For a long time, the Federal Reserve has openly embraced its dependency issues. When asked about future policy, Fed members often avoid making commitments by invoking the Fed’s two favorite words: “data dependent.” What they mean is that they can’t promise any specific action because of uncertainty about future growth, employment and inflation. 1 1 Close The Fed uses many of the same data points that folks in the private sector look at to make forecasts. They even look at shipping, perhaps creating their own Truckometer. There have been a few exceptions when the Fed has promised to keep rates low regardless of what happens in the economy. These are emergency measures designed to combat severe downturns. Once the economy gets back to something resembling normalcy, the Fed gives up its commitments and returns to the numbers. 2 2 Close For the Fed, anything other than a severe recession probably qualifies as normalcy. In the past few weeks we’ve seen a shift in Fed tone, which may have moved markets. Data dependency has been at the core of this shift and an understanding of what it means will shed a thousand points of light on potential outcomes for monetary policy. 3 3 Close We didn’t get Wednesday off for the Presidential funeral, so as a tribute try to find the George H.W. Bush references sprinkled throughout this piece.
It’s no surprise that the Fed pays attention to economic data. It is trying to manage its employment and inflation mandate and it needs to measure those variables. It can use anecdotal information about businesses and consumers, but numbers provide it with a more precise view of how close it is to achieving its goals. 4 4 Close Some would argue this precision is an illusion. The Fed needs to know whether the economy is growing or contracting. For much of the recent past, data dependency has meant that when inflation was high and the economy was strong, the Fed would raise rates and when those numbers were weak, it would cut rates.
Now, the Fed has broadened the scope of data dependency as uncertainty about the neutral rate of interest has increased. Fed members have always had to worry about whether policy should be accommodative or restrictive, but now they aren’t even sure that they know whether it is accommodative or restrictive. The Fed economists have turned to the data to help come up with that answer. If they believe that rates are low, but data on lending show tight credit conditions, then maybe policy is not as loose as they had thought. Fed Vice Chair Richard Clarida summed up this view on Monday: “the data is telling us something about the ultimate destination ... and where is the level of full employment … and those are key inputs that are unobserved that we have to infer from data.” 5 5 Close Bloomberg Transcript: “Richard Clarida, Vice Chairman, Federal Reserve Is Interviewed on Bloomberg Surveillance,” 12/3/18.
The transition in Fed leadership from Yellen to Powell has also raised the importance of data dependence. As we’ve discussed in the past, Powell has less faith in economic models than his predecessors had. Models do require data, but they also lessen the importance of each individual release. For example, if an economic model is saying that the economy will slow down next year, maybe the Fed can ignore a few strong data points. Powell has taken away this filter. In practical terms, he has said that he supports continued slow monetary policy tightening so long as the data is strong enough to warrant it. That is some serious data dependency.
When Powell spoke last week, markets reacted as if his comments were dovish, in that both stocks and bonds rallied. 6 6 Close He said policy was close to neutral, which some economists read as dovish. Some articles focused on comments he made on the neutral rate, but his remarks on data dependency were probably even more important. He stated that, “We also know that the economic effects of our gradual rate increases are uncertain and may take a year or more to be fully realized.” 7 7 Close Federal Reserve Chair Jerome H. Powell: “The Federal Reserve’s Framework for Monitoring Financial Stability,” 11/28/18. This is a subtle but crucial shift to the Powell doctrine. It shows an awareness of the lags in policy transmission, and it lessens the importance of recent releases. It doesn’t necessarily make the Fed less dependent on data, but it means the Fed will be more cautious. It will require more data over a longer period to make decisions.
Because Powell is saying that the Fed needs time to evaluate the effects of the rate hikes, it implies a slower pace of tightening. The Fed will take longer to determine if policy is still accommodative or if it has become neutral or tight. Some folks have posited that the Fed is giving into pressure from the President who has been unhappy about rate hikes. We are quant investors, not psychiatrists, so we don’t know if that’s the case. Such a judgement would require expertise in codependency rather than data dependency. It is important not to overstate the Fed’s shift – this does not preclude a move back to hawkishness at some point next year. While the Fed may have decided that it is prudent to go slowly at this juncture, it does not say anything about how much total hiking the Fed will do. If data holds up next year, or accelerates, the Fed will likely hike rates further. The Fed is by no means saying, “read my lips, no new rate hikes.” 8 8 Close Maybe Dana Carvey can do a Jay Powell impersonation too. As far as market pricing, the implied probabilities of a Fed hike later in the month are also still high, though the odds of further hikes after the meeting have decreased.
In the coming year, the Fed will continue to refine its message. There is no reason to believe that the Fed has materially changed its reaction function, but Powell and his colleagues have changed some of their approach. This change doesn’t answer any of the questions on the neutral rate and chronically low inflation that they have struggled with over the past few years, so they will have to rely on the data as much ever. As investors, we too are dependent on this data. Unfortunately, we are also dependent on how the Fed interprets the data and will be for quite a while.
What We Are Watching
U.K. Parliamentary Vote on Withdrawal Agreement (Tuesday) The U.K. is scheduled to leave the E.U. at the end of March but has yet to finalize the Withdrawal Agreement (WA) that will guide the country’s transition out of the union. The deal hashed out between Prime Minister May and the E.U. will face a vote in the U.K. parliament this week but looks likely to fall short of the necessary support. The opposition Labour Party has indicated its intention to oppose the WA, while a number of members of parliament from May’s Conservative Party and their coalition partner, the DUP, have also criticized the deal. If the WA is voted down, it will set off a potentially tumultuous period in U.K. politics. Possibilities include a leadership challenge within the Conservative Party, a vote of no confidence triggering a general election, and even calls for a second Brexit referendum. Until the path forward becomes clear, and until market participants can rule out the possibility of a chaotic “No Deal” Brexit, there may be heightened volatility in the British pound and other U.K. assets.
U.S. CPI (Wednesday) Core inflation (which excludes changes in food and energy prices) has remained stable over the past few quarters at levels broadly consistent with the Fed’s inflation target. However, with wage inflation rising and the unemployment rate below the Fed’s estimate of the rate that is sustainable in the long-term, an acceleration of inflation appears possible moving forward. Such a development would likely prompt faster-than-expected tightening by the Fed, posing a risk to both stocks and bonds. In this context, each CPI release poses the risk of a negative market reaction on a meaningful upside surprise. Conversely, a continuation of the recent steady trend in CPI figures might provide some support to market sentiment.
European Central Bank Meeting (Thursday) The ECB laid out a roadmap for gradual policy normalization in June, guiding that asset purchases would wind down over the remainder of 2018 and rate hikes would begin no sooner than fall 2019. Since that time, economic data has pointed to a slowdown in eurozone growth, and a standoff between the new Italian government and the E.U. over spending plans for 2019 has led to renewed financial stress in the third-largest eurozone member. Meanwhile, eurozone inflation data has shown little sign of acceleration from the below-target pace of the last several years. Despite these negative developments, the ECB has thus far stuck to the plans established in June and President Draghi has not been particularly dovish in recent press conferences. At the December ECB meeting, Draghi will present updated staff forecasts for eurozone growth and inflation. If forecasts are revised lower (as seems likely based on trends in private sector estimates), President Draghi may take the opportunity to soften his prior guidance on the prospect for rate hikes in 2019. Policymakers may also announce the continuation of long-term financing operations designed to maintain abundant liquidity in the eurozone banking system.