Four points, as my ability to accurately & precisely visualize the macro-finance Cosmic All continues to deteriorate...
The Energizer Bunny U.S. labor market is undermining my confidence in my reading of the macro-finance sitch. Resilient employment, interest rates, exuberance, and inflation are together flashing signals of a new abnormal. So how long can I keep clinging with any confidence at all to my belief that “neutral” is a 3% Federal Funds rate?…
(1) Captain Obvious says: No, the U.S. labor market still does not appear to be cooling at all, with the highest employment job-growth monthly report in three seasons:
Rob Armstrong: The US Labour Market Is Not Cooling: ‘Friday’s jobs report…very strong… a blowout relative to expectations — 256,000 jobs added against an estimate of 160,000…. Vonfirmation that the labour market remains firm, reflecting an unusually strong economy that is cooling very gently, if at all….
Bank of America made some news by being the first of the big banks (that we know of) to come out and say there would be no rate cuts this year, and saying that the real question is whether the Fed will have to raise rates. Unhedged agrees…. Where is inflation, then?….
Since June of 2023 the trailing year’s average HICP inflation has been below the Federal Reserve’s 2%/year PCE & 2.5%/year CPI target. Since July of 2022 the month-to-month observed inflation has averaged less than the target. There never was a “last mile” get-inflation-to-2% problem. There was always only a “wonky CPI housing component” problem.
That said, that the U.S. accomplished its inflation soft landing in July of 2022 or June of 2023, depending on how you count, does not mean that inflation might not be on the rise, and become—again—a problem in the future.
And so if inflation—real inflation, as opposed to clickbait-press inflation—has not been above the Federal Reserve target since July 2022/June 2023, the Federal Reserve should have monetary policy right now at neutral, correct? And if the Federal Reserve’s monetary policy tools are not at neutral, it should swiftly move them to neutral, correct? Both of those are certainly true.
And, indeed, up to a week ago I would have said that:
we think the neutral Fed Funds rate is around 3%';
it is now more than 1.25%-points above that;
the real economy of demand, production, employment, and inflation is near-balance
we don’t have strong views about the unequal relative costs of upside vis-à-vis downside shocks;
therefore a sensible central bank should be rushing to return policy to near-neutral in order to be prudently ready for what comes next;
hence the Federal Reserve should be cutting interest rates rapidly.
In short, I was with Conor Sen here:
Conor Sen: Calling an End to Fed Rate Cuts Is Premature: ‘A pickup in unemployment and the worsening outlook for residential construction argue for more policy easing in 2025…. Downside risks to employment and even inflation are more pressing than the upside risks heading into 2025, despite the stock market hitting new records. All it would take is one soft jobs report…. A deterioration in the outlook for residential construction threatens to exacerbate the negative labor market momentum…. In the Consumer Price Index report for November, shelter inflation continued to ease, with the “rent of primary residence” and “owners’ equivalent rent” categories returning to levels that look consistent with the pre-pandemic trend. Motor vehicle insurance was essentially flat…. These had been the stickiest components of inflation…. Concern that the Fed would have a “last mile problem” when it comes to returning inflation to its 2% target… no longer appears…. Inflation in the year ahead should more closely track wage growth and the state of the labor market…. Until there are signs of a sustainable pickup in hiring and residential construction, the Fed should keep cutting rates… <https://www.bloomberg.com/opinion/articles/2024-12-17/calling-an-end-to-fed-rate-cuts-is-premature>
The only argument I found convincing a week and a half ago against the proposition that the Fed should be cutting interest rates by 0.25%-points per meeting (or more) until it got to what it believes is neutral was Edward Harrison’s argument: that even though monetary policy is restrictive, financial conditions are definitely not restrictive:
Edward Harrison: Financial Conditions Aren’t Tight, But the Fed’s Still Cutting: ‘With every passing day, there seems to be more and more evidence of irrational exuberance in US asset markets — and yet, the Federal Reserve is cutting interest rates… has now reduced the fed funds rates by a full percentage point in the last three meetings without any sign of recession on the horizon, and with inflation well above target and financial conditions about as loose as they have been in years…. I’m actually more concerned about the euphoria in risk assets and the concept that we’re now partying like 1999… <https://www.bloomberg.com/news/newsletters/2024-12-18/financial-conditions-aren-t-tight-but-the-fed-is-still-cutting-rates>
With the latest… not a canary… but rather a humungous Andean condor in the coal mine for the proposition that financial conditions are superbubbly and loose for me and also for Edward being the very bizarre case of MicroStrategy:
Edward Harrison: Irrational Behavior Is a Sign of Irrational Exuberance: ‘My colleague Matt Levine…. “It is approximately correct to say that MicroStrategy Inc. is a $47 billion pot of Bitcoins that the market values at $119 billion… a 150% premium to the value of its underlying assets (Bitcoin). This is quite a weird situation…”. People have been investing in the company as a way to get into Bitcoin without dealing with all the associated regulatory issues. That was worth something. Is it worth a 150% premium? Is it worth a 150% premium when Donald Trump promises to make the regulatory burdens lower? Almost certainly not. So why does that premium still exist? Irrational exuberance, plain and simple.. <https://www.bloomberg.com/news/newsletters/2024-12-18/financial-conditions-aren-t-tight-but-the-fed-is-still-cutting-rates>
(3) But do note that Ed is not mainly worried that the fact that policy + conditions are, as he sees it, stimulative means that the big danger is that inflation will reïgnite. He sees the big danger as one of a sudden collapse of irrational exuberance (perhaps with private equity turning out to have effectively sold a huge number of unhedged options) triggering an orderly or disorderly liquidation, a financial winter, and a significant downturn:
Edward Harrison: Financial Conditions Aren’t Tight, But the Fed’s Still Cutting: ‘I’m actually more concerned about the euphoria in risk assets and the concept that we’re now partying like 1999…. So great is the expectation for further gains that if — or when — those expectations are dashed, it is bound to end in a major market downturn…. What role can the central bank play in keeping animal spirits from bubbling over when its mandate is really about inflation and employment?... <https://www.bloomberg.com/news/newsletters/2024-12-18/financial-conditions-aren-t-tight-but-the-fed-is-still-cutting-rates>
And whether or not the Fed should cut interest rates this month and at its further meetings this winter and spring, it won’t. The Fed is waiting for Trump, as it has as little idea of what he will try to do as anyone:
Tim Duy: Monday Morning Notes, 12/23/24: ‘A new game’s afoot. The Fed looks… to hold policy steady until Trump 2.0 uncertainty abates…. There is no reason to think that uncertainty will disappear anytime soon…. The unexpected upward revisions in the inflation forecasts…. John Williams gave away the story… [when he] acknowledged that his forecasts were impacted by expected Trump policies…. “I have incorporated some thinking about where fiscal policy may be, immigration and other policies, because those are important drivers to thinking about the economic outlook…. But I would just emphasize that there is a lot of uncertainty about what those effects will be…” <https://www.sghmacro.com/>
And the fact that there are zero signs of policy rates higher than the neutral rate slowing the economy is simply reïnforcing that Fed judgment that now is a time to wait.
(4) The interesting analytic question raised by the most recent jobs report is whether my belief that “neutral” is in fact a 3%/year Federal Funds rate is correct. At the moment I still take refuge in the belief that (a) fiscal stimulative multipliers are somewhat higher than I had thought, and (b) irrational financial exuberance driven by the failure of investors to understand that an extra dollar of NVIDIA profits today is not a signal of rapid future economic growth driven by “AI”, but rather a transfer from tech platform oligopolists to NVIDIA driven by their belief that they have no choice right now but to pay NVIDIA through the nose to build “AI” capabilities to purchase insurance against the disruption of their platforms and the erosion of their platform-oligopoly profits. But that is a point for another day.
However, let me set a timer: if what I regard as substantially restrictive interest rates do not bring signs of labor-market slowing, I am definitely going to have to rethink my views about what the American economy’s current neutral rate of interest is.
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We're in for a volatile period going forward and I assume all the data will be noisy. People will be trying to figure out what the Trump administration is going to do, as opposed to what it is going to try to do (which is also not clear, but clearer). At some point along the way they may also be trying to figure out what the Trump administration has done ...
Given the inflation uncertainty a) The Fed's forward guidance should be, "FAIT is 2%. We are data driven." b) The EFFR needs to be at a level such that the next Fed move is likely to be down as up.
We're in for a volatile period going forward and I assume all the data will be noisy. People will be trying to figure out what the Trump administration is going to do, as opposed to what it is going to try to do (which is also not clear, but clearer). At some point along the way they may also be trying to figure out what the Trump administration has done ...
Given the inflation uncertainty a) The Fed's forward guidance should be, "FAIT is 2%. We are data driven." b) The EFFR needs to be at a level such that the next Fed move is likely to be down as up.