Well, last week was an interesting one for monetary policy. We entered thinking the Fed was going to taper QE at its upcoming meeting in an attempt to wind down the controversial program, and that the controversial Larry Summers was going to be appointed to replace Chairman Bernanke when the latter's term expires in January. Of course what we got was Summers pulling his candidacy on Sunday night and the Fed pulling its tapering threat on Wednesday.
You would have thought these pivotal events would have elicited massive readjustments in market discounts. However the story of the week is not that Summers pulled out or that the Fed didn't taper. It's that the markets didn't seem to care all that much.
When I read through the press conference transcript, this comment from Bernanke epitomized the forward guidance flaw (emphasis mine):
The criterion for ending the asset purchases program is a substantial improvement in the outlook for the labor market. Last time, I gave a 7% as an indicative number to give you some sense of, you know, where that might be. But as my first answer suggested, the unemployment rate is not necessarily a great measure in all circumstances of the -- of the state of the labor market overall. For example, just last month, the decline in unemployment rate came about more than entirely because declining participation, not because of increased jobs. So, what we will be looking at is the overall labor market situation, including the unemployment rate, but including other factors as well. But in particular, there is not any magic number that we are shooting for. We're looking for overall improvement in the labor market.
No magic number? Other factors? The Fed says it is data-dependent but it keeps moving the goal posts around on what data it is depending on. How can the market calibrate the Fed’s forward guidance when the guidance keeps changing?
Minyanville’s Michael Sedacca
pointed out this tidbit to me the following day (emphasis mine; full transcript here
... the general framework in which we're operating is still the same. We have a three-part baseline projection which involves increasing growth that's picking up overtime as fiscal drag is reduced, continuing gains in the labor market, and inflation moving back towards objective.
In my opinion, what we have here in Fed policy is confirmation of a de facto nominal GDP target, i.e. growth and inflation. Nominal GDP is running at around 3.0% year-over-year, which is the slowest growth rate of the recovery. This is a reflection of a soft job market and low inflation that is product of weak aggregate demand. In order for the Fed to achieve its dual mandate of maximum employment in the context of price stability, it needs NGDP growth closer to 4.0% or higher.
I said it when it launched QE in December 2012. I said it when it switched to FG (forward guidance) in July. And I'm saying it now after it pulled the taper rug on account of suspect job gains and too-low inflation.
After the December 2012 FOMC meeting I commented in Bernanke Capitulates; Launches De Facto Nominal GDP Target:
As I forecasted back in July at Wednesday’s FOMC
announcement, Bernanke capitulated and opted to attach what are being called “thresholds” to the Fed’s uber-easy and accommodative monetary policy by raising the inflation target to 2.5% in order to bring the unemployment rate down to 6.5%.
Make no mistake about it, this is a de facto nominal GDP target.
Then in July in US Monetary Policy at a Crossroads
, I reiterated this view that the Fed had a stealth nominal GDP target:
Bernanke didn’t want to explicitly launch a nominal GDP target because he instead wants to stick to the Fed's employment mandate, but in his mind he probably thought it was implicitly the same. However it’s not working out that way. Payrolls are not generating an increase in aggregate demand.
This remains the Fed’s biggest problem. Jobs are not translating into aggregate demand which can sustain more jobs in what is typically the virtuous cycle that fosters economic growth. This conundrum can be illustrated in the following chart of PCE and average hourly earnings. Consumption growth relative to wage growth has been declining since 2011. During the credit bubble consumers spent more than they made, financed with debt. Today as consumers deleverage, consumption growth is becoming more aligned with wage growth which remains anemic and adjusted for inflation is virtually flat.
PCE Vs. Average Hourly Earnings
I think the key takeaway from this FOMC decision is that when tapering was first floated in February, it was an admission by the Fed that it was not prepared to defend the inflation target, which was the driver of negative real interest rates. When the Fed officially backed off in May, real rates rose as inflation expectations fell, which pushed nominal yields higher.
The decision not to taper is a re-engagement of its defense of the inflation target. In fact since the weak August employment report, falling real rates and the steeper curve was reflecting this inflation target commitment ex ante. It seems the market already had a sense that the Fed wasn't going to taper. The question for participants going forward is whether this extension of QE will re-raise inflation expectations in order to lower real rates.
Real 10-Year Vs. 10-Year/30-Year Curve
Paradoxically, through forward guidance the Fed wants to raise inflation expectations, but it also wants to lower the term premium that sets long term interest rates. Ironically it is the uncertainty of forward guidance that has increased the interest rate risk premium in the curve. The Fed sees a higher 5-year and 10-year benchmark yield as an indictment of its forward guidance in forecasting when the Fed funds rate would begin to rise. However the problem with this communication strategy is that it is based on the fundamental flaw in the Fed’s presumption that it is responsible for setting interest rates along the curve through expected future path of Fed funds rates plus term premiums.
I would argue that it is the other way around. It is the market that sets rates based on growth and inflation (NGDP). The term premium is a function of the inflation risk one is compensated for along the term structure. The inflation risk is based on where the Fed funds rates is set relative to what is neutral policy. Below neutral would command higher inflation risk premium and vice versa.The Fed can’t engineer higher inflation expectations and thus faster nominal GDP growth without higher interest rates. In fact falling rates and the deflationary implication from a lower term premium are more of an indictment that QE isn’t working.
The immediate market response coming out of last week’s meeting was a reflation discount. Gold shot up, stocks rocketed to new highs, real rates fell, and the curve steepened. On Friday, gold and stocks gave it all back while the curve flattened. What if this renewed focus on inflation expectations proves to be futile? What if the market -- or more importantly, the economy -- is suffering from reflation fatigue and just doesn't take the bait? It would be quite remarkable if in the midst of a renewed inflation campaign the market balks and continues to push real rates higher. The next few months will be critical.
SPX Vs. HY CDX
The rally in stocks since the 2011 low has largely been a function of multiple expansion. Of the 35% gain from the June 2012 low, 28.5% of the gain has been multiple expansion. What many equity investors probably don’t realize is that this expansion in P/E multiples has been a function of credit multiples. Credit spreads have outperformed P/E multiple expansion virtually the entire rally. The market has simply revalued the capital structure with equity benefiting from credit.
This is important in light of the Fed’s recommitment to its inflation target because of the impact of negative real interest rates. The jump in credit off the 2011 low occurred when real rates went negative, and the top in May of this year occurred when real rates began to rise. I wonder if the retail buyers, who have been the main source of demand since the May top, realize this impact of real interest rates. Certainly this can explain why the “smart money” has been fading the market since May. It will be interesting to see if the Fed’s commitment to its inflation target can lower real rates, and if not, whether stocks can continue to rally without the support of credit.
Smart Money Index Vs. 10-Year Real
Since the Fed ceased with QE II and opted for a balance-sheet-neutral Operation Twist, primarily due to the inflation drag on the consumer, the PCE deflator (the Fed's primary inflation bogey) has been trending lower. It hasn't been above its 2% target since April 2012, yet since QE3 was launched in September later that year, the Fed has been expanding its balance in order to engineer higher inflation expectations. Why should we expect status-quo policy to reinvigorate inflation expectations when past inflationary policy has not impacted actual inflation?
Friday we will get the August reading on personal consumption and the PCE deflator after July posted a 3.1% YoY growth in PCE and a 1.4% deflator inflation rate. This will give us a good reading on the current Q3 run rate for nominal GDP. It’s doubtful the Fed will have enough evidence that nominal growth, and thus a sustainable employment trend, will be in place by its next meeting in October. However we can be sure more confusing Fed communication will continue between now and then as evidenced by Friday’s juxtaposed comments from Jim Bullard and Ester George.
Fed officials need to quit talking and allow the market to find equilibrium on its own rather than try to guide the market where the Fed thinks it should be. If the Fed would get out of the way, the market would stimulate or tighten when and where appropriate. With the Fed in the way, long term investors simply go on strike.
The reason the market seemed to fade the Fed’s surprise decision is because it did nothing to alleviate the forward guidance uncertainty that plagues market participants. In fact you can argue the Fed made it worse. By constantly changing the economic thresholds, the Fed is prohibiting investors from committing long term capital. The result is less liquidity and tighter credit conditions. With the Fed continually sending mixed messages, neither price nor participants trust each other, and the discounting mechanism isn’t allowed to work. With this policy projected into the foreseeable future (Janet Yellen favors it), interest rates will likely remain volatile, credit will remain tight, and a truly sustainable recovery will remain elusive.