Bulls Flying With Doves

The Fed I: Brainard’s Dovish Speech. The bull market in stocks is flying high with the doves. On the other hand, the dollar is losing altitude.

Last week, the S&P 500 rose 1.4% to 2459.27, setting yet another new record high (Fig. 1). The trade-weighted dollar dropped 1.2% last week to the lowest reading since September 7 of last year (Fig. 2). The S&P 500 is right smack dab in the middle of our 2400-2500 forecast for yearend, and it is only July!

On March, Joe and I raised the odds of a melt-up scenario from 30% to 40%, lowering the odds of a gradual ascent in stock prices from 60% to 40%. We raised the odds of a meltdown from 10% to 20%, since a melt-up is typically followed by a meltdown. We’ve been discussing the likelihood of a melt-up since the start of 2013, when the economy didn’t go over the widely feared “fiscal cliff.”

The financial press attributed the latest bullish stock market advance to the dovish congressional testimony of Fed Chair Janet Yellen on Wednesday and Thursday. Melissa and I agree, but we also credit Fed Governor Lael Brainard’s dovish speech on Tuesday.

Though it was blandly titled “Cross-Border Spillovers of Balance Sheet Normalization,” the speech significantly discussed the impact of monetary policy tightening on the dollar. In the past, Fed officials rarely discussed the impact of their policies on the dollar. Now, it seems, they are strongly signaling that they don’t want to see the dollar strengthen as they continue to normalize monetary policy.

In her speech, Brainard focused on the Fed’s policy options. Specifically, she weighed the effects of normalizing through the federal funds rate (by hiking it), the balance sheet (by shrinking it), or both in tandem. She discussed several scenarios in a “stylized model” that would have different implications for exchange-rate effects depending on the monetary policy approach. She noted that it is “the commitment adopted by many leading nations to set monetary policy to achieve domestic objectives such that the exchange rate would not be a primary consideration in the setting of monetary policy.” However, she mentioned “exchange rate” 47 times in her comments and footnotes, obviously acknowledging that the foreign exchange value of the dollar is now an important consideration.

Brainard stated: “The balance sheet might affect certain aspects of the economy and financial markets differently than the short-term rate due to the fact that the balance sheet more directly affects term premiums on longer-term securities, while the short-term rate more directly affects money market rates. As a result, similar to the domestic effects, while the international spillovers of conventional and unconventional monetary policy may operate broadly similarly, the relative magnitude of the different channels may be sufficiently different that, on net, the two policy strategies have distinct effects.” Brainard seemed to conclude that it is best to lean toward the balance-sheet approach, as it should have fewer negative transmission effects, in her opinion (Fig. 3).

Oftentimes, Brainard’s remarks tend to foreshadow Fed Chair Janet Yellen’s thinking and the evolving consensus on the FOMC.

Consider the following:

(1) Inflationary pressures muted. In a 3/7/16 speech, Brainard anticipated FOMC policy as follows: “If the labor market continues to improve, higher resource utilization should also put some upward pressure on inflation going forward. However, the effect of resource utilization on inflation is estimated to be much lower today than in past decades.” She also said that the FOMC should put a high premium on evidence that actual inflation is firming sustainably before moving to tighten monetary policy. The FOMC waited until the end of 2016 to raise the federal funds rate by 25bps, the same one-and-done hike as at the end of 2015 (Fig. 4).

(2) Phillips curve flatter. In a 9/12/16 speech, she opined that the Phillips curve has flattened, “appearing to be a less reliable guidepost than in the past.” In other words, inflation has remained remarkably subdued given the drop in the unemployment rate. More specifically, she said, “The apparent flatness of the Phillips curve together with evidence that inflation expectations may have softened on the downside and the persistent undershooting of inflation relative to our target should be important considerations in our policy deliberations. In particular, to the extent that the effect on inflation of further gradual tightening in labor market conditions is likely to be moderate and gradual, the case to tighten policy preemptively is less compelling.”

The CPI inflation rate was back below 2.0% during June, with the headline rate down to 1.6% y/y and the core rate down to 1.7% (Fig. 5). This suggests that the core PCED rate, which was 1.4% during May, might have been even lower in June, since it tends to fall consistently below the core CPI inflation rate (Fig. 6).

Meanwhile, wage inflation remains remarkably subdued around 2.5% even though the unemployment rate has been below 4.5% for the past three months through June (Fig. 7). Job openings are plentiful (Fig. 8). When the labor market was this tight by these measures during the past three business cycles, wage inflation was around 4.0%.

(3) Neutral interest rate lower. In her latest speech, Brainard said, “the neutral level of the federal funds rate is likely to remain close to zero in real terms over the medium term.” Considering that, there would not be “much more additional work to do on moving to a neutral stance” from the moderately accommodative stance now. She added that the FOMC “decided to delay balance sheet normalization until the federal funds rate had reached a high enough level to enable it to be cut materially if economic conditions deteriorate.”

The FOMC hiked the federal funds rate again twice this year so far to a target range of 1.00%-1.25%. The federal funds future market is anticipating one more hike over the next 12 months (Fig. 9). We agree, but expect the federal funds rate to flatten out around 2.00% at the end of next year through 2019. Meanwhile, the real interest rate in the 10-year Treasury TIPS market continues to fluctuate between 0.00% and 0.80%, as it has since late 2013 (Fig. 10).

The Fed II: Yellen’s Dovish Testimony. Fed Chair Janet Yellen still knows how to sprinkle the fairy dust. When the Fairy Godmother of the Bull Market speaks, investors listen and get more bullish. The Dow Jones hit a new record high following her semi-annual testimony to Congress on Wednesday, and the S&P 500 did so on Friday. On numerous previous occasions, we have observed that stock prices tend to rise after Yellen speaks (Fig. 11 and Fig. 12).

Confirming Brainard’s comments, Yellen said that her goal is to reach a neutral level of interest rates, which is lower than it was historically and not so far off from where the federal funds rate is set now. Later this year, the FOMC is also expected to begin normalizing its balance sheet, she said, as Brainard discussed a few days before.

(1) Balance sheet. In her opening remarks, Yellen rehashed the outline for the plan for balance-sheet normalization, which was previously provided in greater detail in an addendum with the 6/14 FOMC policy statement. Yellen’s testimony on the subject seemed rather subdued. She said: “The Committee intends to gradually reduce the Federal Reserve's securities holdings by decreasing its reinvestment of the principal payments it receives from the securities held in the System Open Market Account. Specifically, such payments will be reinvested only to the extent that they exceed gradually rising caps. Initially, these caps will be set at relatively low levels to limit the volume of securities that private investors will have to absorb.” She added: “[W]e do not intend to use the balance sheet as an active tool for monetary policy in normal times.”

Brainard had suggested a similarly easy-does-it approach toward balance-sheet normalization in her speech: “In light of recent policy moves, I consider normalization of the federal funds rate to be well under way. If the data continue to confirm a strong labor market and firming economic activity, I believe it would be appropriate relatively soon to commence the gradual and predictable process of allowing the balance sheet to run off.”

(2) Balanced view. Inflation continues to be the sticking point for the Fed’s approach to accommodation in terms of its dual mandate to maintain its stability and maximum employment. The headline unemployment rate has dropped substantially since the Great Recession. At the same time, inflation has remained remarkably low.

In her written testimony, Yellen observed: “It appears that the recent lower readings on inflation are partly the result of a few unusual reductions in certain categories of prices; these reductions will hold 12-month inflation down until they drop out of the calculation.” During the Q&A with lawmakers, Yellen cited temporary influences holding down prices including mobile-phone plans and prescription drugs. She added: “It is premature to reach the judgment that we are not on the path to 2% inflation over the next couple of years.”

Yellen’s remarks on inflation seemed slightly more dovish than during her 6/14 press conference when she harped on temporary influences holding down prices, including mobile-phone plans and prescription drugs. Bloomberg observed that Yellen used the word “partly” to describe the impact of the temporary effects this time versus the word “significantly” last time. Balancing out her remarks, however, Yellen said: “[Several] developments should increase resource utilization somewhat further, thereby fostering a stronger pace of wage and price increases.” That effect is uncertain, though, in her view.

The Fed III: A Dove’s Swan Song. Commencing the balance-sheet unwinding while potentially raising interest rates closer to neutral at the same time could be Yellen’s final act as Fed chair. For now, the markets don’t seem too concerned about who will replace the Fed chair when her term is up in February 2018 if she isn’t reappointed.

Politico reported on 7/11 that National Economic Council Director Gary Cohn could be Trump’s top choice to replace Yellen. But Cohn might not want the job. Also, Cohn’s nomination might encounter resistance from the Senate given his close ties to the banking industry as a former Goldman Sachs executive. No matter what, Trump will probably look to nominate a Fed chair who will maintain stimulative policies at least until fiscal policies can take over. Politico observed that Cohn is “viewed as closer to Yellen’s preference for gradual rate hikes.”

By the way, though Fed officials proclaim their independence from politics, Brainard is a Democrat with a history of working for and contributing to the Democratic party. She doesn’t seem to be going anywhere soon, as her term doesn’t end until 2026, but her influence could be overshadowed by a new boss. It sure would be interesting to see Cohn step into the Fed chair role. Despite his current role in the Trump administration, Cohn is a registered Democrat, and he has no academic, economic, or monetary policy background. In any case, Yellen is the boss for now, and she seems to highly value Brainard’s opinion, which coincides with her own.

The Fed IV: Dove’s Rule. The FOMC’s projections support the views of Yellen and Brainard. On June 14, the FOMC set the federal funds rate in a target range of 1.00% to 1.25%. According to the Taylor Rule, the federal funds rate should be set at about 2.90%, as of Q2 based on the default inputs into the Atlanta Fed’s utility on its website. That figure happens to approximate the Fed’s latest median projection for the federal funds rate by 2019. For 2017, the median projection is just 1.40%.

The Fed’s 7/7 Monetary Policy Report (MPR), which accompanied Yellen’s congressional testimony, included a section titled “Monetary Policy Rules and Their Role in the Federal Reserve’s Policy Process.” The basic message is that the FOMC pays attention to models like the Taylor Rule, which prescribe the level of the federal funds rate, but the Fed’s policymakers believe that these models ignore too many “considerations” that require their judgment when setting the federal funds rate. In the “rules versus discretion” debate, they clearly favor the latter approach. Here are some key points from the MPR:

(1) Too simple. “Each rule takes into account two gaps—the difference between inflation and its objective (2 percent as measured by the price index for personal consumption expenditures [PCE], in the case of the Federal Reserve) as well as the difference between the rate of unemployment in the longer run (u^LR) and the current unemployment rate. … The small number of variables involved in policy rules makes them easy to use. However, the U.S. economy is highly complex, and these rules, by their very nature, do not capture that complexity.”

(2) Measuring slack. “[W]hile the unemployment rate is an important measure of the state of the labor market, it often lags business cycle developments and does not provide a complete measure of slack or tightness. In practice, Federal Open Market Committee (FOMC) policymakers examine a great deal of information about the labor market to gauge its health; this information includes broader measures of labor underutilization, the labor force participation rate, employment, hours worked, and the rates of job openings, hiring, layoffs, and quits, as well as anecdotal information not easily reduced to numerical indexes.” A footnote makes reference to the Fed’s Labor Market Conditions Index, which includes 19 components.

(3) Measuring inflation. “[T]here are many measures of inflation, and they do not always move together or by the same amount. … For example, inflation as measured by the consumer price index (or CPI) has generally been somewhat higher historically than inflation measured using the PCE price index (the index to which the FOMC’s 2 percent longer run inflation objective refers). Core inflation, meaning inflation excluding changes in food and energy prices, is less volatile than headline inflation and is often used in estimating monetary policy rules because it has historically been a good predictor of future headline inflation.”

(4) Broader considerations. “Finally, monetary policy rules do not take account of broader risk considerations. For example, policymakers routinely assess risks to financial stability. Furthermore, over the past few years, with the federal funds rate still close to zero, the FOMC has recognized that it would have limited scope to respond to an unexpected weakening in the economy by lowering short-term interest rates.”

(5) Different strokes. “Different monetary policy rules often offer quite different prescriptions for the federal funds rate; moreover, there is no obvious metric for favoring one rule over another.”