Christmas came early for those who bought the “Powell Risk Management System” (PRMS) on Black Friday and Cyber Monday. By the end of the week, its namesake and his colleagues had rewarded the early adopters with handsome capital gains in their portfolios.
The Fed is in the process of trying to finesse the final steps towards neutral. Finessing it will allow the Fed to attenuate the current business cycle, without undermining it through tolerating too much inflation, as stated in the latest edict from Chairman Powell in the last report. Atlanta Fed president Raphael Bostic coined the term risk management to describe this process.
In addition, to gradual changes in interest rates, this risk management process also involves moderated guidance in reaction to the signals that Mr Market sends. When equity markets were crashing recently, Fed guidance suggested that the pause in interest rate increases was close at hand. As Mr Market takes confidence in this signal and starts to take on risk, the moderated guidance then pushes the neutral rate just out of reach.
Mr Market may soon tire of this kind of running on the spot from the Fed. The Fed also risks losing credibility by calling wolf on inflation and then recession with consecutive speeches. This kind of febrile behavior may signify that the neutral rate is clear, but the Fed’s credibility and hence influence beyond this point will be damaged. Who will take it seriously, if it keeps micromanaging its guidance? The stakes are high, but the evidence that Chairman Powell has raised his game is clear.
Mr Market may not have got his “Powell Put”, but he has been given something equally as persuasive. This thing is a process for dealing with risk, which can help him climb the Wall of Worry. In addition, the “Powell Put” remains in the deck and may not even be needed. Who needs the “Powell Put” anyway if one has the Powell Risk Management System?
(Source: Federal Reserve)
Fed Vice Chairman Richard Clarida initiated the latest nudge of the neutral rate nearer and yet tantalizingly just out of reach again. Whilst stating his avowed “data dependence”, he intimated that he is just awaiting capex to re-engage after a soft Q3 before pushing on with further interest rate increases. His speech however signaled that with the improved capex, come forces which will temper his enthusiasm to raise interest rates.
Clarida’s speech was primarily a thesis in support of his Chairman’s directive to sustain the business cycle without inflation. As he put it, “I (Clarida) I believe monetary policy at this stage of the economic expansion should be aimed at sustaining growth and maximum employment at levels consistent with our inflation objective.” He also explained that low inflationary growth is currently the trajectory that the economy is already on. The reasons for this trajectory are in his opinion cyclical and structural improvements in productivity. He then introduced U* , the non-inflationary rate of full employment, to the galaxy of indicators. By nature of improved productivity, U* is now lower. This means that R*, the new neutral rate is also lower by default. Thus the capex that he is waiting for, may not make him raise interest rates if it leads to improved productivity.
Clarida believes that the Fed should always be data dependent, applying the prism of its dual mandate. He also believes that it should specifically be data dependent on U* and R*, both of which should be estimated regularly in order to set monetary policy accordingly. One senses that the old Dot Plots are going to get replaced with starred plots for U and R in the brave new world of Fed communications.
Whilst noting global headwinds gathering pace, Chicago Fed president Charles Evans and Kansas City Fed president Esther George do not feel blown away enough to pause the interest rate hiking process. Evans thinks that “it’s time to get back to something that is more normal”.
Reliably as ever and regular as clockwork, when consensus is building amongst his colleagues, St Louis Fed president James Bullard supplied the counter-thesis and counter-factuals. Observing the growing headwinds and declining tailwinds, Bullard predicts that these “cracks” will frame monetary policy in 2019. Equally as reliable was Minnesota Fed president Neel Kashkari’s call, for the Fed to pause because the neutral rate has been reached.
The last report noted the invisible hand of the San Francisco Fed and its former president John Williams in a nuanced approach to the dual mandate. This nuanced approach allows the Fed to demonstrate, to its current detractors, that it is adhering to its mandates professionally and legally.
The nuances also allow wiggle room to accommodate the overt economic welfare distribution concerns of the Fed under Janet Yellen. Distributional choices and policy can only legally be made by elected policymakers. The Fed has therefore had to tread carefully in this arena, especially since it has received numerous attempts to be influenced by President Trump. It is no surprise therefore that the President is unhappy with the Fed, based on his own intentions and capabilities to be seen to be distributing economic largesse.
Thus as Fed speakers give the standard gradual policy normalization heads-up, there are underlying initiatives of a distributional nature going on behind the scenes. The best that these forces can do is to lower the bar on where the neutral rate is and hence when the Fed will pause. The latest distributional commentary, from the San Francisco Fed, therefore presumptuously asked the question Has Inflation Sustainably Reached Target? The answer to this question directly correlates with the level of the neutral rate.
(Source: San Francisco Fed)
The author of the report concludes that, in the absence of further one-off acyclical factors, cyclical factors may revert inflation back to below target. Having established this talking point, it has also been book-marked to be pulled off the shelf when the acyclical forces lose their vector in the inflation indexes.
The last report also observed Mr Market making a fuss in the hope of forcing Chairman Powell to reveal the “Powell Put”. The Chairman has now raised his game and his guidance also. Consummate with the current attempts to finesse the final approach to the neutral rate, Powell played a slightly higher value card from his hand. The “Powell Put” card remains in the hand, only to be played if and when recession strikes. Powell played a card that follows the suit of his intentions to prolong the economic recovery sans inflation. He opined that current rates are “just below” the neutral rate. In addition, the impact of previous rate increases is still yet to be fully felt. This was read as one more rate hike in December and then a pause.
Powell’s comments coincided (un-coincidentally) with the release of Q3 GDP and inflation data, which signaled that he should now in fact pause if he intends to prolong the recovery without inflation. Growth was unchanged and inflation sank considerably. New Home Sales and Pending Homes Sales both cratered, in early warning signals that the impact of previous rate hikes is now already taking its toll in the interest rate sensitive sectors of the US economy. Some folks have also noted and are increasingly worrying about the rise in jobless claims. Powell’s commentary also preceded the release of latest FOMC minutes, which reinforced the message that whilst December is a done deal flexibility is now required thereafter.
The theme of sustaining the economy, without creating inflation, resonated throughout the whole minutes of the last FOMC meeting. A small cut in the interest on excess reserves (IOER) was also debated, to prevent Fed Funds from running above target. This de facto easing of monetary policy indicates that the neutral rate is very close indeed. A data dependent Fed Chairman could easily pause here and remain true to his dual mandate and his promise to extend the disinflationary recovery. What is clear is that all options and maximum flexibility are on the table.
(Source: Seeking Alpha)
Finally, Powell’s commentary came on the eve of what was expected to be a highly contentious G20 meeting. This came off the back of a heavily choreographed and broadcast one-on-one with Robert Kaplan, at the aptly named and timed Dallas Fed Global Perspectives forum a week ago. Powell therefore told the world that he is thinking and acting globally. He also told President Trump, that the Fed is America First at heart even though this patriotism gets hung up by its independence and the dual mandate. The President can play hard-ball with China, secure in the knowledge that the Fed is onside and may even unload the “Powell Put” in extremis.
Powell’s new clarity of vision and guidance doubtlessly is a knee-jerk reaction in some part, to the poor scores he has received from primary dealers in the latest New York Fed survey. The dealers have panned his communication style, especially his “long way” from neutral comment which cost them serious money. With hindsight, this comment and the price action it created may be viewed as a market capitulation. Mr Market spoke about guidance and Powell listened and then responded with alacrity and the words “just below”. Having overcompensated, for his previous indiscretion, Powell needs to make sure that he doesn’t get played by Mr Market into compensating him again like this in the future.
Now hopefully when the Chairman speaks he does so with the full backing of the data, his monetary policy committee and his dual mandate. He also calls it exactly the way the data represents it! No hidden agendas here. Simple guidance, consistent with gradual actions, is the modus operandi. Centrality of Commitment is time stamped and rubber stamped with great precision and transparency. Powell has gotten his game-face on finally, in relation to reforming Fed communications and its policy framework. Even President Trump can take credit for saying I told you so.
It is still important to understand that the Fed Chairman, whilst omnipotent is not omniscient. By nature of being human, he will have missed something or made a mistake. As noted by Bostic however the risk management framework, currently adopted by the Fed, means that the probability of these errors being as life-threatening as they were when Bernanke triggered the GFC is now lower.
In view of Powell’s fallibility, the Fed needs to build-in the research and thought leadership competencies, required to adapt to new threats and early warning signals, into its risk management process. Powell is on record for his healthy suspicion of academia and theorizing that is not empirically robust. He must therefore incorporate the empirically robust ideas into his risk management framework and can the intellectual rambling stuff. The issue of inflation targeting is one such issue that highlights this adaptability requirement.
The San Francisco Fed and its former president John Williams, now the New York Fed president, have shown leadership on the inflation targeting issue. This issue is only as far as accepting that the inflation target is symmetrical and not a ceiling. A process for formally incorporating this as some kind of rule is still missing. Recently, Williams blew the dust off the subject matter, signalling that its formal adoption is being evaluated for potential adoption into the new monetary policy framework. His retaking of the initiative on this matter is a case of necessity fostering invention. The data is suggesting that inflation expectations, which had broken to the upside, are now starting to head back down again. A pause in the interest rate hiking process, therefore risks setting a ceiling on these inflation expectations and sending them lower. Williams therefore needed to move fast and did so.
(Source: New York Fed)
Building on the symmetrical baseline, Williams is now constructing a thesis for the adoption of an “average inflation” and/or “price level” target. This datum could then be used to address the risk of inflation expectations being anchored at a level that is too low. Such anchoring will prevent the Fed form normalizing monetary policy further and remaining in a permanent Zombie stasis of perpetual QE. With the current talk of a pause in the rate hike cycle, Williams is clearly worried that this pause becomes the peak in interest rates this cycle.
Williams’ full speech, cunningly entitled Monetary Policy Strategies for a Low-Neutral-Interest-Rate-World, clearly hints that the Fed has arrived at the neutral rate. Williams now wishes to answer the question of what to do next, before markets and the real economy get lazy and comfortable with the pause in the rate hike cycle and allow inflation expectations to become anchored again.
The only criticism from this author would be that Williams does not talk more about what policy instruments will be used to regulate the inflation expectations curve he has outlined. In a low neutral rate environment, conventional policy options remain constrained by circumstances. He just implies an assumption that the Fed has got the tools to deal with it. Admittedly it does have a conventional interest rate cushion, but this is small and finite.
Williams therefore begs the question and implies that unconventional monetary policy tools will be the main instruments applied to the weakening patient. Guidance is clearly going to figure high on the list of unconventional tools used. Thus contrary to what he has said before, guidance should not be removed from the market as the neutral rate is neared. On the contrary, as demonstrated by his recent speech, guidance represents the acme of skill in the application of unconventional monetary policy at these points. Just as well therefore, that Chairman Powell has got his act together!
The global risks are now understood by the Fed. What is less well understood is what is actually going on domestically, in the diverse American economy and fractured polity. It is here that the Fed is doing pioneering research, which may or not feedback into its risk management matrix. Clearly, Powell has the intention of changing the current 2% inflation target to a new average rate. He may even submit this formally to Congress, to be adopted as the new inflation mandate, in order to give the target and the Fed’s attempts to achieve it the legality and legitimacy that Presidents and populists cannot suborn.
The headwind, from the Blue Wave Surge meeting the Red Tide in Congress, was a growing domestic headwind noted in the last report. A recent Gallup poll quantifies this headwind and puts it into perspective of the recent past, running up to the Credit Crunch that resulted in the GFC. Democrats and Republicans are extremely unlikely to cooperate. The level of cooperation is even worse than when George W. Bush was the sitting Republican President. This is all the more alarming, since there was at least some bipartisanship in the Bush Presidency on the War on Terror. Although there is currently a War on China, which both parties believe in, this has failed to unite them behind the President and his policies.
An optimist would say that the lack of unity will put a check on the President’s ability to create an unsustainable boom that bursts. A pessimist would say that the President will be encouraged to gamble further with the economy, in order to break the deadlock, by creating an economic boom that is popular with the voters.
In either case, the Fed remains hell-bent on extending the non-inflationary business cycle. This is a significant departure from moving, in anticipation of these booms and the inflation they beget just as Bernanke did, so the boom and bust dynamic has been modulated. Politics and politicians may therefore become an amusing sideshow. One particular place where partisanship manifests is in relation to the subject of Climate Change.
A study of how this partisan debate plays out politically and economically illustrates how the Fed’s risk management augmented dual mandate, may already be factoring it in and formulating monetary policy in the light of.
Intentionally or otherwise, the Federal Reserve and the Federal Government are now sleepwalking into economic policy-making in relation to Global Warming. The recently released US Government’s multi-agency Fourth National Climate Assessment placed Climate Change at the focal point of executive policy making at the highest level. Climate Change has now become a core element of US policy-making by agency stealth. It probably always was, but now it’s official. Monetary policy by default will therefore have climate change, either directly by new Congressional mandate or indirectly by its effects on growth and inflation at its core. The report’s summary findings provide a guide as to where and how policy will evolve into legislation. It is only a matter of time and money and Federal agencies using their budgets to promote the issue. Climate Change is big business on both sides of the debate, as it is for the agencies in the middle.
The simplistic initial take-away from the report is the Climate Change lowers productivity, increasing costs and reducing output, in industry and agriculture. It also has the same impacts on those afflicted in their domestic private lives. Climate Change is thus a Stagflationary vector in the first case, which creates increased risk of all kinds and therefore volatility in the indexes that measure them. In its derivatives, it will manifest as responses to and attempts to mitigate its primary vector. It can thus lead to increased productivity over time and then reduced volatility.
Just looking back at what Vice Chair Clarida recently said about productivity and capex, one could see how this would play out for him. Initially he would be biased in favor of raising R*, thereby tightening monetary policy. If the mitigating capex then kicked in later, he would lower R*.
An even more simplistic conclusion, therefore, is that Climate Change is short term bearish and, if it is mitigated successfully, long-term bullish. The rest will be history as they say, and history is kind to those who write it as Mr Churchill said. A lot of money is going to be made and lost in the writing of this history.
(Source: The Hill)
It would be ignorant and unwise to ignore Climate Change therefore, even if one fundamentally disputes that it exists. The sheer economic numbers and inter-agency infrastructure already exists, therefore Climate Change exists de facto and de jure. The Blue Wave that recently swept through Congress is certainly a believer and thus a potential legislator. This wave has more grassroots appeal and therefore legitimacy than the elitism of Al Gore and President Obama. It will thus be harder to ridicule and discredit.
Going forward, the introduction of Climate Change into the guidance and policy making process of the Fed should be watched out for. Chairman Powell has announced that he is going to be undertaking a significant overhaul of policy making during his tenure. Climate Change therefore will go into this reform process, either directly or via osmosis, through its impact on the dual mandates. The direct route awaits Congressional mandate, which will get bogged down in the partisan morass. The most likely route is therefore indirect through its impact on productivity, growth and inflation.
(Source: St Louis Fed)
The Fed or at least the Richmond Fed, embedded in the agricultural and national security hinterland is already ahead of this curve. Back in August, it published a report on the impact of higher summer temperatures on the economy. The study found that a higher decennial rise in average summer temperatures since 1990, has cost US GDP more on aggregate than the growth associated with attempts to mitigate them. In short, Climate Change has been a significant and growing headwind since the 1990’s. It has therefore been in the economic data that Mr Market has been discounting and Fed policy has been dependent upon for some time.
The Fed is also looking at other significant drivers of its dual mandate guideline inputs.
The Fed is even factoring in the change in demographic leadership towards the Millennial/Baby Boomer Barbell. The Fed’s study shows that the Millennials are just like their parents but poorer when it comes to consumption behavior on aggregate. A suppressing delta on the neutral rate and term structure of interest rates is therefore in order for the risk management input from this cohort. At the other end of the barbell, the Baby Boomers are economically challenged, by nature being highly indebted and light on savings.
The propensity of the Bar of the Barbell to sustain these two dead-weights will become a political hot potato. Elected policymakers will thus try and revert to the blunt tool of monetary policy to do the heavy lifting, as they seek to maintain popularity with all the cohorts on the Barbell. The Fed will need to remain independent and flexible as it deals with the fallout from this squabble over economic resources coming through the incoming data.
Using Climate Change as the example, one can see how the Fed’s robust risk management framework is engaging with global and domestic risks. Chairman Powell is simply making it more comprehensive and robust. Adhering to its dual mandate, whilst expanding its inputs to filter them through this rubric is working even if it is boring. But isn’t it time that central banking became boring again? This leaves elected politicians to be the interesting ones, which they are swiftly becoming. The good news is that the Fed has got the measure of them, so to speak.
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.