Productive Challenges To The Fed's Gradual Start To 2017

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Summary

Market perceptions by the Fed and its observers are pivoting from the last FOMC statement towards forward looking FOMC commentaries.

The bond market rout and its signals remain absent from FOMC commentary.

The awkward divergence developing between the Fed “staffers” and “rate setters” elevates the probability of FOMC interest rate rise overkill.

Fiscal and monetary policy are running into a productivity hurdle exacerbated by demographics.

Janet Yellen has taken a pro-active view of the productivity challenge facing the Trump Administration.

(Source: Bank Underground)

The year started with observers looking into the rear view mirror, to see what the FOMC was predicting about what will happen in the year ahead. The latest FOMC minutes revealed that there was in fact considerable debate over what President Trump and his fiscal stimulus will mean for employment and inflation; however, it was not enough to shake the consensus away from its fear of the global unknown reaction to his policies. There is thus no commitment to be anything but "gradual" at this point in time.

The tendency towards gradualism appears to be driven by the FOMC's unwillingness/inability to anticipate the size and scope of the expected Trump economic stimulus and its impact on both growth and inflation. Dallas Fed President Robert Kaplan neatly articulated this position when he recently opined that whilst he sees the case for tightening in 2017, based on rising economic momentum through H2 2016, that: "We (the FOMC) should be removing accommodation in 2017. I think we can do it gradually and patiently." He also clarified that he is not ready to "pre-judge" the future changes in fiscal policy.

The unwillingness to prematurely anticipate the Trump stimulus may also be born out of a palpable fear of his threats to interfere with the Fed. This series of reports concludes that the issue of productivity will define the terms of the relationship between the Fed and the Trump administration. Any measures taken by the President to boost productivity will elicit a less aggressive approach to rate hikes from the Fed.

What is absent in the last minutes is the most worrying omission as it reflects what is uppermost in market observers' minds. The recent bond market rout, if it were to continue, would be catastrophic for bond investors and liquidity conditions in general. Chicago Fed President Charles Evans signaled that, even though absent from the minutes, the specter of rising yields was a concern of his going into the meeting. He reported that had it not been for the Chicago Fed's assumptions about the positive impacts of the Trump stimulus, that his team would have sent in a much lower estimate for growth into the Dot Plot calculation model. Evans has been a noted Dove, lately persuaded to become more Hawkish. Evidently his speculation about the outcome of a fiscal stimulus, has overridden his drift back towards the Doves by nature of the headwind created through rising bond yields.

Currently, market observers are assuming that President Trump goes for the big one in terms of fiscal stimulus and also that it has a strong economic impact. The Fed will thus have no choice other than to tighten more aggressively. Said aggressive tightening, combined with fiscal expansion, will exacerbate the rout in bonds and hence the tightening liquidity conditions. President Trump's stimulus could then be stillborn if it is met with the headwind of tightening liquidity in capital markets. This dilemma illustrates perfectly the economic problems of President Trump's first days in office.

Hype and expectations have served to commit the President to a fiscal policy of over-stimulus, which the Fed is expected to address with over-tightening. Going forward, the President is going to have to adjust his tone or pack the Fed with officials who will not counter his fiscal strategy. Even packing the Fed with appeasers will not satisfy bond investors, who will probably discount even higher interest rates as Trump's policy ends in overheating. The President is already boxed in and thus limited in the economic policy options available to him.

From the Fed's side, it needs to address the spike in yields by talking up a bull yield curve flattening, as Ben Bernanke advised it to do in order to prevent an early economic slowdown. Going off the minutes of the last FOMC meeting, the rhetoric required for a bull curve flattener is totally absent at this point in time. First, the FOMC needs to get comfortable with Trump's policies in relation to productivity. If the President cannot demonstrate a commitment to productivity gains, the FOMC will not oblige him with bull curve flattening rhetoric which enables the fiscal stimulus at lower yields.

In an attempt to get market observers looking forward into 2017, rather than through the rear-view mirror, San Francisco Fed President John Williams attempted to set a baseline summation of all the views of his colleagues. In his opinion, this summation equates to three rate hikes this year: "The central tendency of the views of my colleagues -- around three rate hikes -- that's, I think, a very reasonable view." Philadelphia Fed President Patrick T. Harker also sees three rate hikes this year. Cleveland Fed President Loretta Mester also supported this view in a recent Fox interview. Her support for this thesis is noteworthy, as she has been amongst the most anxious FOMC members to press on with the rate hike cycle and signals that a more Hawkish baseline consensus has developed.

Williams' view highlights the conclusion drawn in the last report, that FOMC members are more optimistic in their rhetoric than they are in their forecasting Dot Plots. The Dot Plots would tend to flatten the yield curve along Bernanke's lines, but this has been frustrated by the more optimistic view of economic growth and rising inflation by FOMC speakers. This divergence between the Dot Plots and the speakers, reflects a wider systemic divergence between the "staffers" and the "rate setters" in the Fed. The "staffers" are the economists who create the Dot Plots whilst the "rate setters" are the FOMC voters. It would seem that the optimistic view articulated by the "rate setters" is neither shared by nor confirmed by the inputs from the "staffers".

This begs the question of where the "rate setters" get their views from. The picture presented is of a dysfunctional Fed, which is not joined together operationally or strategically. As the divergence between the two factions under the same roof widens, the negative implications of this systemic problem will become more concerning for observers and markets, especially given that the Fed must deal with a new presidential administration that is a fiscal policy unknown.

It is important to understand that the "rate setters" have the upper hand and also that their agenda is set by the Chairman. Monetary policy is therefore a hostage to a dysfunctional economic modeling process that is then subjectively biased by the Chair. This sub-optimal decision making process has thus had its utility undermined by a flawed governance structure. The Fed therefore makes things up as it goes along, often in the abstract, depending upon its own dysfunctional economic modeling process.

One should not absolve the "staffers" from contributing to the dysfunctional process of garbage in garbage out forecasting. Based on what Charles Evans had to say about the Chicago Fed's assumptions about the expected Trump stimulus negating the rise in yields, when it submitted its own Dot Plot data, there is a great degree of subjective assumption going on at the "staffer" level too.

If the Fed was an asset manager, it would face massive redemptions and face legal cases for misrepresentation for not following its advertised investment process. With no process, by inference there can be no sincere intention or capability to pursue an asset management mandate. The Fed by default is therefore in breach of its dual mandate, by nature of its procrastination which it calls guidance. The classification of guidance as a policy tool is therefore disingenuous at best and deliberately fraudulent misrepresentation at worst. Following this line of reasoning will provide powerful ammunition for Congress to perform an overhaul of the Fed, even without direct political control of the monetary policy setting process. The Fed is both broken and unaccountable for its process if not for its decisions.

Currently, the outcome of this sorry situation is a bias towards tightening in an already tight capital market liquidity environment. The elevated probability that the FOMC tightens liquidity conditions more than is necessary, by causing bond yields to climb higher, continues to be the highest probability outcome.

Richmond Fed President Jeffrey Lacker, tagged himself as a sample member pushing the central tendency of the FOMC into the overkill zone, based on his comments in anticipation of the Trump stimulus package. Lacker sees the impact of the stimulus package forcing the FOMC to tighten much sooner than is discounted in the yield curve and capital markets. Given that the curve has steepened and the US Dollar has strengthened, Lacker has shown himself to be a follower of these signals in a classic case of confirmation bias. It may be providence that he has signalled his retirement.

Boston Fed President Eric Rosengren is also in the overkill zone, but has devised a gradual way of doing it! In his latest remarks, he called for smaller but more frequent interest rate increases - the aggregate effect of which is an enhanced tightening of monetary policy. Rosengren also noted that the incremental size and pace of rate increases are conditional upon the three factors. Firstly, it depends upon the incoming data. Secondly, upon the global economic backdrop. Finally, it depends upon the Trump stimulus. There are enough limiting unknowns therefore to, undermine the Hawkish tone in his stated baseline and, make him a gradualist by default.

Atlanta Fed President Dennis Lockhart remains on the threshold of the policy overkill zone, but his view is not critical as he does not vote this year and will also be retiring. His view just reflects consensus within the central bank. In his recent comments, he noted that the US economy is out of recession and on the cusp of normal expansion. A fiscal stimulus at this point in his opinion therefore risks becoming a countercyclical overstimulus, which implies that he would tin theory vote for an overreaction. For Lockhart, it is therefore critical that any fiscal stimulus comes with a package of measures that boost productivity. On balance, he sees two rate hikes from his colleagues this year.

(Source: Bloomberg)

The issue of productivity is key for both the Fed and President Trump. Massively tinkering with fiscal and monetary policy may appear to create immediate results, but it is only marginal over the fullness of time, so closer attention should be paid to the human capital that is supposed to deliver these results of tinkering. Ever since the Credit Crunch, older (and many younger) Americans have been exiting the labour force in their droves. The American population has also been aging. If the President is successful in bringing jobs back to America, it is therefore unlikely that there will be anyone to do them, especially if he is barring immigrants from participating.

(Source: Seeking Alpha)

In the absence of immigration, only robots and new technologies will create the kind of productivity that will allow the 4% GDP target growth the President has ambitiously set. Spending massively on infrastructure will also require healthy young workers to do the work, so demographics could make the heavily anticipated Trump fiscal stimulus a large white elephant. Far from being an old industrial play, demographics combined with Trump growth targets, is making America a technology play for investors seeking Alpha. There is also the elevated probability of an embarrassing U-turn on immigration by the President somewhere in the future.

A sensible approach to the unwinding of the monetary stimulus has been taken up by Fed Governor Jerome Powell. He is very worried by the bubble signals emanating from the commercial real estate sector in particular. Whilst he sees bubbles developing in commercial real estate, he does not yet see any of these signs in capital market asset prices broadly speaking. To be fair to Powell, he does not wish to kill the economic recovery. Specifically he wishes to kill the speculative risk asset bubble that is now at risk of becoming inflated, before it undermines real economic growth. On balance, Powell would rather have a painful correction in asset prices in the near term, in order to sustain a healthy economic expansion in the long run. Parsing Powell's comments, the FOMC should therefore continue with incremental rate hikes. His position best fits the approach to sustaining the kind of yield curve bull flattening that Bernanke has suggested.

Powell's enlightened practical approach also informs his colleagues and provides a model for how they should behave. Such a model may serve them well as they go under the microscope of Congress when President Trump takes office. An example of this enlightenment was provided by Powell, in relation to mitigating the very risk of capital market bubbles that he foresees. He suggests that Congress should rewrite the Volcker Rule and that the Fed should police it with judicious macro-prudence in order to allow banks to take on proprietary trades to enhance market liquidity and to hedge themselves. Of all the current Fed "rate setters", Powell is perhaps the one most capable of working with Congress and the Trump Administration. It remains to be seen if the Fed will adopt his enlightened macro-prudential style.

Following the case for rate hikes presented by his colleagues, Minnesota Fed President Neel Kashkari threw his sampling marker into the consensus forming baseline mix. This addition evinced Kashkari's own personal agenda as a "rate setter" in marked distinction from the more mechanistic "staffers" and the imputed policy reaction based on their inputs to the FOMC decision making process. It is clear that Kashkari will not only just clash with "staffers" but also with fellow "rate setters". Specifically he strongly refutes the Taylor Rule in setting interest rates. In doing so he therefore sets out his agenda to resist political oversight and intrusion that would like to force a strictly mechanistic single inflation mandate upon the Fed. In his opinion, the blunt application of this formula would have created an extra 2.5 million unemployed Americans and interest rates as high as 3%, had it been dogmatically enforced during the normalization phase.

Kashkari has thus shown himself to be guilty of the cognitive bias which makes decision makers believe that they know better than others. He abandons the rules of others based on his own self-belief, backed up by the selection of subjective models which he admits are not "rational" in order to back his thesis. It is therefore conceivable that he brings this same level of elevated intuitive self-belief to his second pet-project of bank capital adequacy. One should note that whilst he errs on the side of tightening capital markets liquidity by advocating tighter capital adequacy levels, he vitiates against this with his Dovish self- referencing approach to monetary policy. Net-net therefore Kashkari gives with one hand and takes with the other in terms of his overall impact on the US economy.

Jerome Powell's enlightened pragmatism may serve all his colleagues well, based on the recent comments from three individuals who have allegedly been shortlisted to replace Chairman Yellen. These individuals are Kevin Warsh, Glenn Hubbard and Stanford's John Taylor. All three called for higher interest rates and said that they would deliver them if they were in the Chair. They also lectured the Fed about overstepping its ability to influence the economy with monetary policy, something that President Trump and Congress may find as a useful line of inquiry when the Fed comes under scrutiny later in the year. The signal from the shortlisting of these candidates is that fiscal policy will be prioritised over monetary policy in the search for economic growth under President Trump.

The FOMC and especially Neel Kashkari will need to tread cautiously should Stanford's John Taylor become the next Fed Chairman. This appointment would signal a wider move to force the Fed into a more mechanistic rule based following of its inflation mandate. It would also signal a move towards lawmakers doing the heavy-lifting in terms of fiscal policy. History shows that whenever this occurs, the Fed needs to sharpen its inflation fighting game with tighter monetary policy and higher interest rates.

Dallas Fed President Robert Kaplan has also developed a practical approach to dealing with policy during the Trump presidency. Once again, the key issue of productivity will define his behavior. Whilst conceding that he can see evidence of both growth and productivity gains in Trump's policies, he said that he will be "scrutinizing" the demographic hurdle of the immigration issue carefully. As a contingency, he therefore deems it "reasonable" to start talking about reducing the Fed's balance sheet this year. Kaplan's position is thus borderline overkill, despite his conciliatory tone.

Jerome Powell may be a class act, but Janet Yellen remains the doyenne of rhetoric. Her choice of words and where she speaks remains as skilful and meaningful as ever. She recently chose an education forum and an audience of teachers, to broadcast her broader message to the Trump administration. Acknowledging that employment and inflation are almost normalized, she framed her future policy options in the context of productivity. She noted that productivity is a "key determinant" of living standards over the long term and that is has remained at historically low levels which economists are struggling to understand the cause of. As a result of this low productivity, she said that a greater share of income gains are going to workers with higher education, causing inequality to rise in the U.S.

Yellen was thus able to clearly define the wave of populism that has, created the wave of support from those not participating in the greater income share and, brought President Trump into office. Her critics will opine that it is Bernanke and his QE that have enabled this inequitable distribution of wealth and possibly the populism that has elected President Trump. President Trump may also criticize QE for creating inequality, but he would be foolish to do so when it has clearly benefited him and also when he is relying on the Fed to buy up all the deficit financing bonds that he is about to unload on capital markets. If he is wise and Yellen is betting so, he will engage with the Fed in enabling fiscal policies that also generate structural economic reforms that create higher-value jobs. If Trump and Yellen can see eye to eye on this, then NASDAQ can indeed go to levels some associate with "irrational exuberance", and we may finally see that bull yield curve flattening that Ben Bernanke has called for after all.

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.

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