In the wake of the Brexit shock, Fed governor Jerome Powell was the first Fed speaker to give a speech, which gives some clue to the direction to Fed policy. While what the Fed does near-term is important to traders, the longer term thinking is important to investors as the definition of the Fed’s reaction function to events will affect the timing of rate hikes, the next recession and the next bear market.
The Powell speech laid out two main concerns of the Federal Reserve. One was the global risks posed by Brexit:
These global risks have now shifted even further to the downside, with last week’s referendum on the United Kingdom’s status in the European Union. The Brexit vote has the potential to create new headwinds for economies around the world, including our own. The risks to the global outlook were somewhat elevated even prior to the referendum, and the vote has introduced new uncertainties. We have said that the Federal Reserve is carefully monitoring developments in global financial markets, in cooperation with other central banks. We are prepared to provide dollar liquidity through our existing swap lines with central banks, as necessary, to address pressures in global funding markets, which could have adverse implications for our economy. Although financial conditions have tightened since the vote, markets have been functioning in an orderly manner. And the U.S. financial sector is strong and resilient. As our recent stress tests show, our largest financial institutions continue to build their capital and strengthen their balance sheets.
It is far too early to judge the effects of the Brexit vote. As the global outlook evolves, it will be important to assess the implications for the U.S. economy, and for the stance of policy appropriate to foster continued progress toward our objectives of maximum employment and price stability.
Dallas Fed President Robert Kaplan took a similar wait-and-see cautious tone in a Bloomberg interview last week:
Federal Reserve Bank of Dallas President Robert Kaplan said Britain’s vote to exit the European Union could slow growth and the most significant question raised by the decision lies in potential spillover effects as other countries ponder their own place in Europe.
“Is there contagion? What does Ireland do? What does Scotland do? What do other EU countries do?” Kaplan told Bloomberg in an interview Thursday in Washington. “In this case, political and economic are intersecting. And it will take a significant amount of time to see how all that unfolds.”
The Fed’s leading dove, Lael Brainard, had been hammering away on the theme of global linkages. Here is her speech from October, 2015:
Downgrades to foreign growth affect the U.S. outlook through several channels. First, weak growth abroad reduces demand for U.S. exports. Second, the expected divergence in U.S. growth increases demand for U.S. assets, putting upward pressure on the dollar, which, in turn, weighs on net exports. The estimated effect of dollar appreciation on net exports has been shown to be substantial and to persist for several years.6 Weak demand weighs on global commodity prices, which, together with the effects on the dollar, restrains U.S. inflation. Finally, the anticipation of weaker global growth can make market participants more attuned to downside risks, which can reduce prices for risky assets, both abroad and in the United States–as we saw in late August–with attendant effects on consumption and investment.
Brainard thinks that the global economy is fragile. Even though all may seem well in the United States, weak non-US growth will eventually pull down US growth:
Consider two possible scenarios. First, many observers have suggested that the economy will soon begin to strain available resources without some monetary tightening. Because monetary policy acts with a lag, in this scenario, high rates of resource utilization may lead to a large buildup of inflationary pressures, a rise in inflation expectations and persistent inflation in excess of our 2 percent target. However, we have well-tested tools to address such a situation and plenty of policy room in which to use them. Moreover, the persistently deflationary international environment, the gradual pace of increases in U.S. resource utilization, the estimated small effect of resource utilization on inflation, the likely low level of neutral interest rates, and the persistence of inflation below our 2 percent target suggests this risk remains modest. Financial markets appear to agree, as five-year inflation compensation is well below 2 percent.
Now, take the alternative risk: that the underlying momentum of the domestic economy is not strong enough to resist the deflationary pull of the international environment. A further step-down in global demand growth and a further strengthening in the dollar could increase the already sizable negative effect of the global environment on U.S. demand, pushing U.S. growth back to, or below, potential. Progress toward full employment and 2 percent inflation would stall or reverse. With limited ability to ease policy, it would be more difficult to move the economy back on track.
By contrast, vice-chair Stanley Fischer sounded a more hawkish tone in a CNBC interview:
“First of all, the U.S. economy since the very bad data we got in May on employment has done pretty well. Most of the incoming data looked good,” Fischer said. “Now, you can’t make a whole story out of a month and a half of data, but this is looking better than a tad before.”
He added, “Our primary obligation, it’s set out in the law, is to do what’s right for the American economy. Of course we take what happens abroad into account because it affects the American economy. … We’ll base what we do on what’s happening in the United States and what we think will happen.”
Based on the tone of the latest Fedspeak, it doesn’t sound like the Fed has fully bought into the Brainard “linkages” risk thesis just yet. For now, the world is still mesmerized by Brexit risk. If we use the Russia/LTCM crisis as a template, the Fed had been in a mild tightening cycle when the crisis hit. It responded with several rate cuts and began normalizing rates about nine months later. The chart below shows the Fed Funds target (in blue) along with the Russell 1000 (red) as an indication of the market response during that period.
The Russia/LTCM crisis is my base case scenario for the timing of the Fed’s rate normalization policy, though the rate cut part is in doubt as the markets appeared to have normalized very quickly. However, the wildcard is the question of how the Fed interprets the ongoing developments in the labor market.
The other focus of the Powell speech as employment and inflation. This is particularly relevant as we await the June Jobs Report on Friday morning to see if the weakness seen in May was an aberration.
After several years of improving labor market conditions, recent data have been sending mixed signals on the level of momentum in the economy. Business investment has weakened, even outside the energy sector. Growth in gross domestic product (GDP) is estimated to have slowed to a rate of only 1-1/4 percent on an annualized basis over the fourth quarter of last year and the first quarter of this year. Incoming data do point to a rebound. For example, the Atlanta Fed’s GDPNow model, which bases its projection on a range of incoming monthly data, estimates growth of 2.6 percent in the second quarter. In contrast, the labor market data, especially the monthly increase in payroll jobs, after displaying considerable strength for several years right through the first quarter of 2016, weakened significantly in April and May. While I would not want to make too much of two monthly observations, the strength of the labor market has been a key feature of the recovery, allowing us to look through quarterly fluctuations in GDP growth. So the possible loss of momentum in job growth is worrisome.
Wait! Did he say “weak business investment”? I pointed out on the weekend that analysis from Factset shows that capex was still growing at a healthy rate on an ex-energy and finance basis (green line):
The difference between the Powell comment about “weak business investment” and above chart illustrates the main policy risk as we await the June Jobs Report. The Fed may be mis-interpreting incoming data as weakness, when the economy is actually strengthening. In that case, we may see lower for longer in the short run, only to be followed by a realization that Fed policy is behind the curve and the response of a series of rapid rate hikes that pulls the US and global economy into recession.
As an example, one of the concerns raised by the weak May Jobs Report was that the unemployment rate had dropped, but for the bad reason that the participation rate had fallen. Here is what Janet Yellen said in her Congressional testimony about the participation rate (see WSJ video).
- The Labor Participation Rate (LPR) has been falling for some time because of demographics
- Weak labor markets has also pushed up LPR because discouraged workers leave the work force
- LPR has been flat recently, which Yellen interpreted positively as signs of cyclical gains
The end game
I have laid out the case that there is little slack in the labor market. Should we see weaker than expected employment growth, it’s a sign of a full employment economy, not economic weakness. Under those circumstances, I expect that the debate will rage within the Fed over differing interpretations over the coming months as rates stay on hold while the Brexit risk premium fades.
Despite her dovish reputation, Yellen has rejected Evans Rule 2.0 (don’t hike until you see inflation at 2%) and stated that she doesn’t want to approach the Fed’s 2% inflation target from above:
I continue to believe that it will be appropriate to gradually reduce the degree of monetary policy accommodation, provided that labor market conditions strengthen further and inflation continues to make progress toward our 2 percent objective. Because monetary policy affects the economy with a lag, steps to withdraw this monetary accommodation ought to be initiated before the FOMC’s goals are fully reached.
Assuming that the Brexit crisis blows over, one of the greatest market risks as we approach the spring and summer of 2017 is the Fed stays on hold too long and then recognizes belatedly that it is behind the inflation fighting curve. It will then have to respond with a series of staccato rate hikes that plunge the global economy into recession.