Janet Yellen’s recent testimony in Washington could be her last. She faces threats from without and from outside the Fed.
The last report placed the Fed between the rock and the hard place of trying to finesse a QE exit, in order to deflate a debt-financed risk-asset bubble that it has created, in the absence of any inflation data to justify the exit. Applying the acme of skill in the use of guidance, a picture of a “Goldilocks Economy” was painted with words by various Fed speakers to engage market observers to buy into the plan with duration bets in fixed income. The flat yield curve, which this exit strategy creates, maybe self-defeating.
This strategic defeat has been noted by Kansas Fed President Esther George. The flat yield curve can be interpreted as signaling an economic slowdown. Such a signal would be premature, before the Fed has had the time and opportunity to create a cushion and arsenal to deal with the slowdown. Perhaps the normalization process requires a normal yield curve, rather than a flat one. The apparent deliberate re-ordering of the normalization process, to begin balance sheet shrinkage before more interest rate increases, implies that a normal yield curve shape is now being targeted by the Fed. This would also promote normal rising inflation expectations, which is something the Fed is keen to achieve. In the absence of real inflation however, the creation of normal yield curve will remain a lost cause despite all the rhetoric and guidance to achieve it.
The recent guidance from Philadelphia Fed President Patrick T Harker epitomized the delicate balance and the oratory skills required in this normalization process. Harker tried (unsuccessfully) to frame expectations for gradual interest rate increases in terms of gradually rising inflation expectations. His logic and explanation unfortunately contradicted each other, leading to an unwelcome and unforeseen outcome.
Harker’s failure was in lowering his expectations for inflation in 2018 to below target, in order to justify the gradual rate increase process. Lowering inflation expectations does not make for a normal yield curve, in the circumstances where there is no inflation to begin with. Instead it leads to a flat yield curve, which then begets falling inflation expectations by default. Harker should understand this by now. What he unfortunately succeeded in doing was to make what Yellen calls a “transitory” inflation dip look permanent. In doing so, his words vitiated against further interest rate increases and balance sheet reduction this year. Absent any strong inflation data, it would be unwise for Fed speakers to talk about it too much; especially when they try and maintain a thesis that interest rates should rise and the Fed’s balance sheet should shrink. Harker’s dilemma should inform all his colleagues on the need for a change in communication strategy, to avoid imprisoning themselves alongside him.
St Louis Fed President James Bullard has semi-officially taken it upon itself to hold his colleagues, who are raising interest rates, to account for their actions in the absence of economic data to support them. In order to do so, he has totally ignored the recent macroprudential warning on asset prices from the BIS; and focused solely on inflation fundamentals. In his latest monetary policy critique, he opined that it is "disconcerting" that inflation measures are falling whilst the Fed has raised interest rates twice so far. He implies that the Fed is actually on the wrong curve, rather than being simply ahead of the current one.
Bullard has in fact gone much further in his critique of the Fed by revealing a critical motivation behind his crusade. He may wish to “drain the Swamp” at the Fed, to coin a phrase. In a recent revealing interview with Central Banking he revealed all. His principle issue is in relation to governance of the Fed and how this influences policy creation. He candidly noted that the Fed is dominated by “East Coast” and “Washington” interests; and identified the New York Fed as having an egregiously unhealthy degree of influence. Bullard believes that these influences have undermined the Fed’s perception by America and put it at risk of losing its independence.
Bullard has in fact gone much further in his critique of the Fed by revealing a critical motivation behind his crusade. He may wish to “drain the Swamp” at the Fed, to coin a phrase. In a recent revealing interview with Central Banking he revealed all. His principle issue is in relation to governance of the Fed and how this influences policy creation. He candidly noted that the Fed is dominated by “East Coast” and “Washington” interests; and identified the New York Fed as having an egregiously unhealthy degree of influence. Bullard believes that these influences have undermined the Fed’s perception by America and put it at risk of losing its independence. One could cynically note that Bullard has already said that this independence has been lost to said “East Coast” and “Washington” influencers.
Bullard advocates dilution of these “East Coast” and “Washington” influences as a reform initiative. To defend his calls for reform, he opined that, had it not been for the significant minority of regional Fed Presidents and Governors in executive policy making roles during the Credit Crunch, the East Coast/Washington controlled Fed would have lost its independence by now. He also believes that more regional representation is optimal in creating policy that serves the domestic economy rather than Wall Street and Washington. His rhetoric is far more inflammatory and potentially impactful than anything that has come along recently from President Trump or any other notable Fed critics. The criticism from an insider is more powerful and less easy to ignore, because it is based on years of observation and examples.
Given that Janet Yellen testified shortly after Bullard’s expose and that there are several Fed vacancies to be filled by the President, potentially including the Fed Chair, his comments are both prescient and somewhat loaded. Whilst he may not be considered as Fed Chair material by the “East Coast” and “Washington” elites, his comments will have been digested with interest by President Trump. Bullard is a man on a mission to reform the Fed and his progress from here should be watched with interest.
Bullard’s comments in relation to Fed policy were general and framed in the context of the Trump administration’s attitude towards the Fed Chair. Whilst avoiding opining on the course of monetary policy, he noted that President Trump does not have any major issues with the Fed. This implies that even if Yellen is replaced, which he does not think that the President expressly wishes, her replacement will follow a similar policy. Bullard also believes that, in any case there is such strength in depth at the Fed so, there is an overwhelming institutional integrity that overrules any radical attempts by elected Presidents to interfere in matters of monetary policy. Bullard has also put himself out there as the common man’s champion and hence natural choice for Fed Chair in the future.
Back in the putative Swamp of the FOMC, the publication of the minutes of the last FOMC meeting showed just how split and lacking in consensus the Fed currently is on tactical execution. There was no consensus on when to start shrinking the balance sheet and no consensus on when the next interest rate hike should be despite the fact there is general agreement to address these issues this year. This lack of tactical consensus stemmed from diverse opinion of what the data is saying about growth and inflation.
Some Fed members see the economy on the cusp of an inflation spurt, whilst others see the failure of this spurt to materialize as evidence of a new disinflationary paradigm. Interestingly, the minutes also showed a raging debate over the alleged asset bubble that the BIS has recently nudged all global central banks into deflating. Some FOMC members saw a bubble developing, even before the BIS opined, whilst others saw the lack of capital market volatility as evidence of a rational price-multiples expansion rather than a bubble.
It is evident that the debate over the missing inflation clearly frames perceptions of the asset bubble. In the absence of inflation there is less of a case for the bubble perception. If inflation is subdued, then yield premiums can fall and asset prices can rise substantially to reflect this. Standing back from the divergence within the Fed, it is clear that a bifurcated trading market is evolving, as the status quo in the short-term, until the data creates a consensus view. The continued lack of inflation in the meanwhile gives this trading market and upward bias. The longer inflation is absent, the stronger this bias becomes.
There is however one clear region of consensus, developing within the Fed, in relation to fiscal policy. Having anticipated the potential tailwind of the Trump stimulus, consensus is growing that this will be significantly delayed. This consensus is built on growing evidence. Fed surveys of capex and also private sector analysis of capex expectations are all pointing towards a pause, as the euphoria over the potential Trump fiscal stimulus evaporates. This consensus has not yet embraced the view that the fiscal stimulus will not occur, but the probability of this outcome is rising.
Fed Vice Chairman Stanley Fischer recently showed himself as one FOMC member who is willing to embrace the rising doubt over the timing and impact of the Trump stimulus. He is particularly concerned that doubts over it are holding back business investment. His concerns however do not extend to him suggesting that the Fed should step in with a monetary stimulus to cover the missing fiscal stimulus. Instead, he advocates that the Federal Government should enact structural economic reforms and boost education, to improve what he describes as “dismal” productivity, in order to enable the private sector to boost investment and create economic growth.
Cleveland Fed President Loretta Mester appears to have little sympathy with the stimulus doubters. Instead, she remains keen to focus on balance sheet shrinkage; and to start this process at the earliest opportunity.
Dallas Fed President Robert Kaplan is gradually scaling back his relatively Hawkish position on the gradual pace of normalization. In his latest comments, he sighted the lack of inflation in the data that is motivating his backstroke. He is now more open to the thesis that in fact the current inflation soft-spot may not be “transitory”. Kaplan is now the third Fed speaker, including Lael Brainard and Neel Kashkari, to question the pace of normalization in light of the lack of inflation confirmation.
If one accepts that three points are needed to plot a trend, then a new trend in Fed thinking is under construction. It should be noted that these trendsetters all agree in Fed balance sheet reduction. The headwind from such balance sheet reduction is evidently something that they believe not only creates an economic headwind, but also creates the interest rate cushion required to deal with it.
(Source: Seeking Alpha)
The last report noted Boston Fed President Eric Rosengren’s unease over real estate lending and asset prices. This unease should be put into the context of the recent global central bank pivot towards the deflation of asset prices at the instigation of the Bank for International Settlements (BIS). It should also be put into the specific context of the state of the US real estate market and its potential to trigger another Credit Crunch. Much has been made of the new rules and regulations that have been put into place since the Credit Crunch to prevent a repeat performance. It should also be noted that the Trump administration is busily rolling back these said rules and regulations. The color of the litmus test for the potential threats lurking in the real estate sector was recently articulated succinctly by Fed Governor Jerome Powell.
Powell’s recent analysis states that the Federal Government’s dominance of the housing sector has actually grown in significance since the Credit Crunch. Federal agencies including Fannie Mae and Freddie Mac now account for 80 per cent of the mortgage market, with the remaining 20 per cent financed by private capital. The situation is therefore worse than pre-Credit Crunch and President Trump’s regulation reform is just about to make it even more so. Eric Rosengren is therefore right to be concerned.
Janet Yellen should also be very concerned, since she recently opined that there will never be another financial crisis in her lifetime. Perhaps counter-intuitively, she was signaling that the combined response of the Federal Government to bailout the housing market and then warehouse this bailout on the Fed’s balance sheet is a model and guarantee that this will not happen again. If so, she implies either that the Fed will be back with QE at the first hint of a crisis developing and/or that it will never fully exit the current QE phase if such weakness develops during the normalization process. Perhaps she implies a combination of both.
Kansas City Fed President Esther George would like to get ahead of the impacts of balance sheet reduction, by building a greater interest rate cushion to deal with the next slowdown. Her concerns were clearly articulated through her own interpretation of what the forward curve is signaling to her. She said: “One reason I favor shrinking the balance sheet sooner rather than later is the observed disconnect between short-term rates and long-term rates. Despite four 25-basis-point increases in the target funds rate since December of 2015, longer-term yields remain little changed.”
George does not like the recession signal that the flat yield curve is sending. She also understands that any recession will automatically be dealt with using QE. The Fed thus needs to push long term yields higher through shrinking its balance sheet. This will send a growth signal to the economy through a normal sloping yield curve. If this signal does not stimulate investment and growth, then the Fed can step in and buy long term bonds again. Evidently she feels the risk, of making the headwind of a shrinking balance sheet worse with higher interest rates, is worth taking in order to put the Fed in a position to address it in the future. George is not the dove that she is portrayed to be by the media. She is thinking ahead of pack and thinking outside the box. Her short-term hawkishness disguises a long-term dovishness.
The lack of consensus in the Fed on the timing of, if not the underlying course of monetary policy action, could also be extended to a lack of consensus on macro-stability issues and asset price levels in general. Indeed, the strongest consensus with the Fed seems to be on the fact that it wishes to remain independent in order to manage its internal policy consensus issues. The latest Federal Reserve Board Monetary Policy Report to Congress neatly articulates this status quo at the Fed. The report conceded that the post Credit Crunch rules have impeded market makers in US Treasuries; but then discounted the negative impact on overall market liquidity. Evidently the Fed does not wish to water down the post-crisis rules and regulations.
Moving on to independence the report strongly refuted Congress claims, that the Fed is just winging it on the economy with no due care and attention being paid to its two economic mandates. On macro-stability, even though recently some Fed speakers have warned about asset prices the report concluded that asset valuations are “moderate on balance.” One should therefore take the Fed’s warnings about asset prices with a big pinch of salt. Indeed said warnings should be put into the context of a Fed that wishes to remain independent above all else. Equivocal guidance, on all things including asset prices, is just part of the flexibility required to execute policy that independence begets.
Janet Yellen’s biggest challenge was her testimony to Senate and Congress, where her career and also the Fed’s independence were at stake. In the view that this would be Janet Yellen’s final testimony in Washington, before her term expires next February, her latest testimonial comments had significance in relation to Fed independence and her own career as Fed Chair. Her comments were balanced and seemed to build on the groundwork done by Lael Brainard. Yellen specifically put a cap on how far interest rates will rise, for the same reasons of low inflation combined with balance sheet contraction. Her acknowledgement that the inflation target is a symmetrical one, also signaled that she will tolerate some overshooting without raising the implicit interest rate cap further.
More of interest was Yellen’s retraction of comments about risk assets being over-valued and her blanket statement that another financial crisis would not occur in her lifetime. Yellen thus substantially destroyed the thesis for an ugly Taper Tantrum during the normalization phase ahead at the personal political cost of changing her story. Yellen’s comments were then underpinned by the release of what has been characterized as the weakest Beige Book so far this year later in the day; and a following CPI report in which inflation was absent once again last June.
Noticeably absent from Yellen’s commentary was her previous emphasis that softening inflation is a “transitory” feature. In order not to compromise herself too much she opined that she has still not made up her mind on whether it is becoming more entrenched. This admission in and of itself is a positive spin on the fact that her initial “transitory” call this year was wrong. Suddenly inflation has become a not-transitory feature, that whilst not necessarily permanent is now framed as a permanent cap on interest rates. Ever the optimist, Yellen is thus trying to turn a failed perception and inflation call into an interest rate call. The great wordsmiths Greenspan and Bernanke must be impressed!
The credit markets have thus far voted for Yellen to be retained based on her communication strategy and commensurate policy execution. They are forgiving even if they disagree with her forecasts. Credit spreads give no hint of concern for a Taper Tantrum. The quantum leap in equity markets, post-Yellen testimony and triggered by the weak June CPI number have temporarily deflected attention away from her poor inflation call year-to-date. Complacency is now the corollary of her misperception and overzealous guidance. Maybe her two interest rate increases have been overzealous also, which then provides scope for a rally that questions her initial (then recently retracted) call that asset prices are overvalued. There may also be hint from the credit markets that the economic expansion is slowing, so that more monetary stimulus is just around the corner after the normalization is gradually delivered. A rally even further would then ask the question of whether another crash could occur in her lifetime. Complacency is the price discovery result of the discovery of Yellen’s “transitory” inflation mistake. As markets rally, in relation to this inflation mistake discovery, the probability that they then discover that she was also mistaken about asset prices and the chance of another financial crisis must rise commensurately.
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