Thoughts on the Fed Ahead of Its Jackson Hole Symposium

There has been a noticeable lack of verbal guidance from Fed officials since the July 31 FOMC meeting. That makes FOMC minutes Wednesday and the Jackson Hole Symposium starting Thursday even more important. That said, we do not think the Fed will paint itself into another corner given continued firmness in the US data.

RECENT DEVELOPMENTS

Since the July 31 FOMC meeting, there have been very few Fed speakers. There were some reports that Fed Chair Powell had ordered a media blackout in response to the unprecedented verbal attacks on the Fed by President Trump. However, we note that St. Louis Fed President Bullard gave a television interview last week, while Daly and Quarles speak tomorrow. We also note that the summer and winter FOMC meetings are typically followed by fewer Fed speakers due to the holiday seasons.

FOMC minutes will be released Wednesday. The July 31 meeting saw the Fed undertake what Powell termed a “mid-cycle adjustment.” He downplayed the likelihood of an extended easing cycle then, disappointing Trump and the markets. Given the lack of Fed speakers since that decision, the FOMC minutes will likely take on greater importance in divining the Fed’s future rate path.

The lack of Fed verbal guidance ahead of the September 18 FOMC meeting also makes this week’s annual Jackson Hole Symposium more important. As of this writing, the agenda for the event named “Challenges for Monetary Policy” has not been released to the public yet. However, Bloomberg shows that Fed Chair Powell will speak Friday morning. Many are speculating that Powell will set the table for further easing with this speech. While the door has and should be left open to further action, we do not think Powell will paint the Fed into a corner again, not when the data suggest otherwise.

Indeed, the picture painted last week by the US data is a good one. Headline retail sales rose 0.7% m/m vs. 0.3% expected, while ex-autos rose 1.0% m/m vs. 0.4% expected. The so-called control group used for GDP calculations jumped 1.0% m/m vs. 0.4% expected. On top of that, the Empire and Philly Fed manufacturing surveys came in double what was expected.

Yet the US rates markets remain incredibly pessimistic. WIPR suggests 100% odds of a cut September 18, with 19% odds of a 50 bp cut then. Meanwhile, the Fed Funds futures strip shows 75 bp of easing nearly fully priced in for this year and nearly 50 bp more next year. This seems way to dovish a take given relative firmness in the US economy.

Powell admitted at that last FOMC meeting that the Fed is still trying to figure out how to react to global trade tensions.  As such, no one can really say what the Fed’s likely reaction function is right now with any degree of confidence. Markets clearly believe the Fed will bail Trump out again, but we are not so sure.  We not think that the Fed should reward bad trade and fiscal policies with rate cuts.

We’ve said it before and we’ll say it again: it simply makes no sense to risk a global trade war and recession to get the Fed to cut rates.  Easier monetary policy is a second-best response to a trade war.  What’s the first best?  End the trade war by eliminating the tariffs.

Bottom line: we believe the Fed will be reluctant to cut again so soon. Part of it is bad optics. President Trump continues to jawbone the Fed for lower rates. When he didn’t get the 50 bp cut that he wanted last month, Trump immediately ratcheted up trade tensions with another round of tariffs on China. While risks to the US economy have risen, we do not think the Fed wants to be seen as caving to Trump’s demands. The Fed is also correct to note that the impact of the tariffs has yet to be fully felt and so remains unknown.

 

A BRIEF HISTORY LESSON

Roger Guffey became Kansas City Fed President in 1976. In 1977, Guffey was invited to attend the Boston Fed’s conference that focused on “Key Issues in International Banking.” The Boston Fed’s event was part of a series that started back in 1969 by then-Boston Fed President Frank E. Morris. Due to its location on the East Coast, the Boston Fed was able to attract top academics from the Ivy League schools as well as senior policymakers.

Inspired by the Boston Fed’s event, Guffey and his research director Tom Davis helped launch the Kansas City Fed’s version a year later. They chose agriculture as the topic for his first Symposium. There were more than 200 attendees that focused on “World Agricultural Trade: The Potential for Growth.” It was held in Kansas City, but moved permanently to Jackson Hole in 1982. Along with western Missouri, Wyoming is in the Tenth Federal Reserve District.

Here are Guffey’s opening remarks from 1978: “(This) symposium on agricultural trade represents the first of what we hope will become an ongoing series of conferences on important economic issues. As we developed this program, our major objective was to consider an economic topic about which important public and private decisions will be made during the coming years. We also wanted the topic to be of significant concern not only to the Tenth Federal Reserve District served by this Bank, but also by the nation as a whole. A related objective was to bring together, in a suitable setting, a group of top-level decision makers from business, government and academia who have considerable expertise in the selected topic. In doing so, the symposium would serve as a vehicle for promoting public discussion and for exchanging ideas on the issue in question.”

 

ECONOMIC OUTLOOK

Overall, the US economy remains in solid shape. The Atlanta Fed’s GDPNow model is tracking 2.2% SAAR growth in Q3, up from 1.9% previously. This is above trend (~2%) and little changed from the preliminary 2.1% SAAR in Q2. Elsewhere, the NY Fed’s Nowcast model is tracking 1.8% SAAR growth in Q3, up from 1.6% previously.

Our broad US macro call may not be tested until the first week of September. August ISM manufacturing PMI will be reported that Tuesday, September 3. Because of the Labor Day holiday, ADP jobs will be reported that Thursday, followed by the BLS jobs report Friday, September 6. Consensus sees 168k vs. 164k in July. Weekly jobless claims to be reported this Thursday are for the BLS survey week for August and will be watched closely.

The firm labor market has helped sustain consumption this year. As the tariffs on Chinese imports drag on and even increased, it will get increasingly hard for US firms not to pass on the higher costs. If they do try to pass these on to consumers, then retail sales are likely to suffer. For now, consumption remains robust. August sales will be reported September 13.

We believe the Chicago Fed National Activity Index remains the best indicator to gauge US recession risks. The 3-month average was -0.26 in June, the best since February and well above the recessionary threshold of -0.70. The July reading will be reported next Monday, August 26. Note that a value of zero shows an economy growing at trend. Positive values represent above trend growth, while negative values represent below trend growth.

Inflation readings are rising. July core CPI rose 2.2% y/y, the highest since January and near the cycle highs. Core PCE rose 1.6% y/y in June, the highest since February, with July data due out August 30. University of Michigan survey showed inflation expectations ticking up in August. The 1-year rate is seen at 2.7% while the 5- to 10-year rate is seen at 2.6%. These expectations compare to the current 5- and 10-year TIPS breakeven inflation rates of 1.38% and 1.57%, respectively.

The 3-month to 10-year US curve has recovered to -28 bp currently after making a cycle low near -36 bp on August 14. We acknowledge that the impact of ongoing trade tensions is unpredictable and just the sort of exogenous shock that can tip an economy into recession. Using the shape of the US yield curve, the New York Fed calculates the probability of a US recession 12 months ahead. This fell to 31.5% in July from the cycle high of 33% in June. We expect this to rise significantly in August.

 

INVESTMENT OUTLOOK

For now, we are sticking with our broad macro calls. These include no US recession, a stronger dollar, higher equities, and a bearish steepening of US bond yields. These calls were coming to fruition last month, but the renewed US tariff threat led to a huge reset across all markets. We do not think the reset is over. Yet our calls hinge critically on our view that the trade wars will not trigger a US recession this year. This will be tested time and again this year and we expect heightened volatility across all markets in the coming months.

We remain dollar bulls. That the dollar continues to gain despite low US interest rates confirms our view that as bad as things may get in the US, the rest of the world looks even worse. Dollar bears should be asking whether the euro or sterling look that much better than the dollar. In that regard, EM will likely remain under severe pressure.  The less dovish than expected Fed, renewed trade tensions, and broad-based risk off sentiment have conspired to absolutely crush EM FX and equities.  These drivers are likely to be sustained well into Q4 and so we remain bearish on EM.

The data remain key. If the outlook changes and the US economy slows significantly or even goes into recession, then it would be a likely game-changer for the dollar. The Fed would have no choice but to adjust its expected rate path significantly lower. A recession would also blow out an already tenuous US fiscal trajectory, leading to potential ratings downgrades. Yet even then, the dollar may hold up better than expected since a US recession would likely be part of a global downturn.