There must be something in the Dallas water that makes its Fed presidents immune to the general dogma and brainwashing that emanates from the Marriner Eccles building.
Several years after former Dallas Fed president Dick Fisher repeatedly warned that the Fed's continued "unconventional" policies (which in the past decade have become boringly conventional) and meant simply to push stocks higher (as the Fed "gamble" replaced the Fed "put") would result in ruin, his replacement former Goldman banker Robert Kaplan, has picked up where his predecessor left off, and in an essay released on Monday by the Dallas Fed, Kaplan said that "monetary accommodation is not “free.” I am concerned that adding monetary stimulus, at this juncture, would contribute to a build-up of excesses and imbalances in the economy which may ultimately prove to be difficult and painful to manage."
For those unfamiliar, "excess and imbalances" is central banker speak for "bubble", and is traditionally frowned upon in polite "economists who have never held a job in the real world" circles as it reminds the Fed that every time it forceefully intervenes in the market the result is disaster.
Kaplan is weary because his base case is for "solid" economic growth this year and for the labor market to remain at or past full employment - conditions that in no way require a rate cut at this moment, a moment incidentally where the S&P is trading at all time highs. "In addition, financial conditions - the cost and availability of credit - are particularly robust by historical standards,” he said, hence the confusion: with the rest of the Fed seeing a similar benign environment, why the need for a rate cut now, especially since inflation for the common man is well higher than that hedonically adjusted and calculated by the Fed as discussed recently.
Kaplan’s cautious tone contrasts with expectations in the financial markets that a July rate decrease by the Fed is all but a done deal, which of course makes perfect sense - the only winner from a rate cut, NIRP and QE is, drumroll, financial markets. Which is why investors, having pushed Powell to "throw in the towel", now see an almost 100% probability of a cut next month, with some even looking for a half-percentage-point drop. Some, such as another former Goldman banker, Minneapolis President Neel Kashkari, who last week came out publicly for a 50 basis point move, in what is a clear move at replacing Powell once Trump demotes or fires the Fed chair.
To be sure, Kaplan did not eliminate any possibility of a rate cut and instead focused on the pre-emptive, "insurance" rate cut scenario, acknowledging that "trade tensions and uncertainty have increased significantly over the past two months," dampening business investments and possibly slowing manufacturing output according to Bloomberg. “Downside risks to the outlook have increased,” said Kaplan, who this year is not a voting member on the FOMC.
Ok great, Kaplan believes in a precautionary rate cut... but the problem is that as JPMorgan noted over the weekend, a precautionary move would meant cutting last week, not waiting until the economy deteriorates even further, an admission that the Fed is behind the curve - arguably the worst case scenario the Fed, its credibility, the economy, and capital markets.
Which is probably why Kaplan made clear he was not ready to ease borrowing conditions.
“It would be wise to take additional time and allow events to unfold as we consider whether it is appropriate to make changes to the stance of U.S. monetary policy,” he said.
Addressing what the biggest threat was, Kaplan focused on debt-funded buybacks and M&A- activities which we warned all the way back in 2012 are the biggest threat to the proper functioning of the economy, and the clearest indication of asset bubbles, to wit:
I have spoken about the level of corporate debt as potentially one of those excesses that is likely to be a “burden” on the economy in the event of a downturn. Persistently low interest rates make borrowing for share repurchase and merger transactions highly accretive to a company’s earnings per share. In a world where businesses have less and less pricing power and managing costs is essential, debt-financed activity becomes harder to resist. Debt-financed share repurchase and merger activity may help fuel growth in earnings per share when times are good, but in a downturn, increased debt levels will mean that a higher percentage of cash flow will be necessary to service interest and principal repayments. This is just one example of the type of excess that may seem innocuous when times are good but can become more troublesome in a downturn.
Kaplan also said he was worried about the continued inversion of the yield curve:
As I have said before, I would be concerned about an inversion of the curve—either three-month to 10-year or one-year to 10-year—of some size and duration. My concern emanates from my belief that an inverted curve ultimately makes it more difficult for financial intermediaries to borrow short and lend long—and, if the inversion persists, it would likely begin to impede the creation of credit and lead to a tightening of financial conditions. I will continue to watch this carefully.
When the Fed dropped its "patience" last week, saying they would closely monitor incoming information and “act as appropriate to sustain the expansion, one data point they’re likely to closely watch according to Bloomberg is the June employment report, due out July 5. Growth in U.S. payrolls unexpectedly tumbled in May to 75,000, from 224,000 in April. In his essay, Kaplan played down the significance of the drop.
“We believe that job growth in the range of 60,000 to 120,000 jobs per month will be consistent with a ‘strong’ jobs market for the remainder of 2019,” Kaplan said, noting that the labor market is so tight, making it hard for employers to fill open positions.
Kaplan sounded less worried than some of his Fed colleagues about below-target inflation, saying he expected price rises to accelerate over the next year. Kashkari and St. Louis Fed President James Bullard have made the case that a cut in rates would help bolster inflation, confirming for yet another year that the former Goldman IT banker who is unable to "find" inflation anywhere he looks, has not spent his own money in the past decade on, well, anything.
Inflation has run below the Fed’s 2% target for most of the past seven years and sat at 1.5% in the year through April.
At the same time, Kaplan doubted the tight labor market would produce problematically high inflation because of the inability of firms to raise prices. As companies are forced to pay higher wages, that’s “just as likely to lead to business margin erosion as” higher prices, he said.
Kaplan's conclusion: don't do anything with rates until there is an actual, tangible change in the economy:
I intend to be highly vigilant with regard to the persistence of heightened trade tensions and indications that slowing global growth is spilling over into a material deterioration of the economic outlook for the U.S. In the meantime, I believe it would be wise to take additional time and allow events to unfold as we consider whether it is appropriate to make changes to the stance of U.S. monetary policy.
The market took one look at these comments, and not only did it not ease back on rate cut expectations, but with a July rate cut now in the bag, it pushed the odds for a second cut in July - or a total 50bps - to 38%.