Ahead of today's FOMC announcement, which comes without a press conference and has thus been dismissed as a possible start to a Fed hiking cycle, the Fed has a big problem. It's not jobs, which are running at a pace that many suggest is strong enough to sustain at least a 25 bps hike to nearly a decade of ZIRP, assuming of course one completely ignores the "quality" component as virtually all recent job growth has been in the low-paying job category especially waiters and bartenders...
... but inflation, and specifically the bifurcation between core inflation and headline inflation.
Here is the paradox as succinctly summarized by Deutsche Bank, which notes that the current -29% year-over-year drop in the CRB index implies YoY headline CPI inflation falling from 0.1% to -0.9% over the next couple of months, or just in time for the September or December FOMC meetings both proposed as the "lift off" date. This would be the largest year-over-year drop since September 2009 (-1.3%) and one of the lowest prints in modern history.
However core YoY CPI inflation is likely to edge above 2% in the months ahead which complicates matters.
In other words, Fed will have to pound the table on the commodity crunch being a transitory event, just like every other "transitory event" that forced the Fed to postpone hiking rates since 2011. The problem, however, is that unlike "snow in the winter", plunging oil and commodity prices are proving to be anything but "transitory", and are mostly a function of China's economy whose ongoing decline is also anything but a one-time event. In fact, if anything, China's contraction is accelerating, with the recent bursting of its stock market bubble only likely to add to its headaches and to commodity price downside as Chinese Commodity Financing Deals [19]are unwound.
Which brings us to the WSJ's Fed mouthpiece, Jon Hilsenrath, who largely summarized the above in his preview of what the Fed will today as follows:
The Federal Reserve has framed its decision about raising interest rates around the progress it sees in achieving its dual mandate goals of maximum employment and 2% inflation. Officials could emerge from their policy meeting today with a split decision – progress on the employment side of their mandate and continued uncertainty on the inflation side.
Fed Chairwoman Janet Yellen said in testimony to Congress earlier this month that the economy is “demonstrably closer” to reaching the Fed’s full employment goal. Since the Fed last met in June, the jobless rate has notched down further from 5.5% to 5.3%, its lowest level since April 2008, hiring appears to have returned to a path of steady gains in excess of 200,000 per month after stumbling in March and wages show tentative signs of moving higher. Fed officials will need to acknowledge these advances in their post-meeting policy statement, a sign that a rate increase is approaching.
Still it is hard to see how officials derive great confidence that inflation is surely returning to their 2% goal. Oil prices and commodities more broadly have resumed their march down and the dollar its movement higher, factors that have weighed on inflation all year. The Fed has described these developments as transitory before, but slow growth in China could give them some pause about that conclusion. Broad measures of inflation show little sign of breaking out of the sub-2% trend which has been in place for more than three years. Meantime, inflation compensation in bond markets has notched lower after stabilizing earlier this year. And though wages show signs of picking up, a breakout isn’t yet obvious and the links between wages and broader inflation are tentative.
Hilsenrath's conclusion: "It potentially sets up the Fed and markets for a cliffhanger policy meeting in September. The jobs part of their mandate – so important to Ms. Yellen – is signaling a rate increase is due. But the inflation part of the mandate signals continued patience. Officials won’t want to lock themselves in until they see more data on the economy’s performance."
Which is probably another way of saying what Lloyd Blankfein just stated in a Bloomberg TV interview, namely that the "first rate hike will be jarring."
And while the above covers the Fed's thinking on input drivers, but what about the market's "reaction function" manifesting in the strength of the USD? Here are some thoughts from UBS on the topic:
The dollar's strong foreign exchange value remains a challenge for forecasters and investors. Over the year ended in June, the Federal Reserve's broad trade-weighted dollar index rose 12.5%. (The major currencies component was up 17.3% and the other important trading partners component rose 9.0%.) How much difference does a strong dollar make for Federal Reserve monetary policy and the US economy? Our answer is that a strong dollar means growth and inflation are lower than they would be otherwise but probably not by enough to preclude the Fed funds rate tightening that we still see beginning before year-end.
One way to assess what a strong dollar means for Fed policy and the economy is to consider some recent analyses provided by Fed economists for Fed policymakers. One such analysis comes from Federal Reserve Bank of New York economists Mary Amiti and Tyler Bodine-Smith in a July 17 Liberty Street Economics article titled "The Effect of the Strong Dollar on US Growth". They concluded that sustained 10% dollar appreciation after a year reduces US real net exports enough to subtract 50 basis points from US real GDP growth, with another 20 basis points coming after the second year. (See Figure 1.) These effects are more related to lower exports, which are more sensitive to dollar movements than imports.
If the strong dollar makes near-term real GDP growth 50 basis points lower than it would be otherwise, would that be enough to preclude a Fed funds rate hike before year-end? That might be the case if the Fed only considered actual versus its expected real GDP growth. For instance, in the FOMC's mid-year projections of Q4/Q4 real GDP growth, the members' central tendency forecast was 1.8% to 2.0% for 2015 and 2.4% to 2.7% for 2016. Heading into 2015, Q4/Q4 real GDP growth at the end of 2014 was 2.4%. A 50-basis-point reduction in growth due to a strong dollar would still leave growth at the 1.9% mid-point of the 2015 central tendency forecast if growth momentum outside of the trade sector is maintained in 2015. Clearly, given the uncertainties about how much a strong dollar reduces growth, it is a close call whether the strong dollar over the past year will enable the Fed to achieve its growth targets.
However, the Fed is more likely to be influenced by the unemployment rate and core inflation than real GDP growth. Frequent and uncertain revisions to real GDP growth are a practical reason for the Fed not to hitch its Fed funds rate and balance sheet policies to published real GDP growth. While the unemployment rate and core inflation inevitably are imperfect measures, at least they are not subject to the types of sometimes large revisions associated with real GDP growth data.
So maybe the resumed strength in the dollar won't be enough to push the Fed away from the hike button, but it surely will be enough to crush corporate sales and EPS, as has been the case for the past two quarters and will be for the coming quarters. Recall that the biggest complaint by far during Q2 the earnings season by CFOs [20]has been the strength in tthe USD. How long until the CEOs of US multinationals decide to all dial the Fed and make it clear that the ongoing surge in the DXY will simply not do?
What does the Fed likely do? Nothing today, almost certainly nothing in September, and a small rate hike in December just to show it can is possible. The question then is will this send the dollar surging even more, and lead to an even more acute crash in corporate profitability, one which not even buybacks and non-GAAP addbacks can mask the underlying corporate recession, and more importantly, just how much more credibility can the Fed afford to lose as a result of the recent dramatic flattening in the yield curve, before we finally get the clearest recession signal of all, a curve inversion, at which point the next step after the rate hike becomes inevitable: even more QE?
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