The FOMC's Missing Inflation Mystery: Part 2

by: Adam Whitehead


The BIS is moving the goalposts on normalization and the FOMC is on-board with this.

John Williams blinked and revealed a strange new future world.

Despite its unanimous decision there is still no FOMC consensus.

America Inc. is prepared for and hedged for the normalization.

Trump may pick Jerome Powell but Truman would have picked Daniel Tarullo.

In Part 1 the “mystery” of the Fed’s missing inflation and its main characters were introduced. The plot thickens and has been stirred by the BIS then shaken by John Williams. Unfortunately, the beans have been spilled by Daniel Tarullo!

The recent act of the FOMC members all playing nice and coming to a unanimous decision at its last meeting was perhaps too good to be true after all. It also had the undesirable outcome of being framed a little too Hawkishly for those FOMC members who remember the spirit of Taper Tantrums past.

Having played nice for each other at the meeting, once out of the constraints of Chairman Yellen’s and each-others’ company, the FOMC members individually articulated and vented their own baseline positions; in a manner that provided individual clarity, yet undermined the collective clarity achieved by the allegedly unanimous decision of the last meeting. Evidently, unanimous still does not mean consensus at the Fed.

Chairman Yellen should perhaps share some of the blame for the immediate post-FOMC mixed messages, since she was only able to refer to the collective cognitive dissonant point of tight labor markets without inflation as a “mystery” to her. This “mystery” however appears to be gnawing away at the back of the minds of her colleagues, in a way that they find impossible to keep to themselves in public. Their commentary is becoming confessional rather than pure guidance. It does not however extend to mea culpa.

San Francisco Fed President John Williams kicked off the post-FOMC meeting guidance free for all. He qualified his own baseline, on the unanimous decision, in a way that shows that he is totally data dependent and not at all married to the dogmatic normalization bride. In his view, if things play out the way they have been doing he will continue to support the normalization; however if the economy weakens he will be back in easing mode very swiftly. Based on his comments therefore, the normalization could swiftly become a monetary policy easing at the drop of a hat. Williams also tried to anticipate and therefore prevent the kind of Taper Tantrum, that might cause him to suddenly U-turn on his normalization call, by opining that he expects there to be very little averse market reaction to the normalization process going forward. Williams has blinked!

The Williams Blink needs further investigation because it not only leads to a swift U-turn on QE, but also because it has profound global implications for all that QE in the global economy. Williams chose to be a little more forthcoming on his strategic blink with the Central Bank journal. In his interview he proposed a radical vision for global central bank cooperation, that is perhaps not very radical at all given the dismal future that all are forecasting. He starts with the premise that the 2% inflation target is dead and the old shibboleths that uphold it such as the Taylor Rule are anachronisms. The logical implication of his thinking, is that central banks will need to resort to unconventional policies such as quantitative easing (QE), forward guidance or some way of committing to keep interest rates low for a longer time on a more regular basis, in the event of economic downturns, says Williams. As he conveniently puts it: “so unconventional policy becomes conventional”.

Having seen the suspicious Trade War prone climate that the global economy is now in, Williams is concerned about the interface of global central banks in this environment. Japan got into big trouble for unilaterally easing, so Williams has obviously noted this fact with interest. His solution to this global problem is that all global central banks should multilaterally drop their 2% inflation target in a coordinated and cooperative manner. “There could be a mutual benefit for countries to change their price-stability policies together,” he says. He then suggested that 4% might be the new coordinated common global target ….. Wow! Inflation targets have doubled, implying that we should either wait twice as long to achieve them or double the unconventional monetary policy attempts to get there. One suspects a combination of both, with more emphasis on the latter.

Williams has not only blinked but also let the cat out of the bag on what global central bank thought leaders have in store for us, once the normalization narrative has run its course and things are still no better. We have all been warned. The great inflation that some are anticipating is not necessarily just around the corner but Williams has just flashed it onto the radar screen. It will be the outcome of the next coordinated central bank reaction to sub-optimal growth and low inflation. What is amazing, is the prosaic and mundane heralding of this apocalyptic future. The whole frightening set-up seems rather nonchalant and understated.

Having glimpsed the apocalypse, Fed speaker focus then swiftly drifted back to the mundane immediate future associated with the relatively prosaic normalization process envisioned by most of their commentary.

Dallas Fed President Robert Kaplan is equally circumspect about inflation prospects as Williams. In his post-FOMC commentary, he stressed that: “There are a number of reasons” the U.S. isn’t reaching its inflation target, and a number of those are not -- underline not – transitory.” To underline his own view he stated that, he is “open-minded” about and will “look hard” at a further interest rate increase at the December meeting but, his circumspection prevents him from making him a certainty to vote for one. He is however open to persuasion about raising rates in December, as he does not see the conditionality for inflation to hit target before hiking again. He also feels that since the economy will be softer in 2018, that the FOMC has plenty of time to sit around doing nothing before hiking again.

Non-voting Fed Hawk Esther George then put some kind of practical confidence limits around the Dovish yardsticks erected by Williams and Kaplan. In order to accommodate their positions, she wishes her voting colleagues to proceed on a meeting by meeting basis; rather than to pre-commit to a sequential normalization process, that may be well understood but unfortunately unjustified by real economic performance. Like John Williams, George also reinforced the symbiotic relationship between the FOMC and the market in relation to the normalization process, by expressing that she was “gratified” that the markets took the FOMC communication to shrink its balance sheet with equanimity. The case for clear guidance has been reinforced at the onset of the normalization, which is a positive omen.

New York Fed President Bill Dudley assiduously adhered to Chairman Yellen’s line of guidance, when it was his turn to speak. He remains unpersuaded that the missing inflation is anything other than a temporary situation. In this case, he remains committed to the gradual normalization process and sees no reason to put it on hold.

Outgoing Fed Vice Chairman Stanley Fischer like Bill Dudley is keen to present a theme of closure in relation to QE that is also linked with his decision to step down. In his latest valedictorian remarks, he opined that Fed guidance has improved this time around; thus reducing the probability of a disorderly normalization that will repeat the Taper Tantrum of the last attempt to scale back QE. He also tried to frame QE as still a temporary policy instrument. In his opinion, the only way to prove that it is a temporary solution is to scale it back. In relation to the debate that he ignited about the conundrum of tight labour markets yet low inflation, before he swiftly headed for the exit, he adheres to the orthodoxy as he leaves the building. He still expects inflation to appear, yet perhaps just a little later than originally anticipated.

In his first public commentary on the economy and Fed policy, Atlanta Fed President Raphael Bostic asserted that he can see signs of inflation that give him the confidence to predict that interest rates should be increased in December.

With no FOMC voting pressure on him this year, Boston Fed President Eric Rosengren doesn’t need to be as careful about what he says as his voting colleagues. For those who care what he thinks, he recently affirmed that he still holds the view that the missing inflation is transient and therefore that interest rate increases should be “regular and gradual”. He was however swift to acknowledge that the low inflation conditions have written a very valuable option for the FOMC to tread water and avoid his “regular” suggestion.

Rosengren’s view is equally and oppositely contradicted by that of fellow non-voting member St Louis Fed President James Bullard. Bullard sees the economy stuck in a low growth rut, in which this year’s soft inflation remains entrenched and incapable of being moved by tight labor market conditions.

Chicago Fed President Charles Evans will need further convincing from incoming inflation data before he will commit to press ahead with normalization process as swiftly as Bill Dudley. He does not openly dissent, however he requires the process and formality of ticking boxes on “a couple more months of data” to prepare him to acquiesce to a rate hike at the December FOMC meeting.

Minnesota Fed President Neel Kashkari will remain impossible to convince about the merits of continued normalization. In his view: “When I look at the economy I don’t see any signs that the economy is close to overheating … I don’t see inflation taking off so I see no need to tap the brakes.” If anything, he remains convinced that the Fed is actually the most significant contributor to declining inflation expectations. To overcome this overzealous outcome, in his opinion the FOMC should wait until inflation breaches the 2% target before raising interest rates again.

Double-teaming with Kashkari. Fed Governor Lael Brainard took an educated sociologist’s guess at where the “mystery” of Yellen’s missing inflation is and thus why the Fed should not normalize in any hurry. Whilst noting that less educated and privileged members of the American Family have participated in the economic recovery, especially of late, she warned that the structural outcome of the Credit Crisis is that the educated elite’s share of national wealth has risen egregiously. The structural implication of this alarming statistic is that disinflation for the majority outweighs the inflated pecuniary gains of the few. In fact, the few’s real share of the national wealth increases, because it has had savings and wage increases that the majority has not enjoyed. Empirically, Brainard may be correct but her assertions that the normalization should be slowed/reversed ignores the fact that this plays into the hands (and P&L) of the educated elite (including herself), even more than that of the huddled masses that she is trying to help.

Chairman Yellen’s spectacular recent act of contrition, after initially showing indifference to the “mystery” of missing inflation, contained echoes of Brainard’s own liberal agonizing. Speaking to a Cleveland audience containing blue collar workers, Yellen re-framed her perceptions of the “mystery” to avoid a lynching either metaphorically or intellectually at the hands of the audience. On this occasion she apologetically opined that: “My colleagues and I may have misjudged the strength of the labor market, the degree to which longer-run inflation expectations are consistent with our inflation objective, or even the fundamental forces driving inflation.”

Fed Hawk and Celeveland Fed President Loretta Mester’s own demands for the tough love of a dogmatic normalization stand in stark contrast to Yellen’s speech in her own backyard. Evidently, Yellen changes her speech to suit what she thinks her audience may wish to hear. Her resultant lack of conviction and equivocation, undermine her authority.

(Source: Bloomberg)

Post-FOMC meeting, the market discounting mechanism lowered the estimated probability of deflation further. This does not signal that there is no “mystery” surrounding the lack of inflation, but only that there is growing certainty that deflation risk has passed. The last report noted the Fed’s own equivocation on the successes of QE2 and QE3, despite its unequivocal statement about the success of QE1. Cheerleaders for QE2 and QE3, could use the collapse of deflation expectations and risk pricing during these two phases as evidence that they were a success.

Having prompted developed nation central banks to start the normalization process, in order to avoid creating unstable asset bubbles, the Bank for International Settlements (BIS) showed no mercy or tolerance for slackers. Using the FOMC’s announcement that its balance sheet will shrink, as the latest trigger, the BIS upped the ante. Evidently, the BIS has noted what Janet Yellen calls a “mystery” and is keen to debunk it before it can be used as a further excuse to decelerate the almost inert normalization process into a de facto reverse. John Williams honest admission that he could easily be persuaded to reverse course on the normalization must have worried the BIS. His thought leadership on scrapping the 2% inflation target and boosting it to a global 4% figure must have precipitated a swift BIS response.

By default in following the BIS’s directive, there is an innate bias of central banks towards pro-active normalization therefore. A Taper Tantrum of some magnitude, certainly greater than a 5% correction in risk asset prices would then test central bank commitment to this directive. It would also test the resolve of the dip-buyers who have contributed to the current price levels that the BIS has issues with! Based on the recent comments by John Williams and Esther George in relation to the Taper Tantrum, it is reasonable to assume that the Fed is fully on-board with the BIS’s guidelines and is guiding with the appropriate rhetoric. The Fed is going to normalize as per the BIS guidelines, but it is also doing its best to mitigate the negative market reactions to its normalization that would test its resolve to continue with the process.

(Source: Calculated Risk)

The Fed’s recently released flow of funds data indicates that household balance sheets are not only fully restored, but are now breaking out to new levels of health …. for those families that have assets that is. It is therefore reasonable to expect that the wealth effect may lead said households to start dipping into the home equity piggy banks or even borrowing against its value to fund consumption and/or speculation as the BIS has forewarned. The FOMC should therefore follow the BIS’s edict to pay attention to macro-stability rather than just inflation. Given that salaries have not yet recovered , the tendency for households to fund their speculation and consumption out of savings rather than income looks even more likely; which will only exacerbate the growing leverage bubble.

(Source: Bloomberg)

Anyone considering dumping their stocks, based on the specter of a bubble, should however not be so swift to rush to judgement. Since the Credit Crunch, America Inc. has not expanded capex, nor has it leveraged up. In fact, it has increased cash flows and then hung onto said increased cash flows. At low rates of interest, the growth in free cash flows has been spectacular. Now that the Fed has started to raise interest rates, this free cash flow generation will compound even faster. President Trump and his team are even talking about tax cuts and regulatory rollbacks, in order to improve the financial performance of America Inc. The latest gossip is that corporate taxes will be cut from 35% to 20%. Admittedly this is less than the 15% that President Trump called for, but it will still hit the spot nicely when it comes to compounding the ocean of corporate free cash flows at rising interest rates.

American industrial capacity does not overwhelm aggregate demand, in fact it lags it. Such a lack of industrial capacity build has in fact contributed to the rise of President Trump and his message about making America great again. Any cutbacks in American aggregate demand are therefore more likely to be painfully felt in its global trade partners where the overcapacity resides. America Inc. does not pay higher wages but it is hedged against the lack of consumption that low wages create by being long cash and short domestic industrial capacity.

Going forward, America Inc. will simply consolidate into a smaller number of bigger players through mergers or takeovers during both periods of economic softness and strength. If there is a fall in stock prices, it will simply buy itself back or buy up shares of its competitors. America Inc. sees the cash in itself and will always follow the money. As safe havens go, stocks could turn out to be much safer than Treasuries in any downturn. Even if there is inflation, America Inc. can raise prices and then compound free cash flows further. The problem for America Inc. was and is one of leverage. Companies that leverage cash flows will be at risk, but those that compound them will prosper. The general trend since the Credit Crunch has been one of deleverage, so lower risk premiums for avoiding this banana skin may justify some of the alleged froth in valuations.

In relation to our story and Janet Yellen’s “mystery”, could the missing inflation be found in the coffers and war-chests of America Inc’s corporate treasuries? Keynesian investigators would say yes. Populists have also come to the same conclusion, but the wool is quickly being pulled over their eyes.

Applying John Williams’ spell for the coordinated reflation of the global economy, to such an environment where America Inc. simply uses cash to generate more cash, could create the valuations which even make Bitcoin look pedestrian.

(Source: Seeking Alpha)

As the normalization begins and speculation over who will be the next Fed Chairman grows, it is interesting to return to the report that anticipated these events. Back then, the potential for a Taper Tantrum was put into the context of tightening liquidity in a disinflationary environment being perceived (and discounted) as policy overkill. Since then, the FOMC’s emphasis of the gradual process of normalization and recently its embrace of the missing inflation “mystery”, have gone a long way to taking the surprise out of the normalization process. With no element of surprise, the potential for a Taper Tantrum like the last one has been widely mitigated.

It was noted in the report that Yellen had framed the Fed’s mission as being to sustain the economic activity that had been ignited by the emergency monetary policy stimulus measures. Whilst there has been little follow up by Yellen or her colleagues on this theme since then, the emphasis on gradualism in relation to the normalization certainly meets the criteria for this objective.

The US Dollar’s Petrocurrency fundamentals remain largely unexplored at the national level, even if followed at regional level by the Fed, but very evident in America’s almost 10 million bpd production of which 2 million bpd are crude exports.

Jerome Powell is now on the short-list to replace Yellen. His macro-prudential credentials are evidently admired by the President; as is his commitment to roll back the Volcker Rule and other restrictions on the banking sector. Public opinion seems to believe that the President will go for an “easy money” Chairman. In practice, he may go for an “easy regulation” pick instead. Powell must therefore be very near the top of the list.

Had he been alive today, President Truman may have chosen former Fed Governor Daniel Tarullo for the Chair position; based on what has to be the most honest admission from a central banker to date. Admittedly, Tarullo would have been unlikely to make such a frank disclosure were he still involved with the Fed. Most likely he would have opined the traditional two-handed explanation that President Truman disliked. Speaking candidly, Tarullo recently opined that Economics lacks a “working theory” of inflation dynamics that is “useful for real-time policymaking”. Based on his apocryphal if somewhat inflammatory statement, one is led to the conclusion that the next Fed Chairman, whoever it may be and his/her FOMC colleagues, will continue to make things up as they go along in the absence of said “working theory”.

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.