Macro Wrap-Up

The Fed’s Second Dovish Plot Twist

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The Fed’s Second Dovish Plot Twist

Since Jerome Powell became Chair of the Fed last year, monetary policy has played out like a slow-burning drama. Much of the time Fed members give speeches that do little to move the plot along. They say things like “the economy is close to capacity” or “the Fed is transparent.” Investors watch intently for hints of what the next scene might bring, but get little other than some nice cinematography. Then, occasionally, there is some real action. As you may remember, Powell gave us two of these big reveals last year. First, he told investors that the Fed was normalizing rates and would keep on that path as long as the data held up. 1 1 Close The Fed’s forward guidance after Chair Powell’s first monetary policy meeting and statement in March of 2018 stated: “The Committee expects that economic conditions will evolve in a manner that will warrant further gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.” Federal Reserve: “FOMC Statement,” March 21, 2018. The Fed followed up with four rate hikes. Late last year, he changed that message. With rates no longer obviously below neutral, Powell adopted a wait-and-see approach. 2 2 Close Note that this change in tone was before the most recent rate hike. Federal Reserve, Chair Jerome H. Powell: “The Federal Reserve’s Framework for Monitoring Financial Stability,” 11/28/18. This added some suspense as to what the Fed would do in 2019.

This week, Powell testified in front of Congress. At first glance he didn’t seem to add much new. He said the economy was doing well despite some headwinds, the Fed could be patient, and that he wasn’t worried about fast wage growth causing inflation. Then he fielded the usual set of questions on bank mergers, economic inequality, and lending to cannabis growers. 3 3 Close OK, that last one wasn’t usual, but Powell seemed very prepared for it as if he had been asked about it many times before. For a change, Powell’s speech wasn’t the most important of the past week. The President of the New York Fed, John Williams, and Vice Chair, Richard Clarida, are arguably the two most influential policy makers outside of the Fed Chair. Both of these supporting actors spoke at the U.S. Monetary Policy Forum last Friday. While they were not quite Lady Gaga and Bradley Cooper, they sparked some real intrigue among Fed watchers.

Williams gave a very academic speech in which he reviewed a paper on our old friend the Phillips Curve. 4 4 Close If it were going up for an Oscar, it would be for adapted screenplay. I would suggest you read the speech and the paper he references if you want a detailed defense of the Phillips Curve. See: John C. Williams, “Discussion of 'Prospects for Inflation in a High Pressure Economy: Is the Phillips Curve Dead or Is It Just Hibernating?' by Peter Hooper, Frederic S. Mishkin, and Amir Sufi,” Federal Reserve Bank of New York, February 22, 2019. But instead of just making a dry theoretical defense of an old theory, he called for some serious rethinking of current policy. In the past, the Fed has been very aggressive in keeping inflation and inflation expectations low. Williams argues that this might not be the right approach anymore because inflation is less sensitive to changes in the economy and the unemployment rate. In addition, inflation persistence has declined. This means that if inflation goes up it is likely to come back down – it isn’t sticky at higher levels. Williams says that the reason for less persistence is that inflation expectations are anchored, and consumers expect inflation to stay low. 5 5 Close By this he means that if people expect low inflation then they will be unwilling to pay higher prices. Companies may have to lower prices to sell their products. At the very least, they can’t keep increasing prices at the same rate. Ergo less inflation persistence.

This story line is familiar, but Williams takes it to a different conclusion. He points out that overall and core inflation have both averaged 1.8% over the past 25 years. 6 6 Close John C. Williams, “Discussion of 'Prospects for Inflation in a High Pressure Economy: Is the Phillips Curve Dead or Is It Just Hibernating?' by Peter Hooper, Frederic S. Mishkin, and Amir Sufi,” Federal Reserve Bank of New York, February 22, 2019. This creates the risk that inflation expectations are becoming anchored at too low of a level, which he argues is as dangerous as having high inflation. If the Fed ignores this for too long, the Fed may find itself unable to bring inflation back up. The Fed, therefore, should consider changing its approach, but Williams didn’t offer any practical measures to do so. That he left to Richard Clarida. 7 7 Close He did not sit next to him at the piano.

Clarida discussed the Fed’s upcoming review of its monetary policy strategy, and he echoed some of what Williams said. 8 8 Close For Clarida’s speech, see: Richard H. Clarida, “The Federal Reserve’s Review of Its Monetary Policy Strategy, Tools, and Communication Practices,” Board of Governors of the Federal Reserve System, February 22, 2019. The review will look at how to improve Fed communication and whether it should use unconventional tools if it reaches the lower bound on rates. More importantly for current policy, Clarida asked whether the Fed should consider allowing inflation to run above target to make up for past shortfalls. 9 9 Close This is very similar to price level targeting, in which the central bank targets the price level around a constant growth path. This might solve the problem of persistently low inflation by raising consumer’s expectations of future prices. He said the Fed will have a big conference in June and then make a decision about what to adopt from the review in the first half of 2020. The Fed, he says, is not predisposed to any specific decision from the review. 10 10 Close Despite what he says, they probably are predisposed to act on this. Movies shouldn’t have plot points that go nowhere.

The review sends a dovish message to investors. Even if the Fed does not adopt a new framework, the fact that important members are considering such a change is very telling. The research they do will influence policy and could lead to more caution on rates. In this context, it is worth taking another look at Powell’s otherwise dull testimony to Congress. He didn’t endorse the Williams/Clarida arguments directly, but he didn’t dismiss them either. As we know, he isn’t as interested in the economic models that drive the academics, but he did say that he wants to make the 2% target more credible. This is very much in line with a more balanced approach to inflation targeting and may show some sympathy with allowing inflation to run above target in the next year or two.

This is the second big signal from the Fed that a rate hike is less likely this year. 11 11 Close The first was Powell’s move to a wait-and-see approach. In prior guidance, Fed members had said that the Fed would tighten policy if inflation and other data were strong. Now it’s not clear they will hike even if inflation increases from here. Some folks may attribute this shift to the stock market or to political pressures, but this line of thinking on inflation is not entirely new. Former Chair Janet Yellen and several others had floated similar ideas several years ago. 12 12 Close For example, in 2016, Yellen gave a speech reviewing the Fed’s monetary policy tool kit and mentioned price level targeting as a potential tool, but stressed it should be thoroughly researched before being actively considered. See: Janet L. Yellen, “The Federal Reserve’s Monetary Policy Toolkit: Past, Present, and Future,” August 26, 2016. Maybe the Fed will change its tone again and shift to a more hawkish stance later in the year, but that would not seem to fit the plot they’ve created. No one likes contrived endings to dramas.

Bank of Canada Meeting (Wednesday)
In some ways, the Bank of Canada (BoC) is in a similar situation to the Fed. Strong growth in recent years has pushed unemployment to low levels, and the central bank has been raising interest rates towards its estimate of neutral. However, compared to the Fed, which has recently toned down its guidance for additional rate hikes, the BoC has remained somewhat hawkish. In a recent speech, BoC Governor Poloz declared that “we will need to move our policy rates up into a neutral range over time” while admitting that “the path back to that neutral range is highly uncertain.” 13 13 Close Bloomberg: “Poloz Says Bank of Canada Rate Hike Path ‘Highly Uncertain’,” 2/21/19. According to forecasts published in January, economists at the BoC expect Canadian growth to pick up later in 2019 after a soft patch brought about by lower oil prices and political uncertainty. Market participants will be watching the statement language closely to see whether policymakers are growing more or less confident that rate hikes will be warranted moving forward. A hawkish statement could drive strength in the Canadian dollar and weakness in local fixed income.

European Central Bank Meeting (Thursday)
After acknowledging weakness in European growth data and downgrading its risk assessment in January, the ECB deferred a review of its policy stance to the March meeting. The delay allowed time to assess the persistence of the recent slowdown and to leverage the bank’s next round of quarterly economic projections. Ahead of this week’s meeting, investors have two major questions: will the ECB announce new long-term refinancing operations (which would allow banks to roll over loans maturing this year), and will policymakers adjust their guidance on rate hikes (current guidance only promises not to hike before the end of the summer). Eurozone growth data has continued to look quite soft since January, which might convince policymakers to provide additional support to the banking system and push back the earliest possible date for a rate hike. Should these questions resolve in a dovish direction, it could put downward pressure on the euro and might support local equities and bonds.

U.S. Employment Report (Friday)
While some data series have deteriorated, labor market data has remained consistent with positive momentum in the U.S. economy in recent months. January data showed a strong addition of 304,000 jobs on the month, although warmer weather during the data collection period likely played some role in the positive surprise. 14 14 Close Bureau of Labor Statistics (BLS). In addition to the headline job growth figure, two other components of the employment report will receive attention: measures of unemployment and average hourly earnings. Initial and continuing jobless claims have moved slightly higher over the past few months and there has become some concern that the labor market may be showing small signs of deterioration. Looking at wage growth data will also help determine how tight the labor market truly is. Wage growth has been increasing over the past few years, albeit at a still-moderate rate. An upside surprise to nonfarm payrolls or the wage data would likely be negative for fixed income and equity markets, although reaction may be dampened by the Fed’s recent pivot to a neutral stance.

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