The median of the Fed dot-plot (a summary of the individual member views on where Fed Funds will be over the next three years) indicated no changes in the Federal Funds Rate until 2024. But, because the Fed upgraded its economic (GDP) forecast to 6.5% from 4.2% for 2021, and a few more FOMC (Federal Open Market Committee) members moved their “next rate hike” forecast into 2023, the market is still betting are that the first-rate hike will occur in Q1:2023, a year earlier than the dot-plot median forecast. At the post-FOMC meeting press conference, Powell tried to convince the audience that the dot-plot is simply what 18 FOMC members individually forecast, and has little to do with what the Fed will actually do. What the Fed will end up doing, he said, is dependent on the “actual” data.
The markets are well-aware of today’s data; they see that the core inflation rate is flatting. Core CPI was 2.4% Y/Y in February 2020, 1.6% last December, and 1.3% this past February (latest data). Its latest three-month trend is a 0.7% annual rate. And, as we have indicated in prior blogs, if investors really saw inflation as a problem, gold’s price would be in a sustained uptrend. But, the inflation narrative, or at least an early tightening Fed move, is still priced in. Given the Fed’s new mantra (i.e., waiting for “actual” data), we will soon see if Powell convinced markets that the Fed will only act on “actual” data, and that the game of forcing the Fed to act based on market moves isn’t going to work this time.
The game began the day after the FOMC meeting and Powell’s press conference (Thursday, March 18), when the 10-Year Treasury Note yield spiked up another 10 basis points (0.1 percentage points). In hindsight, this was more likely due to the SLR (Supplementary Leverage Ratio) issue than to anything having to do with the inflation narrative, the Fed’s upgrade of their economic outlook, or the markets’ cat-and-mouse game.
To set the background, last April, the Fed exempted Treasury holdings and deposits at the Fed on bank balance sheets from capital requirements. They did this because they saw liquidity issues developing in what is supposed to be the most liquid market in the world. This capital requirement exemption expires on March 31. That is a key date for banks as it is a reporting date for their regulators and for their capital requirements.
The fact that Powell said he wouldn’t talk about the SLR issue at the post-FOMC press briefing was a sign that the Fed would bow to the wishes of the large bank detractors in Congress and let the exemption expire. [Note: The Trump Administration was much more friendly to the large banks than are the current crop of legislators who control the Congressional Committees which have “oversight” of the financial system. We’ve seen comments from the heads of these important Committees indicating their view that the Fed should let the exemption expire.] As a result of his reluctance to discuss the SLR issue, on Thursday, the banks began dumping Treasuries in anticipation that the exemption would be allowed to expire (or at least as a hedge that such might be the case), and that’s when the 10-Year Treasury rate spiked. As it turns out, the markets were prescient, as on Friday (March 19) the Fed announced that the capital exemption would indeed be allowed to expire on March 31. According to a Bloomberg story, the initial reprieve on the capital requirements last April caused “the largest U.S. banks [to expand] their balance sheets by as much as $600 billion during the pandemic by loading up on Treasuries and deposits [at the Fed] without setting aside funds to protect against losses.” [Excuse us! Risk of loss on Treasuries and Fed deposits? How does that make an iota of sense?] The Fed did say that it was soon going to propose “rule modifications,” with the following statement in its announcement:
Because of recent growth in the supply of central bank reserves and the issuance of Treasury securities, the board may need to address the current design and calibration of the SLR over time to prevent strains from developing that could both constrain economic growth and undermine financial stability.
Let us translate. “For political reasons, we are allowing the exemption to run off, but don’t worry, we are going to change the rules so they make sense.” And, like magic, on Friday, the selling of Treasuries stopped.
Making Sense of the SLR Exemption Expiration
This only begins to make sense when viewed in the context of Powell’s upcoming term expiration, early next February. As indicated above, the key Congressional Committees are controlled by Congressional people who have a less than favorable view of large banks, some of whom have openly advocated for the expiration of the SLR exemption. Powell clearly wants a second term, but this will be up to President Biden and the Democrats who control Congress. “Caving” to their desires, but proposing “rule modifications” may be just the ploy that satisfies all parties, keeps Powell in everyone’s good graces, and is a sign that Powell is a “team” player. [So much for Fed Independence!]
The Labor Markets
Powell made it clear that the Fed won’t tighten until the labor market “heals.” We are far from that. While the official U3 measure of unemployment stands at 6.2%, the Employment/Population ratio has fallen to 57.6%. That ratio was 61.1% pre-pandemic, and the difference between its level then and its level today is a measure of how many people have “dropped out” and are no longer counted in the denominator of the unemployment rate. Doing the math, more than 9 million have dropped out. If you count those as unemployed, the official U3 would be closer to 11.5%. The U6 unemployment rate which takes into the account “part-time for economic reasons” (i.e., want a full-time job but can’t find one)) is currently greater than 11%. The number of “permanent” job losses (these are the ones that started out as “temporary” job losses in the early months of the pandemic) has soared. These are the reasons why the Fed doesn’t see any tightening until 2024 or more than “transitory” inflation.
JOLTS and Unemployment Claims
Markets were exuberant when the BLS’ January JOLTS (Job Openings and Labor Turnover Survey) showed a +142K rise in job openings M/M. As indicated in last week’s blog, markets ignored the “hires” data. The chart shows net new job openings and hires since last June (2020). This isn’t pretty and is symptomatic of the lingering weakness in the labor market.
The weekly state Initial Unemployment Claims (ICs) also disappointed, rising to 746K (Not Seasonally Adjusted) the week of March 13 from an upward revised 722K (March 6)(revised from 709K). The total rise was +37K from the 709K that was in the market just prior to the data release. That doesn’t look promising. But, as usual, the market ignored the Pandemic Unemployment Assistance (PUA) numbers. While the state numbers rose +37K, the PUA data fell by a huge -197K, from 479K to 282K.
PUA recipients are those that aren’t covered under state programs (entrepreneurs, self-employed, gig workers, and yes, the pizza delivery guys/gals). One would expect that, as the economy reopens, the PUA IC numbers, i.e., the self-employed, would lead state ICs. So, perhaps, this is a sign that the state numbers will soon dramatically improve. After all, the economy was only 43% open at the end of January, but that number grew to 67% as February ended. And has continued to rise into March.
Still, as the chart and table show, the Continuing Unemployment Claims (CCs), those receiving benefits from more than one week, remained at more than 18 million. The Fed, of course, knows all this, and data like this are the source of Powell’s “still a long way to go” and “we’re going to wait to see the ‘actual’ data” comments.
The March 18 Wall Street Journal headline (top right hand column for those that still get the print edition) read: “Supply Woes Slam Global Manufacturing.” The article outlined strains in global supply chains due to the pandemic. Last week, we showed a picture of the “parking lot” of cargo ships waiting to enter the Long Beach CA port. We are happy to report that the 40-ship back-up has been reduced to 17 (but 18 new arrivals are imminently expected). We see reports of price spikes in many items. Lumber, for example, has risen some 400% increasing the cost of construction of the average home by $24,000 according to that WSJ report. Private sources have told us that the cost to rent a container for a cargo ship has risen from $1,500 to $5,500. These are the sorts of costs that will result in upward spikes in the CPI and PPI for the next quarter. But, as we have explained in past blogs, these are “transitory.” The Fed clearly agrees with this assessment as Powell, in the post-FOMC press conference used the “transitory” term several times when describing inflationary pressures.
The result is that the majority of FOMC participants don’t see any need to raise rates until at least 2024. Nor do officials in foreign developed economies. Both the Royal Bank of Australia (RBA) and the European Central Bank (ECB) are moving toward further rounds of stimulus. And, despite the supply chain issues, the latest U.S. CPI data were benign (core 1.3% Y/Y). China, currently the world’s strongest economy, just released its 0.0% core inflation rate, and Japan’s ex-food CPI was -0.4% for February (making it seven months in a row of negative numbers). Meanwhile French core CPI was 0.0% M/M for February, and Italy’s was -0.2%.
GDP Growth and the Savings Rate
While the Fed did raise its GDP forecast from 4.2% to 6.5% as a result of the $1.9 trillion “stimulus” bill, the Q/Q sequence is of significant interest. Economist David Rosenberg traced the Fed’s quarterly forecast and found that: 1) there is a growth relapse in the Fed’s Q4 forecast as the stimulus fades, and 2) there are only very slight forecasted changes to the Fed’s GDP growth forecast for 2022 and 2023. This is because the “stimulus” is “transitory,” i.e., no multiplier impacts.
If the savings rate rises, which seems likely and always occurs after shocks (the tech wreck, the housing collapse), then demand fueled inflation is nearly impossible. People who need the stimulus money (the 18 million unemployed) will spend it on essentials like food, rent, utilities, etc. But, those who don’t need the stimulus funds built up their purchases of “goods” in 2020, so there is no pent-up demand for things that normally drive recoveries. This includes housing (sales down, starts down, buying intentions down, buyer traffic down, mortgage applications down, mortgage rates up), autos (sales down), furniture, appliances, etc.). In fact, there is likely pent-down demand for these items as demand was pulled forward during the height of the pandemic. For most households, much of the “stimulus” gets saved. In past blogs, we have referred to the NY Fed studies that bear this out. We never see inflation when consumers are paying down debt and savings are rising.
- The Fed sees inflation as “transitory” and isn’t going to change its accommodative policy until the “actual data” tell them to.
- The Fed’s close-in forecast was revised up to account for the $1.9 trillion “stimulus,” but, like inflation, they see the “stimulus” as “transitory” because there was little change to their GDP or inflation outlook for ’22, ’23 or ’24.
- The initial interest rate spike in February and early March was due to what now appears to be a “debunked” inflation narrative, at least that is what we glean from the Fed’s view.
- The most recent spike in interest rates (week of March 14) appears to be reflective of the reaction of the banking system to the SLR (capital requirements) rollback for Treasuries and Fed deposits. The promise of a “rule modification” has quelled the bond market, at least temporarily.
- We have rate spikes like the one we are currently experiencing in every cycle. But a “Bear Market” in bonds (i.e., rising rates) requires two conditions: 1) sustainable (not “transitory”) inflation; and 2) a Fed tightening cycle. We have neither.
Robert Barone, Ph.D.
Robert Barone, Ph.D. is a Georgetown educated economist. He is a financial advisor at Four Star Wealth Advisors. www.fourstarwealth.com. He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO, and a Director and Chairman of the Federal Home Loan Bank of San Francisco. Robert is currently a Director of CSAA Insurance Company (the AAA brand) where he chairs the Finance and Investment Committee. Robert is the co-portfolio manager of the UVA Unconstrained Medium-Term Fixed Income ETF (FFIU)