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Fed on Inflation Watch as Panic Attacks Come and Go

Fed on Inflation Watch as Panic Attacks Come and Go
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Monday, 26 February 2018 12:31 PM Current | Bio | Archive

Strategy I: Downs & Ups.

Since the start of the current bull market, Joe and I didn’t see most of the panic attacks coming, but we did see them going. In other words, once they got started, we argued that they would pass and be followed by relief rallies rather than turn into a bear market.

The latest selloff was the 60th panic attack by our count. It was among the worst in terms of the magnitude of the downdraft, but it also was among the shortest in duration. It was the fourth correction in the current bull market, with the S&P 500 down 10.2%, slightly exceeding the 10.0% threshold for corrections, but it lasted just 13 days through February 8. (See our S&P 500 Panic Attacks Since 2009.)

Since their January 26 record highs, the S&P 500 is now down 4.4% and the Nasdaq is down only 2.2% (Fig. 1 and Fig. 2). Why the roundtrip? There was an inflation scare on February 2, when wage inflation showed a sign of picking up. That triggered a selloff that was exacerbated by some cockamamie algorithm-driven ETFs. Some investors who had been praying for a correction to provide a buying opportunity swooped in to buy stocks in recent days. The ones who did so apparently aren’t overly concerned that inflation will take off, forcing the Fed to raise rates more quickly, which could trigger a jump in bond yields.

The 10-year Treasury bond yield has risen to 2.88% on Friday, up from 2.38% a year ago (Fig. 3). Inflationary expectations based on the spread between the 10-year Treasury and TIPS yields edged up to 2.1% on Friday, up from 2.0% a year ago (Fig. 4). So what’s the big deal?

The latest correction was reminiscent of the 1987 crash. But that was a bear market, with the S&P 500 plunging 20.5% on Black Monday, October 19, 1987. Then too the selloff was triggered by rising bond yields (among other fundamental factors) and turned into a flash crash by so-called “portfolio insurance.” But it took several months for the stock market to recover, even though corporate earnings continued to rise despite the stock market’s swoon. If the latest flash crash is over already, then the next bear market in stocks will occur when the economy falls into a recession rather than when another flash crash triggers it. Now consider the following:

(1) Leading Indicators. As Debbie reviews below, there’s no sign of an imminent economic downturn in the Index of Leading Economic Indicators (LEI), which rose 1.0% m/m during January to a new record high (Fig. 5). Interestingly, it has been in record-high territory just for the past 11 months. During the previous five economic expansions, the LEI remained in record territory for 38 months on average, ranging between 7 months and 89 months.

(2) Coincident Indicators. Also worth noting is that while the Index of Coincident Economic Indicators (CEI) has been in record-high territory since February 2014, its y/y growth rate continues to meander around 2.0%, along with the growth rate of real GDP (Fig. 6). In other words, it’s still slow but steady growth. There’s no boom in the CEI, which reduces the risk of a bust. Even the Atlanta Fed’s GDPNow forecast for Q1 growth has been revised down from over 5.0% a few weeks ago to 3.2%. Our mantra is: “No boom, no bust.”

Strategy II: Bond Vigilantes as Spoilers. As noted above, the latest correction was more like a flash crash than a bona fide correction. However, whenever the market goes up or down, there always seems to be some plausible fundamental explanation. It may or may not be correct but nonetheless becomes the consensus view on the financial news programs. This time, the consensus instance analysis was a three-parter, with the Bond Vigilantes pushing yields up because they are upset that the Fed started tapering its balance sheet last October, recent fiscal policy initiatives widening the federal budget deficit to over a trillion dollars this year, and inflation potentially making a comeback soon.

As Debbie and I noted two weeks ago, the federal deficit, which was $666 billion (there’s that devilish number again!) during fiscal 2017, is set to widen again—back to over $1.0 trillion this fiscal year and next—just as the Fed is set to reduce its holdings of US Treasury securities by $180 billion this fiscal year and $360 billion in fiscal 2019 (Fig. 7 and Fig. 8). “It’s no wonder that the Bond Vigilantes are getting agitated,” we wrote.

We are predicting that the bond yield will be trading between 3.00% and 3.50% soon. However, we see that as a return to more normal levels after the bond yield had been repressed by the Fed for so long by the various QE programs. As we’ve argued before, in normal times (whatever that means), the bond yield should be trading close to the growth rate of nominal GDP, which was 4.4% during Q4.

Nevertheless, we don’t see the bond yield rising above 4.00% because we believe that inflation will remain subdued. If we are wrong about that, then the combination of Fed balance-sheet tapering, widening budget deficits, and accelerating inflation certainly could rile the Bond Vigilantes into pushing up yields to the point of causing a recession. We think that remains a low-probability scenario, but we are aware of it and will be on the lookout for the posse of Bond Vigilantes. While we are doing so, we are keeping alert by listening to Aerosmith’s 1976 song “Back in the Saddle.”

The Fed: Rooting for Inflation. While the financial markets have started to worry about a reflation scenario, Fed officials continue to hope that inflation will rise in 2018 to hit their target of 2.0% for the core PCED rate. It was 1.5% last year on both a December-to-December and year-over-year basis.

The minutes of the January 30-31 meeting of the FOMC were released last week. The word “inflation” was mentioned 129 times. The word “unemployment” was mentioned just 13 times. However, that doesn’t mean that Fed officials are worrying about higher inflation. Rather, they seemed to spend most of their time on the subject trying to convince one another that it should rise back up to 2.0% this year now that the economy is at full employment.

The FOMC has a tradition of starting the year with a “Statement on Long-Run Goals and Monetary Policy Strategy.” They’ve been doing that since January 25, 2012. They’ve invariably expressed the following view that was repeated in the latest minutes:

“The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.”

In fact, inflation, based on the core PCED, has been below 2.0% most of the time since 2008, even as monetary policy turned ultra-easy (Fig. 9 and Fig. 10). The FOMC’s confidence in the notion that inflation is mostly a monetary phenomenon in the long run begs the question: “Are we there yet?” Nope! If not, then why not? The answer could be that inflation isn’t just a monetary phenomenon. There are powerful structural forces keeping it down, including competition unleashed by globalization, deflationary technological innovations, and aging demographics.

The latest FOMC minutes note that the Fed’s staff presented “three briefings on inflation analysis and forecasting.” Here are a few excerpts from the minutes rendition and our reaction:

(1) Inflation models are error prone. “The presentations reviewed a number of commonly used structural and reduced-form models. These included structural models in which the rate of inflation is linked importantly to measures of resource slack and a measure of expected inflation relevant for wage and price setting—so-called Phillips curve specifications—as well as statistical models in which inflation is primarily determined by a time-varying inflation trend or longer-run inflation expectations.”

And how well have those models been working? “Overall, for the set of models presented, the prediction errors in recent years were larger than those observed during the 2001–07 period but were consistent with historical norms and, in most models, did not appear to be biased.” We think that means: The models have worked terribly since 2007, but that’s normal.

(2) Resource utilization is hard to measure. Monetary policy presumably “influences” inflation by affecting resource utilization. “The briefings highlighted a number of other challenges associated with estimating the strength and timing of the linkage between resource utilization and inflation, including the reliability of and changes over time in estimates of the natural rate of unemployment and potential output and the ability to adequately account for supply shocks.” In other words, the macro inflation models depend on variables that really can’t be observed and measured.

(3) Inflationary expectations are also hard to measure. The Fed also presumably can influence long-term inflationary expectations, which should drive actual inflation. “Moreover, although survey-based measures of longer-run inflation expectations tended to move in parallel with estimated inflation trends, the empirical research provided no clear guidance on how to construct a measure of inflation expectations that would be the most useful for inflation forecasting.”

(4) Insanity is using the same flawed models knowing they are flawed. No comment is necessary on the following: “Following the staff presentations, participants discussed how the inflation frameworks reviewed in the briefings informed their views on inflation and monetary policy. Almost all participants who commented agreed that a Phillips curve–type of inflation framework remained useful as one of their tools for understanding inflation dynamics and informing their decisions on monetary policy.”

And what about long-term inflationary expectations? The minutes noted: “They [FOMC participants] commented that various proxies for inflation expectations—readings from household and business surveys or from economic forecasters, estimates derived from market prices, or estimated trends—were imperfect measures of actual inflation expectations, which are unobservable. That said, participants emphasized the critical need for the FOMC to maintain a credible longer-run inflation objective and to clearly communicate the Committee’s commitment to achieving that objective.” Groupthink continues to flourish at the Fed.

Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.

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EdwardYardeni
Since the start of the current bull market, Joe and I didn’t see most of the panic attacks coming, but we did see them going. In other words, once they got started, we argued that they would pass and be followed by relief rallies rather than turn into a bear market.
fed, inflation, watch
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2018-31-26
Monday, 26 February 2018 12:31 PM
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