Fed: Burden of Proof

Published on May 4, 2016

After the Federal Open Market Committee signaled the door is open to a June rate hike in its April meeting statement, which they did primarily by diluting their previous highlight of financial and global risks, it will now be up to the data this month to pull the Committee through that door to a second rate hike in the long, gradual process of policy normalization.

*** We believe the lean among a majority of FOMC members is still to raise rates at the June 14-15 meeting. But the burden of proof is for now shifting against those making that case due to concerns the data will not be there soon enough to underpin a ratcheting up of messaging on June hike probabilities. May data, beginning with Friday’s Non-Farm Payroll, will have to provide a rare clarity in confirming the forecast for 2% plus growth and continued tightening in the labor market. ***

*** What’s more, the backdrop to the near outlook is rather foreboding, with trend potential, weighed down by terrible looking productivity growth, likely to be marked down to perhaps as low as 1.5% in many Fed forecasting assumptions. Along the same lines, the neutral real interest rate is not only estimated to still be at barely zero in the most recent projections, but it is now expected to persist at such low levels for far longer than previously assumed. ***

*** This somewhat bleaker picture of the economy’s longer term health, in theory, does not preclude a June rate hike if the data supports the forecast in the coming weeks. But it does suggest a lower terminal point to policy normalization, with the 2017 and 2018 rate dot projections pulled down by the longer run nominal neutral rate being marked down again to perhaps no more than 3% or even lower as early as June or by September. ***

A Prized Clarity in the Data

Fed district bank presidents Eric Rosengren and Dennis Lockhart, of Boston and Atlanta respectively, were both quick out of the April meeting gate to stress the Fed messaging that the market would be wise to nudge their June rate hike odds up rather substantially.

The market’s one in ten odds as of yesterday starkly contrasts to the Fed’s consensus probabilities, which we would put as high as even right now.

We wrote previously that it would take Fed Chair Janet Yellen herself to message the Fed’s intentions in June to a highly skeptical market, ideally by the end of this month, if the Fed expects to see any substantial upward movement in June pricing (see SGH 4/27/16, “Fed: April Bridge”).

And on that front, we would note that Chair Yellen has agreed to speak at Harvard University’s “Radcliffe Day” on May 27. While the topic is her “groundbreaking achievements” along with “personal reflections” from former Fed Chair Ben Bernanke, the event will include questions from Harvard’s Greg Mankiw, which offers the possibility of a policy signal if warranted.

And that, of course, will depend on the data between now and the Memorial Weekend break.

The Fed’s base case forecast is still for the data to come in just strong enough to point to yet another second quarter rebound from a first quarter softness. And while data may still be ambiguous for now, it is not all that bad, even if a bit more tepid than usual. Auto sales, for instance, still came in on the upside of expectations – the millennials seem to be finding access to easy credit and buying a lot of Chrysler jeeps while their parents are buying comfy SUVs with gas so cheap.

What’s more the dollar has been weaker, China is looking less bad, and oil prices have risen, which ironically is likely to boost rather than hurt the US outlook, especially with an energy sector potentially edging back from the “financial tipping point” Chair Yellen noted in her dovish Economic Club of New York speech in March.

All of that should take the downward pressure off inflation and inflation expectations. While it is still likely to take anywhere from six months to a year before that shows up in higher core inflation, it provides a much needed boost of confidence in the forecasts for core inflation measures to be indeed heading in the right direction towards and perhaps a bit beyond the 2% target.

Jobs versus GDP

Nevertheless doubts over the pace of economic activity, or that job creation may slow is clearly creeping into otherwise promising prospects. The early stages of the angst is driven in large part by the difficulty in squaring the circle of what has been clearly slowing first quarter economic activity, judging by the GDP estimates, and job creation at a near 200,000 a month clip being clocked in the Nonfarm Payroll prints so far this year. One or the other simply has to give.

Traditionally, when forced to choose between the two, the Fed has always gone with the reliability of the latter over the former, which tends to be continually revised.

Only this year there was no harsh winter as in the previous years that repressed spending that later rebounded with the better weather; consumer spending and retail sales have in fact been running a little weaker than the pattern in previous years. That the economy should pull through and steadily climb back to a solid 2% growth, third time lucky, is not clear just yet. Thus the data in May will be important if not essential in gauging the pace and sustainability of the Fed’s current assumptions on the pace of growth.

That of course underscores the relatively high stakes in this Friday’s NFP print. The market seems to be still looking for a jobs number around the 200,000 mark, which the Fed would be pleased with, but perhaps surprised to see.

Job creation, when the headline unemployment rate at 5% is essentially at NAIRU, should start to slow – the Fed estimated the jobs break-even is currently between 75,000 and no more than 120,000 – while the labor participation rate should ideally at least hold steady, with enough discouraged and longer term unemployed being drawn back into the jobs market to offset the more structural demographic decline in the labor force. In that sense, “flat is the new up.”

But the NFP won’t be enough in itself to lock in higher probabilities of a June rate hike, but at best to perhaps open the door a bit wider. A downside surprise, on the other hand, or market misinterpretation of a surprise low jobs number, would tend to undercut the Fed’s base case at a critical early moment of May’s high profie “data dependent” path.

Falling Trend

That is especially the case against the current backdrop of the somewhat darker turn in the Fed’s assumptions over the state of the economy’s longer term health.

Far and away the biggest drag on the economic prospects is the dismal productivity performance. Some of it may reflect the downturn in energy and manufacturing and the rise of the service sector, or the retirement of productive high earners and the entry of less productive low wage earners. But above all, the biggest letdown has been the near total no-show of business investment spending throughout the years since the crisis.

And without any of the usual levels of capital deepening, it would be difficult for productivity not to be as bad as it is. Likewise, new business formation, long a hallmark of a dynamic US economy, has been equally dismal in recent years, and may account for no small part of the horrible productivity figures, since the smaller and start-up companies tend to have the highest productivity.

All of that is inevitably translating into further mark downs in the estimated trend growth potential of the US economy. It was something of a shock when most of the Fed lowered its trend estimates down to 2% in recent years, but many Fed forecasters now seem resigned to marking it down again, to perhaps as low as 1.5%.

What’s more, it is leading to renewed doubts over the pace at which the effective equilibrium real interest rate, or the real neutral rate, will be rising over the period of the forecasting horizon.

The ongoing research work on the estimated neutral real interest rate by John Williams, President of the Federal Reserve Bank of San Francisco, and Thomas Laubach, the head of the monetary affairs division at the Federal Reserve Board, has garnered most of the attention on the “new normal” for the longer run nominal policy rate, which they report in their most recent paper may be no more than 3% nominal or 1% real.

On the one hand, the neutral real interest rate is assumed to have been rising over the years since the crisis from even lower negative levels, and there was an assumption it would continue to steadily rise towards its projected longer run real levels of at least 1.5% in real terms, or the 3.5% nominal longer run neutral projections of the Summary of Economic Projections quarterly rate dot plots.

But it would seem there is a hardening consensus view within the Fed that the neutral policy rate is going to persist at such low levels for a lot longer than previously assumed. Those rather long lasting “headwind” aftershocks of the financial crisis are perhaps looking a little more secular than “transitory” as originally penciled into the Fed’s forecasting models.

The Look and Feel of Secular Stagnation

In other words, it has all the feel, look, and sound of secular stagnation and perhaps the vindication of Harvard University’s Lawrence Summers, its most vocal proponent.

That of course also points invariably to a lower terminal point to the Fed’s current policy normalization process, and which by definition should flatten the trajectory of rate increases over the three year forecasting horizon.

At minimum, the reluctant, resigned embrace of the new normal will require messaging a new definition of a “gradual” pace of policy normalization that has already gone from four hikes a year, or half that of the 2004 rate tightening cycle, to half again in the current projections for two hikes a year.

If that is halved again, it is not only likely to bring Zeno’s paradoxical arrows into the monetary policy debate, but at minimum it will call for a new definition of what exactly policy normalization is in a world that is still far removed from any thing that can be called normal.

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