'Failure Is Not An Option': How The Fed Symmetrically 'Tweaked' Bernanke's QE Exit Signal

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Includes: DIA, IWM, QQQ, SPY
by: Adam Whitehead

Summary

A plethora of data suggests that the Fed is wise to wait and see before raising interest rates again.

The "Scoop" from the Bank of England is that low oil prices are a consumer bailout rather than a tailwind.

The FOMC announcement about weak Q4 growth is a shadow hanging over the economy and capital markets for 2016.

Central bankers have lost their credibility by failing to hit their inflation targets.

The Fed has "tweaked" its inflation mandate guidelines in order to save its credibility and Bernanke's reputation.

(Source: Bloomberg - link)

The last report suggested that the Fed would wait for the current market volatility to subside and check its impact on real economic data, before embarking on further tightening. For some of those in the markets however, the recent volatility equates to at least four rate hikes this year already. This emerging consensus thus puts the Fed on hold in March and maybe for much longer. The new consensus in a recent CNBC survey sees the next rate hike in May.

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(Source: The Daily Shot - link)

An emerging risk for the Fed is the slowdown in the service industry. Manufacturing is already headed for recession so, without the counterbalancing effect of services, only the consumer is driving the US economy at this point in time.

(Source: Econoday - link)

(Source: Gallup - link)

Fortunately the US consumer has shrugged off the first signs of economic slowdown combined with the first Fed rate hike and capital markets meltdown ….. for now at least.

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(Source: The Daily Shot - link)

The tightening on the financial conditions dashboard is however flashing the warning signals that are not discernible to consumers because nominal interest rates appear low to them.

Click to enlarge (Link)

The Bank of England's Monetary Policy Committee (MPC) is currently wrestling with the dilemma that the deflation caused by falling oil prices is sustaining the UK consumer. Could the same thing be happening in the US? The inference is that the answer is yes, based on the recent lecture MPC member Kristin Forbes recently gave to her fellow countrymen; at a Henry "Scoop" Jackson Society round table meeting of the Trans-Atlantic collective minds.

In the UK and presumably in the US to some extent, the deflation and growth problem is with wages relative to the cost of living. For now, the US consumer can continue the economic heavy lifting as long as oil prices remain low. Since both services and manufacturing industry are slowing, the net effect combined with consumer strength may not be enough to sustain FOMC aggressive rate hikes from here. The Fed has yet another reason to sit on its hands and watch the fallout from oil prices and equity markets.

The Fed's decision to stay on hold at the last FOMC meeting came as no surprise. The concerns voiced about global economic headwinds and equity market volatility all resonated strongly with the audience. The big surprise was however the knee jerk reaction of equity markets lower. It is difficult to discern if the markets are fearful of the potential May rate hike; or if they are more fearful of the Fed's prognosis that the economy slowed in late 2015.

The combination of a future rate hike and the likelihood of weak Q4 earnings reports have conspired to undermine faith in equities. If the Fed's alleged go to guy aka Jon Hilsenrath is to be believed, a March rate hike is still in the ballpark also . A further leg down is therefore required to discount the impacts of all these risks.

Of more interest was the FOMC's "tweak" in relation to its inflation mandate communication from 2012. 2012 is an important year, in monetary history, because it was the point at which the Fed and the ECB cranked up the QE process in response to the headwinds blowing from the eurozone. The new "tweak" has now made the Fed's 2% inflation target "symmetric".

Under Bernanke's stewardship, the 2% inflation target had been established as a notional point at which unconventional policy could be unwound in a kind of mission accomplished signal. Since then the Fed has been haunted by its failure to hit this 2% target. In a classic case of mendacity the Fed has "tweaked" its 2012 communication to try and hide the fact that it is considering normalizing prematurely before the mission has been accomplished.

In another related case of "symmetry", Mario Draghi also felt that it was incumbent to insist that a failure to hit his 2% target was a failure of the ECB's credibility. Likewise in Japan, Hideo Hayakawa a former BOJ official has opined that the BOJ's failure to hit its 2% inflation target would be a heinous "declaration of defeat".

It would seem that the Fed, BOJ and ECB are doing some painful soul-searching about their inflation targets; or more importantly their failure to hit said targets. Their credibility is on the line; and it is the one thing that central banking is fundamentally based upon. Simply put, they cannot afford to lose their credibility. The Fed has "tweaked" to avoid a loss of credibility. Mario Draghi has come out swinging with a commitment to do more QE to the same end. The BOJ is currently wriggling inside its baggy 2% inflation hair shirt, which it has failed to fill out.

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(Source: Seeking Alpha - FOMC Cognitive Bias: "Unanimous Is Consensus Until Someone Disagrees" - link)

Unsurprisingly the weathervane, known as James Bullard, had a hand in the Fed's "tweak". In the last report, Bullard was observed heading for the exit from Stanley Fischer's "ballpark" of four rate hikes for the year. The slide in oil prices has convinced him to voice a conviction that the Fed will miss its 2% inflation target. His role in the "tweak" supports the view that he is positioning himself; in anticipation of the breaking of unanimity at the Fed in relation to the "ballpark" conditions of four rate hikes.

"Turning past institutional failure into a statement of future intentions and capabilities."

(Source: Federal Reserve - link)

The "tweaked" wording now reads as:

"The FOMC would be concerned if inflation were running persistently above or below" (this 2% target - author's emphasis).

Bullard dissented, thus providing the first signal that there is no consensus, within the FOMC to justify Yellen's enforced voting unanimity, which was questioned in the last report. His reason for dissenting was even more illuminating. He does not disagree with the principle of making the new language reflect that the Fed is equally as concerned about sub-2% inflation. He therefore has not broken ranks and hauled his colleagues over the coals for failing to hit the target. This would be dangerous, as it would signal the institutional failure that will drive the Fed into the waiting arms of Congress. Instead, he has allowed the Fed to try and hide its failure behind the "tweak".

His dissent is in the fact that the new language does not over-emphasize the concern about sub-2% inflation. Bullard has therefore imposed his own subjective view onto the "tweak". One has to admire his method, even if his egotism is questionable. The period of low oil prices is going to become a topic of major discussion at the Fed; in view of the FOMC's use of the word "persistently" in relation to sub-2% inflation. It may end up as semantics, but a case can already be made that the "persistently" has been met.

The big take away from the "tweak" story, is that the Fed is not done yet. The "un-tweaked" 2012 communication from Bernanke heralded a period a QE expansion. Bernanke had hoped to be in exit mode, or even to have exited, by the time Yellen was taking over. The global deflation story and headwinds from Europe and China ruined his handover; and now it is ruing his legacy and reputation. The FOMC has just had to use some of its most mendacious casuistry so far, in order to save Bernanke's reputation and its own credibility.

Logic suggests that a new phase of Fed policy has just been announced with the "tweak". The normalization process is therefore only a pause in the monetary expansion process. During this pause, the previous temporary liquidity from the QE process will become a permanent expansion in the money supply. This will however only sustain the economy at its present rate of growth.

A further monetary expansion will then be required to accelerate growth. If this monetary expansion can be justified behind a process of enabling a fiscal expansion by lawmakers, it will be much better accepted by critics of the QE process. The Fed continues to buy government debt, but this time it will be buying debt that is being increased rather than cut back through fiscal austerity.

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Based on this analysis of Fed behavior, it may therefore make sense for investors to digress into the subject of economic cycles. For those readers interested to start investigating Cycle Theory in relation to market timing, a recent Gallup survey is a useful starting point. The survey shows that the US economy is still bouncing along the bottom, as the polity's general misgivings about the failures of its policy makers is still deeply entrenched. The experience of QE has evidently not renewed either faith or optimism. Suspicion of politicians and central bankers is back to where it was during the Watergate and Vietnam years.

During the last existential crisis of lack of faith, the Dollar came off the Gold Standard. If history rhymes, the recent Dollar recovery suggests that America is currently moving to deal with its monetary and fiscal demons. The flirtation with QE to inflate away the Federal Government's liabilities has yet to run its course, but the signs are auspicious. The Fed clearly wishes to frame the current normalization, as the postscript that draws a line under the QE phase, so that the economy can embark on one of its 20 year expansions that great equity bull markets are made of.

The last major economic and credit expansion began with interest rates and inflation much higher. Yellen and her colleagues' jobs are to convince the bulls that today's high real interest rates are similar to the high nominal interest rates of the early 1980's. They have their work cut out for them. If history rhymes, it takes a lost decade for the generational fear of politicians and central bankers to work its way through the mind of the polity. There are therefore another three to four years of this age of mistrust to work through. The good news is that it can't get much worse than it has been though!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.