A Fed Policy Mistake Is 'Not Unusual'

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by: Adam Whitehead

Summary

The implications of the adoption of inflation targeting may get discounted globally in 2018.

The Fed has become a prisoner of the flattening yield curve.

The Fed may become a prisoner of the steepening curve of robot capital investment.

The Fed built the prison that it is now incarcerated in with monetary policy expected to create employment and inflation.

(Source: Bloomberg)

The latest FOMC minutes release revealed that the flat yield curve, which is perturbing many market observers, is "not unusual" for the committee members. The committee's complacency on this subject is alarming in itself, given that at least seven of the members remain confused as to why inflation has not yet picked up yet are steadfast in their belief that it will. The two dissenters at the last meeting are the ones for whom the flat curve and its potential to invert are unusual. The Fed has tried to exit QE before and ended up twisting and extending/expanding QE as a result. Although a minority view, there is a feeling that further rate hikes could slow the economy and compound the declining inflation expectations further. The omens for a successful normalization are therefore inauspicious, suggesting that the normalization will create a legacy of low interest rates and high liquidity. The legacy may even become an anticipation of further monetary policy expansion.

The dissenters on the FOMC also advanced the case for adopting inflation targeting to address the unusual continued undershooting of the inflation target. The longer that this undershooting persists, their calls to have inflation targeting officially tabled and adopted as Fed policy will become more forceful and difficult to ignore.

The adoption of inflation targeting implies a symmetrical target and thus a tolerance for overshooting if and when inflation comes, or the adoption of a higher inflation target which has the same effect. This effect under either case would be felt as a pause and/or an end to the current interest rate hiking process. It would also call into question whether to continue with the envisaged pace of reducing the Fed's balance or even to consider pausing its reduction. The implications are both profound and global.

A pause in the normalization would translate into the global transmission mechanism of a lower US dollar. This would have the impact of putting all plans for normalization by the central banks of America's trade partners on hold. The race to the bottom in the foreign exchange markets would be back on. Would-be inflation targeters would hold that such currency debasement is a good thing since it could potentially de-anchor falling inflation expectations. Yield curves could then become positively sloped, and the Fed could say that this is also "not unusual" based on the new rising inflation expectations. This seductive scenario is all too attractive for the Fed and global central bankers to ignore.

The current rise in oil prices will have a headline impact on inflation. It will not however move the core inflation sufficiently to justify an interest rate increase from the Fed on pure inflation grounds. Conversely and perversely, higher energy prices may act as an economic headwind until the shale oil producers have expanded output as they have promised to do if prices move into the $61-65/barrel range.

The recently released Fed minutes also showed that there is a general consensus that the Trump tax cuts will be growth positive. A further nuance was used to frame this consensus in a following interview by St. Louis Fed president James Bullard. For Bullard, the jury is still out on whether there will be the productivity gain claimed by the Trump administration. Such a gain in productivity would allow the Fed to be even more gradual in raising interest rates. Alternatively, it could also allow the Fed to get ahead of the curve and build a cushion of conventional higher interest rates to address any future economic slowdown. A rise in productivity thus provides greater flexibility and independence to the Fed.

Bullard's view is ironic, because he is a "one rate hike and done" believer. Applying his logic literally, if there were no productivity gains, this would force him to consider increasing the frequency of rate hikes. Bullard, however, would much prefer that the Fed to debate what the flattening yield curve means immediately and respond by delaying rate increases. To fit his "one rate hike and done" perspective, he therefore has to believe that the Trump tax cuts will not boost output and/or wages, since he does not see inflation increasing any time in 2018.

Bullard also came out in support of inflation targeting in his first guidance for the New Year. According to him: "By committing to an inflation target, inflation has generally been kept lower and less variable, and inflation expectations have also been less variable." His commentary suggests that he thinks that the Fed has been too assiduous in following its inflation mandate. His support for inflation targeting is therefore qualified as support for seeing the target as symmetrical rather than as an upper limit.

Philadelphia Fed President Patrick T. Harker revealed that he is becoming persuaded by Bullard's thesis, and thus by inference that he is ready to engage in a debate over inflation targeting. His latest commentary accepts that, whilst full employment has been reached, the Fed is still only prepared to raise interest rates twice more in 2018 because of the new disinflationary fundamentals. He sees inflation only running above target in 2019 and then falling below target in 2010. Based on this view, he opined that: "I [Harker] am more hesitant in this view than I am on economic activity. If soft inflation persists, it may pose a significant problem." His comments show that he does not subscribe to the view that the flattening yield curve is "not unusual."Harker is also not worried about any potential for creating a bubble in asset prices through ratcheting down the number of interest rate increases.

There is something contrived about the latest Fed Dot-Plots, which alludes to the new two rate hike guidance of Harker. They show the economy running faster than at the last projection in September, yet the course of interest rate increases remains the same. The problem for the Fed has been the consistent undershooting of inflation, which has tempered enthusiasm for interest rate increases.

(Source: Seeking Alpha)

The last report suggested that the Fed was becoming a prisoner of its inflation mandate, because it has failed to include specific guidance about low inflation as it has made the case for the normalization. The recent commentary, from the dissenters at the last FOMC meeting, supports this thesis.

Chicago Fed President Charles Evans explained his dissent at the recent FOMC meeting, based upon his worry that inflation is still not evident. Minnesota Fed President Neel Kashkari had similar reasoning for his dissent, but also elaborated further. In his opinion, in total contradiction to what outgoing Fed Chair Janet Yellen opined in her final press briefing, the flattening yield curve is flashing a clear recession risk signal. Further interest rate hikes should therefore be put on hold in his view.

More significant than the Dovish Evans and Kashkari dissent is the concern shown about the flattening yield curve by Dallas Fed President Robert Kaplan. Kaplan has pragmatically accepted the need to continue to raise interest rates as long as the incoming economic data has supported this behavior. Recently, however, he voiced a new concern over how the flattening yield curve should be interpreted. He takes a more traditional view of the signal from the flat yield curve and deduces that: "It (the flat curve) limits the Fed's operating flexibility, in my judgment, in terms of how fast and how much we can raise rates" and also that "the history of inversions is such that it has tended to be a pretty reliable forward indicator of recession. Now, this time may be different, but I wouldn't count on it." As a consequence of becoming a prisoner of its inflation mandate, by default the FOMC is now being imprisoned by the flattening yield curve.

Another cause for concern is the consensus forming within the FOMC about the impact of the Trump tax reform. The latest FOMC minutes show a general consensus that this will be a net positive for the economy, but skepticism pervades this underlying view. Kashkari sees little impact, other than companies employing accounting and tax arbitrage to engineer higher equity performance ratios. Kaplan sees the impact as only marginally positive. Far from being the tailwind that the Fed should counterbalance with tighter monetary policy therefore, the Trump tax reform is a non-event in policy impact terms.

The disappointing December Unemployment Situation report provided further context in which to frame perceptions of monetary policy going forward. Noted hawk Cleveland Fed President Loretta Mester tried her best to break the Dovish halo effect of the data. Speaking after the data was released, she opined that one data point does not shake her view that the economy is strong and still deserving of three or more rate increases this year. At the same time, having accepted that the data was weak she then said that there was strength in the data. She also showed a concern for the vertiginous move in asset prices that Patrick T. Harker is unconcerned about. If the economy is as strong as she believes however and inflation is low, then asset prices should be strongly supported. Mester's primary concern is therefore to sustain the economic recovery by avoiding a bubble in asset prices that collapses with a negative headwind as a consequence. Looked at through this prism, Mester is not a hawk at all but rather someone who wishes to put a floor under asset prices and sustain their rally in parallel with the real economy. For hawk read "Sustainer".

In relation to any future inflation targeting debate, Mester can be seen as someone who will set an upper limit to the symmetrical target that will prevent the accepting inflation overshooting from running dangerously out of control. The doves can therefore nudge the inflation debate towards tolerating an overshooting of a symmetrical target, whilst the constructive position of Mester can prevent this from getting out of control. Incoming Fed Chairman Jerome Powell therefore has the ingredients to resolve the inflation targeting debate very easily by accommodating both viewpoints. This will back out as further gradualism, in relation to interest rate increases, which supports the economy and asset prices. A continuation of trends established in 2017 is therefore the most probable outcome.

(Source: Daily Shot)

The debate over if and when inflation will hit a sustainable 2%+ level continues to color perceptions about the course of monetary policy in 2018. The manufacturing sector has been a bright spot throughout 2017. It is therefore informative to study trends in employment and capital investment within this sector to put the debate over monetary policy into perspective.

It is clear that manufacturers have chosen to focus on hiring skilled workers and investing in robots to drive their stellar performance during the recovery. The gains in productivity provide the Fed with room to normalize monetary policy further, and also to rebuild a conventional monetary policy cushion to deal with the next downturn. The lack of skilled workers is often presented as a trigger for the wage inflation that will justify further monetary policy normalization.

Balanced against the calls for monetary policy normalization however, one cannot ignore the growing unemployability trend in unskilled labor that is being exacerbated by the substitution of this labor with robots. Structural unemployment and exit from the labor pool is an obvious outcome of this trend. Thus far, fear of joining the structural unemployed has reduced the demands for higher wages from the skilled workers still in employment. It will be interesting to see if this fear of unemployment will continue to temper wage bargaining as manufacturers continue to search for skilled workers. Perhaps fear of replacement by a robot or an algorithm will continue to cap wage demands.

Capital investment in robots is now running higher than the declining employment of unskilled labor and the flat demand for college educated labor. The trend in robot investment is also accelerating, so that its impacts will be more significant and also will arrive sooner in time. It would thus seem that fear of the machine is set to swiftly reinforce the subdued level of wage demands. The knock on effect to reduced consumption will then compound the disinflationary economic dynamics. President Trump's legislative attempts "to make America great again" may only serve to accelerate these disinflationary dynamics. Faced with this new environment, it is hard to see the Fed being anything more than gradualist under Chairman Powell. As the yield curve flattens further and the robot capital investment curve steepens, the bets on the ending of the normalization will become more prevalent as 2018 erodes away in time.

The Fed itself enabled the creation of these disinflationary conditions by providing the low level of interest rates that allow companies to borrow cheaply to finance the labor substituting capex. In the final analysis, sometime in the future, economic historians may opine that the Fed actually created unemployment and low inflation with monetary policy that was supposed to have the exact opposite effects!

The Fed has therefore accelerated Schumpeter's Creative Destruction phase. It may also be extending it. Tight labor markets are a manifestation of the fact that machines do not require as many workers to operate them, and that machines rather than people will increasingly do the economic lifting. This may or may not be desirable, depending on whether one has employable skills or not. It is however desirable to investors in the sectors that are perceived to substitute machines for labor.

The constructive debate and resolution of the setting of a symmetrical inflation target, with some notional upper limits, will serve to convince the Fed and its observers that no policy mistake has been made. Further mutual reinforcement of the groupthink and cognitive bias towards the creation of a fully employed, low inflation, low interest rate, high monetary liquidity environment can unfold in 2018. In Japan this condition was referred to as "the lost decades," several years after the fact, once the groupthink consensus began to erode. Currently, this scenario is referred to as "making America great again" and both the Fed and the White House are anxious to take credit for the policies that are creating it.

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.