President Trump is turning up the heat directly on the Fed through rhetoric and indirectly through his global trade policy. The Fed has a narrow congressionally approved mandate to act domestically. The Fed must therefore wait until the global impact of the president's actions show up in the domestic economic data before it can execute remedial monetary policy action. This time may have come.
The last report investigated what was termed Powell Doctrine in relation to the Fed's MO under the Chairmanship of Jerome Powell. The chairman's ability to exercise greater control, over the communication process, was analysed in relation to the verbal reaction from his colleagues after the new doctrine was revealed at the last FOMC meeting.
The recent release of the last FOMC meeting minutes provided further insight into the thesis and antithesis in relation to this doctrine. The minutes show a healthier debate of the salient economic headwinds and tailwinds influencing the emerging doctrine. Chairman Powell may therefore be able to temporarily seize the initiative and frame the guidance narrative at his more frequent press conferences. The Fed's strong internal governance policy of having a recorded agenda and debate however undermines the ability of Chairman Powell to totally control the narrative for any sustained period of time. He is therefore still going to have to work hard to build a consensus to support his position. His recent semi-annual testimony and related commentary from his colleagues have shown that he has made great progress in achieving this consensus.
Unless Chairman Powell can effectively control the FOMC's board schedule and agenda, his ability to project Powell Doctrine will be circumscribed by his colleagues' application of the process. Chairman Powell was thus able to frame Fed policy as deserving of an extra interest rate hike this year, yet the minutes undermined this hawkish tone by clearly recording the granular debate about domestic and global conditions. This granular debate has then unfolded into the finished article that Chairman Powell delivered to Congress.
Using the FOMC minutes as a yardstick, it was also apparent that the veracity and hence utility of the yield curve as an actionable policy signal input was under intense scrutiny. There appear to be three significant structural reasons presented to throw out the yield curve as a primary input, which are:
- A "reduction in investors' estimates of the longer-run neutral real interest rate"
- "Lower longer-term inflation expectations"
- "Lower level of term premiums in recent years relative to historical experience reflecting, in part, central bank asset purchases"
The yield curve is becoming a victim of the new global disinflation phenomenon and its corollary impact of expanded Fed balance sheet, rendering it a policy-making anachronism. By default therefore if the Fed maintains an expanded balance sheet (which it has signalled an intention to do) and long-term inflation expectations remain subdued (a signal of central bank success), the yield curve will continue to become more obsolete for policy makers.
The implication of the binning of the yield curve for credit spreads and asset prices is profound. A structural floor (and hence bid) for risk assets, based on the long end of the yield curve, is being established. All traditional relative value metrics can thus be scrapped. This will effectively make the valuations and volatility of risk assets a function prone to a strong influence of capital flows. An understanding of these capital flows will therefore be of more importance than an understanding of how they influence the derived yield curve. The bubble is asset prices and related macrostability risk which the Fed is hoping to control have thus been structurally inflated and destabilised respectively by the dropping of the yield curve as an economic signal generator. Gradual moves in interest rates to address this bubble risk may thus prove to be ineffective. The Fed will need some new macrostability tools to augment its power to deal with the capital flows.
Minnesota Fed President Neel Kashkari is not about to abandon the traditional interpretation of the yield curve just yet. For him, the signal from the flattening curve is clear. The signal is that the Fed does not need to raise interest rates any further because it has arrived at the neutral rate.
In his congressional testimony, Chairman Powell also showed some empathy towards Kashkari's view. Signalling that the neutral rate is coming close, he opined that the interest rate hiking process is not on autopilot. More interestingly he said that the flattening curve is telling him that the neutral rate is near; at least in Mr. Market's view if not his own. When Powell said that "we're close to full employment, maybe not quite there," the forward-looking Mr. Market began to sense that a pause in the interest rate hiking process is near. It may be near enough for Mr. Market to also discount mission accomplished. He may then also start factoring the economic weakness in the Fed's Dot-Plots from 2019 to 2020 and the monetary policy implications of them. This risk asset bid could also perversely get amplified if Mr. Market begins to think that the next move in interest rates is lower to deal with trade war risks.
In the current state of the global trade war, the truth in relation to who wins and who loses from the current status quo and/or the conflict has been lost in the fake news from all sides. There is however no escaping the fact that the most important casualty is economic growth. Incoming data on all sides is now showing the rising body count. Against this global backdrop, Fed Chairman Jerome Powell is gamely adhering to his doctrine of "Think Domestically, Act Gradually". It is therefore interesting to follow the development of the things that could undermine his adherence to doctrine.
(Source: Philadelphia Fed)
The last report suggested that the Fed's inflation mandate was getting compromised by falling inflation expectations despite recent data upticks. The question over what the FOMC should do when the neutral rate is hit is framed by this disinflation halo effect. The latest inflation expectations data out of the Philadelphia Fed shows that this dilemma is imminent. Inflation expectations are lower than in May of this year and lower than in June of last year. The rise in current incoming inflation data is thus failing to push future inflation expectations higher.
(Source: Atlanta Fed)
On the growth side (or rather lack of it), trade war blowback was clearly evident in Atlanta Fed's GDP forecasts made at the end of June.
(Source: Atlanta Fed)
It should be noted that this emotional reaction was however swiftly reversed by the next forecast. It is fair to say that this growth risk appears to be balanced for now.
The last report noted that Atlanta Fed President Bostic was voicing concerns of such blowback preventing him from going along with further interest rate increases. Evidently, he was cribbing off his own research department and his concerns are empirically rather than speculatively driven.
(Source: San Francisco Fed)
Whilst data dependent Fed Chairman Powell works on his consensus building skills, his colleagues over at the San Francisco Fed have been busy analysing fiscal stimuli past. They have found that counter-cyclical fiscal stimulus has had more bang for the buck than pro-cyclical ones. The conclusion to be drawn is that the current fiscal stimulus will not create the economic growth required to pay for it in the form of tax revenues. The negligible economic stimulus combined with deficit widening outcome is therefore sub-optimal. There may thus be upward pressure on US interest rates in consequence. This upward pressure is in addition to the upward pressure already being exerted by the Fed's normalisation process. The exacerbated pressure on yields is thus a net economic headwind rather than the desired stimulus.
The Fed's semi-annual congressional testimony provided another opportunity to calibrate the gradual approach adopted to the normalisation process under the framework of Powell Doctrine. At the headline level, the testimony signals a continued gradual approach to raising interest rates. The Fed appears to have become more granular in its analysis of the labour market; particularly the components of spare capacity highlighted by the participation rate. This participation rate analysis has been further granulated in relation to demographic structure. The big picture view of this analysis is that the Fed still believes that there is some slack out there that will exert a suppressing force on wage increases.
San Francisco Fed President John Williams framed this analysis in dovish terms by observing that companies are now expending time and money in training workers. There is thus a productivity expansion at play for those in work also.
The consequence of spare capacity and productivity gains will have the impact of slowing the FOMC's enthusiasm to raise interest rates faster and/or by larger increments. It is interesting to note that the Washington Fed's dovish view is diverging from that of the regional Fed members. Eleven out of the twelve Fed regions voted to raise interest rates at the last FOMC meeting with only the New York Fed abstaining. The New York Fed's position is hardly surprising given that its new president is John Williams.
Williams' observation should be put into the context of a background report by the IMF on the subject of missing wage pressure. The IMF attributes this phenomenon to two causes. Firstly, productivity is falling. Secondly, the share of wages in relation to total production costs is falling. Williams has apparently noted American businesses responding to the productivity problem. If they however respond by investing in a more productive robot, then labours' share of GDP will continue to fall. A tightening labour market can thus continue to co-exist with stagnant wages. Returns to capital would then compound, with the P/E multiplier effect exerting ever stronger pressure on valuations of companies substituting capital for labour.
Cleveland Fed President Loretta Mester is more aligned with the feelings in the regions. She is not prepared to play wait and see on the inflation front. In addition, she sees the risk of creating bubbles in asset prices and oversupply in the real economy by delaying interest rate increases further. Consequently, she is in favour of two more interest rate increases this year. Interestingly, she has no broadcast view on the capacity situation under investigation in the labour markets.
The new relatively hawkish position of Chicago Fed President Charles Evans is more notable than that of Mester. In his latest speech, Evans showed himself to have become more comfortable with two further interest rate increases this year. His confidence takes into account the known risks of the unfolding trade wars, which speaks to his confidence in the innate strength and sustainability of the US economy.
Philadelphia Fed President Patrick T. Harker now finds himself being compromised in the same way that the regions diverge from the Washington and New York Fed. Whilst still standing on his baseline of three rate hikes for this year, he is starting to get nudged into accepting one more. It is the rise of service sector inflation, which by far reflects the largest component of national wage inflation, that is nudging him. Should this rise in service sector inflation cause an acceleration in the pace of inflation beyond target, then he will change his view.
In a somewhat similar fashion to Harker, Atlanta Fed President Raphael Bostic now finds his three rate hikes for this year baseline being challenged. Bostic has however reserved some flexibility in which to ponder his future moves by signalling that there is no single data set that is an automatic trigger for his interest rate increase vote. His view is balanced based on an unscientific blend of incoming data and news on the global trade front.
In the absence of data which challenge the basis of Powell Doctrine, Chairman Powell is adhering closely to the Goldilocks scenario baseline, which affords him maximum flexibility to normalise gradually. In his latest assessment, he affirmed his position and the environment with the characterisation that the economy is in a "good place". The combination of Trump stimulus with its impact to be sustained for three years and global trade uncertainty makes for this dynamic Goldilocks equilibrium environment.
Dallas Fed President Robert Kaplan recently alerted his voting colleagues that the impact of the global trade war has showed up in his district. He sees the evidence of this in local business reluctance to make and postponement of plans to invest.
At the extreme hawkish end of the spectrum, there are also signs that the neutral rate pause is just around the corner. Kansas City Fed President Esther George's latest commentary conceded that "gradual further increases in our policy rate will be necessary to return policy to a neutral stance, although there is considerable uncertainty about exactly how far or fast we need to go."
The neutral rate has been reached for some FOMC members and is close for others. There is nobody calling for any acceleration in the normalisation schedule despite the recent inflation uptick that would require this. All of a sudden what this author characterised as the "Think Domestically, Act Gradually" thesis of Powell Doctrine has noted the global environment showing up in the domestic economy.
As President Trump diverges from the global economy, the Fed is converging on it. This is consistent with the Washington/New York Fed diverging from the regional Fed. Such divergence is not necessarily such a bad thing. The latest Beige Book shows that the regions have lowered their assessment of their local economies to "modest-to-moderate" growth. Texas proves to be the exception, with a very localised boom in the oil economy; which in and of itself is also driven by global factors. Texas is now the third largest global oil producer, ahead of Iraq and Iran. It should also be said of Texas that Dallas Fed President Kaplan has already noted the negative externalities from the global economy showing up in the data. Texas is thus very much a global barometer. The regions may therefore also be converging back via the Washington/NY Fed onto the global economy, leaving the president in further domestic isolation.
The president recently broadcast his frustration at not being able to make monetary policy by executive order. Unfortunately for the president, Chairman Powell runs an autonomous independent agency that is answerable to the Congress and not the White House. Evidently, the president's economic advisers have not made him aware that the neutral rate is getting closer each time the he disrupts the global trading system. If the president truly wishes to make Chairman Powell stop normalising monetary policy, he should simply continue to beat up on America's trade partners. If and when the Fed is forced to declare neutral rate arrival, under duress from the global slowdown, no doubt the president will take credit for this event and the risk-on rally that has anticipated it!
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