Fear the Stock Market’s Exuberance, Not the Economy

Note: A case of the flu kept me down all of last week, but I am now recovering. As such, Fed watching has been on the slow side lately. 

This rally in equities could be described as “frothy,” but that might not be a sufficiently strong adjective. These days often feel like the late 1990s, when it seemed any company that added “dot-com” to its name was instantly rewarded by investors, even if the label amounted to little more than putting lipstick on a pig. That phenomenon isn’t entirely unlike the bounce in Kodak’s stock price after the company announced the launch of its own cryptocurrency.

It feels like we have been here before, and it didn’t end well for the economy. Will this time be the same?

Continued on Bloomberg Prophets….

The Economy May Be Set for a Supply-Side Surprise

Will 2018 be the year the supply side of the economy roars back to life? If so, the Federal Reserve’s expectations for inflation may once again be met with disappointment. But be wary of believing this would portend a dovish year for policy. A supply-side rebound would likely trigger upward pressure on the long end of the yield curve, giving the Fed more room to raise rates.

Continued here on Bloomberg Prophets…

Bostic Takes A Dovish Position

Atlanta Federal Reserve President Raphael Bostic – a voting member of the FOMC this year – took to the podium yesterday, delivering a dovish speech that makes clear he is open to the possibility of a less-than-expected path of rate hikes this year. Looks like a number of factors are playing into his analysis, the most interesting of which to me is a reduced expectation of the neutral level of interest rates. This is something to keep an eye on.

On net, Bostic comes down on the soft side of the Fed’s median GDP forecast for 2018. Whereas the median policymaker is looking for 2.5 percent growth, Bostic is comfortable with 2.2-2.5 percent. He does not anticipate much follow through from recent stronger growth numbers for three reasons. First, he is already looking for a first quarter slowdown attributed to seasonal effects. In other words, he thinks a portion of the last three quarters of strong growth is simply an offset for the first quarter (FWIW, I think he may be underestimating the underlying strength of the economy on this point). Second, he attributes some of the recent growth to the transitory impact of hurricane rebuilding (again, thinking this may be overplayed). Third, he reports survey and anecdotal evidence that firms are not expecting stronger growth. Nor does he anticipate a substantial boost from tax cuts, seeing more of an upside risk than anything else.

In my opinion, I would say there is a greater risk that Bostic’s forecast is overly pessimistic than optimistic. Same is true for his unemployment forecast. Bostic expects:

…Employment gains should remain substantial enough to keep the unemployment rate near its low level…

That suggests a fairly sharp slowdown in job growth given the Fed’s labor force growth forecast. That said, this disconnect between the economic forecast and unemployment forecast is consistent with that of his colleagues.

Bostic anticipates inflation returning to target by the end of this year, but he eyes inflation expectations warily. The situation calls for caution:

…Survey evidence—as well as estimates about the expectations gleaned from financial market prices—indicates that individuals may not be completely convinced about the symmetry of the FOMC’s inflation objective. This possibility is one factor that might argue for being somewhat more patient in raising rates, even as the inflation rate moves toward the 2 percent objective…

Altogether, he expects further interest rate hikes, but maybe not as many as anticipated:

…Should the recent data unfold in a manner similar to my outlook, I am comfortable continuing with a slow removal of policy accommodation. However, I would caution that that doesn’t necessarily mean as many as three or four moves per year…

This is somewhat interesting phrasing is that it appears his baseline was another three to four hikes this year, a bit more hawkish than the median policymaker projection of three hikes. Why might actual policy fall short? Bostic is watching the neutral rate:

…Recent evidence suggests that the interest rate that would prevail when GDP and inflation are back on target could be close to 2 percent at the moment, and may rise only modestly over the medium term.

If this is right, then the current stance of monetary policy is still somewhat accommodative but is approaching a more neutral stance. Finally, it is important to remember that the Fed is also removing accommodation by shrinking its balance sheet…

Now he sees policy as possibly just “somewhat accommodative.” He saw the world differently two months ago. In a November speech, Bostic said:

Under my baseline scenario, I think it will be appropriate for interest rates to rise gradually over the next couple of years, as our policy position is still very accommodating rather than neutral.

Did one rate hike in the intervening time take policy from “very accommodating” to “somewhat accommodative”? Doubtful. This seems to reflect more of shift in Bostic’s view of the neutral rate, following in the footsteps of Federal Reserve Governor Lael Brainard.

Bottom Line: Bostic looks to be leaning dovish, more so due to a changing view of the neutral rate than to his economic outlook. Watch to see if more of his colleagues move in this direction. My sense is that it would only take a few stronger inflation readings for Bostic to back off on this line of thought. I also wonder that the consensus central banker would have an easy time reconciling the idea that policy is close to neutral when financial conditions appear to have only eased since the Fed began tightening. Altogether, this is clearly a space to keep an eye on.

Data Lining Up For The Fed’s Rate Hike Forecast

Last Friday the Bureau of Labor Statistics released a fairly lackluster employment report. In most ways, the story remains the same – steady improvement in the labor market but no signs of overheating in the form of wage growth. The mix will keep the Fed on track for three rate hikes this year, as the consensus policymaker will view this kind of report as a reason to neither accelerate nor slow the pace of tightening.

Continued here in newsletter form

Nonfarm payrolls grew a less-then-expected 148k in December. Still, after some mildly net negative revisions to previous months, jobs grew an average of 205k per month over the final quarter of the year and 171k per month over the last twelve months. Unemployment held steady per expectations, but the pace of job growth remains well in excess of that necessary to pull the unemployment rate down in the months ahead. This is key for the Fed; they would be more comfortable pausing rate hikes if job growth were something closer to 100k per month, a rate consistent with steady unemployment.

Claims of full employment by Fed officials notwithstanding, ongoing weak wage growth (up 2.5 percent compared to a year ago) suggests the economy does not face imminent danger of overheating. While wage growth looked to be accelerating in the third quarter, that hope was yet again dashed later in the year. This smells of lingering slack in the labor market. For example, see the continued gains in prime aged labor force participation rates with the possibility of more gains to come as the millennial generation becomes more integrated into the job market.

The combination of solid labor market improvement but tepid wage growth and low inflation leaves the Fed in an all too familiar position. Over the past year, they responded to that position with three rate hikes, plus initiated the process of reducing the balance sheet. The minutes of the final FOMC meeting of 2017 suggests the same response regarding rate hikes this year. The status quo dominates consensus thinking among central bankers:

Most participants reiterated their support for continuing a gradual approach to raising the target range, noting that this approach helped to balance risks to the outlook for economic activity and inflation. 

Those concerned about an overly aggressive projected path of rates remained in the minority:

A few participants indicated that they were not comfortable with the degree of additional policy tightening through the end of 2018 implied by the median projections for the federal funds rate in the December SEP. 

Another minority leaned in the other direction:

A few other participants mentioned that they saw as appropriate a pace of additional policy tightening through the end of 2018 that was somewhat faster than that implied by the December SEP median forecast. They noted that financial conditions had not materially tightened since the removal of monetary policy accommodation began, that continued low interest rates risked financial instability in the future, or that the labor market was increasingly tight.

It appears to me that neither the dovish nor hawkish contingents within the Fed are of sufficient size to drive the conversation. That leaves the status quo of three 25 basis point rate hikes as still the best bet for 2018.

The question is whether or not the status quo increasingly leans dovish in the face of continued inflation weakness. I hesitate to separate that issue from labor market strength. It seems to me that incoming data suggests healthy job growth is more likely than not going to continue in the year ahead. Initial unemployment claims remain low, temporary help employment continues to rise, and the overall economy looks to have gained some substantial momentum in 2017. All suggest continued solid employment gains and thus downward pressure on the unemployment rate. My sense is that the majority of the FOMC would continue to view such a situation as consistent with the gradual pace of hikes.What would cause the consensus to lean in the dovish direction? Two likely possibilities jump out at me. First is an evident slowing in economic activity that looks sufficient to cut job growth almost in half. Second is falling inflation rates; I bet that in the context of a strong economy near what they think is full employment they will hesitate to stop hiking rates even if inflation meanders at current rates. But a decline of inflation at this point would be untenable and would shift the discussion solidly toward the group most worried by the possibility of declining inflation expectations.

And what about a more hawkish direction? On that side, I think you need a substantial rebound of inflation. But be careful here. Just as below target inflation has not deterred them from slowing the pace of rate hikes, nor should a symmetric miss on the other side of the target by itself trigger an acceleration in the pace of hikes. As long as the medium-term inflation forecast can reasonable predict a return to target under the current policy path, they can retain that policy path. Hence, to step up the pace of rate hikes, I think they need not only higher inflation but also clear evidence that the labor market will not slow to a more sustainable pace without a more aggressive rate hike path.

Regarding the composition of the FOMC in 2018, note that on Friday Philadelphia Federal Reserve President Patrick Harker said he thought two rate hikes were appropriate this year. I think then he is the sixth of the below median projection dots in the December 2017 forecasts. He stands along with Bullard, Evans, Kashkari, Kaplan, and Brainard. If these dot guesses are correct, then five of the six low dots are all nonvoters in 2018. Hence the composition of the FOMC members leans hawkish. This suggests to me that the data needs to break to the downside to shift consensus thinking toward dovishness.

Also note that a possible yield curve inversion is something of a wild card for policy this year. Whether or not the Fed could continue to hike rates even after the yield curve inverts remains an open question.

Bottom Line: The Fed looks on track for three rate hikes in 2018. If you are looking at weak inflation numbers as reason for the Fed to back down, be wary that the Fed will continue weigh the economic and jobs outlook heavily in their policy decisions. On the other side of the coin, central bankers will not overreact to a surprise rebound of inflation if they can remain reasonably confident their projected tightening is sufficient to return inflation to target in the medium-run.

Employment Report On The Way

Quick post today as I am still settling back into the swing of things after some downtime during the holidays.

Friday morning the Bureau of Labor Statistics delivers us the employment numbers for December. Wall Street anticipates firms added 191k employees, a healthy pace of job growth, while the unemployment rate holds steady at 4.1 percent. The consensus is also looking for wage growth of 0.3 percent for the month, or 2.5 percent year-over-year.

Some thoughts on this forecast. First, the consensus job growth forecast looks reasonable and only somewhat below my forecast:Second, the unemployment rate may indeed hold steady, but note that the expected pace of job growth remains consistent with a pace that had driven unemployment lower in recent years. In other words, don’t take too much dovish comfort from a steady unemployment rate or even a slight uptick – the decline is coming. Indeed, this is how the Fed would likely view a combination of solid job growth and flat unemployment. From the December FOMC minutes:

Labor market conditions continued to strengthen in recent months, with the unemployment rate declining further and payroll gains well above a pace consistent with maintaining a stable unemployment rate over time.

I continue to believe that central bankers can make all the noise they want about. low inflation, but, when push comes to shove, they will maintain the gradual path of rate hikes as long as growth growth remains solidly above the roughly 100k needed to hold unemployment constant.

Third, tepid wage growth to date has reduced concerns that the labor market was past full employment, but has not reduced those concerns sufficiently for the Fed to back off rate hikes in 2017 or there 2018 projections. My expectation then is that continued soft wage growth won’t deter the Fed from continued rate hikes, but a more rapid acceleration in wage growth would easily help put a fourth rate hike in play for 2018.

Bottom Line: My expectation is that the employment report supports either stability of the Fed’s three rate hike forecast or raises the possibility of a fourth hike. I doubt that we will see a report with more dovish implications; even if the report is soft, the Fed would likely dismiss it as an anomaly given the solid pace of other data in recent weeks. 

A Yield-Curve Inversion Isn’t a Done Deal

The Federal Reserve reaffirmed its 2018 projected path of an additional three 25 basis-point rate hikes at this week’s Open Market Committee meeting. I wrote last week that the announcement set the stage for an inversion of the yield curve by the end of next year.

This “yield curve will invert in 2018” story rose to prominence in recent weeks as many analysts made similar predictions. Where did this forecast arise from and under what conditions will it come to pass? Why might the yield curve steepen instead?

Continued here on Bloomberg…

Is The Fed Finishing 2017 On A Dovish Note?

The December FOMC meeting ended largely as anticipated with a quarter point rate hike, making the Fed good on their expectation of three rate hikes for 2017. What about 2018? The Summary of Economic Projections revealed that the median policymaker still anticipates another three rate hikes in 2018. But will they deliver? The answer to that question depends, of course, on the actual evolution of the economy relative to policymaker’s expectations. But at this point, I wouldn’t bet against them on the dovish side.

Continued here in newsletter form…

There were two key changes in the median forecasts for 2018. The year-end unemployment projected was revised down to 3.9 percent from 4.1 percent while growth was revised upward from 2.1 percent to 2.5 percent. Remaining 2018 forecasts stood unchanged, as did the longer-run estimates.

Consider first the implications of the change in the unemployment forecast. Begin by viewing the changes in the 2018 forecast in the framework described by San Francisco Federal Reserve economists Fernanda Nechio and Glenn Rudebusch. Using the equation

Funds rate revision = neutral rate revision + (1.5 × inflation revision) – (2 × unemployment gap revision).

they show that a widely used policy rule can explain the change in the Fed’s 2016 rate forecast. Table 2 follows the Nechio-Rudebusch methodology of comparing the current forecast for year-end 2018 with the forecast from last December. Using the rule followed by the Fed in 2016, the projection for the federal funds rate projection for 2018 would have risen 45 basis points over the course of 2017, driven by an increase in the magnitude of the unemployment gap that outweighed downward revisions in the inflation and neutral rate forecast. Instead, the 2018 revisions remained unchanged at equivalent of three 25 basis point rate hikes.An important implication falls out of this analysis: Relative to the 2018 economic forecast changes, the projected path of policy is dovish. This can be explained by the surprising inflation weakness over the past year. Policymakers now believe a return to full employment requires an extended period of activity in excess of that consistent with full employment.

Now, one might reasonably conclude that if the Fed holds a dovish rate forecast, then the risk is that they are more likely than not to fall short of their expected three rate hikes in 2018. Indeed, given the persistence of weak inflation, this seems on the surface like a safe bet. I would be cautious, however, of such an interpretation. Note that using the same analysis (see table 3), the Fed would have reacted to the sharp downward revisions in the 2017 inflation and neutral rate forecasts by skipping the December rate hike. In other words, the Fed ran a hawkish policy in 2017 relative to changes in the economic forecast.

The lesson: The Fed could very well ignore another inflation shortfall in 2018 and instead hold true to the projection of three rate hikes. This will be true as long as they can write-off any inflation weakness as temporary and thus see an inflation rebound in 2019.

Also in favor of the Fed’s rate forecast is the likely direction of error in their unemployment forecast. The unemployment forecast is fairly nonsensical. Back in September the Fed predicted a 2.1 percent growth rate in 2018 would drive a 0.2 percentage point decline in the unemployment rate. Now they expect a 2.5 percent growth rate delivers a decline of the same magnitude. Something does not add up.

Perhaps they will claim that faster growth would be possible with a temporary boost to labor force participation or a reduction of underemployment. This runs opposite, however, of their post-FOMC statement, which claims that the labor market will simply remain strong, rather than strengthen further. Without a substantial improvement across the labor market, it seems unlikely that the economy will run at a pace 0.7 percentage points above potential growth yet unemployment will only decline 0.2 percentage points. After all, unemployment in 2017 so far fell 0.6 percentage points on back of the currently projected 2.5 percent GDP growth rate.

In the context of the Fed’s stated view on labor markets, the unemployment forecast makes sense only if you they expect a productivity boost. But no such boost is evident in the longer-run GDP forecast, which was unchanged. And I suspect that a higher estimate of productivity growth would be met with a higher neutral rate estimate and thus wash out in a rate forecast. So what this tells me is that the Fed’s forecast implicitly anticipates a temporary productivity boost. Watch for that. But if I had to bet on the Fed’s unemployment forecast, I would bet that it is still too high. If it comes in lower than expected like in 2017, it will again weigh against any inflation shortfall.

Finally, look at the distribution of dots in the Fed’s infamous “dotplot.” Six of the dots are below the median projection, compared to four above. “Aha,” you say, “clear evidence of a dovish Fed in 2018.” Be careful there. Three of those six dovish dots are defnitely Bullard, Evans, and Kashkari, and I suspect a fourth is Kaplan. All four are nonvoters in 2018. 

What about the remaining two dots? One is likely Brainard. Will she still be on the FOMC by the end of the year? I am not confident of that; not sure she how closely associated she wants to be with this administration. And is the final dovish dot Yellen’s? Obviously, she is departing.

At least four and very possibly all of those six dovish dots will not be voting by the end of 2018. So, while the distribution of dots looks dovish, it really is hawkish.

Bottom Line: Don’t read too much dovishness into the outcome of this FOMC meeting and expect the Fed will easily drop from three to two or less rate hikes in 2018. The Fed’s rate projection is already arguably dovish, the unemployment forecast is subject to hawkish errors, the Fed ran a hawkish 2017 policy, and the voting members of the FOMC turn decidedly more hawkish in 2018. I continue to believe the Fed will have a hard time deviating from their projected path until economic activity in general, and job growth in particular, downshift to a lower speed. The GDP growth forecast, however, keeps moving in the opposite direction.

November Employment Preview

The FOMC meeting next week is anticipated to end with a rate hike. Indeed, this is for all intents and purpuses already a done deal. The employment report won’t change it. But the employment report could either add or subtract to FOMC concerns that the pace of activity remains sufficient to push the economy toward overheating sooner than later. The consensus forecast reasonably expects an outcome that leans toward the former, with job gains well above that necessary to hold the unemployment rate constant. That  outcome would leave the Fed committed to their inflation forecast and hence inclined to maintain their projected policy path.

Continued here as newsletter…

The consensus forecast expects a nonfarm payroll gain of 190k in a range of 153k to 250k. This strikes me as a reasonable expectation consistent with my forecast:Market participants anticipate the unemployment rate holds constant at 4.1%, with a range of 4.0%-4.3%. To be sure, a decline in the unemployment rate would deepen overheating concerns on Constitution Ave. But I would not expect those concerns to ease much if unemployment stayed constant or even rose given the pace of job growth. Given the Fed’s view of labor force growth, they will expect that a payroll gain near the consensus indicates continued downward pressure on unemployment:Until job growth slows to something close to 100k a month, the Fed will anticipate further unemployment declines. Hence why it would be much easier for policymakers to use the weak inflation numbers as reason to pause if job growth looked to be trending much lower on a sustainable basis. But if anything the opposite is true – the economy appears to have some considerable momentum behinds it and is likely to rack up a third consecutive quarter of 3+% growth as the year ends. This suggest continued demand for labor.

A pickup in wage growth would heighten Fed confidence that the economy is indeed operating at full employment. Wall Street expects wage growth of 0.3% for the month, in a range of 0.1%-0.4%. This translates into a range of 2.5%-2.8% compared to a year ago, putting it potentially at the higher end of recent trends:

Obviously, the Fed would like to see something on the higher end to help confirm their estimates of full employment. But even if they don’t get higher wages, they will anticipate wages gains will eventually accelerate as long as unemployment is poised to remain on a downward trend.

Bottom Line: The Fed would have an easier time paying attention to the weak inflation numbers if the economy has not operating near their estimates of full employment and clearly growing at a pace that will soon surpass those estimates. Consequently, a report near consensus expectations will tend to strengthen their resolve regarding further rate hikes. A report that falls short of consensus, however, would likely be deemed as noise given the generally solid path of economic activity this year.