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posted on 07 December 2017

Will Santa Deliver Inflation To The Fed?

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Macro Tides Monthly Outlook for December 2017, Part 1

Will Christmas 2017 be the last one where the Fed will be waiting for inflation to arrive? Will Santa stuff their stocking with higher prices for 2018?

santa.stuffing.stocking


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In the October 6 issue of Macro Tides I discussed Central Banks' 2% Inflation Fetish and the unintended risks it posed:

“The seeds for the next financial crisis have been sown by the Federal Reserve and other Central Banks with their fixation on getting core inflation up to 2%. As long as core inflation remains below 2%, Central Bankers can justify maintaining a level of monetary accommodation that is not justified given economic fundamentals, asset valuations, corporate leverage, and the global reach for yield inspired by extraordinary low interest rates. The negative unintended consequences of delaying the normalization of monetary policy since 2014 are going to contribute to the upcoming financial crisis. To be clear, the next financial crisis is not on our doorstep and may not begin for some time. The onset may be delayed if inflation remains under 2% and Central Banks continue to use low inflation as an excuse to postpone normalization. One thing is clear. The risks posed by the negative unintended consequences from central bank’s monetary experiment are likely to increase, if the Federal Reserve and other Central Banks maintain their 2% inflation fetish.

As financial asset values become more stretched than they already are, they will increasingly pose a risk to financial stability when economic growth slows. Conversely, if the Fed is too gradual, there is a risk that inflation may begin to run above their 2.0% target necessitating the need for a less than gradual process. The decision facing the members of the FOMC is when do the risks to financial stability and the potential for wage push inflation begin to outweigh the FOMC’s obsession to get inflation up toward 2%."

On November 27, Robert Kaplan, President of the Federal Reserve of Dallas gave a speech entitled “A Balanced Approach to Monetary Policy". Kaplan’s speech was remarkable for its frankness, specificity, and for addressing a number of issues that I’ve written about in recent months:

“I am carefully monitoring evidence that might suggest growing risks of real imbalances, which could threaten the sustainability of the current economic expansion."

One of Kaplan’s concerns is the potential that as the labor market tightens further wage inflation could accelerate:

“Experience suggests that the greater the overshoot of full employment, the more difficult it is to unwind. There are surprisingly few historical examples of “soft landings" in cases where employment has risen above its maximum sustainable level. For example, the headline unemployment rate has fallen by 70 basis points over the past year, nearly matching the average rate of decline over the prior seven years of the expansion. If this rate of decline 2 continues, this will further tighten labor market conditions and would likely add to excesses and imbalances accumulating in the economy."

Kaplan’s concerns were reinforced by the assessment of the labor market in the Beige Book which was released on November 28:

“Reports of tightness in the labor market were widespread. Most Districts reported employers were having difficulties finding qualified workers across various skill levels. Wage growth was modest or moderate in most Districts."

welsh.monthly.2017.dec.fig.01

As I discussed in the November Macro Tides, I think the lackluster wage growth in recent years is likely to change based on the spread between the U6 and U3 unemployment rates. My research indicates that when the U6 unemployment rate minus the U3 unemployment rate was less than 3.85%, the labor market was tight enough to cause wages to rise faster than their longer term average of 3.32%.

In the October employment report, the U6 rate fell to 7.9% and the U3 rate dipped to 4.1%, so the U6-U3 spread in October was 3.8%. This is the lowest in nine years, and if maintained in coming months, is at the level that has led to higher wage growth since 1994. Wage growth is finally ready to accelerate in coming months from the 2.5% average in recent months.

In 1958 William Phillips published a paper in which he posited that there was an inverse relationship between inflation and the rate of unemployment that gained the attention of influential economists Paul Samuelson and Robert Solow. The logic of Phillip’s proposition is fairly straightforward. When unemployment falls to a low level, employers will bid up wages to attract workers. As the unemployment rate has fallen from 10.0% in 2010 to under 6%, 5.5%, and 5% since 2014, the Federal Reserve expected that wage growth would rise from the 2.2% level it had held since the spring of 2010.

The Fed was not alone in this forecast and most private economists have been mystified as to why wage growth has remained dormant. I think the Fed and other economists were led astray by putting too much attention on just the U3 official unemployment rate. Had they looked at the spread between the U6 and U3 unemployment rate they would have seen there was still too much slack in the broad labor market to support higher wage growth.

Wage inflation has always been a major component and driver of inflation so the lack of wage inflation is a big reason why core inflation has remained so tame. This has led Janet Yellen to declare that the stubbornness of low inflation was a ‘mystery’. Recently, William Dudley, President of the New York Federal Reserve had this to say about the lack of inflation:

“We’re not seeing quite what we’re expecting to see. That creates a bit of uncertainty about the best course going forward."

As the Federal Reserve was expanding its balance sheet from $900 billion in 2007 to $4.5 trillion in 2014 there was a small but vocal chorus of people warning of hyper inflation since the Fed was printing so much money. The hyper-inflation crowd was wrong because they overlooked that $2.6 trillion of the increase in the Fed’s balance sheet was sitting at the Fed in the form of Free Reserves. In other words, it wasn’t flowing into the economy so the problem of too much money chasing too few goods was not a problem. In fact, one of the reasons why the current recovery has been the weakest since World War II has been a lack of demand in large part because wage growth has been abnormally low.

The Fed and most economists appear to have thrown in the towel about the return of inflation. This might prove ironic as the potential for a pick-up in inflation is greater now than at any time since the financial crisis. To be clear I am not expecting inflation to soar to 3% or 4%. However, an increase that approaches 2.0% or moves slightly above 2.0% in the first half of 2018 could prove particularly disruptive for the bond market.

Currently, the bond market is expecting only one increase in the federal funds rate in 2018 even though the Federal Reserve’s dot plot suggests there will be three increases. Coming into 2017, the Fed had projected three increases but the bond market only expected one or two raises at most. The Fed will raise the funds rate for the third time at its December 13 meeting even though inflation has not been rising toward its 2.0% target.

Clearly, the FOMC has priorities that have outweighed the lack of progress toward their inflation target. The FOMC wants to get the federal funds rate high enough so it can once again be its primary policy tool, since the Fed does not want to implement Quantitative Easing in the future unless it is clearly warranted.

The Dot Plot after the FOMC meeting in September projects a peak in the federal funds rate of 2.75% in 2019. If the Fed is too gradual, there is a risk that inflation may begin to run above their 2.0% target necessitating the need for a less than gradual process which could negatively impact the economy.

These are the reasons why the Fed has pursued its gradual approach of increasing the federal funds rate despite the shortfall in inflation.

In addition to the upward pressure on wage growth there are a number of small incremental factors that are likely to lift inflation toward the Fed’s 2.0% target in coming months. For the first time since 2007, the economy’s actual performance was above maximum sustainable potential in the third quarter, as measured by the Congressional Budget Office. It can be debated as to the efficacy of the CBO’s estimate, but clearly the gap that has existed since the recession ended in June 2009 has narrowed considerably. This suggests the upward pressure on prices is now more broadly based throughout the economy than since before the financial crisis. The Fed’s Beige Book reinforced this point in its assessment of Prices:

“Price pressures have strengthened since the last report. There were also reports of increases in costs in the transportation sector. Several Districts noted input cost increases in manufacturing. In many cases, these increases in transportation and manufacturing were passed through to consumers."

welsh.monthly.2017.dec.fig.02

" It has been years since companies have been able to pass along price increases so this is an important change, which is showing up in the headline Consumer Price Index (CPI).

welsh.monthly.2017.dec.fig.03

In October the headline CPI index jumped above the core CPI which has normally led the trend of the core CPI. If the headline continues to rise in coming months, the core CPI is likely to follow. As you can see, since early 2012 the headline CPI rate has consistently held below the core rate which is why this latest data could be a nascent warning of additional inflationary pressures in coming months.

In October the headline Producer Price Index (PPI) also climbed above the PPI’s core rate. This is important since PPI price increases feed into consumer prices which confirms the analysis provided in the Beige Book. (Charts compliments of Advisor Perspectives and dshort.com)

The New York Federal Reserve has developed its own measure of inflation which it calls the Underlying Inflation Gauge (UIG) and is composed of 346 sub-components. The UIG includes the data subsets included in the CPI and PPI but adds data from the ISM survey, Labor market indicators, money supply measures, and financial market prices on commodities, debt instruments, and stock averages.

welsh.monthly.2017.dec.fig.06

Historically, the UIG has moved up and down before changes in the CPI. In October the UIG rose to 2.96% which is well above the core CPI and the highest since 2005 - 2006. Interestingly, this is the last time the economy was above the CBO’s measure of the economy’s maximum sustainable potential.

The decline in the Dollar during 2017 has caused import prices to rise for the first time since 2012. Although import prices are a small component of core inflation, it is now adding rather than subtracting from inflation.

welsh.monthly.2017.dec.fig.07

Other components which have been subtracting from inflation will subtract less in coming months. Last March, a price war between mobile phone providers caused a huge drop in phone plans which Janet Yellen described as one of the transitory factors that were weighing down inflation. The year-over-year downward pressure from the wireless price war will diminish by next March.

welsh.monthly.2017.dec.fig.08

Used car prices were down -4.7% through March but in October was only down -2.9% as victims of the hurricanes replace their destroyed cars with used cars. Each of these factors by themselves is not a big deal, but combined will add a few more basis points to inflation in coming months.

welsh.monthly.2017.dec.fig.09

I discussed the valuation of the stock market in the October issue and showed the chart of the Buffett indicator which compares the capitalization of the stock market to GDP as a percent. “Whether one uses Tobin’s Q-Ratio, Shillers CAPE Ratio, Crestmont Research’s P/E Ratio, or the Buffett Indicator, the message is the same." (Chart compliments of Advisor Perspectives and dshort.com.)

Click for large image.

In his November 27 speech Robert Kaplan addressed the issue of financial imbalances.

“Excesses can also manifest themselves in financial imbalances. While I would prefer to rely primarily on macroprudential policy tools to manage financial imbalances, I am nevertheless monitoring various measures of potential financial excess. I monitor these and other market measures because I am aware that, as excesses build, we are more vulnerable to reversals which have the potential to cause a rapid tightening in financial conditions, which in turn, can lead to a slowing in economic activity. The U.S. stock market capitalization now stands at approximately 135 percent of GDP, the highest since 1999/2000."

Maybe Kaplan read the October issue of Macro Tides!

In my October 9 Weekly Technical Review I made the following comment about the absence of a correction in the stock market during 2017:

“While the new record highs have been making headlines, the real news is the absence of selling pressure which has made the record prices possible. We’re more than 75% through 2017 and the largest decline in the S&P has been a scary -2.9%. Since 1914 that is the smallest decline in any year, which means the odds of this occurring as we entered 2017 was less than 1%."

This is what Kaplan had to say about the lack of volatility in the stock market:

“Measures of stock market volatility are historically low. We have now gone 12 months without a 3 percent correction in the U.S. market. This is extraordinarily unusual."

In the October issue of Macro Tides I also discussed the level of corporate debt:

“Since the end of 2012, U.S. real GDP had grown 10.7% through the second quarter of 2017. During the same period, corporate debt has grown by more than 35% according to the Federal Reserve, more than 3 times as fast as the economy. As U.S. companies have added more debt to their balance sheets, the amount of corporate leverage has increased from 1.7 in 2010 to 2.44 at the end of the second quarter in 2017. The leverage ratio is the highest on record and above the prior highs in 2008 and 2002."

Kaplan singled out the level of corporate debt as a risk to financial stability:

“While household debt to GDP has improved over the past eight years, corporate debt is now at record highs."

welsh.monthly.2017.dec.fig.11

Kaplan also identified the decline in trading volume in the stock market and bond market as a potential problem during a selloff as the lack of liquidity could exacerbate a decline:

“Debt and equity securities trading volumes have markedly declined over the past several years. For example, NYSE equity trading volume on average for 2017 is down 51 percent from 2007 levels, while the NYSE market cap has increased 28 percent over the same time period. I would also note that margin debt is now at recordhigh levels. In the event of a sell-off, high levels of margin debt can encourage additional selling, which could, in turn, lead to a more rapid tightening of financial conditions. Sufficient market trading liquidity is key to managing the resulting increased volume."

The increase of investors using passive investment strategies and Exchange Traded Funds (ETF) represents another significant risk. The shift to passive investing has not repealed the role of human nature. During the next bear market, passive investors are likely to become active when their monthly statement shows their account has lost more than 20% of its value. They will decide to sell near a market bottom because human nature will override their passivity. The lack of liquidity in the bond and stock market could result in a traditional waterfall decline as passive investors rush to the exit. It is not a question of if it will occur, only when.

The last portion of Kaplan’s speech was entitled ‘Implications for the Stance of Monetary Policy’. Kaplan made two statements which are noteworthy:

“Even though we are not meeting our inflation objective, the size of the expected full employment overshoot is growing and should be taken into account in assessing appropriate monetary policy actions. I would like to avoid a situation where the FOMC is playing “catch-up" in raising interest rates."

Kaplan clearly thinks the risks of an overshoot in inflation from wage growth is increasing and suggests a less gradual approach than the Fed has pursued to date. He also reiterated the risk from financial imbalances:

“I am increasingly cognizant of the risks posed by potential economic and financial imbalances. Such imbalances, if allowed to build, have the potential to, at some point, threaten the sustainability of the expansion and the attainment of our dualmandate objectives."

Kaplan brings up an interesting point even though he didn’t reference it specifically. The last two recessions were preceded by imbalances in financial assets, with the dot.com bubble leading to the 2001 recession and the housing bubble causing the financial crisis.

As those imbalances were building the Federal Reserve did nothing to curb them which allowed them to grow until they could and did negatively impact the economy once they deflated.

Kaplan recognizes that a strict adherence to the Fed’s inflation mandate has already allowed a number of imbalances to develop. If the Fed continues done this path, the risks of another bubble leading to another recession will increase further. Implied in his logic is whether the Fed should lessen the importance of its inflation mandate when excessive valuations begin to threaten financial stability.

His logic also raises an important question. Should the FOMC act or use its forward guidance to trigger a correction in the stock market so valuations come down a bit and pose less of a threat to financial stability?

It is important to remember that Kaplan is just one member of the FOMC and members like Neel Kashkari hold a very different opinion about how quickly the Fed should raise the federal funds rate.

If inflation begins to rise as I expect, the Fed will respond with more interest rate hikes than the bond market is currently pricing in, which should lead to higher Treasury bond yields in the first half of 2018.

welsh.monthly.2017.dec.fig.12

In recent weeks Treasury bond yields have fallen which has caused the yield curve to flatten. The spread between the yield on the 10-year Treasury bond and the 2-year Treasury note is at the narrowest since the financial crisis. This has raised concerns that the yield curve might invert if the Federal Reserve continues to raise the federal funds rate. Every post World War II recession has followed an inverted yield curve when the 10-year Treasury Constant Maturity fell below the Federal Funds Rate. (The yield curve is considered negative when the yield curve is below zero in the chart below.)

welsh.monthly.2017.dec.fig.13

The formula for the yield curve is to subtract the federal funds rate from the 10-year Treasury yield. If the 10-year Treasury bond’s yield was 2.5% and the federal funds rate was 3.0%, the yield curve would be negative by -0.50% (2.5% minus 3.0% = -0.50%). The yield curve has been hovering under +0.90%, so it is positive and giving no warning of a recession.

welsh.monthly.2017.dec.fig.14

The yield curve turned negative in May-June 2000, and in June 2006 and well in advance of the subsequent recession in 2001 and financial crisis in 2008. There have however been negative yield curves that were not followed by a recession as in February 1989 and August 1998. There were negative spikes in December 1985 and December 1986 due to technical factors since November and January in both years were positive. The yield curve is a very important indicator in providing an advance warning of a potential recession but isn’t 100% correct.

Yes, the yield curve has narrowed to its lowest level since the financial crisis, but it is comfortably positive and more importantly, current financial conditions are more accommodative and easier than at any time since 1994.

welsh.monthly.2017.dec.fig.15

The concern about the yield curve fails to acknowledge the relationship between rates in the U.S. and in Germany. The spread between 10-year yields in the U.S. and Germany have been tethered at about 2.0%. The German 10-year Bund yields 0.30% which has enabled the 10-year Treasury yield to hold below 2.40%, even as U.S. short term rates have gone up. This has caused the yield curve to flatten, but it has nothing to do with the prospects for the U.S. economy.

The hand wringing over the narrowing in the yield curve is way over done. The number of internet ‘yield curve flattening’ searches has absolutely soared in just the last few weeks, indicating how much concern has been foolishly generated.

welsh.monthly.2017.dec.fig.16

With the passage of tax reform the bond market is sure about a hike in December, gives a 63% probability of an increase in March, and a 50% chance for a second move in September. The market has not priced in a second hike in the first half of 2018, so the surprise could be that the second increase comes in June.

If inflation does move toward 2.0% in the first half, the market may be forced to price in additional rate increases in September and December. If Treasury bond yields rise in coming months in anticipation of four additional rate hikes, the yield curve will not invert. If the Federal Reserve raises the funds rate to 2.15%, after an increase in December and three hikes in 2018, it is very unlikely that the 10-year Treasury yield will fall below 2.15%.

welsh.monthly.2017.dec.fig.17

Part 2 will be published tomorrow: Bond Vigilantes And Outlook For Stocks.

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