Today's release of the minutes from the Federal Reserve's January meeting was definitely exciting for us economic geeks. Short term, I'm not sure much changes, but it shows a Fed that's perhaps more open-minded than we assumed. Here are some thoughts.
How does inflation work anyway?
The meeting included a here-to-fore unknown briefing on "inflation analysis and forecasting," essentially investigating why inflation has been stubbornly low in recent years. This is a potentially crucial discussion, as how the Fed looks at inflation will be the key driver for policy going forward. In addition, it appears that new Fed Chair Jay Powell is looking to allow the staff to have even more influence over policy than his predecessors, so these staff presentations take on elevated importance.
Their research seemed to reject some popular explanations for low inflation such as "competitive pricing environment" (Amazon (AMZN) effect) or a "change in the market prices over labor costs" (income inequality). They said that the "prediction errors" were fairly large in recent years, but "did not appear to be biased." Translated, this means that while inflation predictions aren't all that accurate, the models aren't always under-predicting or over-predicting. The error goes both ways.
The staff also did not seem inclined to reject Phillips-style analysis, and the FOMC members agreed. "Almost all participants who commented agreed that a Phillips Curve-type of inflation framework remained useful as one of their tools for understanding inflation dynamics and informing their decisions on monetary policy." This is important because the Fed has recently been hiking despite a lack of definitively higher inflation based primarily on Phillips Curve analysis. As long as they stick with that as a key part of their models, the Fed will keep hiking.
All in all, their core approach seems to be unchanged. They will follow their models, which suggest a Phillips-style effect eventually leading to higher inflation. Given that, they will keep hiking at a similar pace, all else being equal.
So nothing changes?
Not immediately, but maybe as time passes. There seems to be a fair number of FOMC members who want to make some kind of change, but there is no consensus about what to change. At least "a couple" or "a few" members want to try ideas like adopting a range target (i.e., inflation between 1.5% and 2.5%) or a levels target (where they try to make up for past misses one way or the other). Neither of these ideas seemed to have many supporters, and for sure the latter idea would be extremely controversial to adopt.
There was, however, a strong consensus that the 2% target should be seen as symmetric (i.e., 1.7% is just as problematic as 2.3% is). If the Fed really feels this way, they need to start acting like it. Until then, I don't believe them.
What about recent wage gains and/or the CPI beat?
Remember this meeting happened before any of that. So the somewhat dovish tone in the description around wage growth should be taken with a grain of salt. To be sure, the Fed isn't going to react in a major way to just one month's worth of data, but if the Fed indeed sticks with their Phillips Curve framework, and if I'm right that 2% is more like a ceiling than a mid-point, then I'd expect them to keep hiking at the same if not faster pace.
The immediate market reaction made sense to me. The discussion of inflation by the staff and subsequent debate by the FOMC was at least a bit dovish. So right after the meeting we saw bonds bear steepen (i.e., long rates rose by more than short rates), TIPS outperform, the dollar sell off, and stocks rally. Between 2:00 and 3:00, however, the dollar made a big comeback and stocks weakened significantly.
I fear stocks may be now overweighting how much interest rates actually matter for P/Es. I re-emphasize, rates can't keep rising unless the economy performs well. If the economy performs well, earnings will be strong. In turn, stocks won't keep selling off if earnings keep growing.
Stock investors should be paying more close attention to Fed policy. The Fed hiking rates too fast is the biggest risk to equity valuations, not the rate on the 10-year.
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