Over the last two days there has been a deluge of Federal Reserve speakers, capped off by the Chair herself speaking Tuesday afternoon. Here are some thoughts on what we've learned and what it means going forward.
Below is my three-point guide to reading Fed speeches.
- Understand how influential the speaker is. The Fed isn't really one person one vote. Note that I don't really care if the person is officially a voter or not. Influence is what matters.
- Determine if the Fed is trying to coordinate a specific communication or if the speaker is just giving his/her own thoughts.
- Understand the context of the comments. Often the Fed will try to lean against a certain market sentiment, which can make a given speaker sound more hawkish/dovish than they really are.
William Dudley, New York Fed President: Highly influential
Most of his speech was on labor force issues that don't have much directly to do with monetary policy. However, he reiterated his prior stance that the recent downshift in inflation was "from a number of temporary, idiosyncratic factors."
Dudley basically speaks for the power center of the Fed. He talks about inflation probably rebounding, but if we look at the Summary of Economic Projections, we can safely assume that this power center doesn't think inflation is going to suddenly rebound to 2%. I suspect they think it will probably rise from the somewhat worrisome 1.4% level on Core PCE to a more comfortable 1.5-1.7%.
Crucially though, Dudley (and I believe others) aren't so much worried about inflation at 1.5-1.7%, or even really that inflation might jump above 2.0%. When they use statements like "temporary, idiosyncratic" to describe why lower inflation will soon rebound, it is a smoke screen. It is much more accurate to say they are worried about various side effects of having rates too low amidst strong growth and low unemployment, mostly financial market effects. They would just be more comfortable with rates a bit higher.
Charles Evans, Chicago Fed President: Low influence
Evans has had his moments, but doesn't currently seem to be terribly influential within the Fed. I will say he hit on what is a critical debate in his speech: Does somewhat lower inflation influence future inflation expectations of the public? If so, it creates a self-fulfilling prophesy, since expectations tend to influence actual inflation. Because Evans is worried about this effect, he wants to see evidence of an inflation rebound before supporting a December hike.
We will see if this argument gains traction. I personally doubt the public can really tell the difference between 1.7% and 2.1% inflation.
Neel Kashkari, Minneapolis Fed President: Low influence
Kashkari, who has dissented against rate hikes in recent meetings, didn't break major new ground speaking at a town hall in North Dakota. The key quote is: "I don't see inflation taking off, so I see no need to tap the brakes." He believes that the only negative consequence to low rates is inflation, so if you don't have any inflation why raise rates? Specifically, he references the idea that if we don't have any inflation pressure now, we can infer that the unemployment could go even lower. Why wouldn't we want lower unemployment if there aren't any adverse consequences?
I'd say the rest of the FOMC sees Kashkari's argument as simplistic. Monetary policy operates at a lag and so we can't just judge the level of slack based on conditions right this moment. In addition, most FOMC members worry about factors other than just inflation, as I mentioned above with Dudley.
For these reasons, if the Fed were to back away from a December hike, it is more likely Evans' argument gains sway than Kashkari's. Watch to see if other FOMC members use this same expectations-based argument. Speaking of which...
Lael Brainard, Board Member: Highly influential
Generally I think of board members as more influential, but Brainard may be currently sitting outside the consensus. In recent weeks she has been making the same argument as Evans: Low inflation can cause inflation expectations to fall, which in turn may cause inflation to be low. When she first made this case in a speech on Sept. 5, it caused a bit of a stir. She previously argued that perhaps the Fed was already close to their neutral rate, and thus may not need to hike much more. I'm skeptical of the former, but find the latter quite plausible.
This particular speech was about income inequality, and did not touch on either of these topics. In fact she said that the Fed's tools are not well suited to deal with income distribution. That being said, I'd still call it a dovish speech. There is a growing view in some corners of academia that running the economy hot would help speed up wage growth, especially helping the lower end of the distribution.
I don't think Brainard is delivering a purposeful Fed communique either today or in her Sept. 5 speech. The Chair herself downplayed Brainard's expectations argument during her presser last week. Still this is one to watch. Any of Brainard's arguments could catch on within the Fed, especially if inflation stays below 1.5% into early next year.
Janet Yellen, Chair: Primary influence
While the Chair is obviously THE voice to listen to, most of her speeches just reiterate what we've heard from the FOMC releases and/or post-meeting pressers. This speech was no exception. She said "it would be imprudent to keep monetary policy on hold until inflation is back to 2%" which sounds like a direct shot at the Kashkari argument and well calibrated to fit the Fed's current baseline.
However, she went on to describe some risks to the long-run inflation picture. In short these are: 1) the natural rate of unemployment might be a good bit lower than we thought, which would mean that tightening now would retard inflation further, 2) inflation expectations might fall (i.e., the Brainard/Evans argument) and 3) the relationship between inflation and the economy may have fundamentally changed, e.g., online shopping could have increased price competition, fundamentally altering the inflation outlook.
Here's how I read all this. Yellen and her colleagues really are struggling with why inflation is so low. But they view this as an intermediate-term problem. In other words, if indeed the inflation picture has fundamentally changed, that would be a reason why this hiking cycle is slow forming and ultimately ends at a fairly low rate. But it isn't a reason to not hike in December. I think the market's December odds for a rate hike are too low.
There are two trades I like based on all this.
I'm long the U.S. dollar. You can use the WisdomTree Bloomberg U.S. Dollar Bullish Fund ETF (USDU) to get broad exposure. You could also short euros, which look like the most overvalued currency vs. USD, but I think USDU is a safer bet. I am more convinced that the market is mis-pricing the Fed and USDU is a more direct bet. The euro is sitting on the 50-day simple moving average (SMA), which isn't a bad set up for a short, but not a trade I'm personally doing.
The second one is to short 5-7 year Treasuries. I'm using the 10-year futures contract, which has a 6.5 year cheapest-to-deliver bond. A more direct bet would be to use 2-year futures, but you'd have to lever that up more than I want to. The 5-7 year part of the curve will get hit harder than longer-term bonds assuming rates are hiked in December.
Not only would both do well if just a December rate hike became a reality, both trades would be a home run if someone besides Yellen were named the next Chair. I'd close both trades if either we find out who the Fed Chair will be or if a rate hike in December becomes fully priced in.
Tom Graff is a regular contributor to Real Money Pro. Click here to learn about this dynamic market information service for active traders.