Myth & Reality

On March 15, the Fed increased the policy rate by 25 basis points and more or less promised at least two more hikes by year-end. Earlier in the month, Yellen made a speech in which she said:

I will spend most of my time today discussing the rationale for the adjustments the Committee has made since 2014, a year that I see as a turning point, when the FOMC began to transition from providing increasing amounts of accommodation to gradually scaling it back.

On March 29, two weeks after the rate hike, San Francisco Fed president John Williams was even more direct:

With an economy at full employment, inflation nearing the Fed’s 2 percent goal, and the expansion now in its eighth year, the data have spoken and the message is clear: We’ve largely attained the hard-sought recovery we’ve been after for the past nine years.  

In light of this achievement, we need to shift the conversation from “how do we achieve a sustained recovery?” to “how do we sustain the recovery we’ve achieved?”

All this is myth. The reality, as depicted in the chart below, is that for all the quarterly blips in annualized quarter-on-quarter growth, the economy remains on the same trajectory since the “non-recovery” began almost eight years ago. For almost three years the Fed, as ascertained by Yellen, has tried, but “scaling back accommodation has so far proceeded at a slower pace than most FOMC participants anticipated in 2014.” They want to “move on”, so they try hard to sell the myth of recovery.

As the next chart shows very clearly, there has been no recovery. In that case, since “Mohamed didn´t climb the mountain, the mountain came down to Mohamed”, as illustrated by the successive scaling down of the estimate of potential RGDP. That´s the way they found to sell the myth as reality, feeling comfortable, as John Williams does, to play with words.

Sentiment (or soft) data has contributed to distort reality, with sentiment describing an economy that “should be” rather than the one that exists, as described by hard data. That dissonance, however, seems to be fading, although the difference between the New York Fed nowcast RGDP growth, heavily weighted by sentiment data and the Atlanta Fed GDPnow, based on hard data were still “miles apart” (2.7% vs 0.2%) for the 2017 Q1 advanced estimate, which came in at 0.7%.

Headline PCE inflation, which in February had surpassed the target, registering 2.1%, in March came back to 1.8%. Meanwhile, core PCE inflation has been a paragon of stability at a below target rate. The Fed has one less excuse and will have to continue to “anticipate” that inflation will climb back to target, as it has been “anticipating” for the past several years.

Market-based data in April, following the March 15 rate hike, continued to anticipate economic weakness. This is gleaned from the behavior of the dollar index, 10-2 year bond yield spread, inflation expectations and the stock market.

How will the Fed behave going forward? Will the March hike be (again) the “one and done” for 2017, just as the “December event” was for 2015 and 2016? Fed “anxiety” is at a high level, and that pushes for rate hikes. On the other hand, “calmer spirits”, like Dudley´s, introduce new considerations, in the guise of “financial conditions”, which could help the Fed “save face” by standing down!


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