike at General Motors. But it also reflects weakness in business investment, which is being restrained by sluggish growth abroad and trade developments. These factors have also weighed on exports and manufacturing this year.

Despite these soft spots, the U.S. consumer continues to do what it does best:

In contrast, household consumption has continued to rise solidly, supported by a healthy job market, rising incomes, and favorable levels of consumer confidence.

While housing investment received a boost from monetary easing:

And reflecting the decline in mortgage rates since late 2018, residential investment turned up in the third quarter following an extended period of weakness.

Powell in particular basked in the glory of low unemployment. Job growth has slowed but remains at a healthy pace. Powell praised the supply side response of persons entering the labor force as a “welcome development.“ He also called attention to the social implications of persistently low unemployment rates:

The improvement in the jobs market in recent years has benefited a wide range of individuals and communities. Indeed, recent wage gains have been strongest for lower-paid workers. People who live and work in low- and middle-income communities tell us that many who have struggled to find work are now getting opportunities to add new and better chapters to their lives.

The job though is not done:

Significant differences, however, persist across different groups of workers and different areas of the country: Unemployment rates for African Americans and Hispanics are still well above the jobless rates for whites and Asians, and the proportion of the people with a job is lower in rural communities.

We should not underestimate the importance of the Fed’s newly-found recognition of the benefits of a long period of low unemployment. For the moment at least, the Fed is not viewing low unemployment as a threat to inflation stability and instead now errors on the dovish side of policy. They are less will to risk pushing the economy into recession and sending unemployment higher than the have been in the past. This helps explain the speed of this year’s dovish pivot.

To be sure, the lack of actual inflation also supports the case for dovishness:

Inflation continues to run below the Federal Open Market Committee’s (FOMC) symmetric 2 percent objective. The total price index for personal consumption expenditures (PCE) increased 1.3 percent over the 12 months ending in September, held down by declines in energy prices. Core PCE inflation, which excludes food and energy prices and tends to be a better indicator of future inflation, was 1.7 percent over the same period.

As far as the outlook is concerned:

Looking ahead, my colleagues and I see a sustained expansion of economic activity, a strong labor market, and inflation near our symmetric 2 percent objective as most likely.

Powell takes the credit for this optimistic outcome:

This favorable baseline partly reflects the policy adjustments that we have made to provide support for the economy.

Powell has made similar statements before, essentially arguing that the reason the economy has weathered the storm so well this year is because the Fed lowered both short rates and the expected path of short rates. He isn’t wrong, although it is reasonable to think that one reason for the Fed’s rapid policy shift was Powell and his colleagues hiked rates too much in 2018 and helped put the economy in a vulnerable position. Water under the bridge now though.

Despite an optimist view, Powell lays out a litany of threats:

However, noteworthy risks to this outlook remain. In particular, sluggish growth abroad and trade developments have weighed on the economy and pose ongoing risks. Moreover, inflation pressures remain muted, and indicators of longer-term inflation expectations are at the lower end of their historical ranges. Persistent below-target inflation could lead to an unwelcome downward slide in longer-term inflation expectations. We will continue to monitor these developments and assess their implications for U.S. economic activity and inflation.

Two things to note. First, Powell is pushing very hard on the “weak inflation” story. He very clearly wants to firm up inflation expectations and that is pushing him to advocate holding rates at this level (or arguably lower) until inflation actually rears its head. Or at least the credible threat of inflation, as I explained here.

Second thing is that Powell doesn’t list any upside risks to the outlook. That suggests to me is that he is bracing for bad news in the future. That suggests he already has the notion that another rate cut may be needed and in turn suggests that the bar to another cut might be a bit lower than he suggested at the most recent post-FOMC meeting press conference.

Powell included comment recent balance sheet actions:

These actions are purely technical measures to support the effective implementation of monetary policy as we continue to learn about the appropriate level of reserves. They do not represent a change in the stance of monetary policy.

The Fed’s story is that the level of interest rates represents the stance of monetary policy while balance sheet actions simply allow for it to effectively control the level of short rates. Hence, recent actions are not quantitative easing as far as they are concerned.

On this topic, I recommend this thread by Janney Chief Fixed Income Strategist Guy LeBas:

Guy’s conclusion is that the surfeit of U.S. Treasuries on the balance sheets of bank holding companies will eventually crowd out the lending capacity of those entities. This will in turn be view by he Fed as tighter financial conditions that will elicit another rate cut perhaps early next year. Something to keep an eye on as the Fed learns how to work in this new world of excess reserves.

Bottom Line: The Fed remains on hold for the foreseeable future. Powell appeared to lean dovish today, perhaps more so than at the last press conference. That suggests he is very biased against hiking rates until clear evidence emerges that worrisome inflationary pressures are real this time. It also suggests he may have a lower bar to cutting rates than his colleagues.

Even the Fed’s Own Research Shows Rates Are Too High

New research from the Federal Reserve’s own economists reveal that estimates of the neutral real rate of interest are well below those of policy makers. The low estimates have important implications for policy makers and market participants, suggesting the Fed may still have some hawkish expectations of what can be accomplished in the future despite its dovish turn this year….

Continued at Bloomberg Opinion…