Fed's Metanoia, Are You Feelin' It Yet?

by: Adam Whitehead


Guidance and the Neutral Rate are dead – Thus sayeth John Williams.

Guidance should be more explicit – Thus sayeth Dr Mojon.

Explicit Guidance and the Neutral Rate are still alive – Thus sayeth FOMC members.

Things could go either way, so I’m a gradualist – Thus sayeth Chairman Powell.

I haven’t got a Scooby – Thus sayeth Mr Market.

The last report asked and then began investigating the related questions of whether the Fed has learned from and reformed since the GFC. The early conclusion is that the Fed has indeed learned and is in the process of "gradually" reforming, but there is a long way to go. Such learning and reform would, however, be pointless, without the Fed's audience undergoing a similar transformation. With this in mind, it is becoming increasingly evident that the Fed is also re-educating Mr Market, in order to optimize the transmission and impact of said learned and "gradually" reformed monetary policymaking.

This education process is one of metanoia, or creative destruction for those who still cling to past economic ideas. The old teachings of economics were also victims of the GFC but nobody has told Mr Market until now.

The destruction phase has begun, with a deconstruction of the yield curve, in order that it can be reconstructed to fit what used to be known as a bull-flattening signal. This process is well underway. However, unfortunately, there are still some educators, like St Louis Fed President James Bullard, who still refuse to be totally re-educated themselves.

(Source: St Louis Fed)

In an act of defiance, Bullard recently continued to elude the FOMC Thought Police by openly discussing the new taboo subject, of an inverting yield curve, in the public domain on the St Louis Fed's internet domain. He called for a pause in the interest rate hiking process, based on his own view that Mr Market does not see an inflation problem yet, as the best way to avoid the self-fulfilling recession prophecy associated with the inverted yield curve. Bullard also showed no intentions of dropping the notion of the neutral rate, since it is central to his own thesis. By his estimation, the FOMC has now reached the lower bound of the neutral rate; and he is looking out for negative feedback, of this tightening of US Dollar liquidity, from the global economy to the US domestic economy. His expectation of a US economic slowdown in 2019, suggests that in fact economic conditions are pushing the neutral rate down to converge on the rising Fed Funds rate. This convergence dynamic is made even more powerful by the fact that he sees no underlying inflation.

Far from being a wide-eyed Dove, however, Bullard remains a pragmatist; especially in relation to the Phillips Curve, which he has no intention of dropping as a guidance tool either. As he sees it, at this level of tight labour markets, only improving productivity can create economic growth. He is willing to take a leap of faith and sponsor this increasing productivity by immediately pausing the rate hiking cycle. Anchored inflation expectations are a necessary evil to maintain his sponsorship, which, fortunately, he still believes are the case. Any un-anchoring of inflation expectations will compromise him therefore.

Standing back and looking at the trail of evidence, that the Fed is laying, one can discern a pattern of removal of traditional market signals from Mr Market's frame of reference. Thus far, the Fed has not inculcated its audience with any new signals to replace those which it is removing. It is quite easy to see Mr Market flailing around in a volatile manner, as his traditional crutches are ripped away systematically by the Fed.

Applying this author's favorite allegory, of sensei Bruce Lee and his neophyte, Mr Market is looking at the finger and not the heavenly glory that it indicates. Unfortunately, however, the finger is now being removed and there is no heavenly glory yet visible to replace it. Indeed, the heavenly glory is increasingly obscured by the hell of a global trade war, Brexit and surging crude oil prices which is blinding Mr Market. We are left with a picture that resembles Bruegel's Blind Leading the Blind.

Presumably, after churning around on data releases and wrecking his P&L in the process, Mr Market will sit quietly and wait for the Fed to tell him what to think and how to react at each FOMC meeting. He may never know when the normalization has stopped until the Fed actually eases again. Ignorance may then move from being frustrating to become bliss. Currently, however, frustration is the order of the day.

Said frustration made itself known as a new spike higher in US bond yields and related spike lower in risk asset prices. The strongest response that this spike elicited from the Fed came from Cleveland Fed President Loretta Mester. Her response only made the frustration worse; as she claims that she is not worried by Mr Market's frustration yet but is watching him writhing around with greater interest. Mr Market's tightening of monetary policy on her behalf by strengthening the US Dollar must certainly be getting her full attention.

Morgan Stanley became the first high profile casualty as Mr Market takes no prisoners. The firm rescinded its big call on the peak in yields this cycle, along with the bull yield curve flatteners it also promoted. JPMorgan (NYSE:JPM), however, chooses to use the current spike in yields and volatility to begin gradually building a long duration position in fixed income rather than to make a big call on outright yield levels. BlackRock's Bond King Rick Rieder also sees this chaos as a door opening to enter the market, as it signals to him that the Fed is nearly done hiking interest rates.

The lack of consensus, but clear two way trading interest, is something that the Fed will be pleased with; since it mirrors its own growing opacity perfectly, whilst keeping Mr Market on his toes. John Williams pronounced his satisfaction, with the carnage he and his colleagues have unleashed, by opining that this Taper Tantrum is all part of a bigger plan to sustain the economy by deflating asset bubbles.

In something close to America First at best or sadism at worst, Williams then ridiculed the Emerging Market sufferers of the Fed inflicted chaos. Trying his best to keep a straight face, he opined that transparency and open communications will be key to avoiding market disruptions and misunderstanding in other countries. He then admitted that said transparency and open communications from the Fed will soon disappear!

(Source: Philadelphia Fed)

The gradually inverting inflation expectations curve is something that the Fed yield curve de-constructors will want to pay close attention to. Short-term inflation expectations are rising, but medium to long-term expectations are falling. The FOMC may need to be a tad more than gradual in the short-term (but not by much) with its interest rate hikes; yet the benefits of doing so are clear in the medium to long term. If guidance is however going to be gagged, this precludes preparing Mr Market for anything more than 25 basis points. Anything more than 25 basis points will therefore make Mr Market confused and panic. This inverting curve does suggest that the neutral rate (which we should not be thinking about anymore!) is theoretically close at hand.

Boston Fed President Eric Rosengren hasn't yet decided to follow Williams' advice and go silent. This suggests that he believes he has some wisdom of his own to inculcate into Mr Market and perhaps also his colleagues. This also suggests that he does not see the neutral rate as close. In fact, he may even see it gradually eluding him.

Noting second round inflationary pass-through effects to pricing power, Rosengren advocates moving monetary policy to become "mildly restrictive". The "mildly restrictive" view is framed by his opinion that ultimately America's trade sanctions will backfire on the US economy. Rosengren's sentiments resonate with the inverting kink in the inflation expectations curve seen above. Evidently, he is following these developments closely. Seeing through the backfiring trade situation, however, he foresees the risk, of an already overheating labor market, leading to the kind of inflation performance that would call for much larger and potentially more damaging interest rate increases. Gradually becoming "mildly restrictive" today is preferable to become massively restrictive later. Sustaining economic momentum by being "gradual", into and through the backfiring trade event is also a prudent form of risk mitigation all of its own too.

Minnesota Fed President Neel Kashkari is certainly due a visit to the Thought Police for re-education. He continues to see no tightening signal in labour markets, or any inflation pressures, that necessitate further interest rate increases at this point in time.

Chairman Powell is happy to demonstrate that he is learning something new every day about the US economy, by observation rather than through re-education. He also recently provided some rhetorical heavenly glory for Mr Market; in order to leave a subliminal positive impression, before guidance and the neutral rate are removed, in the new data-dependent Fed of the immediate future. This impression was entitled "Monetary Policy and Risk Management at a Time of Low Inflation and Low Unemployment".

(Source: Federal Reserve)

The last report discussed the initiative taken by Eric Rosengren, to reform the Fed's monetary policy framework, in a time when there is a lack of a conventional monetary policy cushion and other, fiscal as well as regulatory, buffers to deal with another economic growth shock. It was therefore with great interest that this author noted Chairman Powell's response with alacrity to Rosengren's call to the "buffers". Their co-ordination and media choreography suggest a grander design and methodology; as well as clear intentions and capability to execute. Powell's response came in the form of his own learning process at the hands of the economic data, rather than the Freshwater or Saltwater Schools of economic thought where his colleagues were baptized.

(Source: Jerome Powell!)

Powell wandered ex post down memory lane in economic theory (especially the Phillips Curve) and its grilling tests during the crisis and the recovery. He did so, always taking care to wear the Congressional shoes of the dual mandate on his feet, in order to evade capture by President Trump. He even threw in a Phillips Curve formula for authenticity.

Powell concludes that evidently things are different these days, since the magnitude of the crisis and the response have rendered the traditional theories behind the Phillips Curve and neutral rate of interest redundant in practice. There is an observable lower neutral rate; empirically supported by the strong employment and low inflation conditions currently being experienced. The Phillips Curve, however, is not dead. It is just flat because the Fed has done such a good job in the past of anchoring inflation expectations to its 2% target. It is not too good to be true, since it is all true and apparently self-evident. Whether it may last is however the real challenge that preoccupies Powell's mind.

Powell has an inkling of a risk that, as things gradually get back to normal, there may be a mean reversion back to the kind of economy that the old economic theories could be applied to. His current data dependence is as much a response to the current conditions, which could turn out to be permanent, as it is to the risk of the said mean reversion to historical type. His gradualist approach therefore balances these two diverging forces.

Powell's latest epiphany classified the US economy as "extraordinary", for continuing to show little inflation for such a healthy job market. This lesson does not however mean that Chairman Powell will pause the interest rate rise process. On the contrary, he intends to continue gradually, building a conventional interest rate cushion, to deal with the inevitable slowdown he is helping to create by building it in the absence of said inflation. That lesson is pending.

Dallas Fed President Robert Kaplan is also not ready to return to Fed teacher-training school. The concept of the neutral rate is central to his own line of guidance. Dropping either or both would effectively gag him, which is evidently something that he will resist. Unlike Rosengren, he does not see that monetary policy has entered the tightening zone beyond the neutral rate. He therefore still advocates gradually raising interest rates and then taking a view on whether to pause once the neutral rate has been hit. In his view, the neutral rate is somewhere between 2.5% and 2.75%, some 50p basis points away. He is however adamant that he is not pre-committing to pause at neutral. He frames the current market chaos, from the spike in yields, as a price discovery of new news on the trade negotiations front, which he has no appetite to respond to through any change in monetary policy yet. Through the frame, however, he does see uncertainty about the health and sustainability of economic growth in Mr Market's discovery of pricing in the bond market. Mr Market is thus starting to influence Kaplan's own perceptions in a Dovish way.

Formerly Dove and now Gradual Hawk Chicago Fed President Charles Evans has already been re-educated to become a Hawk, but he is not buying into the guidance opacity thesis just yet. He notes the significant increase of inflation of late, yet remains happy to let it overshoot without adjusting the current gradual interest rate trajectory. Just to be on the safer side of this overshooting, he remains comfortable with another rate hike in December though. He willingly admits that his prognosis is for mildly restrictive monetary policy and laments the fact that currently there is no adopted Fed policy, to deal with the inevitability that a substantial conventional interest rate cushion will not be available to deal with the next downturn.

Evans is thus happy to keep gradually building the interest rate cushion, by as much as the Fed can get away with before it destroys the capital markets and triggers a recession. In this endeavor, he needs the stage prop of the neutral rate to explain the method in his madness. Currently, he estimates that the neutral rate is 2.75%. He will thus keep gradually hiking interest rates by say another 50 to 75 basis points. At this point, he will then pause. This all assumes that inflation hangs around the 2% level. Should it rise from this current level, Evans will be even more Hawkish. In today's febrile state of the global economy, this baseline guidance looks egregious to objective rational observers as well as to President Trump.

Richmond Fed President Thomas Barkin is already in a data-dependent mode of sorts. Unfortunately, the yield curve will still be one of his said data inputs; and he also has one eye focused on the data independent Brexit and global trade talks. Despite the current tailwinds, he therefore sees significant headwinds getting stronger.

Philadelphia Fed President Patrick T. Harker is circumspect . His circumspection manifests itself as a mild form of schizophrenia. Whilst wanting to go slow on the interest rate hiking process, he still has to admit that labour markets are tight.

The recent commentary from Trump nominee Fed Governor Randal Quarles, like Chairman Powell's, also shows that the two Congressional shoes of the dual mandate are being worn with pride at the Fed. Quarles went even further than the Chairman, to emphasize that he thinks that it is his mission to demonstrate that the Fed cannot be influenced by politics. He feels that the Fed's independence has been questioned by its unconventional response to the GFC.

Going forward, certainly, Quarles and presumably his colleagues will be over-compensating in their behavior, in order to avoid being labelled as political captives. This of course means that there will be an innate FOMC bias, to be on the Hawkish side of data dependent; until the data unequivocally indicate that it's once again time to get political to save Capitalism and the American Way again by being unconventional.

A notable rise in concern about the risk of an overheating economy was evident in Atlanta Fed President Raphael Bostic's latest commentary. He also showed that it will be difficult for him to drop the reference tool, of the neutral rate from his own toolbox, as John Williams advises. Bostic candidly opined that he may be underestimating the economy's underlying strength, even though businesses in his territory have not yet provided anecdotal or empirical evidence of this. He is thus in more of a hurry to get back to neutral than the last time he spoke, although he still ostensibly does not want to tighten monetary policy. The inference is that he is willing to sanction an extra rate hike this year which, previously he had not considered as his baseline. This also implies that he will have a more Hawkish bias next year, unless growth and inflation slow.

In his new unofficial role as Mr Market tamer, John Williams was given the point position on framing the latest mixed employment situation report. Having seen his colleagues cling on, to the notion of the neutral rate, he aimed his commentary at its center of gravity. He began his attempt at discrediting it, by opining that nobody knows where it actually is anymore. His line of attack will thus follow the line of reasoning that, since the neutral rate is virtual, it no longer exists for the practical purposes of monetary policy setting. In token recognition of the latest employment situation data, he simply opined that a gradual process of normalization fits the data and vice versa. He then nudged Mr Market's perspective, away from the allegedly invisible neutral rate, by saying that there is still a ways to go before higher interest rates start to subdue the real economy.

(Source: The Bond Buyer)

(Source: Wall Street Journal)

(Source: Credit Writedowns)

Williams has a valid point. The collective hiding behind an amorphous notional neutral rate, on which there is no precise agreement as to its value, is diluting the collective message of all Fed speakers. This dilution comes at the expense of the monetary policy signal and hence its effectiveness. A cursory review of the take on Raphael Bostic's commentary illustrates this dissonance in perception.

Some Fed guiders are very easy to understand. Although she does not vote this year, Kansas City Fed President Esther George continues to support the "gradualist" status quo. In her view, price inflation, in addition to inflation expectations, has stopped falling and are now gradually rising. When she rotates back into the voting chair, her voting behavior is already laid out, unless the data suggests otherwise.

The current trade war environment is a wild card that the Fed hasn't fully gamed out and prepared for. There is clearly an element of panic input buying by American companies and ramped up production for export, in anticipation of higher trade barriers in the future. This situation is therefore cannibalizing and pulling forward future GDP into the present. Layered on top of this is the tailwind from President Trump's fiscal stimulus, the largest budget deficit since 2012, which now has pushed American Federal debt payments to a level equal to the GDP of Belgium. There is an unquantifiable sense of unsustainability about the situation, which the Fed is looking to the data to quantify and thus drive monetary policy decisions going forward. Faced with this maelstrom of headwinds and tailwinds, the FOMC has however decided to push on with gradual interest rate increases until the incoming data clearly act as an objective arbiter of the appropriate policy steps to take.

If Fed rate-setters go back, to school to learn about guidance, a new research paper by Benoit Mojon, the head of economic research at the BIS, entitled "Forward guidance and heterogeneous beliefs" should be essential reading. As luck would have it, this research paper uses the FOMC and its recent guidance as a case study. They will thus be studying themselves and the effectiveness of their decision making and communication. What could possibly go wrong?

The study finds that there are two audience members, for Fed guidance, "optimists" and "pessimists". Fortunately, there is no rational Homo Economicus observer, with access to free and timely information, anywhere to be found in this work. It is all about Homo Schizophrenicus as we all are if we are honest; and not another Efficient Market Theory fairy story.

When the Fed guided for more QE the "optimists" drove markets and economic activity higher, because they viewed guidance as a promise to boost liquidity. "Pessimists", on the other hand, viewed the same guidance as the Fed signalling a slowdown in economic growth ahead. "Pessimists" will sell risk assets and crush their animal spirits; even when the guidance is Dovish.

Dr Mojon thus concludes that: "unless central banks can make this (guidance) more explicit when explaining their policy frameworks, forward guidance may fail to stimulate economic growth. In fact, it may even deter it". The Japanese translation of these findings will be of specific interest to the BOJ!

A rational observer would conclude that today Mr Market is acting like a "Pessimist". Mr Real Economy is still a schizophrenic, who is "optimistic" most of the time for now. Mr Real Economy is however under siege from the growing trade war headwinds. Both agents occupy the same time and space in the global economy and capital markets. At some point, therefore, there must be a debate and a final consensus between them. That time is now.

Dr Mojon advises the Fed to be more "explicit". Dr Williams advises the complete opposite. Removing any form of guidance for both debaters, as Dr Williams suggests, simply brings it on faster.

So, let's have it then!

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.