The Clash Of The Dogmas

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

Summary

Economic and political dogma is now framing the debate and perception of Fed policy.

The Taylor Rule is being used as the object with which to debate the efficacy of a rules based Fed.

The FOMC decision revealed a growing toxic split.

Yellen's own performance in conference revealed a loss of credibility and belief in her guidance.

The Fed is losing its ability to create a conventional policy arsenal to fight the next slowdown.

The debate over the Fed's behavior is degenerating into a battle of intellectual dogma between demagogues. The tension has been further heightened by the view that the Trump campaign will frame any failure of the Fed to tighten as a politically motivated one in support of Clinton.

The growing and overt politicization of the Fed was illustrated by the recent comments of Bill Clinton, in which he made much of the fact that the Fed will do the right thing (and that he is acquainted with Chairman Yellen and Governor Brainard). Ironically, the markets may be less worried about the Clintons, since Bill has shown himself to be a fiscal conservative at heart. Trump has said that he is all about low interest rates and has recently been floating bubbles about big tax cuts for the little guy — though with little in the way of explanation about how he will balance the books.

It is also noticeable that, despite all the hype about diversity and glass ceilings, the campaign has degenerated into a male brawl with Bill stepping in to defend Hillary's honour. This Hollywood Western-style duel obviously plays better with the electorate than the dismal lack of authenticity of the two candidates.

On the one hand there are the demagogues who adhere to the rules of previous economic cycles; on the other there are those who think that "this time it is different." As they snipe at each other, from various halls of economic learning, the Fed remains caught in the crosshairs and seems to be incapable of action. Given that the Fed has two mandates, it may be better served to focus on them rather than the voices in the crowd.

A reinvigorated former Minnesota Fed President Kocherlakota raised his criticism of his former colleagues, as the next FOMC meeting approached. In his latest tirade, the Fed is criticized for being rules based as opposed to discretionary principles based aka winging it by being data dependent. The Taylor Rule was signaled out by him for particular opprobrium, as he hinted that rigid adherence to it prevented the Fed from getting to grips with the Credit Crunch earlier in the QE response. For those who read between the lines, he also suggested that adherence to said rule actually triggered the Credit Crunch.

His attack on the Taylor Rule also suggests that he is lending support to San Francisco Fed President John Williams's thesis of the lower new neutral rate, which Taylor was seen to attack in the last report.

The last report summarized how the Fed has been criticized for its handling of economic data and also in its poor clarity of guidance. The cognitive dissonance between its guidance and the periodic forecasts it has provided, was highlighted as a systemic problem festering away. Both Larry Summers and Narayana Kockerlakota believe that this dissonance will lead to the Fed making a repeat, of its alleged mistake before the Credit Crunch, by tightening prematurely and then failing to ease swiftly. The Fed is not, however, asleep at the wheel, and Janet Yellen seems to be already factoring in contingencies for this systemic failure.

The San Francisco Fed recently released its latest contribution to guidance research. Whilst not offering guidelines on how to communicate, the research provided useful vectors aka Prattle Scores, which measure the effectiveness and correlation of Fed communications. The analysis found that the Dot Plots, a.k.a Summary of Economic Projections or SEPs, correlate positively with the central theme of verbal communications by those making the forecasts.

This is hardly rocket science, but it at least demonstrates that the Fed speakers actually say what they forecast. The real problem is that they say different things and then do not necessarily collectively do what they forecast. Perhaps Summers and Kocherlakota will now sleep a little easier at night, safe in the knowledge that the Fed does not walk its talk!

They must have both had a good night's sleep after Chairman Yellen's unedifying performance in her post-FOMC meeting conference. The FOMC decision was to leave things unchanged, but this brought out a discernible split, which Yellen tried to euphemistically refer to as:

...a rich, deep, serious, intellectual debate about the risks and the forecasts for the economy [in which] we struggled mightily with trying to understand one another's points of view.

The meeting was clearly a shambles which has evidently opened up divisions that will rumble on, in the public domain for months if not years, as those concerned all bicker and posture. Chairman Yellen was forced to project her own opinion onto the voting outcome as a casting majority vote, which will only have inflamed matters further.

The three dissenting voters will feel that Yellen sold them, out with some justification based on her speech at Jackson Hole in which she moved audibly to accepting the inevitability and imminence of rate increases. Once they have removed the knives from their backs, they will no doubt place them into their colleagues and Yellen's backs at the first opportune moment that the data allows. The Fed has become a toxic place.

Her own performance in front of the cameras was stilted, often punctuated with lapses of memory and repeats that evinced the grueling session that she had just undertaken with her colleagues. She looked punch-drunk. This was not her finest hour and unraveled all the political capital that she had created with her Jackson Hole speech.

Whilst remaining upbeat about the economy, she only served to illustrate the cognitive dissonance of this view with the lack of a rate hike decision. In fact, she struggled to provide any cogent narrative to justify the inaction. Her justification for inaction, based on fears of discouraging workers returning to the labour force, was a weak and very obvious form of disinformation.

Her performance is worth watching for those who missed it. The cognitive dissonance was then exacerbated when the she failed to come up with a good explanation of why the latest Dot Plots further signal the onset of weak economic conditions that will in fact lead to an easing rather than a tightening.

(Source: Bloomberg)

Even though she said that November is a live meeting, nobody now believes her, because it is hard to imagine that the data will significantly strengthen by then. The Fed is done for this year and the chance of it doing any tightening in 2017 with a new administration are diminishing, if the Dot Plots are to be believed.

Yellen had blinked, and Mr. Market viewed the beginning of her reversal on rate increases very positively; thus he began to discount the unwinding of expected future interest rate increases and started to price in easier monetary policy in the future. Mr Market also suspects that the big noise about divergent central bank policies at Jackson Hole, followed by the violent equity sell-off circa 9/11 anniversary, was staged to justify the no change at the ensuing FOMC meeting. That's all she wrote as far as the "Taper Tantrum" goes. The plunge protection team at the Fed evidently goes both ways in relation to plunges!

What Mr. Market has also understood is that, with no prospect of a conventional interest rate policy cushion under construction, the Fed will now have to unleash more unconventional policy to address the next economic slowdown.

Yellen's manipulation of the situation surrounding the FOMC meeting therefore has a future price. The price is the loss of a conventional policy arsenal— something BOJ Governor Kuroda is now paying for.

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.