Fed Positioned to Slow Pace of Rate Hikes – Assuming the Data Cooperates

The Federal Reserve has positioned itself to sharply slow the pace of rate hikes this year. There even exists a scenario in which the December 2018 rate hike was the last of the cycle. That said, the Fed still anticipates the economy will need some additional tightening to reach their goals of low inflation and maximum sustainable employment over the medium term. Ultimately the path of rate hikes is data dependent, and that data yet to lead central bankers to the conclusion that rate hikes are now off the table.

With the December rate hike, policy rates at 2.25% to 2.5% now touch the bottom end of the 2.5% to 3.5% range of neutral rate estimates. Hence, policy may now be neither accommodative nor restrictive. Because of the imprecision of neutral rate estimates, however, policy makers do not know exactly the level of accommodation their policy provides. Consequently, they will need to rely even more heavily on the data flow as a guide to the appropriate policy stance.

Indeed, Federal Reserve speakers have made it clear that they will be very sensitive to incoming data in the months ahead. Last week, Chairman Jerome Powell reassured market participants that he recognized the downside risks reflected in recent equity price declines and, perhaps more importantly, that with inflation still low the Fed can afford to be patient before implementing further rate hikes.

What does this mean for the path of policy going forward? The ability for the Fed to remain patient means that in the near term there is no longer an immediate need to hike rates. While the Fed’s interest rate forecasts still anticipate another two 25 basis point hikes this year, those hikes do not need to be front loaded. The Fed can sit back and review its handiwork, waiting for the lagged impact of past rate hikes to filter through to the economy before taking further action.

That said, the data will still be relevant. The mix of data that keeps the Fed from hiking while retaining a bias to hike is best described as a combination signaling that growth will decelerate relative to the rapid pace of 2018, labor market outcomes point to fairly steady unemployment, and inflation remains low.

Recent data may be consistent with this story. The Institute of Supply Management index of manufacturing data slid in December, indicating that the sector still grows but at a slower pace than earlier in the year. The new orders index took a particularly large hit:

That said, the its non-manufacturing sibling revealed a much smaller decline while new orders held at high levels:

Countering the ISM manufacturing weakness, the employment report revealed a strong job market with a blowout gain of 312,000 employees for the month.

The temporary help component showed no reason to expect the job gains will end anytime soon:

And wage growth looks to now be sustainably higher:

I have to admit I am uncomfortable expecting the Fed to delay a rate hike until the middle of the year when employment growth remains on an upward trend. The only saving grace is that the economy delivered the workers necessary to keep pace with such growth.The unemployment rate actually ticked up to 3.9%, leaving it effectively unchanged over the past six months. In turn, continued stable unemployment will reduce the chances that the economy is overheating. Inflation is thus likely to remain in check.

Assuming December job growth is an outlier and will pull back in the following two months, the data flow will likely be sufficiently softer to keep the Fed from hiking in March – but they would retain a tightening bias and would likely hike again mid-year. This would be consistent with the forecasts presented in their Summary of Economic Projections. They will fear that eventually job growth that consistently exceeds 100,000 each month would eat up enough upward slack in the labor market to push unemployment sharply lower. They would be inclined to snug up a policy a notch to prevent that outcome.

If conditions arise that slows job growth toward 150,000, they will push any rate hike back further in the year. If the economy slows more than expected and job growth heads for 100,000, the Fed will move off the stage entirely.

Remember, these scenarios assume inflation remains contained. My general rule is this: The Fed will choose recession over inflation, but as long as inflation looks to hold sustainably near the Fed’s target, there will be a “Powell put” on the economy. That’s something to remember when wrestling with the recession calls that have grown louder in recent months. If you aren’t recognizing that absent inflation the Fed has the ability and willingness to cushion the economy against shocks that could threaten to send growth sharply lower than expected, you are doing it wrong.

Bottom Line: Low inflation means the Fed can move patiently. They don’t feel compelled to maintain the pace of quarterly rate hikes. Still, that doesn’t mean they won’t. My baseline expectation is that the data flow remains sufficiently soft and economic uncertainty sufficiently high to keep the Fed on the sidelines until at least mid-year. There is a chance of course that the correction in equity markets has left us all too pessimistic about the outlook for growth and inflation this year. If so, Fed commentary might turn hawkish again sooner than I anticipate.

State of Play, December 26, 2018

It’s Christmas, and Mrs. Fedwatch isn’t really keen on me typing away on the computer. Hence, I will need to keep this brief and to the point, at least as much as I can. With that in mind:

Fed ends the year with a questionable rate hike. The Fed acted as expected and hiked rates last week. The data drove the decision; even with growth slowing, the pace of activity is expected to remain above the rate of potential growth, stoking inflationary pressures. In simple terms, the economy retains too much momentum heading into the economy for the Fed to hold back from pushing closer to their estimate of neutral.

What makes the hike questionable (in my opinion, an error) was that it felt like a model-driven decision much like the December 2015 hike. Both occurred despite market turmoil that had continued too long to be ignored. And both occurred in the context of low inflation. There was no pressing reason for a rate hike other than they insist on defining policy on the back of long-run forecasts and feel compelled to follow-through with that policy.

That said, if the hike was an error, it was a recoverable error. I think the Fed will follow the 2016 script and step off the stage for at least the first half of the year if not longer. They now have the yield curve flat as a pancake; continuing to hike rates threatens to invite an outright inversion. Why tempt fate when you can sit back and wait for the lagged impact of rate hikes to make itself evident? They can stop now, stand ready to ease if necessary, and still keep the expansion alive. There is simply nothing in the data that says a recession is right on top of us.

Trump’s war with the Fed was inevitable. We all knew how the Fed would react to a fiscal stimulus shock. A monetary offset was always coming down the pipeline. The Fed never fully embraced the story that tax cuts would induce a supply-side response (a story that looks at odds with the decline in very long-term bond yield back down to 3%), something very clear in the Fed’s forecasts. That monetary offset was destined to anger President Trump.

The Fed isn’t the only thing weighing on markets. I don’t think the Fed is helping with the December rate hike while the forecasts of an intention to tighten policy into the restrictive range only adds insult to injury. That said, equities prices are under stress from a variety of directions: The expected fading of fiscal stimulus (including losing the impact on profits from tax cuts last year), expected slowing growth, tighter profit margins due to tariffs and labor costs, external political factors (Brexit), the US government slowdown, and general Trumpian uncertainty about almost every aspect of US policy. FWIW, it’s reasonable to argue that a bear market without a recession is a buying opportunity.

Trump’s ire with Powell creates a dangerous situation. Trump has reportedly discussed firing Powell as well as Mnuchin, who he blames for hiring Powell in the first place. Even aside from central bank independence issues, it is obviously bad precedent for the President to fire his economic team at the first hint of trouble. What does this say about the reaction of the President to a recession or a real financial crisis? What does this say about the ability of the government to manage the economy in such an event? Nothing good – it says that Trump stands ready to let it all burn down unintentionally because he does not understand policy. It is unquestionably now a real risk for market participants.

I feel we need to place nontrivial odds on the possibility that Trump fires, or at least attempts to fire, Powell. Mnuchin too. Yes, Trump did say nice things about both Powell and Mnuchin on Christmas day. How long is that good will going to last if markets keep slipping? A day? And note Trump’smodus operandi.Threaten to fire repeatedly, say nice things after the news leaks of the threatened firing, and then fire by tweet. Trump never accepts fault for anything, if there is a problem it is always caused by someone else, and that someone needs to be fired. Needless to say, firing Powell would rattle markets.

We don’t know how the Fed would react to an effort by Trump to fire Powell. There is a widely held belief that the President can’t “fire” Powell; at most he can demote Powell from Chairman back to governor. But then Powell’s colleagues could just vote to retain Powell in his role as head of the policy making FOMC. Trump would go ballistic of course and want Powell gone. The Fed could send the whole issue to the courts to be sorted out and, in theory, should they be victorious, enhance the Fed’s independence. But it would come at the cost of protracted uncertainty as the court battle rages.

Trump’s war on the Fed is already damaging the Fed. The Fed will deny vociferously that politics plays any roles in its policy making decisions. That said, central bankers are humans and it seems unlikely to me that they can truly make decisions that are not impacted in some way, even if just subconsciously, by politics. We will never know if Trump prodded the Fed into last week’s rate hike subconsciously; pushing back on Trump would be at least icing on the cake. And if the Fed is forced to cut rates going in the months ahead, they will be accused of caving to Trump even if the data or a Trump-induced market meltdown drives the decision.

Trump is placing the Fed in a no-win situation. I understand that my belief that the Fed has substantial exposure here is someone controversial. I don’t think the Fed can escape the Trump years unscathed. When I say this, the response is that Trump can’t fire the Chair or that he can’t influence the voting FOMC members or that the Chair can just make nice with the Senate.

First, I don’t think Trump cares that he “can’t” fire the Fed Chair. In Trump-world, he hired Powell and can fire Powell. Second, the Senate hasn’t shown much backbone when it comes to standing up to Trump. Third, what wasn’t entirely expected is that Trump can make the Fed do his bidding by creating a crisis that forces a Fed response. Exerting Fed independence in such a situation only puts the economy at risk. Heads they win, tails you lose.

Bottom Line: I not naturally prone to hyperbole, but this whole episode has a distinctly emerging market feel. I of course could be wrong here, but I don’t think that Trump-induced volatility is going to end anytime soon. It will arguably only get worse when a Democratic House of Representatives starts issuing subpoenas. We appear to be caught in a doom loop at the moment with each drop in the stock market bringing about a Trump response that induces another drop in the market. That can’t happen forever of course, but it is not clear that anyone wants to catch the falling knife just yet. We don’t know how long Wall Street can remain under pressure before it bleeds over into Main Street. The Fed can’t stand back and watch that happen; ultimately, they will need to cushion Trumpian uncertainty.

Related reading:

Trump Has Likely Done Lasting Damage to the Fed

The Fed Needs a Little Push From the Data for a Pause

Fed Hikes Rates, Market Tumbles

The Federal Reserve hiked rates as expected at December’s meeting while delivering a more hawkish message than Wall Street was hoping for. Equities tumbled and the yield curve flattened further as Federal Reserve Chairman Jerome Powell’s press conference wore on. I can’t imagine that the Fed is pleased with this outcome. That said, they have only themselves to blame. The Summary of Economic projections continues to maintain an unnecessarily hawkish bias that only allows Wall Street’s worries about growth to fester.

In retrospect, the outcome of this meeting is largely what would have been expected if you focused more heavily on the data flow than on the turmoil in financial markets. The Fed delivered largely according to my expectations, with a key exception: The Fed was more hawkish than I anticipated in that they did not drop entirely the “further gradual increases” language in the FOMC’s statement. I had expected them to create more uncertainty about the future; they chose instead to reinforce their expectation that rates would continue to rise.

Arguably, they were forced by their own forecasts to retain the language. To be sure, the revisions to the Fed’s forecasts were dovish in many ways. Expectations for growth, inflation, longer-run unemployment, and longer-run interest rates were all revised lower. But these dovish shifts failed to offset the fundamentally hawkish aspect of the forecasts: The forecasts continue to say that central bankers anticipate they will continue to raise rates until the Fed turns policy from accommodative to restrictive. It’s not just the median; the pattern of dots imply the same.

What’s going on here? The Fed is currently a slave to its own models. In simplistic terms, those models will revert in a predictable fashion to whatever supply side conditions are chosen by policymakers. Growth will slow toward trend and unemployment rise to its natural rate as policy rates rise into restrictive territory. It’s all a straightforward mechanical exercise.

That exercise, however, implies far too much certainty about the path of interest rates. That path is only valid in one particular future, but many futures are possible. Consequently, in the presser Powell tried to downplay the dots. This though is really almost impossible to do because no matter how you spin it the dots tell a clear story about the Fed’s expectations, and those expectations amount to a hawkish policy bias, and that’s a message Wall Street doesn’t want to hear.

I would say that Powell made the situation worse with this in the preamble to the presser:

What kind of year will 2019 be? We know that the economy may not be as kind to our forecasts next year as it was this year. History attests that unforeseen events as the year unfolds may buffet the economy and call for more than a slight change from the policy projections released today.

The implication here is that there is substantial downside risk to the economy. So much that the Fed is reducing its forecasts across the board. So much so that the Fed anticipates they will fall short of their inflation target yet again. And yet they continue to hike rates and signal more rate hikes to come.

It is an unnecessarily and explicit hawkish message that is an artifact of a communications strategy that only made sense when you could reasonably promise zero rates for an extended period. It makes no sense to create the impression of a promise to continue to raise interest rates at a mature point in the business cycle when growth is already slowing.

As for the rate policy itself, I tend to try to focus on what the Fed will actually do instead of what they should do. The latter at this juncture though likely impacts the former. My crystal ball is as fuzzy as any, but my instinct tells me this rate hike was more likely a mistake than not. It appears to be an overly mechanical reaction to the model outcomes.

My ace-in-the-hole for the US economy is that inflation remains low enough to allow the Fed to remain nimble. Or it had been. I don’t know what Wall Street is picking up; it isn’t in the macro data, which ultimately is why the Fed chose to press forward. But whatever it is has been going on long enough that it suggests caution is warranted. In a risk management framework, the Fed would have been wise to skip this meeting and put January in play. By not doing so, I fear the Fed may flip uncomfortably close to my alternative scenario – that they continue hiking until something breaks.

If this rate hike is a mistake, the rate hikes for at least the first half of 2019 will quickly fall off the table. My instinct tells me that should now be the base case. Eventually – and probably sooner than later – the Fed will realize they need to offset the Trumpian uncertainty. They won’t like it. But they will have to do it.

Bottom Line: The Fed hiked rates in a very predictable fashion. It might be a decision that quickly comes back to haunt them.

Fed Stuck In An Uncomfortable Situation

The Federal Reserve faces a most uncomfortable confluence of events as central bankers begin their two-day meeting to ponder the path of rate policy. In a nutshell, equities continued to struggle in the midst of fairly solid data as President Trump complains yet again about rate hikes while stoking the uncertainty that appears at least partly if not mostly to blame for the volatile equity markets. Yes, I know, it’s a lot to follow. Hopefully I can break it down into more manageable pieces.

Begin with the easy part. Recent data remain largely consistent with the Fed’s outlook. As a reminder, the Fed’s forecast anticipates the growth will ease in 2019 relative to this year but remain at a pace that would continue to intensify inflationary pressures. In short then the Fed expects growth to slow on the back of past rate hikes and waning fiscal stimulus. I don’t think the Fed will view incoming data as inconsistent with that outlook. Industrial production continues to gain:

Households continue to spend at a healthy rate:

Even initial jobless claims, the boogeyman of the bears, tumbled sharply by 27k to just 206k, pulling the four-week moving average lower:

And core-inflation firmed:

In response to the data, the Atlanta Fed now estimates fourth quarter growth is tracking at a 3% pace. All told, outside of the downdraft in equities and related financial tightening, I don’t think there is much here to induce large shifts in the Fed’s forecasts for 2019. Those forecasts were as of September hawkish in the sense that they predicted further rate hikes.

We have a fairly good idea of the Fed’s reaction function as it pertains to the employment and inflation. If we review the incoming data and keep our eyes on that ball, the case remains to continue edging up policy rates into the neutral range and then turn increasingly data dependent. By that measure then the case for a rate hike on Wednesday appears fairly straightforward.

The Fed though has an implicit financial stability metric. Because they have never made it explicit though, we don’t know how it might apply in the current situation. The Fed doesn’t like to move on market moves alone. That said, with equity markets tumbling to 14-months lows, it seems easy to make the case that the Fed should opt to simply skip this month and come back to the table in January. Stopping short of the lower estimates of neutral when the economy continues to perform as expected would be a bitter pill for some FOMC members to sallow. But equity prices are data too, and the Fed is data dependent. Hence this becomes the risk to the rate hike call.

President Trump’s latest tweet highlights another aspect of this policy decision. Trump again implored the Fed to stop raising rates, tweeting “It is incredible that with a very strong dollar and virtually no inflation, the outside world blowing up around us, Paris is burning and China way down, the Fed is even considering yet another interest rate hike.”

There are actually two problems here for the Fed. First is that skipping on the rate hike in light of the data and their forecasts could appear to be caving to the President’s demands. As noted earlier though, they could delay on the basis of the equity sell off, but that has its own problem of the appearance of a Powell put on the stock market rather than a Powell put on the economy.

The second problem is that one factor driving the uncertainty on Wall Street is Trump himself. If the “outside world is blowing up” and “China way down,” these events are the direct results of Trump’s policy of weaponized uncertainty. Anywhere you turn, there is a potential crisis attributable to Trump’s chaotic policy approach. Trade wars and the related potential to disrupt global supply chains. The threat to shut down the government over a border wall that is not getting funded. And next year promises to see an increase in the chaos Trump will likely want to deflect attention as a Democratic House of Representatives promises to bring even more investigations into Trump and his family.

In a sense, Trump’s weaponized uncertainty drives down equity prices which in turn induces the Fed to do what Trump wants and stop raising rates. How much does the Fed have to do to cushion the stock market against Trumpian uncertainty? How much to cushion the economy against the same?

It is an ugly situation for the Fed to navigate. So what do they do? I think the most likely approach is:

  1. Hike rates 25 basis points to push rates at the edge of the lower range of neutral estimates. Allows the Fed to follow the data and push back on the notion that markets and Trump are driving policy.
  2. Drop “further gradual increases” for language that imparts much more uncertainty about the future path of rate hikes. Makes clear that future rate hikes are not certain. Arguably also opens the door for a rate cut should the data turn sour.
  3. Emphasize in the statement they are vigilantly monitoring financial, economic, and political developments around the world. Recognizes the fears of Wall Street.
  4. Release forecasts that are on net more dovish than the September version. This may include a reduction in the estimate of longer run unemployment. This acknowledges that persistently low inflation implies the economy can run at a lower unemployment rate. Also recognizes the impact of weaker equity prices on the outlook.
  5. Unlike September, when Powell emphasized the forecasts in his press conference, he will indirectly say to ignore the forecasts as he recognizes that they will remain unnecessarily hawkish.

As far as questions for Powell that I would like to hear:

  1. He will of course not answer questions about Trump’s pressure on the Fed, so I don’t think reporters should waste their questions on that issue.
  2. “What is the information content of the equity market decline? How does or doesn’t it impact the growth forecast?”
  3. “The yield curve is now flatter than it has been in this cycle. How do you and your colleagues interpret the current shape of the yield curve?”
  4. “Do you believe job growth remains in excess of that consistent with long-run price stability?”
  5. “Are you viewing the potential impacts of trade war escalation as primarily supply side or demand side shocks?”
  6. “Vice Chair Richard Clarida has revived forward looking inflation measures from the TIPS market as relevant policy guides. In contrast, your predecessor Janet Yellen downplayed the inflation expectations content of these indicators. Where do you stand on the issue?”
  7. “What will trigger the Committee to reassess the pace at which the Fed is winding down the balance sheet?”
  8. “How do you credibly claim to want to eliminate forward guidance when you retain the SEP as supposedly a key element of your communications strategy? Aren’t you just increasing uncertainty by eliminating an emphasis on the near-term path of policy, which should be more knowable, in favor of the less knowable long term forecast?”
  9. “What is the greatest external risk currently concerning the Fed? Hard Brexit? Trade wars?”
  10. “What is the greatest internal risk currently concerning the Fed? Housing? Corporate debt? Waning fiscal stimulus?”

Bottom Line: The baseline case is for a dovish hike that basically sends the message that the data is consistent with another rate hike but IF the economy turns slower more quickly than anticipated, this will be the last hike for some time if not the last hike of the cycle. The risk is that the Fed skips this meeting and leaves January open IF the data continues to support a hike. It is worth thinking about what the Fed would need to do to offset the impacts Trumpian uncertainty should that bleed over from Wall Street to Main Street.

Unpleasant

The situation on Wall Street is, well, unpleasant, and it in turn is creating considerable uncertainty about the outlook for monetary policy in 2019. The Fed is now caught in an uncomfortable place. Powell & Co. ditched forward guidance in favor of a managing expectations via data-dependence relative to a medium-term outlook. That outlook is fundamentally hawkish as it describes policy as continuing to tighten even as growth decelerates. Moreover, incoming data remains supportive of that outlook.

This isn’t really a problem for rate hikes next year; the data could cut either way by March. It is a bit of a challenge for next week’s meeting as the Fed is loath to appear reactive to markets alone.

What can we say about the data? It’s not bad. Not bad at all. Some of it, such as the ISM surveys, are holding up better than I would expect given the likelihood that economic growth is transitioning to a slower pace of activity as 2019 approaches. The non-manufacturing ISM survey copied its sibling with a solid read in November:

The employment report for November was solid. Nonfarm payrolls grew a touch less than expected:

The three-month average is a bit softer at 170.3k, perhaps indicative of a softening of job growth. Or just an inability of easily finding workers when the unemployment rate dips below 4%. But, most importantly, given the high level of variance in this report, I don’t know that can really say much has changed in the labor market.

The same holds true for wage growth, which was a bit softer, but not inconsistent with normal variance:

On the good side, the strong labor market continues to deliver new workers, holding up labor force growth while preventing the unemployment rate from slipping:

The most forward looking indicator of the report, temporary employment, continues to signal a bright future:

Certainty a number that looking much more worrisome in 2016 than now. Likewise, while I see continued angst over the initial claims numbers, the rise is fairly minimal, occurs during a difficult time to seasonally adjust, and remains not very widely dispersed across the nation:

JOLTS report through October remained strong as well:

The data then remains consistent with a Fed rate hike in December. That said, market participants are picking up on something not in the data. Maybe it’s not anyone thing, but a combination of whole bunch of things. As a primary backdrop, I think the current economic situation places market participants in a very difficult uncomfortable situation. Growth is transitioning down, and we don’t know where it will stop. 2.5% or 1.5%? The latter is slow enough to take the Fed off the table. The former not so much.

Moreover, it seems likely that margins are under intense pressures at this stage in the cycle. Firms are caught between two rocks and a hard place: Tight labor markets, tariffs, and low inflation that prevents them from offsetting the first two factors. And if growth is slowing while labor markets remain firm, then productivity is not rising enough to provide a way out.

Finally, we have geopolitical risk just about everywhere. President Trump’s “bull in china shop” strategy with all of our trading partners leaves the US isolated when we could have pursued a unified approach to addressing issues with China. At home, Trump looks increasingly vulnerable and his response will likely be to create additional chaos. Brexit has devolved into a hot mess of a disaster.

What does the Fed do next month in response? Given the incoming data and the resistance of the Fed to be seen as reacting to market downturns, the baseline case remains that the Fed hikes in December and increases the uncertainty about the path of policy in 2019. The markets will interpret this dovishly, although I suspect the Fed was likely to want to create greater uncertainty about next year in any event.

The risk of course is that the Fed takes a pass next week. For many FOMC participants, I think that would be a bitter pill to swallow with the data lining up as it is, which is why it is difficult to make this the base case. That said, the January meeting will only be six weeks later; they could always come back for another bite at the apple at that time. There is reason to believe this is the correct strategy, but my suspicion is that the Fed will chose the data over the markets. To be sure though, given the fluidity of the situation, financial markets could take an even more severe turn for the worse by next week and scuttle any Fed rate hike plans.

Bottom Line: The data flow clears the way for the Fed to hike next week. The Fed doesn’t need to make any decisions on March yet, so they won’t commit to anything in 2019. That will be interpreted dovishly in this environment. If the data stumbles between now and March, the Fed will take itself off the table, assuming inflation remains quiescent. So far, market volatility by itself is likely not enough to derail next week’s rate hike. The Fed typically wants more to justify a policy change. 

It’s Complicated

Once upon a time, we had a pretty good story in play. It went like this: The Fed positions itself relative to this magical variable called r-star. Unfortunately, no one knows exactly where r-star is, but we can come up with a reasonable range of its values. And as policy rates entered into the lower bound of that range, future changes in policy will become more data dependent. Absent any evident inflationary pressure, the Fed could move more cautiously, assessing the data carefully before tightening further.

It was a good story, and it worked. But then New York Federal Reserve President John Williams blew up that story by downplaying the importance of r-star. This was apparently out of fear that market participants would assume an imminent pause was pre-ordained. The focus shifted away from neutral to talk of going above neutral. Forward guidance was ditched in favor of a focus on the Fed’s forecasts which confirmed the intention of going beyond neutral.

Of course, the forecasts were never supposed to be policy written in stone. But, realistically, the Fed’s forecast-based approach made it appear that the path of rates was not particularly data-dependent. I think, more accurately, that when central bankers started talking about going beyond neutral, they were really getting ahead of the data.

Then equity markets stumbled, oil fell, and the dollar rose. Fed officials apparently feared they had set in motion another Taper Tantrum or, almost worse, another 2015-16 episode. They then shifted the discussion back to r-star with Federal Reserve Chair Jerome Powell noting that policy rates would soon be at the lower end of the range of neutral estimates, basically returning to the story that existed before Williams blew it up.

Like I said, I thought it was a good story. I still do. I like it. It was limited forward guidance; a broad range of potential outcomes, but with some structure. The Fed could basically flatten the yield curve, and then if further rate hikes were appropriate, shift the yield curve up. The long bond even lifted off its perch at 3.0%, giving the Fed some breathing room.

But going backwards is not so easy. Because going backwards kind of looks like panicking. And now you look like you are panicking yet still planning to raise rates in December! Seriously, if it was so important to turn the story around, why are we still talking about December? How do you spell P-O-L-I-C-Y E-R-R-O-R?

With that kind of messaging it makes sense to buy into the belly of the yield curve, which is what market participants have been doing in earnest, generating a messy outcome. The yield curve inverted between the 5 and 3 year treasury rate. Ever so slight an inversion, but an inversion nonetheless:

And the 10-2 spread sank closer to inversion:

It is generally thought the 10-2 inversion that is the long-leading indicator of recession, but I would add only if the Fed keeps hiking after the inversion. But we can worry about that later. For now, the 5-3 inversion is messy enough because it will raise additional concerns about December. So now it has the potential to be a nasty little cycle – the Fed backtracks, causing fear of a worsening economy, which inverts part of the yield curve, which raises further concerns about the economy, etc., etc.

Meanwhile, the data has drifted into the background. Yet that should still be relevant to the Fed. Notably, the ISM manufacturing report was a notch better than expected and holding in a range that one of my readers described as an “early cycle” print:

Except now we are much later in the cycle with a 3.7% unemployment rate. I have a hard time imagining that the economy started falling apart in the final quarter of 2018 yet left the manufacturing sector unscathed. I feel like the Fed’s dovish shift maybe got ahead of the data just as the hawkish shift got ahead of the data. Or the Fed’s dovish shift is already behind the data. Like I said, it’s complicated. We just don’t know what will be left after the sugar high of fiscal stimulus wears off. Nor do I think we should discount the possibility that under divided government, more spending is the path of least resistance.

Bottom Line: In my opinion, I think we focus on the data and the Fed’s basic forecast in the context of a policy rate that is entering into the neutral zone. The strong ISM report suggests that growth is not faltering quickly if at all, which is supportive of the Fed’s current expected path. But inflation remains tame, even softening, which suggests a more dovish path. A little give, a little take. It’s a long time to the March meeting, the next likely opportunity to hike rates under the gradual rate hike regime. Much can happen between now and then. If the data continue to suggest that the pace of activity is likely to place downward pressure on the unemployment rate, they will hike deeper into the neutral range before pausing.

Minutes Emphasize Uncertainty, Data Updates

The minutes of the November FOMC meeting followed the path of recent Fed speakers. The Fed is still likely to raise rates in December:

Consistent with their judgment that a gradual approach to policy normalization remained appropriate, almost all participants expressed the view that another increase in the target range for the federal funds rate was likely to be warranted fairly soon if incoming information on the labor market and inflation was in line with or stronger than their current expectations.

There will be some holdouts with in December:

However, a few participants, while viewing further gradual increases in the target range of the federal funds rate as likely to be appropriate, expressed uncertainty about the timing of such increases.

And some that believe the Fed has already done enough:

A couple of participants noted that the federal funds rate might currently be near its neutral level and that further increases in the federal funds rate could unduly slow the expansion of economic activity and put downward pressure on inflation and inflation expectations.

Overall, they set the stage for a change of language in the December statement:

Participants also commented on how the Committee’s communications in its postmeeting statement might need to be revised at coming meetings, particularly the language referring to the Committee’s expectations for “further gradual increases” in the target range for the federal funds rate. Many participants indicated that it might be appropriate at some upcoming meetings to begin to transition to statement language that placed greater emphasis on the evaluation of incoming data in assessing the economic and policy outlook; such a change would help to convey the Committee’s flexible approach in responding to changing economic circumstances.

The upshot is that with rates near their neutral level, future policy changes are increasingly data dependent. The economy is at an inflection point as this year’ fiscal-induced euphoria wanes. The magnitude of the slowdown will determine how many, if any, rate hikes we see next year.

Separately, on the data front, consumer spending remains alive and well:

By all accounts, the momentum seems to be holding as we enter the final weeks of the year. Which shouldn’t be a surprise. Confidence is high, unemployment low, gas prices down, and wages up. That dynamic keeps household spending powering forward for now.

From the same report, inflation remains quiet despite concerns the economy has surpassed full employment:

These low inflation numbers give the Fed room to pause when they are confident economic momentum has downshifted enough to end the downward pressure on unemployment. Be wary though of possible upside surprise to inflation numbers in the next few months year if we see a concentration of price hikes around the turn of the year (in a low inflation environment firms hike less frequently).

Speaking of unemployment, some economists are raising alarm bells over the recent rise in initial unemployment claims. This isn’t crazy; claims typically rise ahead of recessions. That said, the increase so far is fairly minimal, might be influenced by seasonal adjustment issues, and, as importantly to me but often overlooked, the breadth of rising claims also remains minimal:

We would see a bigger rise in the dispersion of claims across states if there was a significant worsening of the labor market. There was even a subtle rise in the dispersion of claims in 2015-16 in the aftermath of the oil price decline while claims moved sideways. See also the rising dispersion of claims ahead of the 2007 recession.

Speaking of the 2015-2016 oil induced trauma, I sense a fear that we are about to see a repeat of that episode now that oil prices have fallen. Such fears are perfectly understandable given that the US is now both a major producer and a consumer of oil products. For what it’s worth, however, the sector never recovered the jobs lost during that period:

Ditto for capital investment:

Given the lack of recovery, it seems unlikely that the magnitude of the previous downturn will be repeated.

Bottom Line: Fed remains likely to hike in December, but policy beyond that meeting is pretty much a blank slate. There is a lot of data to come between now and March, the most likely next opportunity for a rate hike. It could be soft enough to justify a pause as early as that meeting.

Policy Not On A Preset Course

Federal Reserve Chairman Jerome Powell extended his colleague Vice Chairman Richard Clarida’s comments and emphasized the data dependent nature of monetary policy in 2019. It is a wait and see game at this point. The Fed might not hike in 2019. They might hike four times. It depends on what is left after the sugar high from fiscal stimulus fades.

Market participants zeroed in on Powell’s assessment of the current stance of policy. He did not say, as was initially reported, that rates were near neutral, but instead said that rates are near the bottom edge of the range of neutral estimates. Policy thus could be far from neutral if the upper estimates of neutral are correct.

Still, this was a pullback from Powell’s October remarks that policy rates are a “long way” from neutral, which implied considerable certainty about the appropriate level of rates at this stage in the business cycle. This alleviates concerns that Powell has a fixed notion of where rates are headed.

This was an important shift for Powell to walk back the October remarks. My sense is that Powell and others leaned too far into the “hike above neutral” story ahead of the data to support that call. This made it appear that policy was less data-dependent than in reality. Some softening of the data drove this home as well.

I do find it interesting that Powell & Co. remain tied to the current range of neutral estimates after New York Federal Reserve President John Williams tried to downplay the whole r-star story a couple of months ago. Williams left the impression that the r-star estimates weren’t all that important. But they are.

Prior to that move, we had a nice little story about how policy would become more data dependent as we moved closer to neutral. Now the messaging has moved back to that story. After the December hike, the Fed will be at the lower end of the neutral range, and policy will become increasingly data dependent. As Powell says:

We will be paying very close attention to what incoming economic and financial data are telling us.

Bottom Line: Where does this leave us? Waiting for more data. Assuming inflation remains under control, I think the Fed will pause when they see that economic momentum has faded sufficiently to stabilize the unemployment rate. More on that later.

Fed Not Handholding Anymore

Federal Reserve Vice Chairman Richard Clarida delivered a speech emphasizing the data dependent nature of Fed policy. There were signals on the path of policy, but the path is subject to the evolution of the economy. The Fed isn’t going to tell you exactly where rates are headed anymore. Welcome to the post-forward guidance world.

Clarida presents an optimistic description of the economy. In particular, he watches the inflation data:

The inflation data in the year to date for the price index for personal consumption expenditures (PCE) have been running at or close to our 2 percent objective, including on a core basis‑‑that is, excluding volatile food and energy prices. While my base case is for this pattern to continue, it is important to monitor measures of inflation expectations to confirm that households and businesses expect price stability to be maintained.

Survey and TIPS-based inflation expectations give him to reason for concern. Then he asks:

What might explain why inflation is running at or close to the Federal Reserve’s long-run objective of 2 percent, and not well above it, when growth is strong and the labor market robust?

The answer is faster potential growth due to productivity gains and labor force growth. He expects demographics to eventually catch up to labor force growth but remains optimistic that in the short run we can squeeze some more labor out of the prime-age group. Regarding productivity growth, he sees both structural and cyclical factors at play. Clarida see business investment as an important indicator of structural productivity growth and expresses what I would call disappointment with the third quarter investment numbers. Still:

One data point does not make a trend, but an improvement in business investment will be important if the pickup in productivity growth that we have seen in recent quarters is to be sustained.

One takeaway is that if we get ongoing above-trend growth in a low-investment economy, then we would expect the currently low inflation rates to tick higher.

Clarida presents a very nice description of the intersection of data dependence, monetary policy, and communications:

It is important to state up-front that data dependence is not, in and of itself, a monetary policy strategy. A monetary policy strategy must find a way to combine incoming data and a model of the economy with a healthy dose of judgment–and humility!–to formulate, and then communicate, a path for the policy rate most consistent with our policy objectives. In the case of the Fed, those objectives are assigned to us by the Congress, and they are to achieve maximum employment and price stability. Importantly, because households and firms must make long-term saving and investment decisions and because these decisions‑‑directly or indirectly‑‑depend on the expected future path for the policy rate, the central bank should find a way to communicate and explain how incoming data are or are not changing the expected path for the policy rate consistent with best meeting its objectives.4 Absent such communication, inefficient divergences between public expectations and central bank intentions for the policy rate path can emerge and persist in ways that are costly to the economy when reversed.

He further explains two different ways in which data might impact policy decisions. The first is by tracking the data relative to the forecast:

If, for example, incoming data in the months ahead were to reveal that inflation and inflation expectations are running higher than projected at present and in ways that are inconsistent with our 2 percent objective, then I would be receptive to increasing the policy rate by more than I currently expect will be necessary.

But data can impact policy in a second way by causing policy makers to update their estimates of key parameters, notably the natural rates of unemployment and interest. For example:

I would expect to revise my estimates of r* and u* as appropriate if incoming data on future inflation and unemployment diverge materially and persistently from my baseline projections today.

Which is a signal of what we can all suspect to coming: If inflation remains low with unemployment below the current estimates of the natural rate of unemployment, then he will lower his estimates of key parameters accordingly. Assuming a constant path of actual unemployment, the impact will be to revise down the expect rate path.

The immediate implications for policy:

This process of learning about r* and u* as new data arrive supports the case for gradual policy normalization, as it will allow the Fed to accumulate more information from the data about the ultimate destination for the policy rate and the unemployment rate at a time when inflation is close to our 2 percent objective.

Clarida still supports gradual policy normalization, edging up interest rates until the data tell him enough is enough. What does this mean? It could mean a lot of things depending on the evolution of the economy. But one example of a potential outcome is that if downward pressure on unemployment ended but inflation remains low, Clarida would not see a need to push rates into a restrictive zone.

There has been some attention to Clarida’s shift from “some further gradual adjustment” to “gradual policy normalization.” I think this debate distracts from what otherwise was a very nice speech outlining the data-dependence approach. That said, my interpretation of the shift away from “some” was yet another effort to roll back forward guidance. Clarida doesn’t want to leave the impression that policy is on a pre-set course. How many more hikes? Could be one. Could be six.

Bottom Line: The Fed is data dependent. Growth will almost certainly slow in 2019. If it looks like to slow sufficiently to halt the slide in the unemployment rate while inflation remains low, the Fed will slow the pace of rate hikes. If unemployment continues to slide while inflation remains low, then the gradual pace of rates will continue longer. If unemployment slides and inflation ticks up, the Fed will probably hike a little faster.