Murder On The Disoriented Express?
- The Fed is hiking rates at what it thinks is a modest pace.
- The market is reacting as though the Fed is operating at breakneck speed.
- Fed communication seems to have thrown down the gauntlet.
- Something will have to give.
The Federal Reserve is meeting this week and nothing is expected to happen on the policy front, but there is a lot going on behind the scenes. There is no press conference scheduled, and the Fed did lift the funds rate at its last meeting. The Fed has yet to raise the funds rate in this cycle at a meeting without a scheduled press conference. We have no reason to think it will start in May.
However, there are events in the mix that could push the Fed to faster rate hikes yet this year. And there are also questions about the speed that it already plans.
The low-growth hurdle
The first pass at 2018-Q1 GDP came in at 2.3%, above expectations for it. But the surprise element in GDP was inventory strength, so that the growth overshoot at this time looks like a red herring. But the Fed is watching growth closely, as its speed limit for growth is a touch under 2%. Anything over 2% is a red flag for the Fed and a reason to slow the economic advance with monetary policy (despite the president’s objective of much higher GDP growth).
A policy emphasis on theory
The unemployment rate is below what is construed as full employment, yet wage pressures are building only very slowly. Since the notion of full employment is "abstract" and wage pressures are "real," maybe the Fed should place a bit more emphasis on what is real rather than what is abstract or theoretical? But the Fed has been into its paradigms and forecasts as a basis for policy despite its many policy missteps in recent years. That approach continues.
Inflation at long last?
In the coming months, inflation performance will be put to a stern test. The first test comes Monday April 30th with the release of the Core PCE. This is the report that will drop the weak inflation reading from one year ago, when cell phone pricing was reduced sharply. With this number out of the year-on-year inflation gauge, presumably the inflation rate will rise. Then, in May through August of 2017, there was a sequence of core PCE gains of only 0.1% per month. That will require this year’s gains to match them or be below them, or the core rate’s year-over-year pace will rise. In short, the Fed could be on the cusp of seeing the core rate go to and through the elusive 2% mark - at long last.
Will "success" spoil the Fed?
Once the Fed has one of its gauges with several monthly observations showing year-on-year inflation at 2% or higher, what will it do then? It has already been ready to hike rates without proof of inflation. Once inflation is no longer sub-par, what happens next? What happens even if inflation barely crawls above the 2% mark and shows no sign of accelerating significantly? The Fed thinks policy has been measured, but markets act as though the Fed has been running an express train.
What the market thinks
The yield curve already is showing its own signs of skepticism. Analysts are sizing up the yield curve and trying to make excuses for it because of QE and/or the Fed’s balance sheet size. There is no denying how the yield curve is behaving and what a flattening - and then an inverted - yield curve means. Those who wish to remain bullish have to find a way to set the yield curve aside. An inverted yield curve has very reliably projected recession within about one year’s time. I think we should take the yield curve at face value. The whole curve echoes the same trends.
A wheel within a wheel
The Fed is moving rates up at what it considers a measured pace but that is still flattening the yield curve steadily and rapidly. At its recent meeting, the FOMC muttered in the minutes that it would, at some point, have to communicate that the Fed funds rate would eventually have to move above neutral. Right now, the Fed puts long-run neutral at 2.9% for Fed funds. At the pace that the yield curve is flattening, there is no way the Fed will get to neutral, let alone above it, without triggering an inverted yield curve and, by association, signaling a recession is coming. With its communication, the Fed seems to have painted itself into a corner.
The risk of clear communication
This is the great danger of clear communication. By releasing a statement in the minutes about how it is going to have to tell us that Fed funds will have to move above neutral, it has essentially done just that. And having clearly identified 2.9% as neutral, we know where Fed funds rates are headed, and with that, the policy dilemma is complete and the bond market is choking on the news.
The unyielding message of the yield curve
The 10-year to 3-month yield curve is the best recession gauge, using its inversion as recession signal (here). But the curve from the 10-year note to the 2-year note has been flatter on only 13 days recently. The segment for the 10-year to 30-year portion of the yield curve has been flattening the most relentlessly. The long segment of the yield curve has been flatter only back in 2008. Yield curve signals are quite clear. The 10-year to 3-month curve is still 118bp away from inverting. So, recession signals are not imminent. Yet, they seem inevitable.
And that is a real policy dilemma for the Fed. It seems to want to warn us that it has to take policy somewhere that it will not be able to go. And all of that is in train even if inflation remains restrained. In 2016, the Fed and the markets were famously at odds, and despite lots of bravado from the Fed, the markets were right and the Fed had to abstain from rate hikes until year end when it snuck one in to save face. Will the markets be right again? I’d bet on it.
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