Markets are Spooked - but will the Fed give us a Merry Christmas?

As everyone knows, October has been a terrible month for equity markets. Some market participants feel that this did not just coincide with higher interest rates, but was caused by flawed Fed monetary policy and comments on overshooting. Like the humming chorus in Madama Butterfly, there has been a steady rise in the number of voices supporting a Fed pause in December. These include members of the Federal Reserve Open Market Committee itself, such as Neel Kashkari, and leading economists such as Jason Furman. 

Could the markets be right, that tightening has happened too fast?  After seven years of interest rates at 25 basis points, and a swift concurrent rise in debt levels, interest rates today are nine times what they were in 2008.  Additional supporting arguments for a pause:  scant evidence of above-trend inflation, China’s slowing economy, instability in the Eurozone, trade sanctions, a job market with room to grow, a weak housing market,  stronger dollar, rising treasury yields, and emerging market weakness reminiscent of the taper tantrum of 2013 when bond markets panicked. The list goes on.  In fact, EconVue expert Robert Shapiro already sees signs of a recession as early as 12 months from now.

Add geopolitical risk, the Nov 5th deadline for the Iran oil sanctions, and growing mid-term political turmoil within the US itself, and perhaps the Fed should reconsider its announced path. Over the last month, Bitcoin has been stable while the DJIA has lost almost 7% --equivalent to 25bps of monetary tightening. The claim that the real economy is separate from financial markets ignores the wealth effect on consumers, half of whom own stock. US markets in turn influence global markets: the Fed should no longer be naïve enough to think that it is making monetary policy for the US alone.

My take is that the Fed Chair Jay Powell is not primarily concerned with inflation, or global markets, but with resource utilization in the form of employment rates  (key Fed research paper below) and interest rates that could lead to debt market distortions. Powell after all is not an economist, but a lawyer who dealt directly with the consequences of Too Big to Fail.  At the same time, Vice-Chair Richard Clarida had some interesting things to say about employment having room to grow. So with both Fed mandates, inflation and employment in a state of post-crisis theoretical flux, markets are right to be confused.

Last week two former Fed chairs,  92-year-old Alan Greenspan and 91-year old Paul Volker jumped in and questioned the 2% inflation target. While some deride President Trump for jawboning Powell, they both revealed that they were subject to summons from the White House when interest rates rose. You’ll find a link to the Greenspan talk below. Volker’s book will be released this coming Tuesday.

Perhaps it is time to end forward guidance and pause to see which levers are actually working to regulate the economy. The broader implications could be that the story of US economic exceptionalism has run its course, and data used to make monetary policy is subject to overextrapolation and debate. If the Fed decides to err on the side of caution in December, a pause could be seen both positively and negatively. However, if they decide to go ahead with the rate hike as communicated, the Fed might be seen as guilty of overconfidence - and the Grinch who stole Christmas.

RESEARCH BY ECONVUE EXPERTS

Even at Full Employment, Expansion Has a Good Ways to Go
Michael Lewis

Why do we fear deflation? Japan has faced deflation for the past two decades, and its economy has not fallen apart.

Data Round-Up: Inventory, Consumption Led Upside 18Q3 GDP Surprise
Michael Lewis

Real GDP rose +3.5% in 18Q3, slightly stronger than consensus and FMI estimates. The upside surprise was driven by inventories, consumption (especially services/health care) and government. Payback in inventories will likely subtract more than -0.5% from the 18Q4 topline. Still, FMI is looking for +2.5% real growth for 18Q4, which would make +3% for the year. 

The Latest Outlook on the Economy: Another Canary Swoons
Robert Shapiro 

For several months, I’ve written about growing signals of a possible recession perhaps 10 to 15 months from now. The yield curve has flattened dramatically, because global investors are nervous about our near-term prospects. Investment growth after depreciation has slowed, even with Trump’s costly tax cuts. Inflation has picked up some steam, and interest rates have risen accordingly. Most important, productivity has been virtually flat for three years, and the inflation-adjusted earnings of a typical household have fallen now for more than a year.

No Time to Waste: Revolutionizing Healthcare Data Collection, Curation & Application
David W. Johnson 

Healthcare data wants to be free, but it is oppressed. Entrenched oligarchs trap information within closed, centralized systems that prioritize revenue collection, misuse resources and tolerate medical error. Data gasps for breath as it fights to break into curated systems that produce insight.

STORIES IN OUR SPOTLIGHT

Fed Policy & The U.S. Economy

Pause interest-rate hikes to help the labor force grow
Neel Kashkari 10/25/2018 Wall Street Journal

The president of the Minneapolis Fed adds to the growing chorus asking the Fed to pause in December. Kashkari however will not be a voting member until 2020.

Yes and yes to a Fed pause
10/27/2018 Twitter thread with Jared Bernstein and Jason Furman:

I was comfortable with the Fed hiking again in Dec. But the market just did it for them: the 5% fall in the S&P and 10 bp rise in the 10 yr are roughly equivalent to a 25 bp increase in the FFR. Also the fact that inflation is surprising to the downside says hold off for now.

Outlook for the U.S. Economy and Monetary Policy
Vice Chairman Richard H. Clarida 10/25/2018 Board of Governors of the Federal Reserve System

This outlook for the labor market also reflects my view that the structural, or longer-run, rate of unemployment‑‑that is, the unemployment rate consistent with stable inflation over the longer run--may be somewhat lower than I would have thought several years ago. What this means is that, even with today's very low unemployment rate, the labor market might not be as tight‑‑and inflationary pressures not as strong‑‑as I once would have thought.

Some Implications of Uncertainty and Misperception for Monetary Policy
Christopher Erceg, James Hebden, Michael Kiley, David L´opez-Salido, and Robert Tetlow 10/2018 Board of Governors of the Federal Reserve System

We find that a notable response to the unemployment gap is typically beneficial, even if that gap is mismeasured. Even when the dynamics of inflation are governed by a 1970s-style Phillips curve, meaningful response to resource utilization is likely to turn out to be worthwhile, particularly in environments where resource utilization is thought to be tight to begin with and inflation is close to its target level. 

The Fed could be wrong about inflation and rate hikes
Ed Yardeni 10/24/2018 Marketwatch.com

The Fed could be wrong about inflation and rate hikes - “Could it be that Fed officials have too much free time on their hands, and that's why they concoct all sorts of cockamamie theories?”

No bad economic data or earnings disappointments or excessive valuations that would explain this market sell-off
Patrick Chovanec  10/24/2018 Twitter

I can see potential issues on the horizon, weak spots, vulnerabilities, but nothing that spells impending recession.

Comments on monetary policy at the effective lower bound
Janet Yellen 9/14/2018 Brookings Institute

By keeping interest rates unusually low after the zero lower bound no longer binds, the lower-for-longer approach promises, in effect, to allow the economy to boom following a zero lower bound episode.

Lessons for the future: A history of capitalism in America
Alan Greenspan & Adrian Wooldridge 10/18/2018 Video by Council on Foreign Relations

At about 40:00 Greenspan compares Bitcoin to the Continental dollar as a fiat currency, talks about gold, questions inflation targets, and reveals that more than one president yelled at him about raising interest rates. 

Housing market is raising serious red flags
Lakshman Achuthan 10/15/2018 Bloomberg

The Fed has downplayed falling home prices nationwide and overestimated future inflation based on employment levels. Could something happen to stop a December rate hike? The Fed should be reactive rather than proactive, given so many uncertainties--stealth QE taper perhaps better.

FinTech

Fintech, inclusive growth and cyber risks: Focus on the MENAP and CCA regions
Inutu Lukonga 9/2018 IMF Working Paper

In the Middle East, North Africa, and Eurasia, places that would benefit most from Fintech, uptake is slow.

China

China's coming financial crisis and the national security connection 
Stephen Joske 10/23/2018 War on the Rocks

Another (more sobering) view of China 2025.

Only 40 million people in China will pay income tax in 2019
Driehaus Capital 10/22/2018 Twitter

So income tax paying citizens will be less than 4% of China’s total population—vs 43% in the US. Long term unsustainable, but will increased consumption become sticky behavior?

'Xi is killing China's private sector' narrative, this trend is worth watching
Simon Rabinovitch 10/18/2018 The Economist via Twitter

State-owned enterprises in China are lagging behind the private sector.

An impressive, unnecessary, multi-city bridge
Erin Hale 8/18/2018 CityLab

The 34-mile Hong Kong-Zhuhai Bridge officially opened by Xi Jinping on his southern tour (Yes, we are related.)    

People’s Daily’s courageous attempt at using infographics to explain Xi Jinping Thought. What does this look like to you?
Wang Xiangwei 10/17/2018 Twitter with link to original article in Chinese: https://app.peopleapp.com/Api/600/DetailApi/shareArticle?type=0&article_id=2667723

China may have $5.8 trillion in hidden debt with ‘titanic’ risks
Eric Lam 10/16/2018 Bloomberg

China waited too long to institute local property taxes due to internal opposition from multiple property owners, many of whom are corrupt officials and currently have zero holding costs. 

China must release the renminbi
Yu Yongding 10/16/2018 East Asia Forum

Fear of floating-is the Chinese exchange rate mechanism about to change? Rather than a managed devaluation, will the PBoC reembark on the untethering first attempted in August 2015? Leading Chinese economist Yu Yongding elucidates.

Trump, China, and Ah Q
Kerry Brown 10/12/2018 the Diplomat

Even the sinuous brilliance and calculating genius of Wang Qishan, brought back as vice president last October despite being over the customary retirement age, has seemingly, so far, not ratcheted tensions down.  

Happy Halloween!