Fed Faces Three Uncomfortable Truths

IMF deputy head Gita Gopinath

IMF deputy head, Gita Gopinath, recently highlighted three uncomfortable truths for monetary policy:

  1. Inflation is taking too long to get back to target.
    Financial conditions may not be tight enough and sustained high inflation could make the task of bringing inflation down more difficult.
  2. Central banks’ price and financial stability objectives conflict.
    Central banks can provide liquidity to struggling banks but are not equipped to deal with problems of insolvency which may be caused by a sharp rise in interest rates.
  3. We face more upside inflation risks.
    The past two decades of low inflation are over and the global economy faces inflationary pressures from:
    • On-shoring of critical supply chains;
    • Rising geopolitical tensions (with Russia, China and Iran);
    • Transition away from coal, oil and gas to low-CO2 energy sources (renewables & nuclear); and
    • Spiraling demand for critical materials needed to meet the above challenges.

Balancing monetary policy is going to be difficult, especially where prices are under pressure from a number of challenges. We expect central banks to tolerate higher inflation for longer in order to preserve financial stability.

Fed only expects to hit 2.0% inflation target in 2025

Fed Chairman Jerome Powell recently highlighted the above conflict between policies to tame inflation and maintain financial stability. During a recent ECB panel discussion, Powell indicated that he only expects the Fed to hit their 2.0% inflation target for core inflation in 2025.

The Fed Chair says job creation and real wage gains are driving real incomes and increased spending. That raises demand which in turn drives the labor market. (WSJ)

Unemployment increased slightly to 3.7% in May but remains near record lows. The tight labor market continues to fuel strong growth in hourly earnings.

Unemployment, Average Hourly Earnings Growth

Tighter monetary policy would drive up unemployment — as demand slackens and layoffs increase — and dampen inflationary pressures. But at the risk of financial instability.

Conclusion

Further monetary tightening is necessary in order to increase the slack in labor markets, weaken demand, and curb inflation in the short-term. But the required policy steps — rate hikes and QT — are likely to crash the economy.

Rather than create financial stability through vigorous monetary tightening, the Fed is likely to tolerate higher levels of inflation — above their 2.0% target — for a longer period.

A less-hawkish stance from the Fed would be bullish for Gold.

Will a recession kill inflation?

There is plenty of evidence to suggest that recessions cause a sharp fall in the consumer price index. Alfonso Peccatiello recently analyzed US recessions over the past century and concluded that they caused an average drop in CPI of 6.8%.

MacroAlf: CPI & Recessions

A recession no doubt reduces inflation but it does not necessarily kill underlying inflationary pressures. It took massive pain inflicted by the Volcker Fed in the early ’80s to reverse the long-term up-trend in inflation. Average hourly earnings (gray) is a better gauge of underlying inflation as can be seen on the graph below.

CPI, Average Hourly Earnings & Recessions

Recessions cause a fall in earnings growth but do not interrupt the underlying trend unless the economy is administered a severe shock. In the early 1980s, it took four recessions in just over a decade, a Fed funds rate (gray below) peaking at 22% in December 1980, and unemployment (blue) spiking to 10.8%.

Fed Funds Rate & Unemployment

In the current scenario, we have had one recession, but cushioned by massive fiscal stimulus and Fed QE. Another recession would be unlikely to break the up-trend in underlying inflation unless there is a sharp rise in unemployment.

A study by Larry Summers and Olivier Blanchard maintains that unemployment will have to rise above 5% in order to tame inflation. The chart below suggests that unemployment may need to rise closer to 10% — as in 1982 and 2009 — in order to kill underlying inflationary pressures.

Unemployment(U3) & Average Hourly Earnings Growth

Conclusion

We are not suggesting that the Fed hike rates sufficiently for unemployment to reach 10%. That would cause widespread destruction of productive capacity in the economy and take years, even decades, to recover. Instead, we believe that the Fed should tolerate higher levels of inflation while Treasury focuses expenditure on building infrastructure and key supply chains, to create a more robust economy. Largely in line with Zoltan Pozsar’s four R’s:

(1) re-arm (to defend the world order);
(2) re-shore (to get around blockades);
(3) re-stock and invest (commodities); and
(4) re-wire the grid (to speed up energy transition).

An early Fed pause, before inflation is contained, would drive up long-term yields and weaken the Dollar. The former would cause a crash in stocks and bonds and the latter would increase demand for Gold and other inflation hedges.

A weaker Dollar would make US manufacturing more competitive in global markets and reduce the harm being caused to emerging markets. Unfortunately, one of the consequences would be higher prices for imported goods, including crude oil, and increased inflationary pressures.

The US Fed and Treasury are faced with an array of poor choices and in the end will have to settle for a strategy that minimizes long-term damage. In an economic war as at present, higher inflation will have to be tolerated until the war is won. An added benefit is that rapid growth in nominal GDP, through high inflation, would reduce the government’s precarious debt burden.

Federal Debt/GDP

Acknowledgements

Alfonso Peccatiello for his analysis of CPI and recessions.

S&P 500 rallies while inflation subdued

Average hourly earnings growth came in at 2.7% (All Employees) for the 12 months ended July 2018. Growth in average hourly earnings is an excellent gauge of underlying inflationary pressures in the economy, which remain subdued.

Average Hourly Wages Growth

Consumer price index (CPI) growth is slightly higher, at 2.8% for June 2018, but lower core CPI (2.2%) suggests that food and energy prices are partly to blame.

Consumer Price Index and Core CPI

The S&P 500 respected support at 2800, signaling an advance to 3000. Declining 21-day Volatility suggests that market risk is declining and the market is returning to business as usual.

S&P 500

The Nasdaq 100 shook off recent Facebook (FB) and Netflix (NFLX) tremors and is testing resistance at 7400. Breakout is likely and would offer a target of 7800.

Nasdaq 100

Weak US retail sales belie strong fundamentals

Lucia Mutikani at Reuters writes:

U.S. retail sales barely rose in September and producer prices recorded their biggest decline in eight months, raising further doubts about whether the Federal Reserve will raise interest rates this year. The weak reports on Wednesday were the latest suggestion that the economy was losing momentum in the face of slowing global growth, a strong dollar, an inventory correction and lower oil prices that are hampering capital spending in the energy sector. Job growth braked sharply in the past two months.

Readers of the headline Weak U.S. retail sales, inflation data cloud rate hike outlook could be forgiven for believing the US economy is headed for recession. After all, retail sales growth has slowed to a crawl.

Retail Sales

And the producer price index is declining.

Producer Price Index

But if we strip out food and energy prices, PPI remains close to the Fed’s 2% inflation target. And low energy prices will eventually feed through as a stimulus.

Hourly earnings in the manufacturing sector are starting to grow.

Average Hourly Earnings Growth: Manufacturing and Total Private

“The overall message is that consumer spending has remained extremely strong. If sentiment had indeed shifted, it would be hard to explain why sales of cars, certainly among the more expensive items, jumped in September to their highest level since July 2005,” said Harm Bandholz, chief economist at UniCredit Research in New York.

Light vehicle sales continue their upward trajectory.

Light Vehicle Sales

And construction spending is decidedly bullish.

Construction Spending

Not much here to keep Janet Yellen up at nights. When it comes to rate rises, the sooner we get the economy back on a sound footing the better, I say. Otherwise we encourage further capital misallocation and dependency on Fed stimulus. There are no free lunches from central bankers. Everything comes at a price.

Gold and Treasury yields decline as inflation weakens

US inflation. Core CPI is hovering below 2.0 percent but the 5-year inflation breakeven (5-year Treasury yield minus TIPS yield) suggests that inflation will fall. The recent slow-down in average hourly manufacturing earnings growth (production and non-supervisory employees) may just be statistical noise, but decline of either of these signals below 1.0% p.a. would be cause for concern.

5 Year Inflation Breakeven

Treasury yields remain weak, with the 10-year yield testing support between 1.85 and 2.0 percent.

10-Year Treasury Yields

The Dollar Index continues to range between 93 and 98. Falling inflation would favor an upward breakout. But flight to safety could drive the Dollar up (and yields downward). The biggest factor that may the Dollar down (and yields up), however, would be a Chinese sell-off of foreign reserves (largely Treasury investments) — to support the Yuan and/or stimulate their economy.

Dollar Index

Spot gold is likely to test primary support between $1080 and $1100 per ounce. Declining 13-week Twiggs Momentum, with peaks below zero, signals a strong down-trend. Breach of primary support would offer a target of $1000/ounce*.

Spot Gold

* Target calculation: 1200 – ( 1400 – 1200 ) = 1000