Click to enlargeThe FOMC's tactic of keeping the markets guessing, over the timing of the next expected interest rate hike, is starting to become counterproductive. It has therefore adopted new tactics of choosing an important economic data release and then discussing it as a panel to guide market expectations. This tactical change was deployed for the latest Employment Situation report.
The elevated probability of the FOMC tightening sooner and then ending the process faster than Mr. Market assumes, based on these recent changes in its rhetoric and guidance process, was discussed in the last report.
The view that June is still a real probability for another rate hike, now seems to be held by the Bond Guys Bill Gross, Mohammed El-Erian and Mark Kiesel. Goldman has also called the bottom in the US dollar, based on the view that the Fed's resolve to tighten is stronger than the market thinks. Mr. Market is having second thoughts about the knee-jerk no go in June reaction to the last payrolls number.
Dallas Fed President Robert Kaplan supported this elevated rate hike probability with his remarks, which stated that one of his biggest challenges in setting a monetary policy rule is the difficulty knowing where interest rates should be when the economy is at full employment and inflation stable. From his comment, it can be inferred that he believes that the economy has reached full unemployment. The low inflation rate has yet to confirm his assumption, however. Like James Bullard, in the last report, he therefore accepts the view that the Fed risks tightening just as the economy decelerates. Following Kaplan and Bullard's rationale, the case for tightening sooner yet being forced to end the tightening before a significant interest rate cushion has been built, to deal with ensuing economic slowdown, is more probability than possibility.
Speaking in relation to the latest Employment Situation report, New York Fed President Bill Dudley did not see its headline weakness as lowering the probability of two more interest rate hikes this year.
(Source: The Wall Street Journal)
This view contrasts with that held by Mr. Market and John Hilsenrath, in which a June rate hike has nearly been taken off the table by the recent weaker payrolls number. Hilsenrath reflects the view of Chicago Fed President Charles Evans. Evans would much rather take the risk of inflation overshooting through hiking later, than being premature and triggering deeper economic weakness. In his opinion, the risk of hiking too late is much lower than the risk of being premature.
The view of Evans is also supported by that of Minneapolis Fed President Neel Kashkari. Kashkari showed himself to be of the strong Dovish persuasion when he commented that: "To me, just looking at the raw data, it says we should be accommodative, and I think we have this other societal need that we should be accommodative, because if we can keep people from being lost permanently, boy that's a real positive for society."
The FOMC's real conundrum was best summed up by San Francisco President John Williams at the Fed's recent symposium at the Hoover Institution. From his perspective it is clear that the natural rate of interest, which is neither stimulative nor repressive, has fallen from its previously assumed level of 2% two years ago. Since the Fed also adopted its 2% inflation target during this period the plot thickens.
This therefore begs the question of why the Fed should adhere to either this ancient inflation target or assumed natural rate of interest; or if in fact it has already abandoned either or both of them without telling anyone. Williams sees no point in raising the inflation target, to justify further monetary stimulus, because this move is academic in light of the fact that he accepts that the natural rate of interest has already fallen. He thus implies that monetary policy is currently too tight.
Williams addresses the monetary policy tightness issue from the opposite direction by calling for a growth target, rather than raising the inflation target. Further monetary stimulus could then be justified, if the growth rate does not achieve this target. This methodology is therefore consistent with his view that the natural rate of interest has fallen. It seems evident that Williams is looking for any excuse to ease policy.
Ominously, Williams stated categorically that the natural rate of interest in Europe is now negative 0.5%. This clearly implies that some Fed members are open to the subject of negative interest rates. The further implication is that this may lead to the consideration of new unconventional policies, such as Helicopter Money.
Atlanta Fed President Lockhart, presumably speaking for other colleagues as well as his own view, is reluctant to practically engage with the conundrum raised by Williams at this point in time. He seems happier to retain faith in the 2% inflation target, only because the process of changing it and then articulating this change may be more disruptive than retaining the anachronism. This practical inertia clearly has its own set of associated risks, based on the fact that the view being adhered to is totally incorrect. The Fed is therefore damned if it does change and damned if it doesn't.
Fellow panel member Dallas Fed President Robert Kaplan is also in the inert camp occupied by Lockhart. He also pushes back against raising the 2% inflation target. His opposition is like Lockhart's, based upon the disruption that this would create. Both Kaplan and Lockhart have not yet agreed with Williams that the natural rate of interest has fallen from 2%, thus making the 2% inflation target obsolete. Once free of the constraints of the panel forum, Kaplan felt free to opine that he sees the next rate hike coming in June or July.
The Hoover Institution meeting should be viewed as the point at which the Fed openly began to engage in an inconclusive debate over what to do when the economy softens, rather than what to do prior to this softening. The Fed has therefore agreed in principle that the softness is coming, but not on how to either contribute to or mitigate this softness in the meantime or when it eventually arises. The uncertainty that the Fed has been deliberately creating over the timing of its next rate hike, has therefore just lost its utility. The only thing that is certain is economic softness, sooner or later.
What is also certain is that John Williams is deliberately playing Devil's Advocate to nudge his colleagues one stage further than the current steps being considered in relation to the next interest rate rises. Whilst some of his colleagues are kicking the can down the road, being data dependent, Williams has opened it already. Williams is looking at the rate hike steps in the wider context of the global economy and the domestic softening currently underway. He is trying to focus his colleagues on what comes next, after the tightening.
Cleveland Fed President Loretta Mester isn't buying into the story from Williams or even that from her data dependent colleagues. Speaking at a forum in Germany, she made it clear that analysis is paralysis. The inherent risks in forecasting are all part of the job for a FOMC member as she sees it. This is what they signed up for and what they get paid for. There are errors associated with their forecasts, that are to be expected. This should not stop them from pressing ahead with the normalization process, as long as they have understood and quantified these errors. Addressing inflation, she sees signs that it is increasing, therefore she does not wish to postpone the normalization process any further. It is refreshing to see a practical approach like this, in which an FOMC member will admit that the committee is fallible and makes errors.
St. Louis Fed President Esther George is even more emphatic in her denial of Williams and the data dependent crowd than Mester. In her opinion, the risks of creating asset bubbles from the maintenance of low interest rates are now greater than the risk of tightening prematurely. Despite her dissension however, she is still willing to abide by patient interest rate hikes; so it must be noted that her Hawkishness if framed somewhat by the weak global environment that the FOMC is operating in.
Fed governor Lael Brainard has shown in the past that she is the focal point figure for policy making that embraces a global perspective. Once again she reiterated this global framing of policy. The narrow focus of sticking to a domestic agenda of normalising, in her opinion, overlooks the significant blowback of policy actions taken on this basis from global markets.
Unfortunately, Brainard's valid perspective has been framed in the larger context of her partisan cheerleading for Hilary Clinton. She is somewhat perjured therefore, even though she has clearly opined her political views to address any issues of conflicted interest. Clinton will have a more global agenda than any other candidate from either party. Brainard's monetary policy views totally reflect those of Clinton. It would be disingenuous to say that she will vote to keep monetary easy to avoid a market collapse that would harm the Democrats in the upcoming Presidential election, but clearly many observers will be thinking this.
The positive takeaway from the Hoover Institution is to be found in the common ground of the respective Fed panel members. All agreed that there is now room and opportunity for fiscal policy to take up the heavy lifting. A fiscal stimulus, involving deficit financing, would then allow a rise in interest rates acceptable to all panel members. It is no coincidence that the Fed is talking fiscal stimulus, given that the man who now sets America's economic and political agenda is also tilting the same way.
Having said that he would dispatch Janet Yellen for a Republican Fed Chairman, Donald Trump also signaled that he will try and accumulate more votes by promising a large middle class tax cut. Tax cuts will now become the big election issue, since the Democrats are running scared of and the Republican Party has been usurped by Trump. It will do the Fed no harm to align with Trump's fiscal stimulus plan, even if Janet Yellen is sacrificed. Since the Democrats will now have to out-Trump Trump, a fiscal stimulus can also be expected from them.
The FOMC's future decision also needs to be put into the context of the unfolding political landscape running into the Presidential election. Elites related to the bailout of Wall Street are unpopular; as is the Fed for failing to deliver the benefits to Main Street that Wall Street has enjoyed from QE. The Fed therefore needs to appear objective rather than simply independent.
Congress has already put the Fed and Wall Street on watch, that it will abrogate economic power, when it confiscated the dividends that the Fed would ordinarily pay to the banks that own it for infrastructure spending. The banks may own the Fed but they no longer control the Fed. Having established this fact, the door to the setting of monetary policy by the political executive is now wide open.
Kansas City Fed President Esther George is acutely aware of this problem; and more willing to talk about it than Janet Yellen. She recently urged the Federal Reserve member banks to consider this reality and their future. Richmond Fed President Jeffrey Lacker also joined George in opining his concerns over political interference with the structure of the Fed. He sees the Congressional "appropriation" of the Fed's dividends to the Federal Reserve System banks as the signal that ownership and control of the Fed have passed to the politicians.
Lacker and George's survival skills and senses are attuned to the latest developments in Washington. The promoters of the "Audit the Fed" bill have been able to get traction to reach the markup stage of the process. The Fed is also under attack from the Democrats for not being diverse enough; so this could be the last hurrah of the Hawks as the institution becomes more representative of what the Democrats believe should be represented.
It is interesting to note that the Fed Hawks are more worried about independence than the Doves. Evidently the Doves understand that greater political oversight will actually lead to them being given an even bigger licence to print money; since politicians can never deliver what they promise without an enabling central bank. The tipping point in ownership and control of the Fed is globally synchronous with the politicization of the ECB and the BOJ; and hints at further soft currency policy to come as the Fed joins the race to the bottom for interest rates and currencies after observing its token interest rate normalization obligations.
American banks may soon find themselves in the same situation as those in other developed economies. Political expediency has obliged central banks to enforce monetary policies that reward borrowers (including nations) at the expense of capital formation. Banking business models are under attack from margin compression, created by low and even negative interest rates combined with raised capital adequacy requirements.
The Federal Reserve system is unique in that it is owned by the banks; and can therefore erect significant legal barriers to political influence over its structure and monetary policy. The taxpayer funded bailout, after the Credit Crunch, however put this economic policy franchise at risk. In the bailout the banks lost their franchise, as they were effectively taken into custody, some of them literally so. Going forward, the American banking system may seek to resist further attacks on its lending margins; which translates into pressure on the FOMC to raise interest rates. The FOMC must weigh this internal pressure from the banking system against the political pressure to keep the economy afloat.
In a very timely letter to Representative Brad Sherman, Janet Yellen forecast how such a thought process will play out for the Fed in the event of the next economic crisis. Responding to his probing on negative interest rates, Yellen did not rule them out. Before they can be applied, there would need to be a conditional extraordinary economic crisis and a period of debate at the Fed over the consequences intended or otherwise of going negative. As was observed during the Credit Crunch, the pressure for action swiftly compresses the period of debate into one of hours. In such a crisis, negative consequences are always framed as less risky than the consequences of doing nothing; this is simple human nature. It is therefore reasonable to conclude that negative interest rates are in the toolbox. All that is lacking is the appropriate negative economic or capital market scenario to unlock the box. All eyes on the global economy for said negative scenario.
The release of the April FOMC meeting notes left Mr. Market in no doubt that June is very much a live meeting and that the probability of a rate hike is high. Gone was the language about concerns over the state of the global economy. This is also the meeting where Janet Yellen will follow up with a press conference; so the stage is set for her to deliver an interest rate blow and then promise to respond with alacrity when the negative scenario appears.
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.