Tim Duy's Fed Watch

“Inflation Weakness Is Temporary”

Federal Reserve Chair Janet Yellen made clear two things this week. First, that her and her colleagues are somewhat confounded by the inflation data. And second, that confusion does not yet deter them from their plan for gradual rate hikes. December is still on.

Continued in newsletter form here...

Dueling Federal Reserve Presidents

The battle over that final rate hike of 2017 continues as some policymakers find it increasingly difficult to ignore weak inflation numbers in recent months. Such concerns, however, do not appear likely to take center stage in December. Indeed, the Fed looks fairly committed to a rate hike at that meeting. But the consensus on that meeting and beyond is being held together by forecasts of a rebound of inflation next year. It will be hard to maintain that consensus if inflation numbers don’t soon give more hope to those forecasts.

Continued here in new, experimental newsletter format...

Has The Fed Abandoned Its Reaction Function?

The immediate policy outcomes of the FOMC meeting were largely as expected. Central bankers left interest rates unchanged while announcing that the reduction of the balance sheet will begin in October as earlier outlined in June. The real action was in the Summary of Economic Projections. Policymakers continue to anticipate one more rate hike this year and three next. This policy stance looks inconsistent with the downward revisions to projections of inflation and the neutral rate; under the Fed’s earlier reaction function, the combination of the two would drive down rate projections. Arguably, policy is thus no longer as data dependent as the Fed would like us to believe. That or the reaction function has changed.

Continued here in new, experimental newsletter format...

Fed Would Surprise Markets If It Stays Hawkish

The Federal Reserve meeting this week will likely end with unchanged policy rates and the initiation of balance-sheet normalization. Market participants widely expect these outcomes, so they will come as no surprise. The real action in this meeting will come from the Fed’s description of the economy, the quarterly economic projections and Chair Janet Yellen’s press conference. The totality of the commentary should lean dovish as the Fed expresses concerns about the inflation outlook. The surprise would be a Fed that still leans more heavily toward the hawkish side of policy spectrum.

Continued at Bloomberg Prophets....

Fed May Have Too Much Faith in Inflation Forecasts

Despite a low unemployment rate, inflation slowed this year, confounding central bankers who set in motion a tightening cycle on the expectation of firming prices. This leaves the Federal Reserve stuck in a quandary. Either transitory factors restrain inflation only temporarily, or perhaps expectations sink below the Fed’s 2 percent target.

If the former, the central bank can continue along the current path of gradual rate hikes. The majority of monetary policy makers lean in this direction. But if the latter, sticking to the current plan risks excessive slowing and even recession. It is the type of policy mistake we should fear in the mature stages of a business cycle...

Continued at Bloomberg Prophets...

Fed Round-Up For September 7, 2017

Federal Reserve hawks were on the march today, laying the groundwork for an additional rate hike this year despite weak inflation. 

First off, Cleveland Federal Reserve President Loretta Mester (voter next year), reiterated the "it's only temporary story" regarding inflation:

In assessing where we are relative to the inflation goal, it’s always a good idea to look through temporary movements in the numbers, both those above and those below our goal, and focus on where inflation is going on a sustained basis. For example, when assessing the underlying trend in inflation, we should look through a temporary increase in gasoline prices stemming from disruptions caused by Hurricane Harvey. Similarly, some of the weakness in recent inflation reports reflects special factors, like the drop in the prices of prescription drugs and cell phone service plans earlier in the year. It may take a couple more months for these factors to work themselves through, but these types of price declines aren’t signaling a general downward trend in consumer prices from weak demand. Instead, they reflect supply-side factors and relative price changes.

She did give a nod to Federal Reserve Governor Lael Brainard's argument that maybe trend inflation has fallen:

At the same time, we need to recognize that weak inflation numbers, no matter what the source, can become a problem if they start to undermine the public’s expectations about future inflation. If inflation expectations were to become unanchored and began steadily declining, it would be much more difficult to raise inflation back to the Fed’s goal.

But she doesn't buy it:

I don’t expect the economy to get to that point, and my current assessment is that inflation will remain below our goal for somewhat longer but that the conditions remain in place for inflation to gradually return over the next year or so to our symmetric goal of 2 percent on a sustained basis. These conditions include growth that’s expected to be at or slightly above trend, continued strength in the labor market, and reasonably stable inflation expectations.

On the inflation forecast, this is interesting:

We need to recognize that there are risks around any inflation projection—both upside risks, considering the current and future expected strength in labor markets, and downside risks, given the softness in recent inflation readings. In fact, inflation is difficult to forecast: based on historical forecast errors over the past 20 years, the 70 percent confidence range for forecasts of PCE inflation one year ahead is plus or minus 1 percentage point, and a significant portion of the variation in inflation rates comes from idiosyncratic factors that can’t be forecasted. Indeed, since the 1990s, assuming that inflation will return to 2 percent over the next one to two years has been one of the most accurate forecasts. In the recent period, this is perhaps a testament to the importance of well-anchored inflation expectations and of the FOMC’s commitment to its 2 percent symmetric inflation goal. In any case, I will be scrutinizing incoming data on inflation and inflation expectations and the reports from my business contacts to help me assess the inflation outlook.

Since 1990, a 2 percent forecast has worked more than not, so lets just stick with that as the baseline for policy? By that logic, since the great recession, a 1.75% forecast has worked more than not, a testament to the Fed's one-sided inflation target and falling inflation expectations. I am not buying into her inflation forecast story yet.

Regardless, Mester's commitment to the faith on the inflation forecast means that as of now, she is probably sticking with the current rate path, including a December hike.

Meanwhile, FOMC heavyweight New York Federal Reserve William Dudley stuck to his guns as well tonight. His basic outlook:

Overall, the economy remains on a trajectory of slightly above-trend growth, which is gradually tightening the U.S. labor market.  Over time, this should support a rise in wage growth.  When combined with a firmer import price trend—partly reflecting recent depreciation of the dollar—and the fading of effects from a number of temporary, idiosyncratic factors, that causes me to expect inflation will rise and stabilize around the FOMC’s 2 percent objective over the medium term.  In response, the Fed will likely continue to remove monetary policy accommodation gradually.  But, the upward trajectory of the policy rate path should continue to be shallow, in part because the level of short-term interest rates consistent with keeping the economy on a sustainable long-run growth path is likely to be considerably lower than it was in prior business cycles. 

Dudley, however, will continue watching the inflation numbers, looking for this story:

If it turns out that structural changes have played a significant role, I would generally view this as a positive, rather than negative, development.  It would imply that the U.S. economy could operate at a higher level of labor resource utilization without generating a troublesome large rise in inflation.  More people could be put to work on a sustainable basis, enabling them to gain opportunities not just to earn greater income, but also to develop their skills and grow their human capital.

This opens up a downward revision of estimates of the natural rate of unemployment. Still, he thinks the Fed should continue hiking rates, in part due to easing financial conditions:

This judgment is supported by the fact that financial conditions have eased, rather than tightened, even as the Fed has raised its short-term interest rate target range by 75 basis points since last December. 

Yep, this is an expected response from Dudley. So is his pushback on inflation concerns:

 In addition, the long and variable lags between monetary policy adjustments and their impact on the economy imply that the FOMC may need to remove accommodation even when inflation is below its goal.  In particular, if the unemployment rate were already below its longer-run natural rate, as may be the case currently, the impact on wage growth and price inflation would still likely take some time to become evident. 

But, OMG, he follows up with this:

This would be particularly true if inflation expectations were well-anchored at or slightly below our 2 percent objective, as is the case currently. 

Brainard strikes again! But notice that HE SEES IT AS MORE LIKELY THAT INFLATION EXPECTATIONS ARE BELOW THAN ABOVE TARGET! One would think this would give him a bit more concern before pushing forward with more rate hikes, but no.

Fundamentally, Dudley wants to keep hiking as long as financial conditions keep easing. 

That's enough on Fed speakers for now. Time to return to yesterday's topic of new Fed appointees. This from Bloomberg:

The White House is considering at least a half-dozen candidates to be the next head of the Federal Reserve, including economists, executives with banking experience and other business people, according to three people familiar with the matter.

The breadth of the search goes against the narrative that has taken hold in Washington and on Wall Street that the Fed chair nomination is a two-horse race between National Economic Council Director Gary Cohn and current Fed Chair Janet Yellen, whose term expires in February.

Some of the other possible contenders include former Fed Governor Kevin Warsh, Columbia University economist Glenn Hubbard and Stanford University professor John Taylor, one of the people familiar said. Lawrence Lindsey, a former economic adviser to President George W. Bush, has been discussed. Former US Bancorp CEO Richard Davis and John Allison, the former CEO of BB&T Corp., have also been considered.

This doesn't sound good for Yellen. Sounds like a wide-open field that will keep us guessing for weeks. 

Separately, on the data front, we get this from Commerce, via Reuters:

The U.S. economy probably grew faster than reported in the second quarter, with data on Thursday suggesting stronger consumer spending than previously estimated. 

The quarterly services survey, or QSS, from the Commerce Department implied consumer spending increased more briskly than the 3.3 percent annualized rate reported last week in its second estimate of gross domestic product.

The Fed forecasts are based on more modest growth numbers. Stronger growth numbers will tilt them toward further rate hikes.

On the other hand, the anecdotal evidence via the Beige Book was less optimistic. In that read of the economy, activity was only modest to moderate with limited wage and inflation pressures. That said, I tend to believe that data trumps anecdotal evidence when it comes to policy.

Bottom Line: Hawks are still pushing for additional rate hikes, holding to the story that low inflation is all about transitory factors. This I think remains the dominant position on the FOMC. For what its worth, market participants do not believe this is how it will play out. The odds of a December rate hike are now hovering around 25%. Markets participants are not seeing the same story as most central bankers. Something's gotta give.

The Times They Are A-Changin'

The Federal Reserve is now destined to get a dramatic makeover in the next few months. That is assuming that the Trump administration carves some time out of their busy schedule of managing chaos to nominate more governors. And the Senate finds the time to confirm those nominations.

Until the time the administration and Senate get their acts together, the balance of power at the Federal Reserve will shift to the regional presidents. And that could put monetary policy on a less certain course over the next year as doves on the FOMC are replaced with hawks and the Board lacks sufficient person-power to hold a steady line.

The Board of Governors of the Federal Reserve is supposed to have seven members. At the beginning of the Trump era, two spots were open. Then former Governor Daniel Tarullo resigned. That left four members and three openings.

Today we learned that Vice Chair Stanley Fischer will soon depart, on or around October 13 of this year. The stated explanation for his departure is "personal reasons." I fear this means a serious health issue. If so, my thoughts and prayers go out to him and his family.

That leaves three members and four openings. To give a sense of what this means operationally for the Fed, take a gander at the Board Committee assignments:

Federal Reserve Governor Lael Brainard is serving on SEVEN committees! Federal Reserve Governor Jerome Powell is on FIVE. You might think he is slacking, but he is the chair of those committees. Fischer currently has four assignments. Unless we get some new governors soon, Brainard and Powell will have to step it up a bit more to cover for him. I am thinking they are overworked. Just a bit.

Hats off to Brainard and Powell. Committee work is some of my least favorite work. 

Who am I kidding? It is my least favorite work.

So now we are down to three governors and five regional presidents on the FOMC. At least in theory, this means the regional presidents can roll the governors on policy votes. Which means I have to start taking the presidents a little more seriously. Because in all honestly when the Board is fully staffed, that is where the power resides. And there is only so much time in the day to read speeches. The presidents talk a lot (but will the come speak at my events in Portland, a little hop from San Francisco - noooo), the governors too little.

Moreover, the Board generally offers a certain consistency of thought across years, whereas the regional presidents on the FOMC rotate. So next year, for example, the torch will pass from the dovish Minneapolis and Chicago Presidents Neal Kashkari and Charles Evans to the more hawkish San Francisco and Cleveland Presidents John Williams and Loretta Mester. Also added will be the still-to-be-announced Richmond Federal Reserve President, a hawkish spot in recent years.

The tide might turn on the hawks this year though, as it is easy to tell a story where Chair Yellen, Powell, Philadelphia President Patrick Harker, and New York President William Dudley all support a December rate hike while Brainard, Kashkari, Evans, and Dallas President Robert Kaplan oppose. What fun would that meeting be?

Of course, Randy Quarles is waiting in the wings for Senate confirmation, so perhaps he would tip the balance to the hawkish side. Marvin Goodfriend is rumored for another open position, but has yet to be nominated (I can see both hawk and dove in his record, but I am thinking he will lean hawkish). So it may be that by the beginning of the year the voting power will tip back to the Board, backed by a fairly hawkish rotation of presidents. So if the doves want to take a longer pause before hiking rates again, they need to ensure Yellen is on their side going into the end of the year.

Speaking of Yellen, a decision on the Chair will soon need to be made. Yellen term expires in February of next year. Trump has toyed with the financial press by claiming she is in the running. I hope this is true, but Trump appears more interested in wiping the slate clean of Obama appointees than anything else. And she would be the pro-regulatory fly in the ointment, opposing Trump's preferred deregulatory agenda. So I can't get on board the Yellen train just yet.

White House economic advisor Gary Cohn had been thought to be in the front-running for the spot, but the latest word is that he tanked that opportunity with his frank (but belated) criticism of Trump's handling of the Charlotsville incident. What a way to go - catching it on one end for not speaking out soon enough and then, after already having lost that battle, grows a conscience and then catches it on the other end. Long story short, the White House is scrambling for a new name - and now need to get a replacement for Fischer (who could have stayed after his term as Vice Chair ended).

The Washington Post is reporting that Powell could be up for the job. That would be a good pick in my opinion. Former Governor Keven Warsh is also reportedly in the running. He has something few can match: Trump's childhood friend Ron Lauder is Warsh's father-in-law. It's not what you know, it's who you know. My feelings about Warsh are not warm. 

Also, to add a bit more excitement into the mix, Yellen can stay on as Governor even if she is not the chair. Would she stay? Maybe not. Maybe. No chair has stayed since Mariner Eccles. Maybe it is a good time for one to stick around a few more years.

Bottom Line: Phew. I think that is the current state of play.  Many potentially significant changes happening at the Fed over the next several months, and it is hard to predict how it will all end. All we know for now is  a reported debt-ceiling deal removes the final potential obstacle to balance sheet reduction this month. That first step of unwinding the quantitative easing of the crisis years has wide support at the Fed; central bankers would like to get it underway before leadership changes begin in earnest.

Can She Do It Again?

In the fall of 2015, Federal Reserve Governor Lael Brainard began building the intellectual framework to slow the pace of rate increases. Not soon enough to stop the rate hike of December that year, but the rest of the Fed soon fell in line, and the projected four rate hikes in 2016 became only one actual hike, a hike delayed until December of 2016.

Can she shift the focus of the FOMC again? She made a valiant effort today. But will her colleagues get on board as they did last time?  A key issue: he doesn't have the downtrend in the economy and financial markets of 2016 to back her up.

 Brainard begins by acknowledging the problem facing the Federal Reserve:

The labor market continues to bring more Americans off the sidelines and into productive employment, which is a very welcome development. Nonetheless, there is a notable disconnect between signs that the economy is in the neighborhood of full employment and a string of lower-than-projected inflation readings, especially since inflation has come in stubbornly below target for five years. 

The US economy is in the midst of what could easily become a record breaking expansion. Labor markets have shown dramatic improvement in that time as steady job growth pushed the economy into the range of full employment. Moreover, the outlook remains bright:

There has been a noteworthy pickup in business investment this year compared with last year. Investment in the equipment and intellectual property category has risen at an annual rate of 6 percent so far this year after remaining roughly flat last year. The latest data on orders and shipments of capital equipment suggest that solid growth will likely continue in the second half of the year. In addition, oil drilling had rebounded this year after dropping sharply last year, although Hurricane Harvey creates uncertainty about drilling in coming months. While lackluster consumer spending was one of the key reasons for the weak increase in first-quarter gross domestic product (GDP), growth in personal consumption expenditures (PCE) bounced back strongly in the second quarter, and recent readings on retail sales suggest another solid increase in consumer spending this quarter.

And, as Brainard notes, even if the anticipated fiscal stimulus has failed to materialize, the economy has been supported by a global upturn in growth as well. Sure, Hurricane Harvey may dent the short-term numbers, the medium term picture is solid.

But all is not well:

In contrast, what is troubling is five straight years in which inflation fell short of our target despite a sharp improvement in resource utilization. 

Brainard runs through the usual suspects offered as explanations for the inflation numbers - import prices, resource utilization, and transitory factors - and finds them all wanting. So what's going on? Brainard turns her attention to a fundamental element of the Fed's inflation model:

...In many of the models economists use to analyze inflation, a key feature is "underlying," or trend, inflation, which is believed to anchor the rate of inflation over a fairly long horizon. Underlying inflation can be thought of as the slow-moving trend that exerts a strong pull on wage and price setting and is often viewed as related to some notion of longer-run inflation expectations.

There is no single highly reliable measure of that underlying trend or the closely associated notion of longer-run inflation expectations. Nonetheless, a variety of measures suggest underlying trend inflation may currently be lower than it was before the crisis, contributing to the ongoing shortfall of inflation from our objective...

This is a big deal. Brainard suggests that inflation expectations are not anchored at 2 percent. And they have not become unanchored to the upside as so many of her colleagues fear will happen if they do not act preemptively. Expectations are unanchored to the downside.

Why are expectations falling? Brainard posits that perhaps households and firms are reacting to the persistent undershooting in recent years. She also relates this to low neutral interest rates, noting that the resulting lack of conventional monetary policy power increases the episodes of below target inflation, further entrenching low inflation expectations.

Now comes the tricky part. How should policymakers respond? Can low unemployment do the job? This is interesting:

Given the flatness of the Phillips curve, it could take a considerable undershooting of the natural rate of unemployment to achieve our inflation objective if we were to rely on resource utilization alone. 

For all these reasons, achieving our inflation target on a sustainable basis is likely to require a firming in longer-run inflation expectations--that is, the underlying trend. The key question in my mind is how to achieve an improvement in longer-run inflation expectations to a level that will allow us to achieve our inflation objective. The persistent failure to meet our inflation objective should push us to think broadly about diagnoses and solutions.

It is not enough to just force down unemployment. Policymakers need to match such a policy with a commitment mechanism that pulls up inflation expectations. And that mechanism likely includes explicit overshooting of the inflation target. 

She highlights this point in the context of setting rates. Brainard believes the neutral rate is low and likely to stay low (this will be exacerbated by the balance sheet run off). Consequently, the Fed might reach the neutral level of the federal funds rate in very short order. That means they need to be cautious moving forward, and should adjust down the expected path of tightening accordingly. Moreover, central bankers need to match the policy with a stronger goal:

To the extent that the neutral rate remains low relative to its historical value, there is a high premium on guiding inflation back up to target so as to retain space to buffer adverse shocks with conventional policy. In this regard, I believe it is important to be clear that we would be comfortable with inflation moving modestly above our target for a time

But will Brainard's colleagues listen as they did in 2016? At that point the economic conditions appeared fragile as the impact of the oil price crash filtered through the manufacturing sector. Moreover, financial conditions had tightened with a period of higher corporate yield spreads, declining equity prices, and a strong dollar. The opposite is true now - not only does the economy look healthier, but financial conditions have loosened despite Fed tightening. So I am not yet convinced she can carry the day. But this is undoubtedly a space worth watching.

Bottom Line: Brainard is making a push to slow the pace of rate hikes. I am not sure she will be as successful as her last effort to change the course of policy. But she still has two important takeaways for investors. First, if you think interest rates will rise sharply, think again. The neutral rate of interest is too low to expect much more tightening - we need much faster growth to justify a higher estimate of the neutral rate. Second, assuming she is right and the Fed doesn't take her advice, her colleagues are positioning themselves for a substantial policy error that would both bring the expansion to an end sooner than later and further entrench disinflationary expectations. And that would only make the Fed's job harder in the future.

Mediocre To Solid Data Flow, But Weak Inflation Still Key

The data flow is generally supportive of additional Fed action, surely enough to allow the Fed to move forward with balance sheet action later this month. But what about another rate hike? That remains an open question as low inflation remains an obstacle to further rate hikes for a sizable faction within the Fed.

The employment report disappointed with job growth of 156k, shy of expectations for 180k. Previous months were revised downward. Looking through the monthly volatility, the report does little to change the basic story that job growth continues the slow downward trend that began in 2015: 

Mediocre, but not disastrous. A key issue for the Fed is where does this slowdown stop? If they were reasonably confident job growth would soon stabilize around 100k a month, then the pressure for additional rate hikes would ease substantially. For the Fed that figure would be sufficient to bring stability to the unemployment rate. For now, though, it looks like the current pace of job growth is likely to bring further declines in the unemployment rate:

In other words, the recent stability in unemployment around 4.3-4.4% is only temporary. A significant faction of the Fed will worry that additional declines in unemployment will signal that the economy is operating beyond full employment, placing inflation stability at risk. Hence that faction will press for additional pre-emptive tightening.

That said, tepid wage growth calls into question the Fed's current estimates of full employment:

I think that going forward the Fed will essentially split the difference by edging down estimates of full employment while remaining concerned that the pace of job growth still exceeds that required for inflation stability over the medium-term. On net, that leaves December still open for a rate hike. More on that later.

In the meantime, it looks like the manufacturing sector continues to shake off the 2015-6 doldrums. The latest ISM report was strong:

To be sure, a slowdown in auto sales will weigh on manufacturing in the months ahead. That said, Hurricane Harvey wiped out a half a million vehicles in Texas, so that throws some needed support to that sector going forward. 

Overall, consumer spending looks solid, continuing to hold the pace of the last 18 months:

Not the best of the cycle, but not the worst either. Something that might be expected in a more mature phase of the cycle, which is probably about right. And within a reasonable margin of error of what might be expected given consumer sentiment numbers:

 And then there is inflation. Or, more accurately there isn't inflation, at least any to be concerned about:

It is fairly clear that the disinflation this year is more persistent than the Fed would like to believe. It seems like too many one-sided errors to be just coincidence. Truth be told, looking at that chart makes me think that inflation expectations are anchored around 1.75% rather than the Fed's target of 2%. I don't think the Fed thinks that, but I also don't think it is an unreasonable idea either.

Bottom Line: So where does this leave us? The Fed continues to be caught between the push of the generally positive momentum of the US economy and the pull of the surprise weakness on the wage/inflation front. Luckily for them, they don't need to decide between the two until December. Their next move is to start reducing the balance sheet - they want to have that process underway before any leadership changes next year. Moreover, they would like to ensure the process begins smoothly before returning to the issue of rate hikes. My expectations about December are, not surprisingly, data dependent. If the current mix of activity continues - generally upward momentum suggestive of actual or forecasted declines in unemployment, coupled with what the Fed will view as fairly easy financial conditions (watch the dollar!) - the Fed will hike in December even if inflation remains tepid. I think the Fed will need to see more evidence of slowing in the real economy before they cease rate hikes - I suspect they will see the economy as operating to close to full employment to risk the potential inflationary consequences of delaying additional rate hikes.