On Thursday, August 27, Fed Chair Jay Powell spoke at the Fed’s annual Jackson Hole symposium. His talk was much anticipated, as it was expected that the old 2% inflation objective would be updated. In fact, the Fed had telegraphed the change; and the Fed has been following the newly announced policy for several months.
The policy change allows the Fed to permit inflation to exceed the Fed’s announced 2% target without preemptively raising the Fed Funds rate or otherwise tightening policy to head off a rise above that 2% target, as the Fed had done beginning in 2015 and ending in 2018. In effect, the new policy is different from the one it replaces in that it changed the 2% target inflation rate from 2% as a hard ceiling to 2% as a long-term average. Since we haven’t seen 2% inflation this century, if inflation rises above 2%, the Fed won’t have to react. And it may be several years before it does react depending on how far and how fast inflation rises above that 2% “long-term” target.
Since current inflation is nowhere near 2%, there is no immediate action implied by the new policy. It does mean that interest rates will continue to be minuscule as far as the eye can see, and for a much longer period than would have been the case under the replaced policy. As indicated above, had this policy been in effect in 2015, that tightening cycle (including the monthly reductions in the Fed’s balance sheet) would likely not have occurred.
The Anomaly: Rates Spiked Up On the Policy Announcement
Despite the fact that Powell just announced that interest rates are going to be lower for longer, interest rates spiked. No doubt, someday down the road, inflation above 2% will occur if the Fed pursues this ultra-easy monetary policy long after the economy has healed. But, at this time, we are far, far from that point.
Economists have often noted that, at least theoretically, inflation appears to be partially a function of “expectations.” There is a high correlation between what consumers “expect” inflation to be, and what it actually turns out to be. Did the mere announcement by Powell that the Fed was willing to tolerate more inflation actually cause the market to add an inflation premium to the yield curve? Apparently so. Yet the reality, at least for many more quarters, is that in the service sector of the economy, where the consumer spends most of her money, prices won’t be rising above February levels – at least not in airline fares, movie theater tickets, theme parks, or restaurants. Nor will rents be rising since a significant percentage of Americans have missed their rent or mortgage payments for the past few months (an eviction tsunami is coming!). These sectors have significant influence on the major rice indexes.
In addition, all of the surveys that measure consumer inflation expectations have indicated that consumers “expect” inflation to be flat to lower over the near and medium-term horizon. As mentioned above, this “new” policy wasn’t really “new,” in that the Fed had telegraphed this policy several months ago. The Wall Street Journal described this in its Friday (August 28) edition as follows:
It won’t lead to a significant change in how the Fed is currently conducting policy because it had already incorporated the changes it formally codified Thursday.
The markets already knew this. So, this wasn’t new data or a shock. Yet, rates still spiked.
Another debunked theory as to why rates have spiked is the fact that the CPI and PPI for August showed some upward price movements. That really can’t be why rates spiked, as this was just the bounce off of the price craters of April/May/June when no one would buy anything no matter what the price (except TP!). (Similarly, we don’t consider the spike in the employment data of several million people in June as the start of a tight labor market.) Here are some current data:
- The NY Fed Inflation Gauge: 2% in February; currently 1.1%;
- Atlanta Fed Wage Tracker: 4.1% in May; 3.6% in July;
- Employment Cost Index: +0.5% – the lowest in the past five years;
- Nonfarm Business Price Deflator: 1.5% in Q1; -0.2% in Q2 (first time <0 in 70 years).
It’s For the Banks
Another possible reason for the Fed to spike inflation expectations is to steepen the yield curve for the benefit of its constituent banks that need curve steepness to improve their profit margins. Banks borrow short-term but lend long-term, so a positively sloped and steep yield curve gives them higher lending rates while holding down borrowing costs. As discussed briefly in my last blog (“The Economy: On a Sugar High”), the Fed minutes for their July meeting indicated that the Fed would not be pegging the yield curve at this time. That announcement along with Thursday’s policy change clearly indicates that the Fed will tolerate a steeper yield curve.
This has other benefits, too. It supports the value of the dollar in the foreign exchange world, as higher longer-term Treasury yields attract foreigners to demand dollars to be used to purchase those Treasuries. The value of the dollar vis-a-vis other currencies has been falling since the pandemic began due to Fed money printing, and it continued its downward spiral even after this Fed announcement. But it isn’t surprising that the Fed would like to stem that trend. The price of gold is quite sensitive to the dollar’s exchange rate. It rose rapidly from early June to early August, took a breather, and now seems to have formed a base from which it may move higher.
The economists and policy makers at the Fed are top notch. As indicated above, there may be unannounced motivations for such a policy announcement. Likely, they don’t want to be caught having to raise interest rates if inflation returns while there are still significant levels of unemployment. The 2% inflation target was adopted in 2012 when the expectation was that interest rates would return to the levels experienced in the 1990s and before the Great Recession. Today, there is no such expectation. Demographics have changed such that economic growth in the developed economies is much harder to achieve. Furthermore, technology has vastly lowered production costs.
So, why is 2% still the target? Looking at the PCE deflator (Personal Consumption Expenditure Chain Price Index), the index the Fed uses to measure inflation, the Fed hasn’t achieved that inflation level since adopting the target. It has averaged about 1.5%. In fact, we haven’t had sustained 2% PCE inflation this century! What is so magic about 2%? Why not 1.5%, 1% or even 0%? Remember, the written Fed mandate is “price stability!” (Sometime back in the 80s or 90s, when asked at a Congressional hearing what the rate of inflation should be for price stability, then Chair, Alan Greenspan, answered 0%!!).
Nevertheless, Powell has laid out the path that the Fed is going to pursue, artificially low interest rates until inflation rises above 2% for a significant period of time. During this time, there will be no real price discovery in the fixed income markets, as the Fed will either intervene directly, or simply print more money to keep rates artificially low. The best hedge for investors is gold. The dollar’s value is already in the tank and is likely to erode further. If 2% isn’t the right magic inflation number and is unachievable in a world of high unemployment, the pursuit of it may cause the world to look for an alternative reserve currency.
Employment-the Seasonal Adjustment Issue
Meanwhile, the economy continues under the constraints imposed by government(s) over the pandemic issues. Employment, of course, is the primary measure of the economy’s health in today’s world. For the past few months, this blog has been following the trends in the unemployment data, both the state unemployment programs, and the new PUA program (Pandemic Unemployment Assistance) mandated by the CARES Act for the self-employed and independent contractors that don’t qualify for the state programs. The data I have been using are not-seasonally adjusted (NSA) because seasonal factors don’t make sense (i.e., the economy doesn’t seasonally shut down every March!).
Well, lo and behold, the Department of Labor (DOL) has finally recognized the seasonal adjustment (SA) issue! Beginning with the data presented on Thursday, September 3, the DOL will use much toned-down seasonal factors (i.e., using an “additive” instead of a “multiplicative” methodology. From their August 27th release:
…in the presence of a large level shift in a time series, multiplicative seasonal adjustment factors can result in systematic over- or under- adjustment…”
To explain using an example: if the normal data point is about 100,000 and the seasonal factor would add +5,000, a factor of 1.05, then, using the additive method, one would add 5,000 to 100,000 to get the SA number of 105,000. Under normal circumstances, using the multiplicative technique, 100,000*1.05 is also 105,000. But if the base suddenly jumps to 1,000,000, the additive technique puts the number at 1,005,000, while the multiplicative technique distorts the data to 1,050,000, i.e., there is a 45,000 difference in the two techniques in this example.
While this new technique will begin next week, it doesn’t appear that the SA data beginning in March will be revised. The DOL note indicates that data revisions will occur at the beginning of the calendar year. This means that there will be no consistency in the methodology used in the SA data, so best to stick with the NSA data, as I do here.
The Employment Trend
The week ended August 22 saw a -68k drop in the state Initial Claims (IC) data. This offset the disappointing IC rise of +51k the prior week. Continuing Claims (CC), those on unemployment for two consecutive weeks, showed another significant drop of nearly -273k, after falling more than -1.0 million the prior week. Looking at the table and graph, except for a three-month period in early and mid-July, the rate of decline in the ranks of “those who work for an employer” continued its downtrend. From this data, it appears that large and medium-sized companies (factories, and large white collar businesses) have begun to recall or rehire employees.
The news is not as good in entrepreneur land. The PUA IC data are going the other way. PUA Initial Claims (IC) rose +83k the week ended August 22, after having risen +35k the prior week (August 15). I am guessing that the business re-opening pauses or reversals in some states is, at least partially responsible, as it is small businesses (bars, restaurants, salons …) that suffer most with these closures and social distancing rules. It is these constituents who would most likely use the PUA programs. The spike here may also be due to catch-up, as PUA is a new program (awareness on the part of the public, and capacity on the part of the administrative agency). Data for PUA Continuing Claims (CC) for the week ended August 8 (latest data) did fall -252k.
As shown in the table and graph, the combined programs showed a fall of about -1.6 million (from 28.6 million to 27.0 million). Good progress, but still a long, long way to go!
The worst part of the Recession hasn’t hit yet due to the various and sundry money gifts from Uncle Sam. The virus appears to be heartier than anyone’s (except maybe Dr. Fauci) forecast. Most of Europe is now experiencing upticks in case counts as are some states in the U.S. This may mean a return to “normal” business is still significantly “down the road.” The concept of a “V”-shaped recovery should, by now, be completely debunked.
The Fed’s new policy ensures minuscule interest rates for years. While this, on the surface, appears good for business, it just may not be. For the past 18 months or more, historically low interest rates have created a mountain of debt in corporate America, debt that has kept zombie companies alive. Such debt will be an issue going forward. We already know that corporate America was caught short of liquidity when the pandemic hit, and that caused a surge in bank borrowing and new debt issues. In addition, at the urging of their CFOs, to build up liquidity going forward, the boards of America’s corporations have begun to reduce their future CapEx. That means even slower growth and fewer new future hires.
The Fed’s program of minuscule rates also impacts retirees and those baby-boomers nearing retirement. Their retirement savings, normally invested in safe-haven assets, now must seek more risky assets to throw off enough earnings for the retirees’ expected lifespans.
When uncertainty occurs, as it does every few years, the Fed is now obliged to save the zombie corporations and print more money to support equities. Thus, it isn’t any wonder why the equity market keeps rising despite the historic new heights in risk ratios, like Price/Earnings, and junk bond yield spreads to Treasuries are at historic lows. Under these conditions, how long will it be before the world seeks a different reserve currency?
Maybe, just maybe, the new Fed policy and similar policies for the last 15 years have been ill-designed.
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).