The last report framed the Fed's schizophrenic behaviour, in relation to the normalization process, through the prism of Exter's Pyramid. It was suggested that the Fed's prime directive is to manage the inflation in capital asset market prices rather than in the real economy. The FOMC was concluded to be in the process of raising interest rates, whilst being careful to avoid the Taper Tantrum that has occurred during previous attempts.
The Fed's behaviour has sparked similar investigation in the analyst community. Deutsche Bank has concluded that the Fed acts only in reaction to economic surprises. The schizophrenia continued, leading up to and immediately after the release of the last FOMC meeting minutes. There was, however, a discernible pattern in the schizophrenia, as the Fed tries to address every possible scenario that may challenge the interest rate increase process.
Cleveland Fed President Loretta maintained the theme that the Fed is anxious to normalize interest rates as soon as possible. Mester does not believe there should be a reflective pause between rate hikes in order to assess the damage. She therefore leaves room open to a potential increase in April, rather than the widely accepted June.
Chicago Fed President Charles Evans maintained the perception of the Fed's patient stance. Whilst envisaging two more rate hikes this year, he cautioned about the risky global picture that will necessitate vigilance and patience.
Boston Fed President Eric Rosengren then swiftly alternated perceptions back to expectations of a swifter rate hike trajectory. According to him, "while problems could still arise, I would expect that the very slow removal of accommodation reflected in futures market pricing could prove too pessimistic."
Perhaps sensing that the Fed is attracting too much attention for the wrong reasons, Dallas Fed President Robert Kaplan diverted attention back towards elected policymakers. He renewed pressure for political leadership by observing that the U.S. will struggle to accelerate growth from the current pace unless its government invests in infrastructure, manages immigration policy and improves education. If not the whole Fed, then at least the Dallas Fed appears to want Kaplan's agenda items on electoral manifestos as the presidential election campaign gathers steam.
(Source: Seeking Alpha)
The schizophrenia at the Fed was first noted in the report entitled "Soul Searching At The FOMC". In this report, the skillful seduction of the Oregon University professor, Tim Duy, to get his fifteen minutes of fame replacing Jon Hilsenrath as the market's go-to guy on Fed intentions and capabilities was also noted. Duy is now purportedly the key to understanding the Fed's schizophrenic behaviour. His latest illumination of Fed behaviour addressed the tricky topic of what Janet Yellen will tolerate in terms of inflation overshooting.
Evidently, the Fed has noted that its recent Dovish moves towards "patience" have come at a time when inflation is ticking up in a dangerously compromising fashion. Duy has, therefore, been hoodwinked into framing the risk of these two conflicting paths in a way that market observers will accept without triggering a new volatility spike.
In Duy's final analysis, the Fed is going to err on the dovish side of its tightening obligations and let inflation overshoot the 2% target. Mr. Market is therefore supposed to behave as though the inflation overshot will not require a significant greater level of tightening to address it. Inflation expectations are therefore supposed to get nudged higher permanently, and to become associated with a bullish tightening story. If this transpires, Mr. Duy will be rewarded with fame in posterity, as the spotlight lingers upon him rather than the invisible hands of Janet Yellen.
He may not have long to enjoy the fame of perspicacity, however, since the scenario he is outlining has the innate risks of stagflation inherent within it. This would suit the Fed, because it would allow the FOMC to ease and still get away with overshooting on inflation. Mr. Duy is being set up.
Duy's final analysis was conspicuously coincident with the release of the latest FOMC meeting minutes. The minutes showed considerable debate about the choice of hiking in April versus June. The FOMC's decision to stay on hold in April should, therefore, be put into the context of Duy's final analysis on overshooting.
Viewed through Duy's prism, the FOMC will always appear to be behind the curve this year, thus creating the overshooting tendency. This should not, however, be viewed as a cause for concern, but rather, with confidence as a signal that the Fed is determined to shift inflation expectations without creating the need for a dangerous interest rate spike when this occurs. Having framed this desired outcome, Tim Duy is now part of the process of inception by which this desired Fed outcome will be discounted by Mr. Market.
Once the latest FOMC minutes had been released, FOMC members removed their gags. The orations that followed were consistent with Tim Duy's script. Robert Kaplan sees "solid" economic growth allowing the economy to achieve the FOMC's inflation target. He also sees the attendant interest rates increases as justified by the data.
James Bullard's latest comments were also congruent with the Duy script. According to Bullard, the Fed's panic knee-jerk stay on hold reaction to the global risk sell-off in Q1 was not based on causality. In his opinion, the Fed was reacting to seasonal headwinds - those are now dissipating to leave the way open for interest rate hikes. By his reckoning, the Fed is therefore in the position to raise interest rates at any subsequent meeting.
Cleveland Fed President Loretta Mester is also in sync with Duy and her own FOMC colleagues. She emphatically denies that the Fed is behind the curve, even though it will only gradually tighten going forward. Those in the inflation overshoot camp would argue that the Fed is behind the curve. Mester's comments, therefore, squarely defend the FOMC from this criticism, whilst simultaneously allowing the overshoot to occur.
Janet Yellen then started to nudge market perceptions towards acceptance of the premise that inflation overshooting is a long way away. As she sees it, there is still significant slack in the labour market despite the "tremendous progress" on economic growth. The Fed has, therefore, nearly reached its full employment mandate target.
Deftly switching to the flip side of this argument, Yellen then headed off any notions that by remaining "patient" about tightening, asset price bubbles have developed as a consequence. She "certainly wouldn't describe this as a bubble economy". Such bubbles would then require some excessive remedial tightening, which may then have negative economic impacts and undermine the Fed's good work.
Her comments are consistent with Duy's analysis, whilst providing her with both flexibility and ultimate control of the rate hike decision-making process. To underline the perspicacity of Duy's recent comments, in relation to the 2% inflation target, she opined, "But it's also the case that 2 percent is our goal, and it's not a ceiling". At this point, it is fair to observe that the Fed's stage-managing of market perceptions is starting to become a little overzealous and too obvious.
Throughout this series of reports, Janet Yellen's ability to maintain FOMC unanimity despite lack of consensus has been a recurrent theme. This impressive feat has allowed Yellen to maintain a semblance of order and hence credibility. It has also allowed her to persuade observers and speculators that this time around, the tightening process may not necessarily beget a Taper Tantrum of the magnitude witnessed in previous tightening attempts.
Yellen's prowess in creating this broad church of diverse views continues to roll on. The most notable example of this applies to the Hawkish Kansas City Fed President Esther George. George is now freely able to call for immediate rate hikes, even though she subscribes to their gradual application.
She is even able to return the favour to Yellen by opining that such a strategy is warranted - to prevent the creation of asset bubbles rather than an overshooting of the inflation target. Just to throw observers off the scent, George focussed their attention on the "potential" bubble developing in commercial real estate.
Attention has therefore been deflected away from the very real bubbles developing in equity and US Treasury prices. Any sell-off in these asset classes would derail the Fed's attempt to tighten a serious blow, and that may potentially create an economic headwind.
An overshooting in asset prices has thus been substituted for an overshooting of inflation. The FOMC, therefore, avoids the banana skin of potentially excessive remedial tightening that destroys asset prices and creates another credit crunch. Yellen and her team have done their homework this time and are trying to cover all the bases, in order to avoid the blowback from the capital markets of the current tightening cycle.
The breadth of Yellen's broad church of consensus can be seen in the contrasting position of the New York president and FOMC voting member Bill Dudley from that of Esther George. Dudley felt secure enough within the façade of the broad church to opine that low inflation expectations are still a cause for concern and, thus, a justification for gradualism.
Interestingly, Dudley chose a capital markets inflation indicator, aka the bubble in TIPS - rather than economic data inflation indicators such as CPI and PCE deflator - as his deflation risk indicator. Dudley has therefore allowed the Fed to embrace/deflate the "potential" bubble in TIPS in order get all inflation indicators on the same page. Going forward, if he is successful, the Fed will have no more conflicting inflation signals to deal with; and will therefore have brought market-based consensus in line with the economic indicators. Managing expectations and executing monetary policy will then, by default, be much easier to achieve. The Fed truly has a comprehensive behavioural finance plan to evade the Taper Tantrum.
Dudley then embraced the dove-hawk duality, which Yellen has fostered, with his own relatively strong view of the US economy. He is the first dove, and possibly the first FOMC member to signal that the 5% unemployment rate will get broken as economic strength pushes it towards the 4.75% level.
At this level of unemployment, all the discussion about the natural rate of unemployment and wage push inflation will materialize, so the flagging of this issue by a purported dove signals that this issue will not produce a heavy-handed overreaction from the Fed. Doves talking like hawks, and vice versa, are yet another Fed tactic to take the sting out of the tightening to avoid a Taper Tantrum.
San Francisco Fed President John Williams is the model of the mean view of the broad church that observers will revert to by default when they do their discounting process to solve for the number of expected rate hikes to come this year. Williams currently envisages that at least two rate increases this year is the "right course" that the FOMC should follow.
(Source: Business Insider)
To provide the authenticity required by observers to accept the basis for the gradualist approach to the tightening, which also mitigates the inflation overshooting fears, the Fed rustled up the obligatory confirming data.
Allegedly, the Fed now pays close attention to the Employment Level Part Time for Economic Reasons and the Employment to Population Ratio for Prime Age Workers. Conveniently, both data sets show economic recovery and considerable slack.
Further down the road, the Fed may find itself forced into the debate over the reasons for the low level of labour force participation if it adheres to the alleged veracity in these data sets. No doubt, the Fed will cross this bridge when it gets to it, or conveniently find a replacement set of indicators that fit its desired story.
The Taper Tantrum and bubble risk stakes for the Fed have been elevated, not least by the debt situation in the American economy. Whilst global headwinds remain a threat, the level of debt relative to assets by American issuers has risen to levels above those before the Credit Crunch.
In the latest Fed QE-enabled credit cycle, most of the debt raised has been to fund share buybacks, M&A and debt refinancing. Very little debt has been used for capital expenditure and investment to grow business. Businesses have the same levels of income generation, whereas their debt levels have increased. It will, therefore, not take such a significant economic downturn to trigger another debt crisis. This explains why the Fed is vigilant and worried about the blowback from the global markets.
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