Fed's Kashkari Says "Stock Prices Appear Somewhat Elevated", Explains "What Might Be Wrong"

This morning, Minneapolis Fed Chairman Neel Kashkari penned an essay "Why I Voted to Keep Rates Steady" in which the former Goldmanite says that while core inflation “seems to be moving up somewhat, it is doing so slowly, if at all.”  He adds that “financial markets are guessing about what fiscal and regulatory actions the new Congress and the Trump administration will enact. We don’t know what those will be, so I don’t think we should put too much weight on these recent market moves yet."

Repeating a on often heard lament about the lack of rising wages, Kashkari points out that “the cost of labor isn’t showing signs of building inflationary pressures that are ready to take off and push inflation above the Fed’s target” and adds that “it seems unlikely that the United States will experience a surge of inflation while the rest of the developed world suffers from low inflation."

Further complicating the analysis of labor market slack, Kashkari writes that “the U-6 measure suggests that there may still be additional workers who might re-enter the labor force if the job market remains healthy” even though “the job market has improved substantially, and we are approaching maximum employment. But we aren’t sure if we have yet reached it. We may not have.”

Admitting that a core analysis presented by Zero Hedge many years ago, namely the participation rate of the prime working-age group, those aged 25-54, remains subdued, Kashkari writes that "I prefer to look at these measures by focusing on prime working-age adults. The next chart shows that in both measures, there appears to be more labor market slack than before the crisis."

So why is the Fed hiking again? We"ll leave that open to answers.

Stepping away from jobs, Kashkari gives a uniform justification for the Fed"s accomodative policy, stating that “this level of accommodation seems appropriate today given where we are relative to our dual mandate" and makes notable admission that “although stock prices, housing prices and especially some commercial real estate prices appear somewhat elevated, they do not appear to pose an immediate financial stability risk.” Naturally: after all the S&P is only over 200 points from the last time Yellen made the same warning about "stretched valuations." He does concede, however, that "over the long term, I continue to be very concerned about the systemic risks posed by the largest banks. Monetary policy most certainly cannot address the too-big-to-fail risk."

Moving to the level of the US Dollar, Kashkari says that “the strong dollar will likely continue to put some downward pressure on inflation. Overall, the global environment doesn’t seem to be sending a strong signal for a change in U.S. interest rates" and adds that “some argue that gradual rate increases are better than waiting and having to move aggressively. It isn’t clear to me that one path is obviously better than the other."

In an interesting tangent, Kashakri touches on the topic of Trump"s fiscal stimulus and says that "financial markets (both the stock and bond markets) seem to be pricing in some form of fiscal stimulus, perhaps tax cuts and/or increased spending, and perhaps a reduction in regulations from the new Administration and the new Congress. Those developments could be important to overall economic growth and, by extension, to the future path of monetary policy. But we have little information about what those new policies will actually be, what their magnitude will be and when they would take effect. Markets are guessing. Financial markets are good at some things, but, in my view, notoriously bad at forecasting political outcomes. They didn’t forecast Brexit. They didn’t forecast the results of the U.S. presidential election. I don’t have much confidence in their ability to forecast fiscal policy given how little we know today. So I am not yet incorporating the markets’ guesses about fiscal policy changes into my outlook for the economy."

Well, it"s safe to say that markets have little confident in the Fed"s ability to forecast much if anything so at least it"s mutual.

Finally, in one of the few honest admissions by a Fed president, Kashkari gives his take on "what might be wrong." This is what he says:

What might my analysis be missing? Some economic or financial shock could hit us, from within the U.S. economy or from outside. That is always true, and we need to be ready to respond if necessary. In addition, if we are surprised by higher inflation than we currently expect, we might need to raise rates more aggressively. Some argue that gradual rate increases are better than waiting and having to move aggressively. It isn’t clear to me that one path is obviously better than the other.

Some others argue that there may be nonlinearity in the inflationary process and that as inflation crosses the 2 percent threshold, it might suddenly accelerate. I see no evidence of this, especially considering that inflation expectations are well-anchored. Historically, U.S. inflation expectations have moved slowly, generally making large changes only in response to persistent changes in inflation trends. As long as the FOMC remains committed to acting decisively to defend against sustained deviations from our 2 percent target, I see the risk of a sudden change in inflation expectations as low.

Perhaps the better question for Neel and his peers is what happens if inflation, instead of spiking, tumbles now that China is actively tightening and no longer exporting inflation. We wonder if the Fed will be as committed to "act decisively" and cut rates and/or launch even more QE when the time comes to admit that the post-Trump sugar high is ending.