March Quick Read on the US Economy

In my opinion, the latest numbers on the US economy were positive last month. After plummeting for the first half of February, stock markets became markedly more positive over the second half. International equity prices seem to have regained their footing and oil prices are well off the lows of the year as well. I still see the global growth environment as tepid: with the US being the main bright spot. Despite the international headwinds, I expect the Fed to begin to signal it will continue to tighten according to plan.

Domestic highlights in February

Our Astor Economic Index® (“AEI”) shows growth somewhat above the recent average and slightly stronger than last month. The AEI is a proprietary index that evaluates selected employment and output trends in an effort to gauge the current pace of US economic growth.

I saw the employment report (nonfarm payrolls) for February as broadly positive. The number of new jobs was almost exactly at its two year average. I see no sign of broad based weakness in the economy when viewing the payroll numbers. Readers who want to burnish the negative case may have to dive into the weekly aggregate payroll. This number takes the number of employees and multiplies by the hours per week and again by dollars per hour. The result is something like a weekly wage bill and it posted a rare down month in February as hourly earnings and hours worked both posted modest declines.

In short: I think the pessimism in the first two months of the year were driven by fearful projections rather than data and that current views of the state of US economy are more realistic.

International environment

Last month, I was hoping for signs of strength in the world manufacturing cycle. It seems as if my hopes will have to wait at least until spring. While the Institute for Supply Management’s Manufacturing Index for the US showed a modest (but welcome!) bounce for the month, the picture in the rest of the world was not so rosy. The chart below weighs PMIs in roughly the G-20 countries, each one weighed by their GDP. This measure is looking for new low since 2012.

 

world.pmis.2016-03-04.png

Source: Institute for Supply Management, Markit, Astor calculations

The Fed

I believe the next red-letter day for the market should be FOMC Chair Yellen’s post meeting press conference on March 16th. Few expect the Fed to raise rates but many will be placing bets on the nature of the committee’s communications. Will the FOMC be hawkish or dovish? The Fed has repeatedly said they are data dependent and not tied to the calendar. However, as University of Oregon Economist Tim Duy has pointed out: we will need some clarity on which data they are dependent on.

In my view, the case for promising to raise rates again soon is that continued strength in the economy will move unemployment below the natural rate by a fair amount and perhaps for an extended period. In the view of Vice Chair Stanley Fischer for example, such labor market strength would risk setting off enough of an inflationary process that even larger rate hikes would be necessary to contain it.

However, I believe there are several complicating factors to give the Hawks a pause. First, is the tightening of financial conditions reflected in higher rates for corporate borrowers as well as the volatility and general decline of equity prices.  Second, inflation expectations, while hard to measure, may be declining. Inflation expectations derived from market prices are substantially lower than they were a year ago though survey-based expectations may have stabilized.  The chart below shows five year forward forecasts of CPI from surveys an derived from market prices.

infl.png

Source: Bloomberg, Federal Reserve bank of Philadelphia

My prediction is the Fed will raise not rates in either March or April and instead, focus on the tightening in the financial markets and weakness in inflation expectations in its released statement.  Therefore I am expecting the Fed to promise two or more hikes in 2016.   My preference (if I were a voter) would be for the Fed to make it clear that it is willing to be symmetrical around the 2% inflation target and would tolerate a year or two above the target as we have spent each of the last 8 years below it.

Conclusion

Overall, I am pleased to see continued growth in the US despite the tepid international environment. I expect the Fed to try to move back towards, but not fully achieve, its plan of four hikes this year.


All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. The investment return and principal value of an investment will fluctuate and an investor’s equity, when liquidated, may be worth more or less than the original cost.
The Astor Economic Index® is a proprietary index created by Astor Investment Management LLC. It represents an aggregation of various economic data points: including output and employment indicators. The Astor Economic Index® is designed to track the varying levels of growth within the U.S. economy by analyzing current trends against historical data. The Astor Economic Index® is not an investable product. When investing, there are multiple factors to consider. The Astor Economic Index® should not be used as the sole determining factor for your investment decisions. The Index is based on retroactive data points and may be subject to hindsight bias. There is no guarantee the Index will produce the same results in the future. The Astor Economic Index® is a tool created and used by Astor. All conclusions are those of Astor and are subject to change.

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How the Fed Sees Inflation

The Fed sees inflation a bit differently than many in the markets do.  In this note I will discuss some of the folk-economics that get talked about casually on the trading floor. I will contrast that with how Janet Yellen has recently described her view of US inflation dynamics (mainly as expressed in her very interesting speech Inflation Dynamics and Monetary Policy).

If you feel like you have a good handle on how inflation works, maybe you should think again.  Macroeconomists in general would not describe inflation as a well-understood problem.  Economist Noah Smith, for example, says baldly that “macroeconomists don’t yet understand how inflation works.”  Despite that chastening counsel, many of us have simple models of inflation that we use.

For example, perhaps inflation is caused by commodity prices.  Roughly, copper gets expensive so wire gets expensive so electronics get expensive so everything gets expensive.  Those of us with memories of the 1970s and the high oil prices are particularly susceptible to this.  And to be sure, in the 1970s inflation and commodity prices did increase together and some economists have found a statistical relationship in that blighted decade.  In the more recent period, however a rise in energy prices in one year will not forecast a rise in inflation in the following year (see this paper by Kansas City Fed economists Todd Clark And Stephen Terry, for example).

Since 1980, however, it is tougher to find a consistent pass-through from commodity prices to broader inflation.  What we actually tend to see is prices of commodities tend to fluctuate widely, and hence CPI tends to move more than core CPI.  But the equation seems to be that the ex-food and energy CPI tends to be more stable than CPI including commodity prices.

Source: Bloomberg

Source: Bloomberg

To be clear, of course if gas prices go up 10% today that will have an impact on today’s inflation.  What is not so obvious before careful investigation is that it will have little direct impact on tomorrows inflation.

Do rising wages forecast changes to inflation?  Like commodity prices, this is an intuitive idea without empirical support in the United States since the 1980s.  A summary of the state of research can be found in The Passthrough of Labor Costs to Price Inflation Peneva and Rudd.  This research undermines the idea of a wage-cost spiral operating recently in the US, and instead suggests the preferred interpretation is high wages are an indicator of a tight labor market.

What does cause inflation?  The prices of inputs to production, especially imports, matter for inflation as does the level of resource utilization.  But, again, this is only for the current level of inflation.  What can we use to forecast tomorrow’s level of inflation?  For the longer trend around which prices fluctuate, however, economists have settled mainly on the idea that one of the most important determinants of inflation is inflation expectations themselves, or more precisely, the difference between realized and expected inflation.  This is called the expectations augmented Philips curve.

In some sense, regressing from inflation to expected inflation does not sound like it solves much. What causes inflation expectations in their turn?  The expectation of inflation expectations?   Nevertheless, this seems to be the best that economist have for the time being.  People make plans and contracts based on some sort of expectation of inflation and when the world does not meet their forecast the adapt in some way.

The great thing about stable inflation expectations is that once you have gotten the expectations to a level you are comfortable with then prices should revert to target as people assume that moves away from the target will be reversed.  The bad news is if expectations are stuck away from the desired level, small deflations tend to move back to the bad level too.  The Fed feels it has built up some credibility by moving expectations to around 2%, the target which was implicit for the second half of the Greenspan years and which because explicit under Bernanke.  I believe a large part of the motivation for the balance sheet expansion (QE) was to take insurance against inflation expectations becoming anchored significantly below 2%.

An important question is whether inflation expectations are indeed well anchored.  Presumably, businesses and consumers extract some sort of trend rate of inflation when making expectations.  A long period of actual inflation away from the target will likely eventually shift inflation expectations.  However, no one knows the parameters of such a function.  The Fed has undershot its 2% target much more than it has overshot it, and its extreme actions to move inflation back to target in the last few years have not been successful to date.  The Fed believes that is because of temporary factors which should wash out over time.  We shall see.  The reality is that actual inflation expectations, however measured, have come down dramatically since the crisis and have not recovered.

Overall, then, the Fed thinks it can solve its inflation mandate by reacting with studied earnestness to sustained tightness in resource utilization because this could lead to the extended bouts of inflation that could shift inflation expectations away from the target.  At the same time they can look though inflation caused by temporary changes in market prices of currencies or commodities, as these do not forecast future levels of inflation.

How does this play into the Fed’s current decision and likely course of hikes?  Here is my interpretation based on closely following what FOMC members are saying: The Fed is raising rates a small amount now so it does not have to raise them a large amount later.  This calculus is all based on keeping inflation expectations well anchored.  The Fed feels resource utilization is tight enough that it needs to ensure the economy does not experience a protracted bout of high inflation.  To that end, it seems to slow growth slightly.  The alternative, in the Fed’s view, is in the medium term there will be a long period of above target inflation which will take a substantial slowdown in the economy to contain.

Source: Bloomberg

Source: Bloomberg

I think it is possible to disagree with this logic. I would likely vote against a hike if I was on the board, but it does make sense.  Given the tepid realized inflation figures over the last fifteen years, it also suggests to me that the Fed will not raise rates much.  My guess is 25 basis points every other meeting for the next year, leaving fed funds at about 1% a year from now.  Note that at that level, real rates would still be negative, and thus the Fed will still be “easing”, though at a reduced level.  I expect Low and Slow to be the watchwords for the Fed in 2016.

[Edited 2015-12-17 to add various links accidentally dropped]

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. The investment return and principal value of an investment will fluctuate and an investor’s equity, when liquidated, may be worth more or less than the original cost. 

The Fed’s Inflation Problem

As 2014 draws to a close the Fed is presented with a problem. Based on recent speeches, a substantial part of the committee seems eager to raise rates. At the same time. some of the Fed’s preferred metrics suggest this may be premature and the market is trapped in between. Market participants are on the lookout for clarity in next week’s press conference from Chair Janet Yellen. The expectation among Fed watchers is that at next week Yellen will solidify expectations that rates will begin to rise in June 2015.

Why do I think the Fed is getting ready to raise rates? We discussed the shifting composition of the voters on the committee a few weeks ago and came to the conclusion that the shift involved roughly equal numbers of hawks and doves coming and going. When we look at the statements from the permanent members such as Vice Chair Stanley Fischer (see this WSJ interview) and NY Fed President Dudley, I see a more hawkish tone.

Why this shift? Below I graph the Fed’s performance against its dual mandates of stable prices and full employment.   The chart shows unemployment and inflation along with the Fed’s inflation target (in blue) and the unemployment rate consistent with stable prices (in pink). The economy has improved without inflation over the last five years.   Today, the Fed is in the happy spot where there is slack in both inflation and unemployment.

phillips.pce-2014-12-09

With inflation below target today, are inflation expectations what are causing the hawkish tilt?  Not really. The chart below shows three measures of inflation expectations – two derived from various market prices and one from a survey of professional economists asking for the average inflation rate expected over the next five years. Any way we look at it, inflation expectations for the intermediate term are low and, if anything, falling. It is not clear to me what, other than a simple distaste for rates remaining at the zero lower bound is moving the Fed to raise rates

infl

What does the market think about the Fed’s likelihood of raising rates? We can plot the fed funds futures against the Fed’s forecast of where rates will be at year end as revealed in their quarterly reports. This chart shows that as of yearend 2015 the FOMC expects short term rates to be around 1.375% (up from about 0.125%) and the fed fund futures market expects the same rate to average around 0.55% that month.

Forecasts of the fed funds rate

We see similar skepticism in the low level of yields in US treasures. One interpretation of US ten year bonds yielding 2.16% is that the Fed’s expectations of rates (the blue dots) are either will not materialize or will need to be quickly reversed. That is, if the bond market believe that short term rates were going to 3.75% by 2017 and staying there, the ten year bond would yield a lot closer to 3.75%. In fact the Fed’s survey of major market participants reveals a 20-30% possibility that the Fed will be led to quickly undo its rate rise. It would not be the only central bank to reverse course since the crisis.

How might the Fed square the circle? If inflation expectations remain low it is hard to see the forecast of rates represented by the blue dots coming to pass. On the surface, this is very odd. The fed gets to set the level of short term interest rates, its forecasts of fed funds should be as accurate as my forecasts of my daughter’s allowance: completely with the control of the forecaster.   Perhaps the forecast should be seen a way as allowing hawkish members to blow off steam. If so, it would be better to discontinue them.

I am currently expecting 1) the Fed will raise short term interest rates beginning in June 2) they will only raise rates slightly over the course of the year and fed funds will end the year below 1%. It will remain to be seen if the Fed will walk back the higher expectations found in their quarterly forecasts. My guess is that hints of more aggressive moves will cause some substantial moves in the fixed income markets.

(Other views of the upcoming meeting you should consider: Tim Duy, Gavyn Davies, Paul Krugman)

FOMC Quick Reaction

[Before press conference]

There is the danger of inconstancy in the Fed’s communications. On the one hand, the language in the FOMC statement about the “considerable period” is still there, which Chair Yellen described as six months. On the other, the FOMC median expectation for fed funds at the end of 2015, which after all the FOMC controls, is for 1.375%. That rate today is about 0.10%. So that means five 0.25% increases of out eight meetings, which all adds up to the Fed’s projections are implying rates to begin to rise in June of next year. Is that a “considerable” amount of time away?

We hope we get some clarification from the press conference.

[After press conference]

With the animating spirit of Alan Greenspan obfuscating her answers, Chair Yellen allowed the ambiguity noted above to stand. My best guess is that the tension between the “considerable time” formulation and the FOMC consensus opinion on where rates should go will be resolved by how inflation (and the expectations for further inflation) move and how quickly. That is to say, the FOMC is not sure exactly when it will raise rates and wants to maintain freedom of maneuver. Our best guess is that the modest pace of economic growth and residual slack in the economy will allow rates to stay low.

There were some technical details about unwinding QE and normalizing monetary policy. The major change to what we knew before being that rates will rise before the Fed allows a passive reduction in its balance sheet by ceasing to reinvest principal and interest as it is paid.

There was a good question in the press conference about the divergence between fed fund futures and the famous Dot Plot(page 3 of the FOMC Projection Tables report). That is Fund Futures are now implying a funds rate of 0.75% at the end of 2015, while the dot plot says 1.375% One source of divergence is that the Fed is polling its members about the appropriate rate, not the rate which will obtain.

 

Fed Watch – Jackson Hole

The Kansas City Fed is hosting its annual Jackson Hole conference this weekend (motto: “interrupting Wall Street vacations since 1978”) . Several times in the last few years we have gotten a good preview of the Fed’s concerns for the year ahead by listening to the Chair’s speech. The last two rounds of Quantitative Easing, for example, were foreshadowed by Chair Bernanke’s talks.

The detailed agenda has not been announced yet (watch this space) but it may again be worth taking a day off the beach as the theme of the conference is “Re-Evaluating Labor Market Dynamics” and Janet Yellen’s speech is titled simply “Labor Markets.”

This is timely as one of the most important economic questions of the day is how much slack is truly remaining in the labor market. My forecast, along with many other Fed watchers, is that Yellen will make a point of emphasizing the slack remaining in the labor market.

While the unemployment rate is approaching more normal levels digging deeper we do find evidence of slack beyond the unemployment rate. The number of involuntary part time workers, which I noted in this post, is very high, perhaps three million above typical levels. In addition, the lake wage gains above the level of inflation indicates that despite record corporate profits, employers are not finding it necessary to compete on price. The labor participation rate is more complicated. A large number of people have dropped out of the labor force since the recession though a mixture of the median American getting older and through the difficulty the long-term unemployed have in getting a new job. These contending forces are examined in an interesting report by the Council of Economic Advisors find that about half of the reduction in the labor force is due to aging and about half due to other factors we might hope to be reversed.

Against these indicators of slack what do we see when we look for tightness? I noted the improvement in the unemployment rate above and referring again to my post from July, the quit rate and the job opening rate are both looking as good as they have since the recession and about as good as they did during the last recovery.

Where does that leave the Fed? We can look at the Fed Dual Mandate Report Card below. The X axis show the unemployment rate (with the Fed’s estimate of long run unemployment in pink) and the Y axis shows five-year-ahead expected inflation (with the Fed’s 2% target plus an error band in blue). The details are explained in my post Janet Yellen’s Report Card.

phillips.expectations.pce-2014-08-19

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My interpretation of this chart is that the Fed is in the happy situation when its two mandated goals (price stability and full employment) are not in conflict so there should not be a reason to raise rates any time soon.

In thinking about what the Fed will do in the future we need to bear in mind that by law they are mandated to try and manage both inflation and employment. My sense is that Yellen and most of the FOMC see today’s balance of risks tilted toward problems of employment and will let inflation expectations drift somewhat above their target. This may be a change in tolerances from what many of us are used to from the Fed policy in the 1990-2007 period, as economist Tim Duy writes: “Yellen can point out that since the disinflation of the early 90’s, the Fed has not faced an inflation problem, but instead has struggled with three recessions. This on the surface suggests that monetary policy has erred in being too tight on average.” I hope Chair Yellen will give us some clarification and some arguments to shape the discussion.

Yellen testimony confirms view of labor market slack

Fed Chair Janet Yellen gave her semi-annual report on monetary policy to the Senate today. Its content is consistent with our interpretations of both monetary policy and the labor market. The key phrase from our standpoint is:

“we currently anticipate that even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the federal funds rate below levels that the Committee views as normal in the longer run

We interpret this to mean a delayed and slow increase in short term rates, starting perhaps in the second quarter of 2015.