Fed re-think runs into real time market impact

Week ending Friday 19th August 2016

Data took a back seat to FOMC members and group statements. They appeared to be in conflict not only with each other, as in the FOMC Minutes released mid-week, but even with themselves. The USD has remained weak while bonds have been merely volatile, apart from the short end. Equities have remained near the highs, bolstered by a good recovery in oil prices. The most significant dichotomy has been the USD weakness versus higher 12m interest rate expectations – a superficially puzzling phenomenon but maybe explained by the current and upcoming debates within the FOMC.

Williams v.1.0 vs Dudley v.2.0

On Monday, John Williams posted an Economics Letter http://www.frbsf.org/economic-research/publications/economic-letter/2016/august/monetary-policy-and-low-r-star-natural-rate-of-interest/ on the official SF Fed website that showed quite a change of view from the “influential centrist” as one newswire called him. He seemed to embrace the rethinking of monetary policy at the Fed appearing to endorse a higher inflation target but also to ask for consideration of price level targeting and even of NGDP growth. Our blog comment on it is here  .

While not having an instantaneous impact, the USD fell heavily that night with the USD Index dropping over 1%. For once bond yields rose on news of a potentially easing of monetary policy. The Fisher/expectations effect trumped any liquidity effect.  The only economic news was the weak reading from the very volatile Empire State Manufacturing Index for August, but that came out after the move in financial market prices.

On Tuesday, perhaps alarmed by the strong negative impact on the USD and maybe on longer term bond yields, up popped William Dudley, the markets man on the FOMC, with an impromptu interview conducted in a hallowed corridor at his NY Fed. He rowed back on his strongly dovish speech in Indonesia at the end of July warning that one or two rate rises by the end of 2016 were absolutely possible, even probable given his expectations for 2H16 GDP growth.

Dudley v.1.0 vs  Dudley v.2.0

To be fair, in that Indonesia speech he did also strongly affirm that the Fed was not targeting an exchange rate. Back then, he was probably trying to reassure the Japanese in particular who had been browbeaten by the US Treasury into tempering their exchange rate depreciation. He actually looked dreadful in the interview which indicates to me just how hurriedly arranged it had been.

Data not helping the hawks

He may have been concerned that the much weaker than expected CPI numbers would also have prompted an expectation of rate cuts to come and wanted to stop any such thinking. As it happens the weak CPI data actually saw long bond yields rise further. The market seemed to be saying it didn’t believe him. The USD recovered, but only a little. Later, Lockhart echoed some of Dudley’s hawkish views on rates and the related optimism on economic growth but the markets weren’t interested.  The July Industrial Production data was a little better than expected but still negative YoY and the market seemed more interested in what Dudley had to say, or wasn’t able to say.

FOMC Minutes: the split Fed

The action-packed week continued into Wednesday afternoon with the July FOMC Minutes causing some worries about tightening ahead of their publication. The release caused confusion, mostly. We have blogged about how lively it must be on the FOMC, and it clearly still is. Headlines most often cited the “split Fed” see here and here.

What is clear is that the USD has been weakened as the index flops back towards 18-month lows. It seems more a reflection of a depressing bow, based on lower expected rates, rather than a nominal recovery sag. The earlier Williams-induced USD drop coincided with a bond yield rise, a good combination. The back-to-normal USD plus bond yield dip is a bad combination, presaging nominal and real weakness.

Williams v.1.0 versus Williams v.2.0

On Thursday John Williams gave a speech that was far more hawkish than his thought-provoking Economic Letter on Monday. It was far more on-message, threatening two rate hikes this year in line with FOMC projections.

If anything it was even more over the top hawkish, as one section discussing jobs growth concluded:

“We should expect the pace of job gains to slow, and no one should be alarmed when it does—we should only be alarmed, frankly, if we don’t see that necessary slowdown.”

Although I have called the latter speech Williams v.2.0 it wasn’t all that different to a hawkish speech he gave in May and bullish interviews in July post-Brexit. It may be that the odd one out is the Economic Letter, who knows? Who knows if he even wrote the Economic Letter, or read it? It was relegated to a footnote within a footnote in Thursday’s speech.

Justifiably angry Japanese

The Japanese authorities are rightly angry about monetary policy in the US. Having forced the BoJ to roll-back the JPY depreciation, the US is now causing it to appreciate further as US monetary policy descends into chaos.

At the end of the week the Philly Fed surveys about summed things up with just about OK manufacturing conditions but collapsing hiring intentions. Productivity may thus pick up but it is against a very dull backdrop in the economy.   The overall weakness of data during the week tended to trump all the confusing signals from the FOMC and led to a small reduction in the likelihood of a rate rise in December.

Base Money: as you were

Back in the real world of the money supply data we saw a return to the very dull trend of the last year. Last week’s pop turns out to have been a blip and the -3% average fall still on track.

Next week monetary policy trumps data and surveys

Next week we have the actual Jackson Hole meeting at which some of this re-thinking should be on display. It will be interesting to see which John Williams turns up, which William Dudley? Which external economists might be there to challenge the FOMC members.

The full agenda will be published early evening on Thursday August 25th, with Janet Yellen scheduled to make a set piece speech on Friday morning at 10.00am ET. The title of her presentation is intriguing: The Federal Reserve’s Monetary Policy Toolkit. It fits with the title of the symposium as a whole: Designing Resilient Monetary Policy Frameworks for the Future. This topic is clearly part of the switch over amongst Fed staffers from the great normalization project undertaken, that has so frustrated markets since 2014, to one that “evaluate[s] potential long-run frameworks for monetary policy implementation” as the latest FOMC minutes put it. In plain English: normalization has failed and we now need to work out why.

The stage is set for surprises. August surveys of manufacturing are due as is the second estimate for the (initially-reported) very weak 2Q 2016 GDP. The “flash” Markit services PMI at the end of the week should be the most important release for the current state of the economy as a whole.

Economic outlook

Expectations for the state of the economy as whole are fairly dull judging by the USD and the yield curve but equities and oil are strong, and expectations for Jackson Hole are running high following Williams and other noises we have detected.

Fed Officials in their review of the economic situation for the July FOMC described 2Q 2016 RGDP growth of just 1.2% YoY (and QoQ annualised) as “moderate”. It would be interesting to know how they describe current conditions.

The two 3Q 2017 nowcasts are both showing healthy growth as the NY Fed version jumped to 3.0% annualised QoQ growth following the Industrial Production data and capacity utilization figure. It hasn’t quite reached the optimism of the Atlanta Fed’s elevated 3.6% nowcast.  Although it should be said that even 3.6% QoQ annualised would still only imply around 1.7% YoY. Underlying these figures are forecasts of continued trend growth in Personal Consumption Expenditures (PCE) with less drag from investment, inventories and next exports. Curiously, the evidence on PCE from July in the form of the retail sales figures was not positive, and signs of income growth were mixed – and trending poorly.

Our own NGDP Forecast for four quarters ahead has also ticked up, thanks to the rise in equities and recovery in oil.


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