Fed Still Ready to Hike, But Slow Inflation Remains a Worry

 | Oct 11, 2017 | 4:30 PM EDT
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My working theory on the U.S. Federal Reserve is as follows. There is pretty broad consensus that a rate hike in the near term is appropriate. Economic growth seems to be accelerating a bit and labor conditions are favorable. However many on the Fed are worried about slower inflation reads lately. It could be a sign that monetary policy isn't as accomotive as they think. A few think this makes it worth waiting to hike even one more time, but most think the inflation slowdown will ultimately prove temporary. Worth watching, but more of an intermediate-term concern.

In short, today's release of the Fed's minutes from their September meeting is consistent with that view. Here are a few highlights and how I am positioned.

There was definitely a robust conversation about inflation

This is hardly surprising since Fed officials have recently began admitting that their old models of how inflation comes about may not fit today's reality. The conversation flowed through everything from demographics, trade, Amazon, the ACA, cellphone price wars, etc. The minutes only really give us a glimpse into the arguments that are being made, but suffice to say this seemed to take up a good bit of the conversation during their meeting.

But actions speak louder than words

Many commentators are already keying on this debate and claiming that this shows there is no consensus about hiking in December. I disagree. When reading the minutes or listening to Fed speeches, you always have to put things in context. The main decision coming out of this meeting was the balance sheet normalization, and that was a foregone conclusion. And They weren't even considering hiking rates. So the only thing they had to talk about was this more intermediate term question about whether inflation had somehow fundamentally changed and their models were no longer useful tools.

More importantly, however, is the fact that 12 out of 16 FOMC members thought a December rate hike would be appropriate despite lowering their Core PCE forecast to just 1.5%. In other words, the debate around inflation is what they said, but when asked "what would you do?," they generally wanted to hike.

So does this inflation debate not matter?

In fairness, they weren't debating inflation conditions for their health. Of course it matters. But given what we saw in the dot plot for 2017, it seems obvious that the debate is really around 2018 and beyond. What should they do if inflation stays this low but labor markets remain very strong? Or if inflation falls but financial markets keep rising? I think this is an ongoing conversation within the Fed, but not one that necessarily gets in the way of a December hike.

Short-term data influencing intermediate-term rates

If you think a mild rebound in inflation would influence the pace of rate hikes in 2018, then it is really 3-7 year bonds that are most vulnerable. That is how I am going to be thinking about upcoming data releases.

For example, take the wage figures that came out of the payroll report from Friday. I warned that average hourly earnings would probably come in deceptively high in the September report. The Bureau of Labor Statistics calculates wages based on anyone who was paid during the survey week. Salaried employees count as working a full slate even if they didn't actually come to work, whereas hourly employees would not. So a Houston-area accountant would have counted in this survey, but an hourly Wal-Mart cashier wouldn't. Obviously that skews the "average" wage. Hence I wouldn't put any weight on the +0.5% pop in average hourly earnings in September.

However, the prior month revisions are meaningful. Both July and August were revised up slightly. Nothing to get too excited about (August went from +0.1% to +0.2%), but it may be a sign that what looked like an actual downshift in wages was just a survey problem.

Even this mild upward revision to wage growth is meaningful. If wage growth slowed to a problematically low level, maybe they'd slow the pace of hikes. These small revisions keep us out of that "problematic" territory. So the Fed is full steam ahead.

What about actual inflation?

Later this week we will get the Consumer Price Index report. While not the Fed's preferred inflation metric, the market will certainly be paying attention. My view is that you should think about each inflation print in terms of the next 2-3 hikes, not the December hike. I don't think any reasonable number will stop the Fed from hiking again at the end of this year.

However there is a number that would cause the Fed to slow down in 2018. Of course, that's all dependent on who is Chair, but if that person is roughly aligned with the current Fed, I'd say Core PCE needs to stay at or above 1.5% to keep hikes coming. Whereas I think even 1.2% would be enough to hike in just December.

The upward revision to wages may be a sign that we will also get small upward revisions to inflation. That could cause a major shift in how people are thinking about the Fed in 2018, even if a continuity candidate winds up as Fed Chair.

I continue to like a USD long and a 5-7 year Treasury short

Both trades took a mild hit the last couple days, but I still like both. USD sold off mainly on the relief rally in Europe, but my main thesis was all about quicker Fed pace plus optionality if a hawkish candidate becomes Fed Chair. The Treasury short is admittedly crowded. However the price action seems balanced enough such that I'm not real worried about a squeeze. I think the 5-7 year part of the curve has the best risk-reward given a more hawkish Fed stance. More adventurous traders could put on a more levered trade in 2-year bonds, but I think the 5-7 year part has more outs and doesn't require as much leverage to make for a solid trade.

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