Strategy: Prudence Warranted? It seems to me that the stock market’s anxiety attacks are getting shorter (Fig. 1). There have been several during the current bull market, which I’ve characterized as a series of panic attacks followed by relief rallies. Many lasted for several weeks. A few were full-fledged corrections, with the S&P 500 dropping by 10% or more.
During the summer, there was another panic attack after the Thursday, June 23 Brexit vote (Fig. 2). However, it only lasted two days, during the following Friday and Monday, taking the S&P 500 down 5.3%. The index then rose 9.5% to a record closing high of 2190.15 on August 15.
A few of the selloffs during the current bull market have been “tightening tantrums,” which were sparked by one or more of the talking Fed heads who are on the Federal Open Mouth Committee opining that it may be time to tighten monetary policy a wee bit. These stock swoons seem to be the shortest because other talking Feds scurried to calm the markets down with soothing words like “data-dependent,” “gradual,” and “uncertainty.”
Friday’s 2.5% drop in the S&P 500 seemed to be triggered by another tightening tantrum, as FRB-Boston President Eric Rosengren started flying with the hawks rather than the doves on the FOMC. In a speech, he said that postponing another rate hike could create problems for the economy.
Friday might have been the start of a bigger move to the downside for stocks, but I doubt it. On Monday, Fed Governor Lael Brainard remained firmly in the dovish camp, which most likely still includes Fed Chair Janet Yellen. Brainard presented a speech titled “The ‘New Normal’ and What It Means for Monetary Policy.” At the end of her talk, she gave the punchline after reviewing the five features of the new normal economic landscape. She said, “This asymmetry in risk management in today’s new normal counsels prudence in the removal of policy accommodation. I believe this approach has served us well in recent months, helping to support continued gains in employment and progress on inflation.”
By the way, Brainard has contributed to Hillary Clinton’s presidential election campaign. She is often mentioned as a candidate for the job as the Secretary of the US Treasury in a Clinton administration. Brainard is also close to Yellen, and seems to share her views more closely these days than FRB-NY President Bill Dudley. Not surprisingly, Donald Trump sees a conspiracy. Yesterday, the WSJ reported:
“Republican presidential nominee Donald Trump ratcheted up his criticism of the Federal Reserve and Chairwoman Janet Yellen on Monday, saying the central bank is keeping rates low to help President Barack Obama. Mr. Trump, presumably speaking of Ms. Yellen, said interest rates have been kept low ‘because she’s obviously political and doing what Obama wants her to do.’ Mr. Trump, in an interview on CNBC, added ‘what they [the Fed] are doing is, I believe, it’s a false market. Money is essentially free.’ Ms. Yellen, he said, ‘should be ashamed of herself.’”
But why didn’t the stock market drop yesterday on news that Hillary Clinton has pneumonia? The widespread view among our accounts is that the stock market might do better under the status quo of a Clinton administration than the unknown of a Trump White House. Yesterday’s Washington Post story about her weekend malady was titled “Hillary Clinton’s health just became a real issue in the presidential campaign.”
Perhaps the market perceives that if Clinton has to drop out of the race for health reasons, the Democrats might replace her with Joe Biden, who might have a better chance of beating Trump. This scenario could get very messy if Bernie Sanders claims that he should be the nominee.
Let’s go back to Brainard’s speech and review her five features of the new normal:
(1) “Inflation has been undershooting, and the Phillips Curve has flattened.” Brainard observed that the drop in the unemployment rate from 8.3% at the start of 2012 down to 4.9% currently hasn’t boosted wage inflation as much as would have been expected from the Phillips Curve model (Fig. 3). This model posits an inverse relationship between the unemployment rate and wages inflation. The latter has remained remarkably subdued as the labor market has tightened.
As a result, price inflation remains subdued as well since labor costs aren’t rising significantly (Fig. 4). Furthermore, inflationary expectations also remain very low (Fig. 5). The core PCED inflation rate is at 1.6% y/y, while expected inflation in the 10-year TIPS market is 1.5%.
Brainard concluded, what’s the rush to tighten? 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.”
(2) “Labor market slack has been greater than anticipated.” Brainard is not convinced that the labor market is as tight as suggested by the low unemployment rate. In her opinion, the low pace of wage inflation suggests that there is more slack left in the labor market. She also observed that “the share of employees working part time for economic reasons, for example, has remained noticeably above its pre-crisis level” (Fig. 6).
Brainard argued: “My main point here is that in the presence of uncertainty and the absence of accelerating inflationary pressures, it would be unwise for policy to foreclose on the possibility of making further gains in the labor market.”
(3) “Foreign markets matter, especially because financial transmission is strong.” Brainard believes that the Fed needs to give more weight to overseas developments: “Headwinds from abroad should matter to U.S. policymakers because recent experience suggests global financial markets are tightly integrated, such that disturbances emanating from Chinese or euro-area financial markets quickly spill over to U.S. financial markets. The fallout from adverse foreign shocks appears to be more powerfully transmitted to the U.S. than previously.”
Then there is this LOLLAPOLUZA buried in her speech: “In particular, estimates from the FRB/US model suggest that the nearly 20 percent appreciation of the dollar from June 2014 to January of this year could be having an effect on U.S. economic activity roughly equivalent to a 200 basis point increase in the federal funds rate.”
Debbie and I have been making this point since late last year. The Fed has already tightened significantly with the 20% appreciation of the dollar, which was caused by the Fed moving to normalize monetary policy while the ECB and BOJ continued to move in the other direction, with more QE and negative interest rates (Fig. 7). It certainly must have contributed to the flattening of real merchandise exports over the past year and a half (Fig. 8).
(4) “The neutral rate is likely to remain very low for some time.” Most of the Fed officials seem to have concluded that the neutral real federal funds rate is probably lower than in the past. Brainard agrees and thinks it is close to zero: “Several econometric models and estimates from market participants suggest the current real neutral rate is at or close to zero, and any increase is likely to be shallow and slow.” She concluded, “These estimates imply that it may require a relatively more modest adjustment in the policy rate to return to neutral over time than previously anticipated.” Many of her colleagues agree, but want to get on with the gradual normalization of monetary policy. Brainard is in no rush.
(5) “Policy options are asymmetric.” Given that interest rates remain so close to zero, some Fed officials would like to see them move higher above this “zero bound.” Not Brainard. In her view, raising and lowering interest rates may not be the best monetary policy tool in the new normal. She noted: “There is a growing literature on such policy alternatives, such as raising the inflation target, moving to a nominal income target, or deploying negative interest rates.”
The bottom line is that Brainard seems to have prepared five talking points for Fed Chair Janet Yellen to use at the FOMC meeting on September 20 and 21 to argue why doing nothing may be the best option once again.