Phillips Curve bites the dust

Week ending Friday September 22nd 2017

The FOMC meeting dominated the week. Although the market felt that policy had been tightened a little more than expected as bond yields and the USD rose, it wasn’t a big deal. Equities were flat. The bigger story was really quite dovish for monetary policy. As well as lowering the “normalized” interest rate level Janet Yellen revealed doubts about the Phillips Curve.

Inflation wasn’t picking up as theorised by the Fed orthodoxy and, for once, transitory factors weren’t blamed. Perhaps “our understanding of the forces driving inflation is imperfect”, she admitted. And if the inflation drop were not transitory then it “would require an alteration in monetary policy”. An alteration to what, exactly, was not specified.

Bond market moves intriguing

The yield curve flattened a little more after the FOMC meeting as short rates rose in expectation of firmer guidance on the one rate rise in 2017, but longer rates moved up less as expectations for rate hikes further out fell back. This flattening of the curve meant that (Fisher-type) expectations of faster nominal growth were also lowered or not dominant, i.e. a bit hawkish on monetary policy. Perhaps confirmation of the start of the reduction in the Fed’s balance sheet meant markets were a bit more concerned about Fed tightening given quiescent inflation.

It is puzzling that given low inflation, new doubts about the Phillips Curve, and such low and falling nominal growth, that the FOMC is still raising rates and shrinking its balance sheet – science seems to have given way to faith.

Data and surveys

There was very little concrete information on the current state of the US economy over the week. The weekly jobless numbers showed a lessening impact from the severe weather.

The Philly Fed survey of manufacturing was a bit stronger than expected but the employment index showed a continuing loss of momentum. The provisional September Markit manufacturing and services PMIs showed drift.

This week we get more current month surveys and the August personal income, expenditure and PCE Price Indexes. Retail sales and inflation disappointed already in August and had seen growth trending down in 2017Q1 and Q2. It will be interesting to see how big the weather impact was and if there are indications that it will affect 2017Q3 GDP. The nowcasts are expecting a poor out-turn with the NY Fed at 1.56% and Atlanta at 2.2% – both hurt by weak Industrial Production and Capacity Utilization for August.

Equity markets should remain robust as revenue expectations for 2017Q3 are running well ahead of normal – although much of this is due to the benefit to overseas revenues from USD weakness.

The big news could be Warsh appointed as the next Chair. He is now 33%, 1% ahead of Yellen in what looks like a two-horse race. Warsh has few fans amongst the expert Fed-watchers.

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