The minutes of the July 2o2o FOMC meeting were released today. They were somewhat disappointing  as they walked back expectations that further policy action would soon arrive. 

The Fed is moving closer to concluding its policy review:

Participants agreed that, in light of fundamental changes in the economy over the past decade—including generally lower levels of interest rates and persistent disinflationary pressures in the United States and abroad—and given what has been learned during the monetary policy framework review, refining the statement could be helpful in increasing the transparency and accountability of monetary policy. Such refinements could also facilitate well-informed decisionmaking by households and businesses, and, as a result, better position the Committee to meet its maximum-employment and price-stability objectives. Participants noted that the Statement on Longer-Run Goals and Monetary Policy Strategy serves as the foundation for the Committee’s policy actions and that it would be important to finalize all changes to the statement in the near future.

The “near future” is likely the September meeting. The most significant change to the Fed’s strategy is likely to be some flavor of an average inflation target whereby the Fed attempts to allow inflation to rise above 2% to compensate for periods of time below 2%. This differs from the current strategy in which the Fed only attempts to return to the 2% target. The practical implication of this policy shift is that the Fed will keep policy easy for longer than was the case in the last recovery. 

Although the Fed had an understandably dour outlook, they are not inclined to change the forward guidance just yet:

With regard to the outlook for monetary policy beyond this meeting, a number of participants noted that providing greater clarity regarding the likely path of the target range for the federal funds rate would be appropriate at some point.

This is somewhat surprising given the outlook for inflation and unemployment; the Fed would obviously like to accelerate the recovery. That said, it appears that they still have yet to decide what shape such guidance would take:

Concerning the possible form that revised policy communications might take, these participants commented on outcome-based forward guidance—under which the Committee would undertake to maintain the current target range for the federal funds rate at least until one or more specified economic outcomes was achieved—and also touched on calendar-based forward guidance—under which the current target range would be maintained at least until a particular calendar date. In the context of outcome-based forward guidance, various participants mentioned using thresholds calibrated to inflation outcomes, unemployment rate outcomes, or combinations of the two, as well as combinations with calendar-based guidance.

It may have been too much to expect the Fed to both change its policy strategy and its forward guidance at the same meeting. This extension was interesting:

In addition, many participants commented that it might become appropriate to frame communications regarding the Committee’s ongoing asset purchases more in terms of their role in fostering accommodative financial conditions and supporting economic recovery.

As if it was a surprise that asset purchases had already evolved past their initial rational as supportive of market functioning. In the press conference that followed the July meeting, Federal Reserve Chair Jerome Powell said as much:

while builder confidence is now at its highest level since 1998:

Traditionally, housing is a good leading indicator for the economy as a whole; I don’t think we can ignore the possibility that the economy grows around the virus more quickly than anticipated. The conventional wisdom has fully embraced the idea that this recovery will mirror the last. That already isn’t happening.

Bottom Line: The Fed remains focused on downside risks but as of yet is unwilling to act further to support the recovery. Maybe they won’t need to.

Initial unemployment claims fell below 1 million to 936,000:

There were an additional 488,622 Pandemic Unemployment Assistance claims. Continuing claims maintained its long, slow decline:

Still one of those glass half empty, half full situations. Claims continue to move in the right direction even if still above the worst of the Great Recession. But they remains at high levels, and with the enhanced benefits now expired, the fiscal cushion is limited. Moreover, we aren’t yet sure how quickly claims will decline considering the ongoing epidemic is keeping a lid on growth in many regions, the payroll protection plans has ended, and state and local governments face revenue constraints.

The standoff in Washington D.C. continues as neither side is ready to give ground. The Wall Street Journal speculates that the fight over the coronavirus support may spill over into late September:

The gulf in legislative proposals and the complicated political dynamics have prompted some lawmakers and aides to begin eyeing an alternative course on coronavirus relief: pairing the measures with legislation to keep the government funded after Sept. 30.

Congress must pass legislation by that deadline to prevent a government shutdown, and lawmakers will likely opt to approve a temporary measure that would fund the government until after the election. Coronavirus-relief measures could be attached to the stopgap bill, providing another deadline to try to force lawmakers to put together a compromise.

That seems to raise the possibility of a government shutdown in the fall…which would be a bit ugly going into the election. I am a bit surprised that the fact that we are currently going over a fiscal cliff has yet to rattle Wall Street. I imagine that we shouldn’t discount entirely the possibility that even with the fiscal cliff the economy will remain on the mend.

Wednesday, Boston Federal Reserve President Eric Rosengren gave some rather pointed comments about the economy:

While the fiscal and monetary stimulus has been significant, it cannot fully offset the economic drain caused by the public health crisis. Limited or inconsistent efforts by states to control the virus based on public health guidance are not only placing citizens at unnecessary risk of severe illness and possible death – but are also likely to prolong the economic downturn.

Very direct and ratcheting up the rhetoric from the Fed that Covid-19 still threatens the economy and there is only so much it can do to compensate for the resulting economic damage.

Bonds are selling off a bit as the market absorbs new supply:

I know, not the sell-off of the century. Roberto Perli attributes part of the move to an inattentive Fed:

Treasuries selling off again after lower bid/cover at the 30yr auction.

9 of the 21 bps increase in the 10yr rate since the Aug 4 low is due to a higher expected future fed funds rate.

9 bps is small but doesn’t help. Wouldn’t have happened with better forward guidance or YCC. pic.twitter.com/Hnd4YZbniI

— Roberto Perli (@R_Perli) August 13, 2020

This echoes my thoughts on Bloomberg earlier this week. The Fed will only let this go so far before they tighten up the guidance. This move though by itself won’t garner much Fed attention.

Bottom Line: Slow but ongoing progress in the economy that is threatened by the continuing pandemic and faltering fiscal support. Nothing here to move the Fed in any direction but easier.

Inflation jumped higher in July as core-CPI rose 0.6%, well in excess of Wall Street’s expectation of a 0.2% gain. This surprise gain can be attributed to a pricing rebound compared to the negative prints earlier this year and a response to temporary supply constrictions. It certainly does not by itself indicate the U.S. economy is poised for a 70’s-style Great Inflation. That said, it opens up the possibility that disinflationary forces are less severe than initially perceived at a time the Fed has embraced the fight against disinflation.

The pop in core-CPI was as impressive as the earlier collapse:

The gains were fairly broad-based. Among the major categories, only food and piped gas services posted negative month-over-month numbers. Core goods gained sharply:

As did services less rent:

Even shelter has firmed in the last three months:

The conventional wisdom is that this is nothing more than a short-term bounce from earlier weakness and temporary supply constraints. Fellow Bloomberg Columnist Coner Sen says:

But what’s really happening is that pandemic-related supply and demand dynamics are distorting price signals in the short term. While we might get hot inflation prints for a few months, we should expect them to get back to normal as production does the same.

Coner does not expect the numbers to become the inflation of a failed state, and rightly so. To get interesting inflation like that, you need to see wage inflation of a similar magnitude. We just aren’t anywhere that point; that’s a whole different dynamic.

Instead of sustained high inflation, Coner says we return to “normal.” What exactly is “normal”?  This question has me thinking that the underlying inflation forces are stickier than the Fed perceives them to be. Indeed, survey-based inflation expectations have actually firmed in recent months:

And recall that former Federal Reserve Governor Daniel Tarullo questioned the strength of our understanding about inflation:

The substantive point is that we do not, at present, have a theory of inflation dynamics that works sufficiently well to be of use for the business of real-time monetary policy-making.

When Tarullo wrote this, he was doing so at a point in time when we were trying to explain why inflation was not rising as fast as we anticipated. The logic works both ways. We could run into a period of time when inflation does not fall as much as anticipated. Or put it in a different way: In February we all came to the conclusion that the Phillips curve was dead and could not be a useful guide to inflation. Now, just a few months later, we are all using Phillips curve logic to confidently predict that disinflation is a major threat.

But if the Phillips Curve is flat:

Then as we shouldn’t conclude that low unemployment will drive substantially higher inflation, we also shouldn’t conclude that high unemployment will drive substantially lower inflation.

So the way of thinking about inflation is not to look at the extremes, but to think of it as sticky at 2% or a notch below. That’s enough to keep the Fed focused on the possibility of disinflation even if that possibility is less of a risk than we like to believe given the unemployment rate. The Fed has said absolutely, for sure, don’t even ask, that they aren’t thinking about thinking about thinking about raising interest rates anytime soon. Instead, all of the Fed’s energy is currently direct at looking for ways like yield curve control to boost the effectiveness of monetary policy and pushing for more fiscal stimulus to the point where they can’t raise interest rates because they have basically committed to not offsetting that stimulus.

If you have inflation sticky near 2% and a Fed that is dead set to holding rates at zero for as far as the eye can see, you are looking at a sustained period of real interest rates at nearly -2%. That should be friendly for real assets, especially if you get another blast of fiscal stimulus right before a Covid-19 vaccine hits the market. 

Bottom Line: The inflation numbers aren’t telling us hyperinflation is on the way, but at the same time maybe the negative inflation earlier year this might not have been signaling deflation. Maybe the reality is much more boring and inflation is stuck in its recent range. Even that though has implications when the central bank remains positioned to fight disinflation.

If You Don’t Have Any Time This Morning

Incoming data still reflects the push-pull dynamics of the shutdown and reopening; we don’t have a clear picture of the growth trajectory after those dynamics play out. Fiscal policy in the U.S. is a mess.

The Dollar

I noticed this via Reuters:

The dollar is at its most oversold level in over 40 years, investment bank Morgan Stanley said on Friday, adding it had now shifted from its dollar-bearish stance and turned “tactically neutral” on the U.S. currency.

I want to make clear that there are two separate dollar stories circulating. One story is that the dollar is less attractive due to anticipated growth differentials between the U.S. and other nations, particularly Europe. Perfectly reasonable but note that that story can take on a life of its own until the dollar is oversold; Morgan Stanley apparently believes we have reached that point, at least in the near term. The fiscal follies in the U.S. hint that maybe this bet has more room to run, but be wary that Democrats and Republicans eventually reach a deal.

The second story is that you should sell the dollar because it is about to lose its status as a reserve currency. All I am going to say on that point is that I have heard a version of that story every few years since I was in grade school (don’t ask how exactly how long; long enough) and yet the dollar seems to only grow in importance. Recall that just a few months ago, there was a dollar shortage that required the Fed to open up swap lines with global central banks.

I would suggest leveraging your dollar negative bets, should you be inclined, on the first narrative rather than the second.

Key Data

The highlight of the week was the employment report. The U.S. economy added 1.8 million jobs in July, a surprisingly strong number given still high initial unemployment claims, weak ADP report earlier in the week (a gain of only 167k private sector jobs), and Census Pulse data that suggested a downturn in the jobs market. The combination is somewhat puzzling. I suspect the establishment report is still being push and pulled by the dynamics of the sudden shutdown and the initial reopening and has yet to reveal where the labor market stands after those dynamics have played out. The other data I think is signaling that we are close to seeing that process conclude and will soon settle into a slow grow trajectory.

The headline unemployment rate fell from 10.9% to 10.2% while the broader U-6 measure of unemployment declined more sharply, falling to 16.5% from 18.0% in June. On the other hand, workers are not streaming back into the labor market yet. Labor force participation edged down 0.1 percentage points to 61.4%, 2 percentage points lower than prior to the pandemic, a decline that helps hold down the unemployment rate. Watch of course how this number evolves going forward. Now that the enhanced unemployment benefits have expired, some persons currently not in the labor force may reenter (of course it is not clear that there are jobs available for them). Also, widespread school closures and childcare issues may pull some working parents from the labor market or prevent them from returning. Meanwhile, initial unemployment claims fell to 1.186 million in the final week of July while continuing claims maintained their slow decline.

Early in the week, the Institute of Supply Management release solid reports for both manufacturing and the services sector of the economy. Note though that the data is bouncing off the bottom, and a diffusion index like these should get a solid pop when the economy goes from “closed” to “mostly open.” Also note that the improvement in most components has not yet translated into similar gains in the employment component . This again suggests a weak employment picture after the start-stop dynamics end.

Fedspeak

Federal Reserve officials reiterated some common these last week. Dallas Federal Reserve President Robert Kaplan said increasing Covid-19 infections are weighing on the recovery and more fiscal support is critical. Cleveland Federal Reserve President Loretta Mester echoed these themes. Federal Reserve Vice Chair Richard Clarida was fairly optimistic in a CNBC interview:

“It will take some time I believe before we get back to the level of activity we were at in February before the pandemic hit,” he said. “My baseline view is that we could get back to the level of activity perhaps towards the end of 2021. There are a lot of moving parts with the virus and the global outlook.”

That said, his forecast was dependent on the current stalled fiscal support talks and, curiously, the view that the U.S. economy has suffered little permanent damage. The still high level of initial unemployment claims, however, suggests otherwise.

Boston Federal Reserve President Eric Rosengren attempted to defend the struggling Main Street Lending Program at a Congressional Oversight Panel. The program has seen limited use although Rosengren expects interest to rise if the economy worsens. I find this somewhat distressing as it suggests the Fed no longer hopes the program will accelerate the recovery and instead is only a backstop in case the economy slides further. That said, I never really had high hopes for the program in the first place. Fundamentally, to survive this crisis and thrive on the other side, many firms need grants not loans. A useful alternative would be zero rate long term loans with weak underwriting conditions that expected a high rate of business failures. But loans that just saddle a firm with additional debt that they will struggle to repay in the future are just simply not that attractive.

Upcoming Data

A fun week ahead. It starts off a bit slow with JOLTS for June (more of a data nerd report, so I like it but I am not convinced it is a market mover) on Monday and PPI on Tuesday. Thursday is the usual initial claims data. Friday it gets more interesting. We get retail sales for July; expectations are the core sales continue to improve and rise 1.6% over the previous month. But how much value is this data now that enhanced unemployment benefits have ended? Industrial production is expected to gain 3.0% in July over June. Productivity growth for Q2 is expected to come in at 1.5%. We also get preliminary Michigan sentiment numbers, expected to ease to 72.0 in August from 72.5 in July. For the most part, the data flow for July will likely reveal the impact of the rebound from the initial shutdowns; probably more important is the August data in which we will have a better sense of the likely growth trajectory going forward.

Fiscal Policy Update

Talks between Democrats and Republicans broke down last week leaving the economy adrift without the substantial fiscal support that has kept the lights on for many households. President Donald Trump responded with a series of executive orders intended to force through additional support by decree and force Democrats back to the table. It is not clear, however, that the orders will provide much support for the economy. I think the best bet is that they will provide little benefit anytime soon.

One order directs $44 billion of disaster relief funds to federal unemployment benefits, providing an additional $300 per week compared to the existing $600. It is not yet clear when or if these benefits will ever see the light of day (see Jack Balkin here). To utilize the benefits, states need to contribute another $100 per week of benefits; given that states were already struggling with a revenue downturn, it is not clear when or if they will be able to support the match. In addition, the order includes a cutoff that limits the additional benefits for those earning $100 a week or more from regular UI benefits. In large part, states lack the capacity to fine tune unemployment benefits in such a way and may opt out knowing that the money might be gone by the time they remake their systems. It thus seems unlikely that this money would arrive anytime soon and even if it did it only provides benefits for roughly six weeks.

A second order defers payment of the worker portion of the payroll tax from September 1 to December 31. “Defers” is just what it sounds like; the tax will still be owed next year. Trump promised to create tax relief if re-elected, but of course can’t do that unilaterally. So for the moment firms are caught in legal limbo. Do they stop collecting the tax from workers knowing that they could be liable for the tax at some point in the future? I would think that most firms continue to collect the tax. Moreover, it is not particularly effective stimulus as it does nothing to address the problem of people without jobs. Finally, it opens up a nasty political problem because the payroll tax funds Social Security and Medicare (notice I said political problem; it’s just an accounting issue at a certain level).

A third order claims to extend the eviction moratorium, but doesn’t really and directs agencies to fund funds or find other mechanisms to help prevent foreclosures, if possible. A fourth order continues the zero-interest rate interruption of student loan payments until the crisis is over. This probably isn’t legal but it is not evident who would challenge the order

It thus seems like these orders are a lot of smoke but not much fire. The only potentially meaningful part, the extension of unemployment benefits, has a limited lifespan and may never really get off the ground, certainly not in a timely fashion. For the moment at least we need to recognize that the economy has lost a key part of support and still faces a dire need for state and local aid.

Bottom Line:  The U.S. economy continues to bounce off the bottom; we don’t have a good sense of the ultimate growth trajectory. The fiscal setback is a red flag for the economy; the Fed can’t compensate entirely if the Federal government pulls back from supporting the economy.  At this point, the U.S. looks positioned to repeat the fiscal mistakes of the last recovery. 

If You Don’t Have Any Time This Morning

The Fed will do what it can to support the economy, but if fiscal policy stumbles, the Fed will have a hard time picking up the slack. And fiscal policy might be about to stumble badly.

Key Data

It’s All About Fiscal Policy Right Now

The second quarter GDP report was, as expected given the sudden stop of activity associated with efforts to contain the pandemic, quite dismal. GDP fell 9.5% during the quarter or 32.9% on an annualized basis, a bit better than market expectations of -34.1%. Consumer spending drove the decline which of course speaks to the nature of the specific shock of the shutdowns early in the quarter. The decline of nonresidential investment was consistent with that of the last recession; inventory reduction and residential investment extended the decline.

While consumer spending declined for the quarter overall, spending picked up sharply in May and June. This, along with inventory rebuilding and gains in housing (see this on lumber prices), helps set the stage for third quarter bounce in GDP growth. Still, gains will fall short of those needed for a complete recovery. Note the substantial gap, for example, of current levels of consumer spending relative to the pre-Covid trend. The inability to fully restart some sectors of the economy such as leisure and hospitality will put a lid on the near-term recovery and limit the extent any third quarter gains will be transmitted into the fourth quarter. The crucial issue is not so much that second quarter output collapsed; it’s really about where we end up at the end of the third quarter and how quickly the economy can grow from there. Until a widely available vaccine becomes available, we need to assume slow and choppy growth and a protracted period of high unemployment is the most likely path forward.

PCE inflation rebounded in May and June; annualized, core-PCE grew at a 2.5% rate in June while the year-over-year rate is 0.9%. The overwhelming expectation is that the last two months are something of an anomaly and that the ongoing recession will weigh on inflation for the foreseeable future. I think this has to be the baseline expectation; I also think we should watch for the possibility that income support helps ease the disinflationary pressures relative to those normal associated with protracted double-digit unemployment.

Initial unemployment claims have flatten out around 1.4-1.5 million while continuing claims edged higher ; the lack of improvement in these data suggest the economic recovery stalled out in July and argues for the importance of extending enhanced unemployment benefits.

Fedspeak

The FOMC concluded a two-day meeting last Wednesday; my full reaction is here. From the statement and the press conference, my main takeaways are:

1. The Fed knows that there is not a tradeoff between the economy and the virus.
2. The Fed very much wants continued fiscal support for the economy given the inability to contain the virus.
3. The Fed understands that they have limited near-term power to offset a fiscal retreat.
4. The Fed expects to keep interest rates low for years and don’t want you asking about when that’s going to change.

Minneapolis Federal Reserve President Neel Kashkari gave an interview to CBS news Sunday. Some interesting stuff here. For example:

KASHKARI: Well, the thing that surprised me the most economically, we knew the GDP would be very low with 20 million Americans still out of work, you know, the economy is reeling. There’s one bright spot that I saw, though. The US personal savings rate has taken off. Before the crisis, it was around 8%. Now it’s around 20%. Now, let me tell you what’s going on. Those of us who are fortunate enough to still have our jobs, we’re saving a lot more money because we’re not going to restaurants or movie theaters or vacations. That actually means we have a lot more resources as a country to support those who’ve been laid off. And so while historically we would worry about racking up too much debt, we’re generating this savings ourselves. That means Congress has the resources to support those who are most hurting.

Kashkari attributes the rise in the savings rate to spending collapse among those who did not lose their jobs. That savings, he argues can be funneled into safety net spending. I am clearly not the person who is going to argue against fiscal stimulus here, but I find this particular logic somewhat strained. I don’t think the savings rate necessarily justifies the fiscal spending in this manner; the fiscal spending drove up incomes and was a factor in driving up the savings rate. I see this as a reminder that we should be careful in assigning causality to accounting identities.

Kashkari also adds this:

And if you look over the long term, our inflation has been very low. Inflation continues to be low. Inflation expectations continue to drift lower.

I am kind of wondering where he is seeing inflation expectations drift lower; the survey measures have firmed up since the recession began. And we know that market-based TIPS measures have also firmed in recent weeks. I am not really worried about inflation, but I am still watching for signs like this that policy makers are so entrenched with the idea that inflation can’t be a problem that they kind of miss any inflationary signals.

Separately, Nick Timiraos at the Wall Street Journal writes that the Fed will soon make a substantial policy shift:

The Federal Reserve is preparing to effectively abandon its strategy of pre-emptively lifting interest rates to head off higher inflation, a practice it has followed for more than three decades.

Instead, Fed officials would take a more relaxed view by allowing for periods in which inflation would run slightly above the central bank’s 2% target, to make up for past episodes in which inflation ran below the target.

Remember, you heard it here first. From my Bloomberg column two weeks ago:

For the Federal Reserve, this time really is different. Having learned a hard lesson in the last recovery — don’t tighten monetary policy too early — the central bank is leaning in the opposite direction. In practice, that means the Fed will not just emphasize actual inflation over forecasted inflation, but will also attempt to push the inflate rate above its 2% target. It’s a whole new ballgame.

Upcoming Data

Employment week!

ISM manufacturing numbers for July arrive Monday; market participants expect it to edge higher to 53.6 from 52.6. In contrast, the ISM services number (Wednesday) is expected to retreat 57.1 in May to 55.0; there is a solid possibility that the decline might be more pronounced due to the rising number of Covid-19 cases.

Wednesday we also see the ADP report with an expected gain of 1,500k relative to 2.369k rise in June. This will potentially provide a preview of Friday’s employment report. Currently, Wall Street expects a continuation of recent trends with a 1.65 million gain in jobs and a decline of the unemployment rate from 11.1% to 10.5%. In contrast, high frequency Census data suggests a job loss, which would also be consistent with the ongoing high pace of initial jobless claims and slowing activity in the regions most heavily impacted by Covid-19.

Discussion

The focus of the week is fiscal policy. A key reason that the economic damage of the Covid-19 pandemic is less severe than the sharp drop in GDP would suggest is that Congress threw a bunch of money at the problem including a critical enhanced unemployment benefit of an additional $600 a week. With Senate Republicans flailing to respond to a House relief package passed months ago, the benefit expired last week. This is not good and, quite frankly I am surprised given that the GOP electoral prospects will not be helped by the ongoing delays.

The Wall Street Journal reports that Democrats have yet to budge on their demand that the $600 payment continues:

House Democrats led by Speaker Nancy Pelosi want any economic-relief package to include a long-term extension of the enhanced unemployment benefit, arguing the extra funds have been a critical support to those who lost their jobs amid the pandemic. The White House and Senate Republicans, however, want to trim that additional payment, saying in some cases people are being paid more to stay at home than if they returned to work.

House Leader Nancy Pelosi suggested tying the benefit to the unemployment rate such that it would decrease as the economy healed. Great idea; an automatic stabilizer would end the need to have this fight repeatedly. Democrats are also pushing for substantial state and local aid and a public health strategy to contain the virus.

Democrats are digging in their heals while Senate Leader Mitch McConnell has a challenge to move anything without their support. Via the New York Times:

But at least 20 Senate Republicans are unlikely to support any additional spending, party leaders have acknowledged, in part because of concerns over the level of spending and its effect on the national debt. Under a $1 trillion plan Republicans unveiled on Monday — a narrower proposal than the Democrats’ plan — a number of provisions, including the $600 weekly federal unemployment benefit, would be severely curtailed.

This seems like a very bad place for McConnell. The longer this continues, the worst will be the economic damage. The worse the economic damage, the more the White House will push for a deal, and the greater the pressure for McConnell to make deal that without the full support of Senate Republicans.

I don’t entirely know how this gets resolved in the near term. My instinct continues to be that the end result will be something with broad contours that look closer to the Democratic proposal than the $1 trillion that many Republican Senators have their hearts set on.

Bottom Line: Continued income replacement is crucial to sustaining the recovery. With the economy still producing a steady stream of job losses as indicated by initial jobless claims and still restrained by the ongoing pandemic, a failure to soon enact a new fiscal response would threaten the recovery. I still think, however, the longer this drags on, the larger the ultimate package will be.

The Federal Reserve reiterated its intention to “act as appropriate to support the economy” at the conclusion of this week’s policy meeting while worrying that resurgence of the virus threatens to derail the recovery. Federal Reserve Chair Jerome Powell emphasized the importance of fiscal policy in supporting the recovery, a not-thinly veiled hint that Congress (or, more specifically, Senate Republicans) need to get their act together. No new policy measures were announced although Powell did hint that the policy review would be complete by September. Overall, a dovish message. The Fed intends to maintain accommodative financial conditions for years.

The FOMC statement was little changed from June, with the most notable addition being:

The path of the economy will depend significantly on the course of the virus.

This is not exactly news for most of us, but the Fed felt it important to emphasize that there is no tradeoff between the economy and public health. Until the virus comes under control, the economy can’t full recovery. The Fed is especially concerned that a resurgent virus already worsens the outlook. From Powell’s opening statement:

Indeed, we have seen some signs in recent weeks that the increase in virus cases and the renewed measures to control it are starting to weigh on economic activity.

Powell reviewed the Fed’s actions to support the economy and highlighted the importance of fiscal policy in minimizing the extent to the recession:

Elected officials have the power to tax and spend and to make decisions about where we, as a society, should direct our collective resources. The fiscal policy actions that have been taken thus far have made a critical difference to families, businesses, and communities across the country. Even so, the current economic downturn is the most severe in our lifetimes. It will take a while to get back to the levels of economic activity and employment that prevailed at the beginning of this year, and it will take continued support from both monetary and fiscal policy to achieve that.

Powell commented heavily on fiscal policy, including praising the steps taken to date while making clear that the job is not done. It is hard to interpret Powell’s position as anything less than a rebuke to Senate Republicans who have positioned the U.S. economy to fall over a fiscal cliff despite months of warning. Powell could not be happy that he has to be the adult in the room; the Fed would prefer to stay out of fiscal policy. My suspicion is that he doesn’t think staying quiet is an option. Why? Because buried under Powell’s plead for more fiscal support was the implication that the Fed would be unable to compensate for a fiscal retreat. To be sure, in response to a reporter’s question Powell said the Fed has more tools available. Those tools, however, would not be sufficient to compensate for the fiscal cliff that lies ahead.

Powell said that meeting participants discussed the policy and strategy review and that they will “wrap up our deliberations in the near future.” That to me sounds like September. He did not give any hints as to the outcome of that process. He played his cards a little closer to his vest than I anticipated. We will need to wait until the Fed releases the meeting minutes to learn more about the discussion.

The overall message was dovish: Powell indicated that disinflationary pressures were likely to dominate for the foreseeable future, that the recovery would not happen quickly and hence unemployment would remain persistently high, and that people really need to stop asking him when they will consider raising rates. That question is so far from his mind that he can’t even begin to answer it.

Bottom Line: The Fed remains committed to accommodative policy. I expect that the Fed will conclude its policy review by September and then they will be free to take additional action. The three most obvious future actions are enhanced forward guidance, shifting asset purchases to the long-end of the yield curve, and yield curve control at the short end. Those would most likely occur prior to an expansion in the pace of asset purchases.

If You Don’t Have Any Time This Morning

It will be a busy week for data. The Fed will continue to paint a dovish picture of the economy. I am watching four other stories right now: Delayed fiscal policy, rising inflation expectations, a weaker dollar, and a potential leveling off of Covid-19 infections.

Bloomberg Opinion

My Bloomberg column last week:

The Federal Reserve has come around to the conclusion that inflation isn’t going to be a problem. So now it’s time to start wondering if inflation is going to be a problem. The Fed has a tendency to fight the last battle, which could lead policy makers to miss what may be the “Great Inflation” era.

Continued here.

Key Data

The U.S. housing market remains remarkably resilient. New single-family home sales rebounded to an annual rate of 776k, their highest level since 2007. Existing home sales continue to recover lost ground; I anticipated they will come closer to full recovery in the July numbers. Median sales price also rose and is 3.5% higher than a year ago.

The strength of housing appears inconsistent with a recession, but the pandemic comes at a time of structural strength for the sector. Aging millennials provide demand for housing after a long period of low levels of construction. Low mortgage rates create further incentive to buy. And those boomers you thought were ready to leave their homes and open up some supply? That’s going to be delayed again. Seriously, if you are 60 years old and watching the news, you probably think that retirement communities and nursing homes are basically death traps. To me, that argues for people working harder to stay in their own homes for longer.

Initial unemployment claims edged higher; continuing claims continue to fall slowly. Slower activity and renewed firm closures in the worst-hit pandemic regions will likely put some upward pressure on claims in the coming weeks. The labor market simply will not heal easily until the pandemic is contained.

The IHS Markit flash report for July improved to a six-month high but also indicated headwinds to growth from rising Covid-19 cases. The Eurozone version posted the strongest numbers in two years. Almost as if a credible response to the pandemic was important for the economy.

Fedspeak

Blackout week ahead of this week’s FOMC meeting, so thankfully we could all take a break.

Upcoming Data

Busy week ahead as the data flow picks back up. Monday we get durable goods orders with core orders excluding defense and air are expected to be up 2.3% in June. These numbers have held up better than expected given the depth of the downturn; stronger investment now would help mitigate some of the negative long-run impacts from this recession. Conference Board consumer confidence comes on Tuesday; it is expected that virus-pessimism drags down the number to 94.5 from 98.1 in June.

Wednesday is FOMC day plus press conference; no policy changes expected but the overall event will have a dovish feel. Also Wednesday is pending home sales for June. Watch for more signs of a V-shaped recovery in this sector.

Thursday will be exciting! Be ready for a historic collapse in the GDP numbers over the second quarter, expected to be down 34% on an annualized basis (block anyone who says output dropped by a third). We are all prepared for the worst so I am a little cautious that there is room for an upside surprise. Also on Thursday we get the usual initial claims report.

Friday brings the household spending and income numbers for June although we should have a pretty good idea of the outcome from the GDP report the previous day. Pay attention to the core-PCE numbers as all of our dovish Fed bets hinge on that staying weak. Likewise, we get the University of Michigan sentiment numbers for July. I am watching the inflation expectations numbers in particular.

Discussion

I discussed the Fed last week, and nothing much there has changed. The Fed is stuck between the emergency actions of this past spring and the next steps to bolster the recovery that will come later this year. The most likely outcome for this week is no policy change but a dovish tone to the statement and the press conference.

Aside from the Fed, there are four stories I am watching right now. The first is fiscal policy. The enhanced unemployment benefits – a critical lifeline for the economy – are coming to an end. Republicans in the Senate are rushing to cobble together their own package two months after the House Democrats passed theirs. I find this delay hard to believe given that with each passing day the Republicans look to be suffering more in the polls and this would have been an easy way to get ahead of at least the economic concerns. Instead, the Republicans look like they were hoping that if they didn’t do anything, the virus would just disappear on its own. In the very near-term, the delay could weigh on spending and consumer and investment sentiment. That said, the delay may have shifted the bargaining strength to the House Democrats; if so, the ultimate package will be larger.

A second area is inflation and inflation expectations. Interest rates on TIPS are down as investors look to secure protection from inflation. Or maybe not. Roberto Perli from Cornerstone Macroeconomics argues that this is not the case:

(4/4) As liquidity normalizes, the TIPS liquidity premium drops. This pushes TIPS yields down and spot breakevens up. There is no inflation story, just a liquidity story. pic.twitter.com/u3ocFeKDnH

— Roberto Perli (@R_Perli) July 24, 2020

The TIPS market is known for being less liquid; you have to expect you might have a hard time selling a position and thus would need to protection in the form of a lower price/higher rate. If liquidity in the market is now improving and you can more easily find a buyer, prices should rise and rates fall, but this is not about inflation expectations.

I wonder if we can so clearly separate liquidity conditions from inflation expectations. If I think that other investors are worried about inflation, then I might reasonably conclude that market conditions would improve. Likewise, if I think the tail risks of deflation have lessened, I might think there were more potential buyers. I have in my head the idea that a market for inflation protection would be more liquid if participants were actually worried about inflation (or at least no longer worried about deflation). Also, is you think the Fed will via financial repression hold nominal rates flat, you would think there would be a bias towards TIPS.

Regardless, narratives matter and the story around inflation is one worth watching. I have said before that inflation is not likely a problem given the size of the negative demand shock and, consistent with that observation, the rise of inflation expectations doesn’t yet approach a level that would be concerning from a policy perspective. But there is also room to rise between here and where there might be some policy implications. So I am just keeping an eye on these next few inflation numbers and how they might feed into this story.

A third and related story is the dollar, which looks to be vulnerable. As noted earlier, the Eurozone looks to be recovering from the Covid-19 shock more rapidly than the U.S. This coupled with a Fed looking to ease further is dollar negative, at least for now. And, as you know, once a narrative takes hold in currency markets, it can be sticky and trigger a big move. Which interestingly would put upward pressure on core inflation and thus create some interesting dynamics on that issue.

The final story is the possibility that Covid-19 infections in the U.S. are leveling off. This thread from Jens Nordvig of exante data is important:

Most likely, the US will now stay in an odd greyzone, with more stable, but still very elevated case growth into August. And each state will have to worry about importing cases from others states with bigger outbreaks (as domestic travel bans are unrealistic)

— Jens Nordvig (@jnordvig) July 24, 2020

Stabilization of Covid-19 cases would be good in that it might short-circuit more pessimistic scenarios of further shut-downs but bad in comparison to the Eurozone. That too could be on net dollar negative.

Bottom Line: Housing is a stand out sector, but can’t carry the U.S. economy all by itself. The inability of the U.S. to manage the pandemic leaves the economy struggling in absolute terms and relative to its peers. Delays in the next fiscal support picture negative in the very near term but might lead to a big package. Fed will stay dovish. 

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The pandemic will continue to weigh on the economy but ongoing fiscal support matched by Fed easing will

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help ease the pain and support markets.

Bloomberg Opinion

My Bloomberg column last week:

For the Federal Reserve, this time really is different. Having learned a hard lesson in the last recovery — don’t tighten monetary policy too early — the central bank is leaning in the opposite direction. In practice, that means the Fed will not just emphasize actual inflation over forecasted inflation, but will also attempt to push the inflate rate above its 2% target. It’s a whole new ballgame.

Continued here.

Key Data

June retail sales were above expectations and May numbers revised higher. Core sales (excluding gas, autos, food services, and building materials) are solidly above the pre-pandemic trend even though unemployment is in double digits. To me, this is pretty clear evidence that fiscal policy works. Put money in the hands of people who can and will spend it, and they spend it. Looking forward though, renewed shutdowns in states such as California and the general loss of confidence as Covid-19 numbers track higher calls into question the ability of the consumer to sustain this momentum going into the back half of the year. This likely accounts for the softening from 78.1 to 73.2 in the preliminary July release of University of Michigan consumer sentiment. Fiscal policy is crucial here; Congress needs to deliver a package that includes extending enhanced unemployment benefits.

Industrial production jumped 5.4% in June as the lockdowns eased, but remains 10.8% below last year’s levels. The nation’s car manufacturers are ramping up production to meet a rebound in demand. Remember though the initial gains will come most easily. Future gains will be slower.

One sector that looks to be having a real V-shaped recovery is housing. Housing starts continued to regain lost ground in June and homebuilder confidence in July to almost its pre-pandemic levels. Unlike the last two recessions, we didn’t head into this downturn with a substantial over-investment in any one sector of the economy such that it was impacting overall activity. If anything, the opposite was the case this time with housing still recovering from lost ground in the aftermath of the last recession while experiencing demographic-driven demand. Housing will provide some much-needed support for this recovery.

The story remains the same as far as initial unemployment claims are concerned. Progress has basically stopped with claims flatlining. Too many firms are realizing that they can’t either stay afloat or retain all their employees given the protracted period of time until the pandemic eases and life resumes to something approaching normal. The case for retaining enhanced unemployment benefits and a new round of PPP remains strong.

Consumer price inflation came in a bit above expectations; see my comments here.

Overall, the data continues to deliver something for everyone. There is enough bounce in the data to see the way forward, there is enough weakness in the data to justify pessimism about the sustainability of that path forward, and there is evidence that fiscal policy works and needs to be sustained.

Fedspeak

Chicago Federal Reserve President Charles Evans came out in support of allowing inflation to drift above 2% before tightening policy. Via Ann Saphir at Reuters:

“I am hard pressed to think of reasons why we would need to move away from accommodative monetary policy unless inflation was well above 2% for an extended period of time, and the economy was just very different from what we are seeing right now,” he said in a virtual event held by the Global Interdependence Center. “That doesn’t seem to be very likely.”

He follows comments by Federal Reserve Governor Lael Brainard arguing for holding policy steady until inflation reaches 2% in support of overshooting the inflation target:

With the policy rate constrained by the effective lower bound, forward guidance constitutes a vital way to provide the necessary accommodation. For instance, research suggests that refraining from liftoff until inflation reaches 2 percent could lead to some modest temporary overshooting, which would help offset the previous underperformance.

See my comments here for more on Brainard.

While the majority of the Fed is moving toward enhanced forward guidance, some are resisting. Via Greg Robb at MarketWatch:

In a separate interview with Yahoo Finance, New York Fed President John Williams suggested new forward guidance wasn’t needed in the short-term.

Right now, the Fed’s guidance language “is serving us well,” Williams said.

“So we do have some time to think about how we should evolve that guidance as we go forward,” he added.

Williams tends to be a lagging indicator on these sorts of things. Williams also commented on the lack of use of the Fed’s emergency lending facilities, via Reuters:

“This is in fact a measure of success — the existence of the facilities, even in a backstop role, has helped boost confidence to the point where borrowers are able to access credit from the private market at affordable rates,” he said.

The Financial Times also reports on the limited use of the Fed’s programs and notes that it is reducing investor expectations for the growth of the balance sheet. The much-anticipated Main Street Lending program has been a dud. Personally, this is as I expected. This isn’t the Fed’s job and they don’t have any experience in it. Nick Timiraos and Kate Davidson at the Wall Street Journal write that U.S. Treasury officials also worked to limit the attractiveness of the program:

Fed officials generally favored easier terms that would increase the risk of the government losing money, while Treasury officials preferred a more conservative approach, people familiar with the process said.

While Treasury didn’t make the Fed’s job any easier, I think there is a more fundamental problem. Firms with operations that can survive the pandemic are probably both solvent and do not face a liquidity constraint from tight credit. They are already getting the financing they need. Firms that cannot survive the pandemic are insolvent and if you want to sustain them, they need a grant (like what U.S. Treasury Secretary is arguing for PPP loans less than $150,000; see the Wall Street Journal), not a loan, even a long-term, low-interest loan. It’s still a weight on their future profitability and enhances the risk of business failure after the pandemic is over. I suspect the space in-between, firms that both can’t get financing now but are fundamentally solvent and can afford to pay back the loan after the pandemic, is fairly small. Federal Reserve. Chair Jerome Powell though thinks I could be wrong. Via Reuters:

Fed Chair Jerome Powell has said he expects the Main Street Lending Program to come in handy in the fall, when more companies may be financially stressed enough to need to tap it.

Time will tell.

Upcoming Data

Only a handful of major data releases this week. Tuesday we have existing home sales, expected to be 4.86 million for June compared to 3.91 million the previous month. More housing data will come Friday with new home sales for June, 700k expected versus 676k in May. See comments on housing above; this sector has shown remarkable resiliency to date. Thursday we get the usual unemployment claims data. Market participants are looking for initial claims to remain flat at 1.3 million; obviously a substantially lower number would be a ray of sunshine on the bleak labor landscape but such an outcome seems unlikely.

Discussion

The Fed is moving past the emergency response phase of this recession and into the supporting/accelerating the recovery phase. They will continue to fiddle with the lending programs, but I suspect the take-up of those programs won’t accelerate greatly unless the Fed drops interest rate to zero and extends the repayment horizon to 10 or 20 years. I am thinking the Fed will lose interest in the programs sooner or later and adopt William’s position that the lack of use reflects sufficient credit availability. In other words, the Fed did its job saving the financial system; anything else is just a bonus.

It is fairly evident that the Fed is thinking about what comes next. I continue to anticipate the following themes:

1. Deflationary forces dominate the landscape, so there is no reason to think about raising interest rates.
2. No, really, we aren’t thinking about raising rates.
3. Because we know you probably won’t believe us as soon as the economy looks a little better, we are going to have to lock down your expectations with more aggressive forward guidance.
4. And, because we kind of screwed up in the last expansion, this time we are not going to pull back on accommodative policy until inflation is actually at 2% and we can be sure we are going to overshoot.
5. Overshooting though isn’t part of our policy set yet, but we have been reviewing our strategy and procedures (nudge, nudge, wink, wink).
6. If unemployment stays high, we are going to have to do something else, probably yield curve control but not everyone is on board with that yet.

The obvious implication is that interest rates will remain close to zero at the short and medium end of the curve and held down at the longer end. This is going to stress a lot of people out because “interest rates and stocks are telling different stories.” Seriously, like rates haven’t been falling since the mid-80’s while stocks rose? Rates are structurally low now. They don’t need to rise to confirm the gain in equities. Remember what happened in 2018 after the Fed got it into its head they it could raise rates to something closer to “normal.” They had to reverse course.

Another thing to watch for are claims that the Fed is pushing on a string with regards to inflation. I get that story. After all, the Fed didn’t get to 2% in the last cycle, why would we believe them now? And, well, you know, Japan. A couple of responses: During the last cycle, the Fed didn’t really have a strategy for getting to 2% on a sustained basis because they were trying to come in from below, particularly early in the cycle. In effect, the Fed sabotaged itself with excessively tight policy because they were trying to hit exactly 2% not an average of 2%. This was compounded by an adherence to a Phillips curve framework despite persistently low inflation. The Fed is trying to remedy both errors.

Also important is the Fed is sending a signal that they won’t automatically offset fiscal policy. They need to see actual not forecasted inflation. The Fed not getting in the way of expansionary fiscal policy should support inflation, assuming Congress keeps up a rapid pace of deficit spending.

Bottom Line: The virus is dictating the agenda. Until we can control Covid-19, the recovery overall will struggle even if some sectors like housing look promising. We have the fiscal capacity to ease the pain, and will probably continue to use it. The Fed is looking more toward the future and seeing an array of options to support and accelerate the recovery.

Consumer price inflation came in higher than expected in June. Headline prices rose 0.6% (expected 0.5%) on the back of a sharp 12.3% rise in gasoline prices but also a 0.6% gain in food costs. Still, even after excluding food and energy, core prices rose 0.2% (expected 0.1%). That said, one month does not make a trend. It is a challenge to expect strong inflationary pressures to emerge given the weak economic environment. The Fed should be free to maintain a very accommodative policy stance. Federal Reserve Governor Lael Brainard indicated the Fed is heading toward even easier policy and gave a strong signal that yield curve control was coming.

Core CPI snapped back to a 2.6% annualized pace in June as activity across the nation picked up:

Shelter inflation, typically a source of cyclical pressure, remained weak:

Outside of shelter, food, and energy, prices were firmer:

As I wrote yesterday, one upside inflation surprise isn’t very interesting. Given the general economic weakness and high levels of unemployment, the outlook screams “disinflation.” That’s the baseline expectation. Still, it is always worth thinking about a counter-intuitive position. To get to an inflationary outlook, I think you have to expect considerably longer support for incomes such as that in the first half of the year coupled with the negative supply shock delivered by the virus. Basically, a story in which we have finally delivered enough fiscal stimulus to generate some upward pressure on prices given that a nontrivial fraction of what we would normally be spending on has been shuttered or we are avoiding for safety concerns. Again, not my baseline, but I am always on the lookout for changing dynamics when we all finally agree to some conclusion. When and if inflation ever does become interesting again, I am confident that we will first spend 5 years denying that it is interesting.

Federal Reserve Governor Lael Brainard presented a rather sobering outlook for the U.S. economy anticipating that conditions will be sufficiently weak to generate years of below-target inflation. What does that mean for policy? She provides a roadmap:

Looking ahead, it will be important for monetary policy to pivot from stabilization to accommodation by supporting a full recovery in employment and returning inflation to its 2 percent objective on a sustained basis. As we move to the next phase of monetary policy, we will be guided not only by the exigencies of the COVID crisis, but also by our evolving understanding of the key longer-run features of the economy, so as to avoid the premature withdrawal of necessary support.

In other words, the Fed learned from the last expansion that they shouldn’t rush to tighten policy. Notably, the Fed need to avoid a deterioration of inflation expectations:

Because the long-run neutral rate of interest is quite low by historical standards, there is less room to cut the policy rate in order to cushion the economy from COVID and other shocks. The likelihood that the policy rate is at the lower bound more frequently risks eroding expected and actual inflation, which could further compress the room to cut nominal interest rates in a downward spiral.

Remember when we used to worry about inflation expectations becoming unanchored to the upside? Good times. Brainard argues that the Fed should ignore past estimates of the Phillips curve and make the pre-pandemic labor market the Fed’s policy objective:

With underlying inflation running below 2 percent for many years and COVID contributing to a further decline, it is important that monetary policy support inflation expectations that are consistent with inflation centered on 2 percent over time. And with inflation exhibiting low sensitivity to labor market tightness, policy should not preemptively withdraw support based on a historically steeper Phillips curve that is not currently in evidence. Instead, policy should seek to achieve employment outcomes with the kind of breadth and depth that were only achieved late in the previous recovery.

What tools does the Fed have to work with? Brainard goes first to the obvious two:

With the policy rate constrained by the effective lower bound, forward guidance constitutes a vital way to provide the necessary accommodation. For instance, research suggests that refraining from liftoff until inflation reaches 2 percent could lead to some modest temporary overshooting, which would help offset the previous underperformance. Balance sheet policies can help extend accommodation by more directly influencing the interest rates that are relevant for household and business borrowing and investment.

Note how she presents the inflation goal. The goals is to fall behind the curve and not act until actual inflation reaches two percent on a sustainable basis. That is very different than the Fed’s strategy of the last recovery. Then the Fed tightened on the basis of the inflation forecast. Now Brainard is looking to set policy on inflation outcomes. By doing that, policy lags will ensure the Fed creates above target inflation. She then gives a nod toward average inflation targeting by calling for a make-up strategy that offsets past inflation shortfalls.

Then she opens the door further for yield curve control:

Forward guidance and asset purchases were road-tested in the previous crisis, so there is a high degree of familiarity with their use. Given the downside risks to the outlook, there may come a time when it is helpful to reinforce the credibility of forward guidance and lessen the burden on the balance sheet with the addition of targets on the short-to-medium end of the yield curve.

The logic is essentially how I outlined the situation last week. The Fed will feel pressure to do more without expanding the balance sheet further. That leaves yield curve control as the next likely path forward. They have to talk it out first:

Given the lack of familiarity with front-end yield curve targets in the United States, such an approach would likely come into focus only after additional analysis and discussion.

Bottom Line: Don’t fret about the inflation number. It’s not yet a trend and telling a story of how it becomes a trend feels a bit forced even if interesting to think about. The Fed will soon be turning its attention on what more it can do. Eventually it will get to yield curve control.

Correction: In yesterday’s post, I incorrectly stated market expectations for today’s CPI report and instead used last month’s actual. Sorry for any confusion.

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economy. We might not get the rapid recovery we were hoping for months ago, but a recovery nonetheless.

Key Data

The ISM non-manufacturing numbers bounced back in June. I wouldn’t want to read too much into this yet; it simply should be the case that activity picked up across the economy as the first round of shutdowns ended. This is a diffusion index; improving business conditions from a very low level can be easy to accomplish in this circumstance but doesn’t necessarily signal the momentum needed to support rapid recovery. More importantly, the employment component remains under 50, indicating weak labor demand. Business might be up, but not enough to promote much needed job growth. That said, the numbers are all in the right direction.

Hiring spiked in the JOLTs report for May. This isn’t exactly news as the employment report revealed a surrise jump that month as firms rehired workers separated in the early stages of the pandemic. Attention is better placed on the level of job openings. Though still much higher than the lows of the last recession, the declines indicate caution on the part of firms. Also, the level of quits might be the most telling indicator here on the state of the labor market. Employees are wisely choosing not to leave their jobs, likely fearing it will be difficult to find another.

Initial unemployment claims and continuing claims remain stubbornly high. The second and third order impacts of the initial shutdown continue to force additional layoffs at a rate that exceeds the worst of the last recession. The need for ongoing enhanced unemployment benefits seems pretty clear here. It’s hard to throw people into a labor market where jobs continue to dry up, particularly if very sector specific weakness remains that prevents people from returning to their previous positions.

Fedspeak

In a Financial Times interview, Atlanta Federal Reserve President Raphael Bostic worries that the surge in Covid-19 cases will weigh on the recovery:

“There are a couple of things that we are seeing and some of them are troubling and might suggest that the trajectory of this recovery is going to be a bit bumpier than it might otherwise,” Mr Bostic said. “And so we’re watching this very closely, trying to understand exactly what’s happening.”

He correctly noted that more fiscal stimulus is needed. The original packages did not anticipate the crisis dragging past the summer as it most obviously will. Bostic is apparently cool on enhanced forward guidance:

“I think a lot of it depends on where we are. I do think that talking about the benchmarks that we’re looking at is an important thing,” he said.

“But I do worry that circumstances are going to be very different in the future than they are now and so I want to be careful about being too presumptuous about where we’re going to be. All this uncertainty is definitely in my mind”.

I am not entirely sure what he means, but it sounds like he is worried about committing the Fed to any particular policy path given the uncertainty. This quote sounds a bit wishy-washy to me. I don’t think the point of enhanced forward guidance is to presume where you are going to be. It is that you don’t know where you are going to be but you know where you want to go.

Dallas Federal Reserve President Robert Kaplan wants to strike at the heart of the problem. Via Reuters:

“How the virus proceeds, and what the incidence is, is going to be directly related to how fast we grow,” Kaplan told Fox Business Network in an interview. “While monetary and fiscal policy have a key role to play, the primary economic policy from here is broad mask wearing and good execution of these health care protocols; if we do that well, we’ll grow faster.”

It’s good to have the Federal Reserve authority from Texas reinforcing this message. Kaplan’s correct; monetary and fiscal policy will only take you so far. What the economy real needs is a public health solution to the virus.

San Francisco Federal Reserve President Mary Daly worries that unemployment will remain unacceptably high. Via MarketWatch:

“We don’t know how long it will fully take to put the virus behind us,” she said in a virtual chat held by the National Association of Business Economists. “I am assuming [unemployment] will level off at someplace we don’t want to be.”

What does this means for Fed policy? Richmond Federal Reserve President Thomas Barkin speaks the truth:

Asked if the Fed will have to do even more to help the economy, Barkin said: “Unemployment is 11%, so yes.”

Right now, any plausible scenario includes the Fed under continued pressure to do more.

Daly added that she is closely watching the possibility of nonperforming loans in the banking sector. That topic was also taken up by Federal Reserve Governor Randal Quarles. He sounded optimistic about the stability of the banking system:

Less than two weeks ago, we at the Federal Reserve concluded that our banks would generally remain well capitalized under a range of extremely harsh hypothetical downside scenarios stemming from the COVID event. Even with that demonstrated strength, however—given the high levels of uncertainty—we took a number of prudent steps to help conserve the capital in the banking system.

But he isn’t ready to take a breath of relief:

We know that the financial system will face more challenges. The corporate sector entered the crisis with high levels of debt and has necessarily borrowed more during the event. And many households are facing bleak employment prospects. The next phase will inevitably involve an increase in non-performing loans and provisions as demand falls and some borrowers fail.

This is obviously a space we should all keep an eye on – how well can the post-GFC financial system weather a series of bankruptcies?

Upcoming Data

The data flow picks up again this week. Tuesday we get the consumer price index for June; Wall Street anticipates that both headline and core decline by 0.1%. Fed officials also think that deflation will be the challenge going forward; obviously negative prints would reinforce their resolve to maintain accommodative policy. A surprise positive print would be ignored; a series of positive prints would be more interesting but very unlikely. Wednesday brings the industrial production report for June, which is expected to show the sector gained 1.4% as the reopening continued.

Thursday is a big day. We get the usual jobless claims data; the story there has been one of a very slow decline that is not consistent with a rapid recovery. June retail sales, however, are expect to explode 17.7% higher as consumers continue to make up the ground lost earlier in the year. How much that sticks in July now that Covid-19 cases are on the rise is a big question. We also get the NAHB home builder’s index for July which will be followed by the June housing starts (1.17 million expected) and building permits (1.28 million expected) data on Friday. The housing market has shown considerable resilience; continued strength in the sector would mean the economy would be on firmer footing to rebound when the pandemic eases. The preliminary Michigan Consumer Sentiment number also comes on Friday.

Watch also for the latest Beige Book on Wednesday; it is sure to be depressing. More interesting though will be a speech by Federal Reserve Governor Lael Brainard titled “Economic and Monetary Policy Outlook.” Sounds relevant.

Discussion

As we move deeper into the second half of the year, we face three big questions. To what extent does the renewed surge in Covid-19 cases slow the economic recovery from the first-wave of shutdowns? How much fiscal stimulus will Congress deliver? What will the Fed do to support the recovery?

There are no easy answers to the first question. Virus numbers are surging across the south and west, but will we see a return to stay-at-home orders or more modest interventions? My instinct is that we will see a mixed strategy of wearing masks coupled with sector specific shutdown such as the closure of bars in Texas, capacity reductions for restaurants, and the shutting of fitness centers. With continued fiscal support though, the economy could weather such a storm. To be sure, growth will be slower than desirable in the near-term, but longer-term growth requires controlling the virus.

How much would this impact Wall Street? In the category of “things that will make people unhappy,” leisure and hospitality is the icing on the cake in the economy. Even though the sector has grown in importance in recent years, it’s valued added was only 4.2% of GDP going into the crisis. The economy can transition away from a shock to this sector. The key is not to allow that transition to translate into cascading shocks to the financial system like occurred after the burst of the housing bubble (see Daly and Quarles above). That’s where fiscal and monetary policy can continue to help. Barring such a major meltdown, I suspect the rally on Wall Street can survive without keeping the bars open.

Given the deteriorating conditions in some states and resulting political impact to Republicans, my expectation is that we see a fiscal support package in excess of the $1 trillion max the White House wants but less than the $3 trillion passed by the House. A key element of any package is that some form of enhanced unemployment benefits will continue, although not with the $600 weekly add-on as before. Via CNBC:

Mnuchin said the White House wants to change rather than extend the enhanced unemployment provision. He did not give details on how it would want to structure aid to unemployed workers.

“You can assume that it will be no more than 100%” of a worker’s usual pay, Mnuchin said. He echoed Republicans who argue the generous insurance deters some people from resuming work because they make more at home than they otherwise would at their jobs.

This is a glass half full sort of situation. Realistically, the full additional $600 a week wasn’t going to last forever. From a market perspective though, a continuation of benefits at 100% for many workers would be supportive. More generally though, if you believe conditions will rapidly deteriorate in (formerly?) Republican strongholds in the next two weeks, I think you should expect the final numbers on the next pandemic response bill to climb higher. Yes, I understand this has the unpleasant implication that a worsening Covid-19 situation is a market positive.

The Fed will continue to lean toward easier policy; see Barkin above. With unemployment expected to remain high and inflation low, the Fed will be under enormous pressure to take further action. I expect that first in the form of enhanced forward guidance and then eventually yield curve control. See what I wrote last week.

There has been some notion of late that the Fed is deliberately moving in the opposite direction by withdrawing stimulus. This idea has gained some traction because the balance sheet has contracted a bit as the repo operations have fallen to zero. I don’t think you should interpret this as an intentional reduction of support by the Fed. It simply reflects better market functioning and more excess reserves such that the repo operations are no longer needed.

Three further points. First, the relationship between the Fed balance sheet and equity prices is murky at best. To the extent that the relationship appears, it is spurious. So I wouldn’t bet that a reduction in the Fed balance sheet resulted in a sustained decrease in stock prices. We already did that experiment. Second, the Fed already committed to sustaining the current pace of asset purchases:

To support the flow of credit to households and businesses, over coming months the Federal Reserve will increase its holdings of Treasury securities and agency residential and commercial mortgage-backed securities at least at the current pace to sustain smooth market functioning, thereby fostering effective transmission of monetary policy to broader financial conditions.

Third, realistically if market conditions deteriorate, the Fed will accelerate asset purchases if they feel necessary. Which altogether gets to the old story of “don’t fight the Fed.”

Bottom Line: If I am cautious going forward, it’s because I am worried that rising Covid-19 cases could turn market sentiment negative. I also worry that another shutdown risks cascading problems in the financial sector. I weigh those concerns, however, against my expectation that the next round of shutdowns will be more limited to sectors that are a fairly small part of the economy, that we will thus not see the general collapse in spending as we saw in the initial phase of the crisis, that we will likely get sufficient fiscal stimulus to limp along at worst, and the Fed will continue its efforts to support the recovery.