“Patience” To Make Its Way Into the SEP

Fed policymakers from around the nation once again descend upon Washington D.C. to ponder the path of monetary policy as the economy eases down from the fiscal-stimulus boosted pace of 2018 to something more consistent with what the Fed believes to be sustainable growth. The expectation is that the Fed will leave policy rates unchanged and will reiterate their intention to remain “patient” while awaiting the data that will guide their next move. Still, there will be plenty of excitement even if rates hold steady. More important will be the new set of forecasts, which will likely shift to reflect the “patient” stance adopted at the January FOMC meeting. In addition, I anticipate the Fed will announce a plan to wind down the balance sheet runoff.

Incoming data generally continues to support the Fed’s plans to hold rates steady. In my eyes, there are clear signs the economy continued to slow in the first quarter but the pace of the deceleration remains inconsistent with recession.  New orders for core-durable goods, for example, edged higher:

The gains did little to reverse the recent declines, but given the experience of the past two recessions, we would have expected a much sharper decline if the economy was decelerating rapidly. The same can be said for industrial production, which slid during in January and gained only a touch in February. The pace over the past year has decelerated:

In addition, the number of sectors contracting rose higher as would be expected in a slowing economy. Remember though that during a recession, typically the declines in industrial production are deeper and the dispersion across sectors is greater. We also should not ignore the lesson of 2015-16, during which a manufacturing shock remained fairly well contained. In short, the numbers again suggests softening, not recession.

Core retail sales rebounded from the dreary December number (again, as expected in a still growing economy):

My expectation at this point is that when the recent volatility passes, retail sales stabilize closer to the 2015-16 pace than the 2017-18 pace.

Initial unemployment claims edged down last week:

Here again, the modest rise in claims and widening of deterioration across states is consistent with a slowing economy, but the overall pace of worsening still remains short of recessionary.

Soft inflation numbers certainly caught the Fed’s attention:

I suspect the above data will support a downgrade in the median growth forecast for 2019 to something closer to 2%, close to the median longer run forecast of 1.9%. That would mean the economy would fall to its sustainable growth rate about a year ahead of what the Fed expected in December.

With growth downshifting, inflation soft, and rising concerns about deteriorating inflation expectations, the Fed has the opportunity to sharply pull down the expected path of rate hike and wipe out the two 2019 rate hikes expected at the December meeting.  This would be consistent with recent communications and I suspect that the Fed would not want to whipsaw markets with a set of projections that was markedly different from what the mantra of “patience” they have been chanting all up and down Wall Street and Main Street.

A shift downward in the dots is the expectation; the risk is that the gap between longer run unemployment and forecasted unemployment remains wide enough to keep a sufficiently large subset of FOMC participants thinking that they still need to snug rates higher that the median dot calls for another hike this year. More interesting to me, however, is the possibility that at least one dot anticipates a rate cut in 2019. I would not be surprised if one FOMC participant thought a slowing economy with already soft inflation numbers would more likely that not justify a rate cut by the end of the year.

Bottom Line: I expect the Fed will revise their projections to reflect the dramatically more dovish tone taken since the ill-fated December rate hike. Such a move also appears consistent with incoming data. Moreover, Fed speakers have given little reason to believe that market participants have taken an overly dovish view of policy. Altogether, that means the dots will reveal a marked downshift in the expected path of rate hikes. If we don’t see that, we will be pondering the cause of yet another communications divide between central bankers and market participants.

Payroll Growth Retreats

As expected, the broad trends in January’s employment report reversed in February. That said, growth in Nonfarm payrolls was a meager 20k. Per usual, you need to make a choice. Did you think the 300k+ number in January represented the true trend? Do you think the 20k February number represents the true trend? Or was February more likely just the occasional pothole that happens? I lean in the latter direction; I suspect the Fed will as well.

Nonfarm payrolls were revised up for the previous two months by 12k, but that was  cold comfort given the weak gains of February:

To be sure, “cold” likely contributed to the February softness. The three-month moving average is 186k, which is probably a lot closer to reality than the either the January or February numbers. Importantly, the leading indicator in the employment report of temporary help remains on a general uptrend:

This has been a good leading indicator in the past two cycles and I have no reason to think it won’t be again. My short story is to analyze the headline payroll number in context of the overall data flow. If temp helps was rolling over, if the ADP number was equally soft, if consumer confidence were plunging, I would be more concerned about the soft employment gain.

The unemployment rate pulled back to 3.8%. A decrease was expected due to the end of the federal shutdown. Less expected was the slowdown in labor force growth:

Solid labor force growth over the past year helped stabilize the unemployment rate and supported the hypothesis that the economy was not overheating. A sustained slowdown in labor force growth in the context of still upward pressure on labor demand would call that hypothesis into question. That said, one month does not make a trend.

Wage growth accelerated as expected:

The twelve-month change was at a cycle high of 3.4%. A solid number but not one that would rattle the Fed. They are most likely to see it as consistent with productivity growth.

Separately, new starts for single family housing jumped in January, reversing the downtrend in the final months of last year:

A couple of factors are likely at play. Primarily, mortgages rates are down and the panic that reverberated through the economy late last year subsided. What does this tell us? That the underlying dynamics in housing are probably still in play – demographics are likely a drag to multifamily but support single family as the Millennial generations ages. I suspect the net impact will relegate housing to fairly neutral to small drag on GDP. This would be a continuation of recent trends. Housing has been a small drag on GDP in 6 of the last 7 quarters:

Bottom Line: Looking through the noise, the labor market most likely retains its Goldilocks aspects of solid job growth, low unemployment, and improving wage growth. Note that we should anticipate some slowing of growth over the next year is the economy slows as expected. Housing looks to remain on fairly stable ground but don’t expect miracles as the sector is not likely to provide a large boost to growth at this point in the cycle.

Payrolls Likely To Retreat From January Blowout

The February employment report will be released Friday. The most likely outcome is the direction key variables in the report mirror their January outcomes. It is unlikely that the outcome of the report will, by itself, have much impact on monetary policy now that the Fed is in “patient” mode. Absent a dramatic near-term shift in the pace of activity, the Fed will focus on the totality of the data over the next few months before making a decision about the next policy move.

Nonfarm payrolls jumped by 304k last month while the unemployment rate climbed to 4.0 and wage growth pulled back to a 1.3% annualized rate (3.2% year over year). Wall Street expects payroll growth to slow to 178k (range of 138k-200k). That expectation is consistent with my model:

The unemployment rate will likely edge back down (consensus expectation is 3.9%) now that furloughed government workers and contractors are back on the job. Importantly, the Fed will be keeping a close eye on labor force participation; solid gains in participation are holding unemployment fairly constant over the past year, which lessens any residual concerns about overheating. Wage growth is expected to pick up and drive the year-over-year growth to 3.3%. Wage growth in that zone would not be considered inflationary by Fed policy makers.

Overall, the expectation is that we continue to see the labor market deliver Goldilocks outcomes of continued job growth, stronger labor force growth, low unemployment, and improving wage growth. That kind of combination will keep the Fed happily on the sidelines. Reasonable departures from this story on either side would likely be met with a shrug. The data after all is volatile and the Fed has already been clear they are in no rush to make another policy decision.

Separately, New York Federal Reserve President John Williams presented his current economic outlook. Critical points were that he estimates potential growth to be about 2% while actual growth is expected to slow to 2% as last year’s tailwinds fade or become headwinds. He lists the usual lions, tigers, and bears:

Three developments contribute to this view: a downturn in global growth, heightened geopolitical uncertainty, and the effects of tighter financial conditions.

With actual growth equal to potential growth at already low unemployment rates, the world is pretty much perfect according to Williams:

From the perspective of monetary policy, the overall picture of the economy is about as good as it gets: very low unemployment, sustainable growth, and inflation just about at our 2 percent goal.

And policy is neutral:

Given this favorable situation, when you look at monetary policy, things are looking pretty normal as well. My current estimate for r-star is 0.5 percent, so when you adjust for inflation that’s near 2 percent, the current federal funds rate of 2.4 percent puts us right at neutral.

Williams is now back to his old self. Remember, just a few months ago he was telling us not to pay too much attention to r-star. Now r-star is back to its old place at the beginning, center, and end of Williams’ analysis.

The policy implications are at this point well known – it’s all data dependent. If growth looks faster than anticipated, they may need to snug policy higher a bit. If growth falters, rates are heading down.

Bottom Line: The Fed generally believes they have policy and the economy just about where they want it, not too hot, not too cold. The employment report is expected to fall in line with that view.

Recessions Are Getting Tougher to Predict

Although the U.S. government said the economy expanded at a faster-than-expected rate of 2.6 percent last quarter, there’s little doubt that activity has slowed considerably this year. Market participants should prepare themselves for an environment going forward where growth in any one quarter might be negative in the next even if the economy avoids recession.

The Federal Reserve Bank of Atlanta’s initial estimate of first quarter 2019 growth is a meager 0.3 percent. That kind of number will generate plenty of recession warnings. Moreover, it doesn’t take much imagination to push that estimate below zero. But would a weak first quarter number signal a recession is underway, or even close at hand?

Continued at Bloomberg Opinion….

Nothing To See Here Yet

There has certainly been no shortage of angst about the economy in recent months. The ISM indexes for February certainly don’t justify that angst. The manufacturing number is softer, to be sure:

But it is nowhere near being in recessionary territory or, for that matter, even nowhere near matching the levels seen in the 2015-16 soft patch. The service sector side of the economy reveals even less cause to worry:

Services are a much larger portion of the economy than manufacturing. We have many cyclical indicators of the latter, but if manufacturing is less important than the past then weighing those indicators too heavily in our analysis will only lead to an unjustified bias toward recession calls. This is what happened in 2015-16 when the threatened recession failed to materialize.

Also, don’t be fooled into thinking this is “lagging” data. It’s just a couple of weeks old and realistically, if this recessionary slowdown started in the fourth quarter, this ISM data should be much weaker already.

Bottom Line: Be careful with some of the old tricks as they are likely less relevant in the new economy. 

What Can We Learn From The New York Fed’s Underlying Inflation Gauge?

Click here for newsletter version!

Working on examples for a class, I stumbled upon one with implications for market participants. Specifically, what has the New York Federal Reserve’s Underlying Inflation Gauge (UIG) been telling us? The answer is somewhat surprising. It does provide new information about the path of core-inflation. Still, even at its height it wasn’t predictive of any worrisome inflation. There are two interpretations. One is that you ignore the UIG, the other is that you embrace the predictions of low inflation. I pick the latter interpretation.

The New York Fed UIG is an effort to capture the underlying trend in inflation. An attractive feature of the UIG is that its construction utilizes a wide array of financial and economic variables; The “full-data-set” version is based on 346 monthly, weekly, and daily series. This allows it to capture a number of factors such as, for example, tighter labor markets that may influence the path of core inflation. The objective is to add information to our traditional measures of core-inflation as those measures arguably exclude important information that might shape our inflation forecast.

Last year the UIG created angst within some quarters of the investment community as it rose to highs last seen prior to the Great Recession. Examples can be found in the news here, here, here, and here. Neil Dutta of Renaissance Macro Research, however, argued prior to the highs in the UIG that “…if loose financial conditions and stronger growth do little to move price inflation, perhaps the premise of those who rely on UIG to claim inflation will turn up is flawed.”

With this in mind, I set out to understand a bit more about the dynamics between the UIG and inflation. While the UIG is presented along with year-over-year core CPI inflation, I focus on year-over-year core PCE inflation because the latter is the Fed’s preferred inflation measure (technically, the Fed targets headline inflation but use core as a predictor of the likely path of headline inflation). I also use the “full-data-set” version of the UIG as it received the most press last year and I am interested in the importance of the wider range of variables in predicting inflation.

Visually, the turning points of the UIG correspond to turning points of core-inflation. Moreover, high values of the UIG have corresponded to inflation rates in excess of the Fed’s 2% target. This is more easily seen in a scatterplot.

What I want to know is a.) does a change in the UIG predict a change in core-inflation and b.) what does the UIG say about the inflation forecast? To get at these issues I set up a simple two-variable vector autoregression with six lags. The Granger causality tests indicate that the UIG and inflation both have an impact on inflation but inflation does not have an impact on the UIG. That suggests a shock to the UIG will have an impact on inflation but not vice-versa, which is what the impulse response function show.


Roughly, a 0.07 percentage point shock to the UIG will be translated into an equal shock to core-inflation after three months (right hand charts). Moreover, the impact on core-inflation is fairly persistent (upper right chart). Shocks to core-inflation are not persistent and dissipate over the next twelve months (upper left chart) while having very little impact on the UIG (lower left chart). These basic results are not very sensitive to the choice of lag length, but lag lengths beyond 12 months tend to result in models where the cycles overrun each other and are not particularly instructive. 

I find these results reassuring in that they suggest the UIG does capture factors that have a persistent impact on core-inflation. That said, has the magnitude of shocks been sufficient to heighten inflation concerns? To get at that question, I compute the 24-month inflation forecasts from the model for each month beginning with 2017:1 and ending 2018:11 (using recursive regressions that re-estimate the model each month). Those forecasts  all point toward inflation settling into a range of 1.7-1.8%. In other words, adding the UIG to the inflation forecast has indicated for the past two year that inflation will fall short of the Fed’s target. 

I think these results point toward the strength of the mean reverting properties of inflation in recent years as inflation expectations have become more entrenched and the Phillips curve less pronounced.

Bottom Line: The New York Fed UIG appears to provide new information about the direction of inflation but that information for the past two years has indicated inflation below the Fed’s target.

Backwards Looking Data Likely To Justify Fed Patience

We have a big week of data ahead, but with a twist: Because of the government shutdown, the incoming data is an even deeper look into the past than normal. How much of it will really be new news at this point when market participants already appear to have discounted a weak fourth quarter and are looking forward to the future? Which leaves me thinking this week could be one of those “bad news is good news” situations when soft data reinforces expectations that the Fed is done hiking for this cycle.

The durable goods report for December came in on the soft side:

But note that the degree of softening so far is more noise than a substantial decline:

Of course, that is December data and hence fairly backward looking. More timely data though has followed a similar pattern. Regional manufacturing surveys have generally been on the weak side, with the latest example being the Philly Fed measure coming in weak. Consequently, we should anticipate some weakness in the national ISM report to be released this upcoming Friday.

Still, when I am looking at the manufacturing data, I am wondering if any weakness in that sector remains fairly well contained. Note that while the preliminary Markit PMI for manufacturing for February was a bit softer than expected, the services measure came in better than expected. That might be particularly important given that the service sector dominates the US economy. We may again experience a repeat of the 2015-16 episode when the manufacturing sector diverged from the service sector with the net result being that the economy slowed but did not slip into recession.

Last week saw another soft reading on existing home sales; high prices and higher mortgage rates turned the tide on what had been fairly hot markets in many metros. We get more December housing data Tuesday with building starts and permits along with Case-Shiller home prices. And on Wednesday we get pending home sales for January. I don’t think may are expecting any big positive surprises in the data and instead anticipate it will further justify the Fed’s decision to hold rates steady in January and beyond.

Thursday brings the delayed fourth quarter GDP report. Expectations are low; the Atlanta Fed GDP tracker anticipates a growth rate of just 1.4%. The December retail sales report, regardless of whether or not you believe it to be just a blip, will take a large piece out of growth for the quarter. Again, not only do we have low expectations, it is very backwards looking data at this point.

More forward looking is the initial claims report. Last week brought a decline in claims, but it really has been all over the place in recent weeks. Still, on average the trend is a notch higher, and the dispersion of rising claims across states a little wider:

Definitely an indicator that we need to keep our eyes on, but also one that has made false recession calls in the past.

Friday brings the December personal income and outlays report and with it an inflation reading. Again, weakness is anticipated and will be largely anticipated by the results of the previously released GDP report of this week. Also, as noted earlier, we also get ISM and Market PMIs. In additional, a final February reading on consumer sentiment from the University of Michigan.

Plenty of Fedspeak for the week, including a trip by Federal Reserve Chairman Jerome Powell to the Senate (Tuesday) and House (Wednesday) for the semiannual monetary policy report. Vice Chair Richard Clarida will deliver an economic outlook Thursday morning. That evening, Powell has a speech titled Recent Economic Developments and Longer-Term Challenges. Between the two we should get some insight on the expected path of policy. That said, I anticipate it will largely be confirmation of what we already know: The Fed is on the sidelines for the time being and I suspect the bar to a rate cut is lower than the bar to a hike.

One thing to note is that the Fed has effectively eased policy by shifting down the expected path of short-term rates. This pulls down interest rates across the curve, for example on the shorter end here:

At least for now, equity markets have responded and retraced their December loses:

The important point to remember here is that if you are sitting around waiting for the Fed to move, you already missed it.They did move and set the stage to move further if needed.

Finally, in case you missed it, it is worth your time to review the action at last week’s monetary policy forum, paper here, comments by New York Federal Reserve President John Williams here, and comments by Richard Clarida here. A takeaway is that the Fed is preparing for the next downturn with the expectation that new tools need to be ready to address another trip to the effective lower bound. Importantly, the Fed will be looking for tools to prevent downward drift on inflation expectations by, for instance, policies such as makeup strategies that allow for higher inflation to make of for periods of low inflation. I think a result of this work will likely be a more aggressive monetary policy in the wake of the next downturn.

Bottom Line: Plenty of delayed data, mostly backwards looking, will be released this week. Expect it to justify the Fed’s shift to a “patient’ policy stance. Expect Fedspeak to reinforce this point. Keep in mind that the Fed has already eased policy and done so fairly early in a soft patch. That’s bullish for the economy.

January 2019 FOMC Minutes: Shifting Gears

As is often the case, one could linger for hours over the minutes of the Fed meetings, pulling out interesting bits and pieces to chew on. This one is no exception, but the short story in the January minutes is that the Fed was concerned enough about the outlook to shift to its current “patient” stance, but not so worried that they were contemplating a rate cut in the year ahead. They are also closer to ending the balance sheet reduction; I expect they will slow the pace they are reducing the balance sheet within the next two meetings with an eye toward ending entirely by the end of the year.

The operating procedures and balance sheet discussion came early in the meeting. Recall that the Fed announced in January they had decided to manage short-term rates in a system with ample reserves. With that in mind, the Fed sees that the end of “quantitative tightening” is upon us:

Almost all participants thought that it would be desirable to announce before too long a plan to stop reducing the Federal Reserve’s asset holdings later this year.

They also noted the implications of their plan on the mix of their asset holdings:

Participants commented that, in light of the Committee’s longstanding plan to hold primarily Treasury securities in the long run, it would be appropriate once asset redemptions end to reinvest most, if not all, principal payments received from agency MBS in Treasury securities.

In other words, they will eventually find themselves once again buying Treasuries to offset continued reduction in their mortgage holdings as they work to exit the housing business.

Participants were generally upbeat about the economy:

Participants agreed that over the intermeeting period the labor market had continued to strengthen and that economic activity had been rising at a solid rate

Still, they saw growth slowing in 2019 more than anticipated in December:

Participants generally continued to expect the growth rate of real GDP in 2019 to step down somewhat from the pace seen over 2018 to a rate closer to their estimates of longer-run growth, with a few participants commenting that waning fiscal stimulus was expected to contribute to the step-down. Several participants commented that they had nudged down their outlooks for output growth since the December meeting…

Recall that in December the median 2019 growth forecast was 2.3%. The above suggests that by January it had fallen to something closer to 2% (the Fed’s median estimate for longer-run growth was 1.9%). A particular concern was the investment outlook:

Participants noted that growth of business fixed investment had moderated from its rapid pace earlier last year.

With regards to inflation, hope springs eternal:

 Participants continued to view inflation near the Committee’s symmetric 2 percent objective as the most likely outcome.

Despite the reality:

Some participants noted that some factors, such as the decline in oil prices, slower growth and softer inflation abroad, or appreciation of the dollar last year, had held down some recent inflation readings and may continue to do so this year. In addition, many participants commented that upward pressures on inflation appeared to be more muted than they appeared to be last year despite strengthening labor market conditions and rising input costs for some industries.

They took a fairly benign view of falling market-based measures of inflation compensation, favoring the interpretation that this was less about falling inflation expectations and more about declining risk premiums and a greater risk of downside to the inflation forecast. Stable survey measures of inflation expectations supported this view. Since then, however, the University of Michigan longer-run inflation measure slipped to 2.3%. Most interesting is that series has not begun to edge higher despite a period of unemployment that is supposedly persistently below its natural rate.

Not unexpectedly, the Fed worried about the financial markets:

Among those participants who commented on financial stability, a number expressed concerns about the elevated financial market volatility and the apparent decline in investors’ willingness to bear risk that occurred toward the end of last year.

These concerns played into their policy decision:

Participants observed that since then, the economic outlook had become more uncertain. Financial market volatility had remained elevated over the intermeeting period, and, despite some easing since the December FOMC meeting, overall financial conditions had tightened since September. In addition, the global economy had continued to record slower growth, and consumer and business sentiment had deteriorated. The government policy environment, including trade negotiations and the recent partial federal government shutdown, was also seen as a factor contributing to uncertainty about the economic outlook.

They subsequently concluded that they should hold rates constant and signal they would be patient with respect to future policy changes. Interestingly, I would argue that most of these factors were present at the December policy meeting, which would explain why markets puked in the wake of that decision to hike rates and signal more rate hikes to come. The Fed was then less willing to see what everyone else saw.

Policymakers on average retain a hawkish bias with respect to the likely direction of rates:

Many participants suggested that it was not yet clear what adjustments to the target range for the federal funds rate may be appropriate later this year; several of these participants argued that rate increases might prove necessary only if inflation outcomes were higher than in their baseline outlook. Several other participants indicated that, if the economy evolved as they expected, they would view it as appropriate to raise the target range for the federal funds rate later this year.

Note that they seemed focused on the possibility of additional rate hikes and not focused at all on cuts. Also, the Fed made clear that they will dump “patient” before any rate hike:

Many participants observed that if uncertainty abated, the Committee would need to reassess the characterization of monetary policy as “patient” and might then use different statement language.

This on the dot plot is interesting:

A few participants expressed concerns that in the current environment of increased uncertainty, the policy rate projections prepared as part of the Summary of Economic Projections (SEP) do not accurately convey the Committee’s policy outlook. These participants were concerned that, although the individual participants’ projections for the federal funds rate in the SEP reflect their individual views of the appropriate path for the policy rate conditional on the evolution of the economic outlook, at times the public had misinterpreted the median or central tendency of those projections as representing the consensus view of the Committee or as suggesting that policy was on a preset course. However, some other participants noted that the policy rate projections in the SEP are a valuable component of the overall information provided about the monetary policy outlook.

The ongoing debate at the Fed. Does the dot plot help or hurt? The Fed is having a hard time convincing market participants that the dot plot median is not a consensus forecast and that any of the individual forecasts are much more uncertain than commonly believed. This was particularly an issue in December when the median dot anticipated another two rate hikes in 2019 after the Fed pushed through what market participants already considered an ill-advised rate hike at that meeting. The Fed argues that was a forecast, not a promise. This and similar dynamics have been an ongoing issue. In my opinion, the Fed’s models make the dot plot inherently hawkish, which arguably sets expectations such that policy is less accommodative than the Fed believes.

All that said, many FOMC participants still find value in the dot plot in that it conveys the Fed’s reaction function. The challenge is finding a new version of the dot plot that retains this communications element while losing the problematic elements.

Bottom Line: Policy on hold through mid-year at least, the Fed still retains a modestly hawkish internal bias, the balance sheet reduction will soon be over, and the Fed still doesn’t know exactly what to do with the dot plot.