Macro Tides – “New Monetary Gospel”
The FOMC followed the script as outlined in last week’s WTR and Treasury yields rose as expected. “Chair Powell is going to reiterate the FOMC’s commitment to keep rates down so unemployment can fall and tolerance of any pick-up in inflation toward its target of 2.0%. Chair Powell will state the Fed’s expectation that the coming rise in inflation is likely to be temporary, so the FOMC will not react by hiking rates if the Core PCE is above 2.0% for a period of time. Some market participants are eager to hear if Chair Powell hints about the FOMC implementing Yield Curve Control (YCC), which would be expected to minimize any increase in Treasury yields. I doubt Chair Powell will provide even a hint that the FOMC is considering YCC anytime soon. If correct, the Treasury market may be disappointed and sell off.” The 10-year Treasury yield rose from 1.621% on March 16 to an intra-day high of 1.754% on March 18, while the 30-year Treasury yield traded up to 2.505% from 2.391% on March 16.
The FOMC communicated its resolve through its quarterly projections for GDP, Unemployment, and PCE inflation. The FOMC increased its GDP estimate from 4.2% to 6.5% for 2021, lowered its Unemployment rate projection down to 4.5% from 5.0%, and projected that PCE inflation would reach 2.4% and Core PCE would tick up to 2.2%. Even with strong GDP growth, falling unemployment, and the FOMC’s favorite inflation gauges rising above 2.0%, the FOMC indicated no rate hikes should be expected before 2023. The commitment to keeping the federal funds rate just above 0% was despite the increase in the number of FOMC members favoring an increase in the funds rate in 2022 from 1 to 4. This represents a significant change in monetary philosophy by the Federal Reserve.
After Paul Volker became Chairman of the Federal Reserve in 1979 and during the decades that followed, the Federal Reserve relied on the Phillips Curve as its primary guide. The Phillips curve is named after economist A.W. Phillips, who examined U.K. unemployment and wages from 1861-1957. Phillips found an inverse relationship between the level of unemployment and the rate of change in wages. As slack in the labor market fell as measured by the unemployment rate wages began to grow faster, company’s increased prices and inflation rose. In the U.S. the relationship between the unemployment rate and the lagged increase in the Personal Consumption Expenditures (PCE) index was fairly tight in the 1950’s, 1960’s, 1970’s, and 1980’s. However beginning in the 1990’s and since, the PCE didn’t rise much, even though the unemployment rate fell to historically low levels. The expansion after the financial crisis was the longest in U.S. history and by 2019 the unemployment rate was the lowest in 50 years. Based on the Phillips curve the PCE should have gone up but it remained muted. The breakdown in the relationship between the unemployment rate and the PCE brought about the demise of the Phillips Curve, and the Fed’s willingness to allow it to guide monetary policy.
The FOMC will no longer increase rates based on projections of low inflation but instead will wait until inflation materializes, even though there is a risk the Fed could fall behind the inflation curve. The economic projections provided by the members of the FOMC reinforce their expectations that the coming increase in inflation will give way to lower inflation in 2022 and 2023. There are political and social pressures on the FOMC pushing the members of the FOMC in this direction. Income inequality is a real problem and the only way the Fed can help is by allowing the economy to run hot in hopes that wage growth for the lowest paid workers rise faster. This was occurring in 2019 when the bottom quintile of workers saw their wages grow faster than any other group. If you have any doubt about the political pressure on the Fed just listen to the questions about income inequality Powell is asked anytime he appears before Congressional committees.
In coming weeks, members of the FOMC will act as disciples for the new gospel of allowing the economy to grow, inflation to exceed 2.0%, and the FOMC refraining from hiking rates. In the short term this ‘forward guidance’ may restore some calm to the Treasury market and allow yields to come down. However, inflation is likely to run hotter than the Fed expects and the Treasury bond market will test the Fed’s commitment by pushing yields higher until the Fed is forced to launch Operation Twist. The members of the FOMC may believe in the New Gospel but there are many traders (sinners) in the bond market that lack the faith to keep them from selling when headline CPI inflation holds above 3.0% for a few months.