Data Still Favors Rate Cut

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.

Labor Market, Wage Growth, Kaplan Capitulates on Inflation

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. 

Data, Fed Updates

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.

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.