Powell's Outa Touch, Fed's Outa Time And It's 'Agonizing'

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by: Adam Whitehead
Summary

The global environment may re-engage with Fed monetary policy before it has reached its inflation target and/or the new neutral rate of interest.

The Fed attempts to explain the meaning of "symmetrical" inflation targeting policy.

The Fed is still struggling to distinguish perceptions of a "symmetrical" inflation target from a ceiling level.

Steepening the yield curve, or at least positively framing perceptions of its current shape as a bull flattening, is a current Fed priority.

Chairman Powell is going to strangle his colleagues' guidance in favor of his own voice.

(Source: Gallup)

The Fed has chosen to debate inflation targeting and tolerance for an overshooting of its inflation target at a time when American optimism is just starting to break higher. A classic rise of inflation and growth will cut short the debate and bring further tightening of monetary policy. If there is no growth but there is inflation, the Fed will have to explain its tolerance for Stagflation. If there is no growth and/or no inflation, the Fed's dual mandate adherence will lead to further calls to maintain or even expand the current monetary stimulus.

The Fed faces a delicate near-term future, as it remains data dependent. Whilst the Fed adopts a blinkered domestic viewpoint, the global economy is starting to dissociate itself dangerously from America however. The Fed Chairman and his colleagues ignore the global backdrop at their peril.

The Fed thinks that it is close to hitting the neutral rate and is now "agonizing" over what to do when it hits it. Whilst it agonizes over these details, the global financial markets are "agonizing" with price action. The Fed's primary focus now seems to be the US Yield Curve. Focus on the curve is obscuring the Fed's view of the global picture.

(Source: Seeking Alpha)

The last report tracked the evolution of and initial benign Fed response to nascent Stagflationary conditions. A default bias towards accepting stagflation was noted at the Fed by nature of a growing consensus to tolerate inflation overshooting target. New York Fed President Williams was even noted as calling the Stagflationary conditions a "Goldilocks" scenario. The damaging dissonance caused by a Fed tolerating Stagflation, which is in conflict with its dual mandate, was noted with the suggestion that the central bank would be asked to explain exactly what it means by "symmetrical" inflation targeting. The 10-Year Treasury breaching the three percent yield threshold and attendant risk asset wobble then signaled that this explanation was due.

(Source: Seeking Alpha)

This market enforced trigger point should also be a wake-up call for Chairman Powell. The last report observed his unease and difficulty sounding convincing on economic policy issues in comparison to his candor and comfort talking about regulatory matters. Unfortunately for him, the economic policy part of his job description is more significant than the regulatory one; even though he got the Chair through his abilities in the latter rather than the former. Specifically, his ignorance of his own research team's analysis which strongly contradicted his "intuitive" view that tighter Fed monetary policy does not affect global economies was highlighted.

The recent market trigger signal, which has been amplified across emerging markets, once again shows that Powell's intuition was incorrect. The risk associated with the Chair was noted as rising significantly by nature of his economic policy weakness and key man position. The latest market trigger signal should therefore elicit a response from him, in which he tries to be more authoritative about economic policy issues in both a domestic and global context. His silence on these matters will only erode confidence further and raise uncertainty along with market volatility.

St. Louis Fed President James Bullard does not vote this year; however, if he did vote, he would be right up there with those FOMC members who have a tolerance for inflation overshooting aka Stagflation bias. What New York Fed President John Williams refers to as the "Goldilocks" economy, which gives the Fed the flexibility and option to tolerate an inflation overshoot, Bullard characterizes as a "Champagne" economy.

Bullard recently celebrated what he believes is the achieving of the new neutral rate and hence the red light on further interest rate increases. According to Bullard: "We should probably be opening the champagne here, have this be a champagne breakfast," since "it doesn't get any better than this." Apparently, companies also now have the option to either raise wages or capital investment. Why they can't do both simultaneously does not seem to occur to Bullard. Should they elect to pay higher wages without capex, the Stagflation take-off point will have been reached.

As the "Champagne" went to his head, Bullard then started to abuse his colleagues for flattening the yield curve and making markets believe that a recession will occur. He unequivocally blames his colleagues' rhetoric for what he perceives as a bear yield curve flattening, in which fear of future rate hikes translates into a self-fulfilling recession prediction. His conviction that the neutral rate has been hit, negating the further "scramble" to raise interest rates, forms the basis of his abuse of his colleagues.

In particular, Bullard singled out Fed communication policy for criticism and looked back fondly on the days of obfuscation under Chairman Greenspan. Specifically, he focused his ire on the dot-plots and suggested that their visibility, in combination with misguided communications, was tipping the yield curve into giving a dangerous inverted recession signal.

Perhaps as a knee-jerk reaction to Bullard's attack, Dallas Fed President Robert Kaplan then stated that he would not like to see the yield curve invert and that his projection for two to three interest rate hikes this year is not cast in stone.

New York Fed President John Williams swiftly dismissed Bullard's criticism and reiterated that his "Goldilocks" economy can withstand three to four rate hikes this year. For him, the "Goldilocks" scenario gives the Fed the green light to normalize. He does not see that the neutral rate has risen during the economic recovery. It remains languishing around 2.5%. This means that in the next two to four interest rate hikes, the Fed will have hit the neutral rate.

Evidently, Williams is more interested in building a conventional interest rate cushion at the risk of inverting the curve and causing a Taper Tantrum. Perversely this implies that he is building the conventional monetary policy cushion to create the recession that he is signalling and bringing into fruition. He is walking a very fine line of credibility since he sees no conflict between opining that there is no pressure on the neutral rate to be higher even though he is at the Hawkish end of the scale for interest rate hike projections. Clearly Bullard and Williams are going to go up against each other over the rest of this year.

Inflation Targeting is a dish best served cold.

(Source: Seeking Alpha)

A previous report noted that Cleveland Fed President Loretta Mester is the de facto key person managing the process of reforming Fed policy and guidance.

(Source: Central Banking)

Mester uses less hyperbole than either Williams or Bullard to describe the situation, but she is no less voluble as a consequence. Her latest comments supported this thesis and signaled that inflation targeting is the next piece of business on the Fed's policy reform agenda. Whilst getting into line with her colleagues on accepting an inflation overshooting of a "symmetrical" target, she still gave herself sufficient wiggle room to wiggle in three to four further interest rate hikes without being viewed as Hawkish. She did this by stating that the "symmetrical" inflation target is a long-term guide, which will allow her to see through any near-term vicissitudes in the data.

As the doyenne of central bank strategic operators, Mester then wove her inflation targeting narrative into the wider context of macrostability policy. The current "Goldilocks" environment in her view creates an ideal opportunity for the Fed to build a countercyclical macrostability buffer in the form of a commensurate conventional interest rate buffer.

Minnesota Fed President Neel Kashkari's contribution to the inflation targeting debate is based on his view of wages and the lack of inflation in them. This remains a "conundrum" for him that he has thus far not been able to explain empirically. He needs more evidence that wages are rising and notes that total pay is only growing at 2.7% annually compared to 3.5% before the crisis. He also acknowledges that Inflation has only just reached the FOMC's target having undershot for the last six years of alleged economic recovery. His uncertainty implies that he will accept inflation targeting overshooting in principle. He will also wish to keep the interest rate increase process on hold until he has a better handle on the cause(s) of his "conundrum".

Philadelphia Fed President Patrick T. Harker's view is converging on that of Kashkari. Whilst happy to gradually raise interest rates another two or three times this year "judiciously and when we (the FOMC) can", he is now looking to the next pause in the rate hike process. He refers to the Fed's monetary policy tools as being "ill-equipped" for fine tuning. This perceived inadequacy prompts him to suggest that the FOMC should pause when the neutral rate is hit within the next two or three hikes.

(Source: Atlanta Fed)

Atlanta Fed President Raphael Bostic, who has shown himself thus far to be an excellent communicator, took an educated stab at explaining what "symmetrical" inflation targeting means to him. In doing so, he revealed that he is in fact not tolerant of Stagflation after all. Bostic noted that capex has not increased in response to the Trump fiscal stimulus. The "Stag" part of the descriptor has thus been explained by him as a loss of capex. He also noted the "flation" with his observation that labor markets are still tightening. His take on this current Stagflation is that it is potentially a dangerous fall in productivity.

Bostic's take on the yield curve is that he and his colleagues must do everything in their powers to prevent a recession signalling curve inversion. This means that their rate increase commentary should be framed to steepen the curve by talking up future growth and inflation prospects. As James Bullard has noted, this will be difficult without a quantum shift in the dot-plots to reflect rising growth and inflation however.

The fall in productivity is not something that Bostic will tolerate. He therefore comes down on the tighter side of the interest rate increase trajectory as a consequence. It can thus be seen that his "symmetrical" inflation overshoot is only acceptable to him, if it comes with the increase in productivity of combined employment and capex increases. Just to be on the safe side, he advocates the continuation of building a conventional monetary policy cushion to deal with the next recession, given the challenge created by the low neutral rate to achieving a cushion of significant size.

Bostic's view of the medium to long term however shows that his tolerance for inflation overshooting is higher. His longer-term view of inflation and growth is that both will underwhelm. The period of Stagflation that worries him is therefore a short-term phenomenon. His longer-term projection sees disinflation as a greater risk.

The release of the last FOMC meeting minutes shone some more light on what the Fed thinks about inflation target "symmetry" in the context of the signal being sent by the flattening yield curve. There was a sense that the June rate increase is a done deal in order to signal that the FOMC does not want the market to assume that it will tolerate a large overshooting of the 2% target. There was also a growing concern over the recessionary interpretation of the flattening curve. The FOMC has a dilemma. If it stops in June and the incoming data is weaker on the inflation and growth front, then the curve will continue to flatten. The FOMC is therefore hoping for and betting on the "Goldilocks" scenario to gradually steepen the curve. It will also need its guidance to match its aspirations for the yield curve. As the minutes showed, the first order of business post meeting is to stop recession perceptions of the flat yield curve and/or to steepen it.

Dallas Fed President Robert Kaplan had the dubious privilege of being the first Fed speaker to frame the perceptions of the latest FOMC minutes. Kaplan focused on his definition of "symmetry". In his view, "symmetry" is a small tolerance for inflation running above target, which he reinforced with the vision of four more interest rate increases and possibly more all the way into the hitting of the 2% inflation target. Given his tone, it is hard not to come away with the view that since he only has a slight tolerance for inflation slightly above target, his view of "symmetry" is closer to a ceiling limit rather than a flexible pivot point. Whilst therefore potentially steepening the yield curve, by promising more rate hikes, his stricter definition of "symmetry" in effect will flatten it.

Kaplan then obfuscated further in a second outing post-minutes by choosing to focus on the risks to economic growth for 2019. His discourse on the risks basically conflicted with and unraveled all his earlier Hawkish remarks. He then advertised this conflict and dilemma by discussing his uncertainty surrounding what to do when the neutral rate has been reached. He is "not yet there on what we (the Fed) should do once we get to neutral," but "I (Kaplan) think we are going to have quite an agonizing debate for lots of reasons, including the shape of the yield curve." If his commentary is a good guide, then it may be a blessing that he does not vote this year. Unfortunately, he will be a voting member when the "agonizing" debate over what to do next happens.

Bostic's candor over the Fed's inability to finesse the normalization through a lack of precise economic measuring tools and process added to the sense of trepidation created by Kaplan. With disarming yet worrying humility, he confessed that "sometimes I worry there's an illusion of precision that we know to the very decimal place exactly where we are at any moment, so that we can say, this is exactly where we should stop, and I don't think that that's true". As a practical solution to mitigate the risks he suggested that "once we get kind of in the neighborhood (of the neutral rate), then you have to see what's happening in the marketplace to get the signals as to have you gone too far or have you not gone far enough."

Being led by the market, which expects to be led by a confident central bank, may sound practical in theory but may end up being anything but so in practice however. The current evidence suggested by the yield curve perception debacle should not convince Bostic or his colleagues to follow Mr. Market blindly. The blind leading the blind is not a practical way to subcontract out monetary policy decisions in practice.

So perverse has the Fed's "agonizing" become that previously predictably easy to categorize speakers have second guessed themselves so much as to completely U-turn on their initial positions. Chicago Fed President Charles Evans is a classic case that illustrates this point. Having been a recognizable Dove, his position is wobbling the closer the Fed gets to the neutral rate. He now "agonizes" over what if he is wrong about inflation and rhetorically speculated out loud that "you wouldn't want inflation to pick up too much. That could be consistent with a faster pace, and that would be cautious in terms of outcome."

Seemingly worried by his own Hawkish theorizing Evans then quickly discounted it by saying that he is not sure that the Trump fiscal stimulus will move the GDP significantly higher. He then went into further Dovish withdrawal with the old favorite theme that technological driven innovation is the secular disinflation driver that will win in the long term. Like his Dovish and Hawkish colleagues, he is everywhere and nowhere simultaneously.

Philadelphia Fed President Harker spoke with a far more nuanced interpretation of the word "symmetry". For Harker it is an issue of vectors; whereby the rate of change of inflation is more important than the difference between the headline number and the target. He would therefore tolerate a slow acceleration of inflation to and beyond target, as we see now. He would not tolerate a rapid acceleration. By inference his tolerance would apply to a disinflation vector also. Consequently, Harker would go for three rate hikes this year and then a pause, with a view to three more rate hikes in 2019 if the same vector forces are in place. Harker's view is more likely to beget a steeper yield curve than Kaplan's.

Harker's practical approach was then underlined by Atlanta Fed President Bostic. He would first like to get to the neutral rate and then pause for reflection and forecasting once there. He therefore complies with Harker's plan of continuing to hike interest rates gradually into and slightly beyond the inflation target, and thus the new neutral rate by default.

The Fed is doing its best to reframe perceptions of the yield curve. Its job would be made easier if it only had to frame perceptions of the "Goldilocks" US domestic data. Unfortunately, there has been a rash of data out of Europe which has shown a troubling softness in Q1. Improving trade relations between China and the US may lead to managed trade and quotas between the big two which will involve the cannibalizing and then sharing of other nations' trade surpluses with the US. As China and the US share the "Goldilocks" scenario between them, it may be at the expense of global trade in general. Rising US interest rates are also causing a significant Taper Tantrum in the emerging markets which will negatively impact global growth.

Sooner or later, the Fed will once again be forced to factor in global economic developments into its narrow domestic perspective. Unfortunately, this growing realization may be some way off. Chairman Powell is on record for saying that tighter US monetary policy has little impact on the global economy, despite a study by his own staffer colleagues that shows the contrary and also the current real-time risk-off environment in emerging markets. Rather than perjure himself, early in his career as Fed Chairman, he is more likely to ignore the developing global carnage in the hope that observers will have forgotten what he said in their new demands that he now comes to the rescue of the global economy. He will then appear as the solution rather than part of the cause.

Faced with this major global tipping point, as the Fed nears the neutral rate and the global economy hits a negative inflection point, the reaction of Chairman Powell was underwhelming. Perhaps he is deliberately trying to take the angst and volatility out of the situation. If this is the case however, it is not working, so that his credibility is becoming even more challenged.

Chairman Powell chose the venue of the celebration of the world's first central bank's 350th anniversary to address his growing list of critics. The criticism he chose to answer was in relation to his and hence the Fed's independence. During the confirmation process of new Fed Governors and the Chair, it has been suggested in some quarters that these are political appointments that have allowed President Trump to capture the Fed. Chairman Powell therefore chose this moment to opine the subject of Financial Stability and Central Bank Transparency in order to illustrate his and the Fed's independence.

Chairman Powell's speech fell back on his familiar ground of rules and regulations, conveniently avoiding monetary policy directly and thereby subsuming it to the headline of macrostability. He spoke passionately and authoritatively of the reasons for the Fed to remain transparent and independent, using his own bailiwick of bank stress tests to illustrate these two key features of the central bank. The inference was therefore that since he is talking the independent talk that he will walk the independent walk. By further inference, if the Fed gets the independence and transparency right, Mr. Market will reciprocate with alacrity, with signals that the Fed can make informed and correct monetary policy decisions from.

In specific relation to monetary policy, Chairman Powell then obliquely addressed the Fed's current "agonizing". His oblique address was very revealing. It revealed that not only does he not understand the subtle interplay between Mr. Market and Fed guidance but also that he has very little respect for or belief in its utility. Given the current disconnect over the yield curve, one has to say that Chairman Powell has a very good point. Given the current "agonizing" of his colleagues and the market reaction to it, one would have to further support his thesis. Powell announced that going forward, as the Fed nears the neutral rate, the policy tool of guidance will lose its importance and utility. Going forward the dumb (Fed policy makers) will follow the blind (Markets). This new communication, policy transmission and price discovery system should make for a trader's paradise. Investors will like it less than traders however and will raise risk premiums accordingly.

A previous report explained that Fed guidance, under the stewardship of Loretta Mester, will be reformed this year. Taking Powell at face value, it is going to be strangled not reformed! All eyes on the data from now on and ears only on Chairman Powell. The Chairman has responded to the challenge to his credibility by strangling the voices of his colleagues so that only his will be audible. He has therefore responded to the challenge by raising the stakes just at a time when the global stakes have also been raised by his indifference to the economic wounds that he inflicts on America's trade partners with his narrow domestic focus. Talk about "America First" maybe one should be talking about "Federal Reserve First". Better still, "Chairman Powell First"!

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.