Waller’s Gambit

Posted by Cam Hui -
In the wake of the August Payroll Report, let’s review the Fed’s dilemma and the views of Fed Governor Chris Waller, one of the frontrunners to be the next Fed Chair.

 

Is monetary policy restrictive? Yes, by a number of measures. The Cleveland Fed recently published a study that estimated r-star, or the neutral rate of interest, and concluded: “The model estimates the implied (medium-run) nominal neutral interest rate to be 3.7 percent, with a 68 percent coverage band ranging from 2.9 percent to 4.5 percent. Given that the effective nominal federal funds rate is currently in the range of 4.25 percent to 4.5 percent, this model estimates with a high level of certainty (77 percent probability) that the policy stance is in restrictive territory.” In addition, the 2-year Treasury yield, which is the market’s estimate of the terminal rate, has been falling.

 

Will the Fed cut rates at the September meeting in response to labour market tensions? Most likely. Fed Chair Powell pivoted to emphasizing the Fed’s full employment mandate in his Jackson Hole speech. Fed Governor Waller has been making the rounds pounding the table about labour market weakness. The weak August Payroll Report makes a September rate cut a virtual certainty.

 

What about the Fed’s price stability mandate? Inflation indicators are rising in the short run in response to the imposition of tariffs. There is some dispute about whether inflation expectations are well anchored or rising.

 

 

What follows is an examination of Governor Waller’s view on monetary policy and the implications for Fed independence. What is his economic case for rate cuts and is it based on sound data, theory and solid judgment?
 

 

Waller’s Case for Rate Cuts

Governor Chris Waller was one of the two dissenting votes at the last FOMC meeting, which decided to keep interest rates stable. Waller, along with Governor Bowman, voted to cut rates by a quarter point. Since then, Waller made a speech and appeared on CNBC to make his case for a rate cut:

 

Waller mainly focused on the Fed’s full employment mandate and argued that the labour market is coming in much softer than expected. To be sure, an unemployment rate of 4.2% is at or near the Fed’s estimate of full employment, but the internals of the job market are much weaker. In particular, he relied mainly on the weekly reports from ADP, which indicates a no-hiring, no-firing economy, and firms laying off workers. The revisions from the July nonfarm payroll report confirmed his view, which is based on weekly ADP data:

I also look at timely data that Federal Reserve staff maintains in collaboration with the employment services firm ADP to construct a measure of weekly payroll employment, which covers about 20 percent of the nation’s private workforce. This measure is comparable to the one ADP publishes. The current May–July contour for the staff measure of ADP-based private employment is broadly consistent with that of the Current Employment Statistics numbers. And in the weeks after the July jobs report’s reference period, preliminary estimates from ADP show continued deterioration.

Waller’s speech about payroll revisions contained an element of anticipating the data, or wishful thinking: “I warned that job creation was weaker than it seemed in the payroll numbers and that data due in early September would indicate that payroll growth will be significantly lowered when annual revisions are made next spring… After accounting for these revisions and what we will learn in a few weeks, the data are likely to indicate that employment actually shrank over those three months.” [Emphasis added]. Assuming “what we will learn in a couple of weeks” refers to the preliminary benchmark estimate published on September 9…that estimate will only cover data from March 2024 to March 2025. It will not cover the May–July period.
To be sure, the recent history of nonfarm payroll employment revisions tended to be negative. Waller added:

[JPMorgan] did find that large revisions are often associated with major turning points in the labor market. One possibility is that the recent large revisions in the payroll data for May and June indicate the labor market is at an inflection point and may worsen in coming months.

Waller’s forecast mainly relied on ADP employment data (red line), which has shown a rough but uneven correlation with monthly nonfarm payroll growth (blue line).

 

 

The August Payroll Report was weak. Employers added 22,000 jobs in August, short of the consensus expectation of 75,000. June was revised down and July was revised up, for a net subtraction of 21,000 jobs compared to previous reports. The unemployment rate edged up to a new cycle high of 4.3%. This report cements the odds of a September rate cut.

 

Waller also made the point that when the jobs market deteriorates, the decline can become non-linear. He is referring to an effect that economists call “hysteresis”, which is  extensively discussed by a Federal Reserve study. During recessions, the unemployment rate (blue line) surges and the labour force participation rate (green line) plunges and it takes a long time to recover.
 

 

Waller may be making two modeling errors on the effects of hysteresis. First, there are no signs that the economy is about to enter a recession. In fact, Waller has acknowledged that growth is slowing and he sees no recession on the horizon. In addition, the U.S. government’s immigration policy pivot will significantly reduce the number of foreign-born workers. unemployment rate of native-born workers (red line) may not rise as rapidly as it did in past instances.
 

 

Wishful Thinking on Inflation?

Waller’s case for rate cuts is weaker when it comes to inflation.

 

He implicitly used the tr*nsitory word to describe tariff-induced price increases, which he is prepared to look through because of their one-time nature. Notwithstanding the “transitory” nature of the inflation assumption that turned out to be a policy error in the wake of the COVID-19 pandemic. His underlying assumption is that the increased price effects from the tariffs will be over in 6–7 months and inflation will return to its decelerating trend in 6–7 months.

 

Waller admitted in his speech that the uncertainty surrounding tariffs caused a pause in capital spending and hiring, but “I’m starting to hear some rumblings that businesses cannot sit on the sidelines forever. So we could see, at least, investment projects that were postponed begin to pick up, which would be positive for the economy.” It’s surprising that Waller hasn’t changed his risk management considerations for a rate cut in light of his anticipated pick-up in growth.

 

If economic growth is rebounding, or anticipated to rebound, yield should be higher, not lower. Indeed, the Citi U.S. Economic Surprise Index (ESI), which measures whether economic reports are beating or missing expectations, has recently surged. In the past, ESI has shown a rough degree of correlation with the 10-year Treasury yield.
 

 

As well, he assumes that “the three groups [exporters, importers, and consumers] affected by tariffs will share the costs roughly equally—one-third, one-third, and one-third”, which is contrary to anecdotal accounts. The data shows that import prices, which exclude tariff effects, have been flat to up since the trade war began, indicating that exporters are not bearing the cost of the tariff increase.
 

 

Anecdotal accounts indicate that the initial uncertainty over tariff policy caused many importers to adopt a wait-and-see attitude. They front ran the tariff increases where they could and loaded up on pre-tariff inventory and sold that inventory based on their old input prices. Importers gradually raised their prices as old inventory was sold. Goldman Sachs estimates that the consumer’s share of tariff costs will increase from 22% in June to 67% by October, and the split will not remain constant at one-third each.
 

 

The prices paid component for both Manufacturing (blue line) and Services (orange line) was still higher in August, though Manufacturing saw a reversal from July. These readings are consistent with the CPI and PPI inflation reports showing deceleration in goods inflation but strength in services, which are not subject to tariff effects.
 

 

When questioned on CNBC about the bond market’s reaction, Waller acknowledged that the 2-year Treasury yield was falling in anticipation of rate cuts and the 10-year yield and inflation expectations were well anchored. But he threw up his hands at trying to explain the rising 30-year yield: “Long end I’m not sure.”
 

 

Even the question of inflation expectations is a case of glass half-full or half-empty. While the 5×5 forward inflation expectations rate has been broadly flat in the last year, it rose significantly from the cycle bottom on “Liberation Day”.
 

 

Torsten Slok at Apollo warned that the U.S. runs the risk of another “inflation mountain” in the coming months.
 

 

 

Fed Independence the Real Issue

In summary, Fed Governor Chris Waller is a leading candidate to be the next Fed Chair, and the issue of Fed independence is paramount. My evaluation of his economic case for rate cuts should be whether the decisions are based on sound data, theory and solid judgment.

 

By contrast, Stephen Miran, Trump’s nominee for Fed Governor, had previously attacked Lael Brainard and Austan Goolsbee as an example of the “revolving door’ between the White House and the Fed:

Brainard and Goolsbee are both extremely talented economists who have made significant contributions to our nation. But to pretend that one can easily shift between highly political and allegedly nonpolitical roles without letting political biases inform policy is, at best, naïve—and, at worst, sinister.

In his latest prepared testimony for his confirmation, Miran wrote that he is supportive of the Fed independence principle:

Independence of monetary policy is a critical element for its success. Given the central bank’s outsized role in the economy, it’s no surprise that outsiders have opined on its decisions for decades. However, if confirmed, I plan to dutifully carry out my role pursuant to the mandates assigned by Congress. My opinions and decisions will be based on my analysis of the macroeconomy and what’s best for its long-term stewardship.

The WSJ revealed a surprising arrangement that Miran would keep his White House position and take unpaid leave while serving as Fed governor until January, when his governorship term is expected to expire. Miran added that he would resign his White House job if his term at the Fed were to be extended. So much for any notion of Fed independence. Equally surprising was the tone of his hearings. He was not questioned on his views of monetary policy, the nature of his models and so on.

 

Greg Ip at the WSJ also highlighted Miran’s about-face in his views on monetary policy:

Last September, while Joe Biden was still president, Stephen Miran, then an investment fund strategist, said it was a mistake for the Fed to cut rates with underlying inflation between 2.5% and 3%. Now chairman of Trump’s Council of Economic Advisers and a candidate for a spot on the Fed and with rates a full point lower and underlying inflation the same, he has echoed Trump’s criticism that the Fed has been slow to lower rates. He argues Trump’s policies will deliver lower inflation.

An examination of the contrast between Miran’s past and current views is an example of the degree of scrutiny that members of the Fed Board of Governors and Fed Chair should be subject to ensure the Fed’s independence in setting monetary policy.

 

My review of Waller’s case for rate cuts shows that he has shown solid thinking on employment, but his justification for rate cuts based on the Fed’s inflation mandate is weaker and shows signs of wishful thinking.