There is an obvious desire by the Federal Reserve to
normalize monetary policy by taking a less accommodative approach. In my
opinion it appears an increase in the Fed funds rate this year is an inevitable
event even if we do not see employment and inflation statistics start to heat
up. The postponement of tighter monetary policy will only come should we see
major deterioration in the employment and inflation picture. At the "The
New Normal Monetary Policy," a research conference sponsored by the
Federal Reserve Bank of San Francisco, Janet
Yellen said, “An important factor
working to increase my confidence in the inflation outlook will be continued
improvement in the labor market. A substantial body of theory, informed by
considerable historical evidence, suggests that inflation will eventually begin
to rise as resource utilization continues to tighten. It is
largely for this reason that a significant pickup in incoming readings on core
inflation will not be a precondition for me to judge that an initial increase
in the federal funds rate would be warranted [emphasis added]. With respect to wages, I anticipate that
real wage gains for American workers are likely to pick up to a rate more in
line with trend labor productivity growth as employment settles in at its
maximum sustainable level. We could see nominal wage growth eventually running
notably higher than the current roughly 2 percent pace. But the outlook for
wages is highly uncertain even if price inflation does move back to 2 percent
and labor market conditions continue to improve as projected.”
She is putting forth the notion that, “neither wage nor price inflation is indispensable for me to achieve
reasonable confidence that inflation will move back to 2 percent over time.
That said, I would be uncomfortable raising the federal funds rate if readings
on wage growth, core consumer prices, and other indicators of underlying
inflation pressures were to weaken, if market-based measures of inflation
compensation were to fall appreciably further, or if survey-based measures were
to begin to decline noticeably.”
Of course when tracking and analyzing economic statistics
one needs the appropriate runway to smooth out any erratic readings but it
certainly appears that the economy has stalled in the first quarter of this
year. Admittedly this slowdown has much to do with inclement weather conditions
but what if these trends start to take hold and appear in the second quarter. Claes
Fornell wrote an oped in the Investors Business Daily entitled, “Recovery
Will Lose Energy Unless Consumers Start Spending”. In it he states, “Many economic forecasters predict growth and
momentum building in 2015. However, economic growth is usually not associated
with prolonged near-zero interest rates, continued low inflation, weak consumer
spending, global slowdown or declining customer satisfaction.” He
concludes, “At the same time, it is
important to recognize that increased productivity, the standard cure for slow
growth, won't do the job this time. Improved productivity matters little if
consumers don't buy. On the contrary, it is likely to have a detrimental
effect. When fewer workers are needed to produce the same output of goods and
services in a market with weak demand, the result could well be greater
unemployment, less consumer spending growth and a weaker economy.”
TownHall
Finance.com sums it up nicely, “Steady
hiring is supposed to fire up economic growth. Cheap gasoline is supposed to
power consumer spending. Falling unemployment is supposed to boost wages. Low
mortgage rates are supposed to spur home buying. America's economic might is
supposed to benefit its workers. Yet all those common assumptions about how an
economy thrives appear to have broken down during the first three months of
2015.”
Retail Sales
Indeed retail sales have been quite soft in light of lower
gasoline prices. Many economists and investors (including this investor)
thought increased disposable income would be reflected in the retail sales figures
and that has yet to materialize. Our investment thesis that we shared with our
clients was flawed in this respect although the investment outcome was
acceptable with the consumer discretionary sector up over 7% for the year as
opposed to the S&P 500 that is up roughly 2%.
This soft patch in retail sales hasn’t deterred the Fed yet
but clearly they are monitoring the progress in the figures. Janet Yellen
states in her speech, “I am cautiously
optimistic that, in the context of moderate growth in aggregate output and
spending, labor market conditions are likely to improve further in coming
months. In particular, and despite the somewhat disappointing tone of the
recent retail sales data, I think consumer spending is likely to expand at a
good clip this year given such robust fundamentals as strong employment gains,
boosts to real incomes from lower energy prices, continued increases in
household wealth, and a relatively high level of consumer confidence.”
We are seeing more and more folks coming out and telling us
that gasoline prices and retail sales just do not correlate. According to the Robin
Report, “Let’s start with the gas
theory. The Robin Report Chief Strategy Officer Judith Russell looked at the
monthly change in gas prices and retail sales for the past eight years. And as
indicated in the chart below, there is neither a significant bump up, nor down,
in retail sales accompanying rising or falling gas prices. She even looked at
regressions with different segments in retail, and found that there simply does
not seem to be a correlation, period. In other words, the gas theory is an
empty tank.”
So where is the increased disposable income
going. There seems to be an increase in household savings but perhaps more
importantly is the dramatic increase in health care spending. The chart below
found on Zero
Hedge shows the spending habits of Americans in the final GDP readings. 
Wages
The theory supported by Fed Chair Yellen is that increased
improvement in employment will absorb excess labor slack and thus wages will
start to rise. With the unemployment rate declining one needs to assume this as
logic, except wages have been slow to rise along with the employment situation
and has only recently started to show slight increases. So why have wages been
stuck in no-growth mode since the economic recovery started.
According to Lance
Roberts, “The issue is that the only
type of employment that really matters with respect to long-term economic
prosperity is "full-time" employment. It is only full-time employment
ultimately leads to higher rates of household formation. Unfortunately, since
the financial crisis, full-time employment has been primarily a function of
population growth rather than a strengthening economy. This is why the labor force participation rate
remains near its lows.”
Thus if a large part of the decline in the unemployment
number (the Fed seems to be targeting 5% to 5.2%) is due to decreased labor
participation and under-employment, it may be quite some time before true
employment gains are reflected in wages.
Inflation
It is widely known that the Federal Reserve wants to get the
rate of inflation up to its threshold level of 2%. Global deflation has been
the topic of discussion amongst economists everywhere and while Fed Chair
Yellen has commented that a rise in the inflation data is not a precursor in
her decision to raise rates, the figures are bleak.
Looking at both the CPI data and the Fed preferred PCE data
(taken from Fat
Pitch), the inflation rate remains solidly below the 2% mark and seems to
be going in the wrong direction.
Why not be Patient?
We completely understand that monetary policy is a blunt
tool and the timing of policy moves needs a vision that looks several quarters
and years in advance. The unenviable task of projecting the movement of such a dynamic
economy that far in advance through a brume of ever changing economic
conditions is difficult to say the least. Global economic growth projections
are being lowered and U.S. economic growth projections are no different. The Atlanta
Federal Reserve trimmed 1Q GDP projections. Corporate earnings and revenue
growth have been in decline with 1Q15 earnings season expected to show
contraction year-over-year. Employment, retail sales and inflation on the
surface doesn’t paint an urgent need for tighter monetary policy, although the
folks at the Fed are surely smarter than I am and their interpretation of the
various economic models is far more sophisticated. That said there’s still a
sense of necessity to get back to normalized monetary policy in spite of still
subdued economic recovery statistics.
Crisis mode.
Jamie Dimon rattled the financial world with his shareholder
letter last week basically saying there exists another crisis looming. He
writes, “Treasury markets were quite
turbulent in the spring and summer of 2013, when the Fed hinted that it soon
would slow its asset purchases. Then on one day, October 15, 2014, Treasury
securities moved 40 basis points, statistically 7 to 8 standard deviations – an
unprecedented move – an event that is supposed to happen only once in every 3
billion years or so (the Treasury market has only been around for 200 years or
so – of course, this should make you question statistics to begin with). Some
currencies recently have had similar large moves. Importantly, Treasuries and
major country currencies are considered the most standardized and liquid
financial instruments in the world. The good news is that almost no one was
significantly hurt by this, which does show good resilience in the system. But
this happened in what we still would consider a fairly benign environment. If
it were to happen in a stressed environment, it could have far worse
consequences.”
He is highlighting “liquidity risk” inherent in the market
currently. A run on the market in an illiquid environment is a very bad thing.
I was watching CNBC one morning and saw Larry Summers basically agreeing with
the statements made by Mr. Dimon (see the interview here).
Then I started reading an article (via Business
Insider) where Deutsche Bank's Torsten Slok stated, “...Before the crisis, monthly volumes in Treasury trading for primary
dealers was 10% to 12% of the total stock of Treasuries outstanding, see the
blue line in the chart below. Today, volumes have fallen to just 4%. So it is
clear that there is much less liquidity in the sense that dealers are trading a
smaller share of all Treasuries outstanding. Is liquidity in markets low for
structural reasons, including regulation, high frequency trading, and more Treasuries
held by the Fed and other central banks? Or is liquidity low simply because
investors are sitting on the sidelines and have been burnt too many times by
betting on higher rates? I hear from clients a broad range of views on this and
whether it is going to be a problem as we get closer to Fed liftoff. I continue
to believe that this is a topic investors across asset classes need to spend
time on; just because the risks are difficult to quantify doesn’t mean that we
can ignore the issue.”
So perhaps the Fed is attempting to get back to normalcy so
that it has ammunition in place in the event of a new crisis. Certainly a
crisis of liquidity will require Fed assistance and if they are unprepared or
lack substantial abilities to help stem the damage then the next crisis could
indeed be worse than 2008. Not to sound like a conspiracy theorist but I
decided to go back and read the transcript of the speech by Chair Yellen.
Indeed she makes mention of such a scenario in her speech. “A second reason for the Committee to
proceed cautiously in removing policy accommodation relates to asymmetries in
the effectiveness of monetary policy in the vicinity of the zero lower bound.
In the event that growth in employment and overall activity proves unexpectedly
robust and inflation moves significantly above our 2 percent objective, the
FOMC can and will raise interest rates as needed to rein in inflation. But if
growth was to falter and inflation was to fall yet further, the effective lower
bound on nominal interest rates could limit the Committee's ability to provide
the needed degree of accommodation. With
an already large balance sheet, for example, the FOMC might be concerned about
potential costs and risks associated with further asset purchases.” [emphasis
added].
Fiscal policy is largely ineffective at this point. Banking
regulations that have been put in place to detect and possibly deter the next
financial crisis will actually stymie damage control (according to both Mr.
Dimon and Mr. Summers) in the event of a crisis. Perhaps the Fed is our last
line of defense in such a scenario and perhaps there lies a concern by the Fed
to its effectiveness in providing that much needed liquidity in the event of a
crisis. As Mr. Dimon states in his letter, “The
trigger to the next crisis will not be the same as the trigger to the last one
– but there will be another crisis.”
Perhaps something worth watching.
Additional Reading:
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