Bi-Weekly Economic Review: Is the Fed Behind the Curve?

By Joseph Calhoun of Alhambra

Is the Fed Behind the Curve?

Economic Reports Scorecard


There was little improvement in the economic data the last couple of weeks, the Citigroup Economic Surprise index still well below zero (-8.1). And frankly, where there was improvement such as the GDP report, it doesn’t look sustainable…unless the US is about to become a soybean exporting powerhouse. Anything is possible I suppose but counting on Brazil to have a lousy soybean crop every year doesn’t sound like much of a growth plan. Neither does adding to inventories when shelves are already more than fully stocked, inventory to sales ratios at recession levels.

I said in the last report that it appeared that, based on what we were seeing in the bond market, real growth expectations were rising. It took a mere two weeks to make me look a fool on that front. Bonds have continued to sell off but it is nominal bonds leading the way with TIPS outperforming. In other words, the bond selloff isn’t about real growth, it is about inflation fears. Those fears have been bolstered by some data such as the Case Shiller and FHFA house price indexes (+5.1% and 6.4% YOY respectively), a CPI that is rising closer to the Fed’s alleged target and the Employment Cost Index, up 2.2% YOY. But more than that I think is the new meme coming out of the Fed about allowing the economy to “run hot” for a while to make up for lost ground in the inflation indices. Janet Yellen, in a recent speech, touted the supposed benefits of operating a “high pressure economy”, one with inflation higher and unemployment lower than what the Fed believes to be appropriate in normal times.

Of course, this tradeoff between inflation and unemployment is one that, while oft alleged, has been tough to see in a real, actual economy. The alleged benefits of a high pressure economy are so extensive – raise consumer spending and business investment, raise the labor participation rate, increase R&D spending and new business formation according to Yellen – that to not pursue them would seem to be monetary malpractice. Of course, all the reckonin’, allowin’ and speculatin’ (as my father used to say) about such a high pressure economy presumes that the two variables are in some way linked and can be easily controlled by the Fed. The market seems to have no problem believing the Fed will let inflation run beyond its target but is much more skeptical about any benefit to the real economy.

I am frankly horrified that the leader of the Federal Reserve has such reverence for the old, rough Keynesian distortion of the A.W. Phillips study of labor markets and real wages. The original study did nothing more than prove that the forces of supply and demand apply to labor markets like any other. It had nothing to say about general inflation or any alleged trade-off with unemployment. The idea that more people working creates inflation is one that should spring only from the mind of a simpleton with limited critical thinking skills or a politician with an agenda – often one and the same for sure. It is as if the new person working adds to aggregate demand but has no impact on aggregate supply – which if true should limit their employment to a very brief period. The productivity figures in the new century are nothing about which to brag but they aren’t that bad.

Anyway, the point is that inflation expectations are on the rise and may or may not be a result of Janet Yellen’s inane mental maundering. As I said above, there is some evidence of inflation pressures in the economic data but it is unlikely to be anything other than – to use Yellen’s favored phrase – transitory absent a supporting move in the dollar. Inflation is about the purchasing power of money and a sustained burst of higher inflation isn’t going to happen without the dollar falling in value. Which it may do and indeed our momentum indicators say is likely. If so, this initial move higher in bond yields may be just that – initial and subject to further rises. For now though, the rise in inflation expectations is modest although the losses in the long end of the curve are not. Which makes me wonder if Ms. Yellen has considered the impact of higher bond yields in a world that thinks her daft and inattentive to the one thing over which she has some control – inflation.

Sorry, I got a little off topic there; Yellen does that to me. Let’s get back to our market indicators. The yield curve has steepened slightly since the last update:


As inflation expectations rose:


Real rates stayed steady:


While nominal 10 year rates rose


faster than the two year note yield:


Note to Bob Doll over at Nuveen and all the other twits who have been talking up this steepening as an indication that the economy is improving: this is called a “bear steepener” and it isn’t called that because things are getting better.

Credit spreads have been narrowing since the peak in February but they did widen since the last update by 15 basis points. It doesn’t mean anything….yet:


By the way, the TED spread which we’ve been keeping a close eye on, actually pulled in a bit since the last update. It is still trending in the wrong direction though and will have real world implications. How much debt is indexed to LIBOR?


The rally in the dollar index appears to have fizzled out about a point and half below resistance:


The rally never flipped our long term momentum indicator which is still pointing to further downside:


The dollar rally also did not have a big impact on commodities which stayed firm and may resume their rally as the dollar falls:


Gold was more directly affected by the dollar rally but it held support and looks ready to resume the rally:


The outlook for the economy has not changed materially but the bond market does seem to be getting anxious about what the Fed might do. Yellen’s bloviating about a “high pressure” economy may have short circuited any chance she has of letting the economy “run hot”. In any case, all she’s been able to accomplish so far is decidedly tepid. Or it may be that the rise in inflation expectations has nothing to do with Yellen; it could well be anxiety about the election next week and both candidates’ plans to ramp up fiscal spending which may be the only time the Yellen/Phillips curve actually applies. Politicians are uniquely skilled at finding ways to make workers less productive.

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