The Key Things To Look For In Today's FOMC Minutes

Looking at today"s scheduled release of Minutes from the September FOMC meeting (which at least according to one trader will be the "start of the market changeover process"), RanSquawk reminds us that the Federal Open Market Committee stood pat at the meeting, as expected. The Committee also announced that it would begin to shrink the size of its balance sheet in October, as expected, with the process falling in line with a previously disclosed detailed plan. Additionally, the summary of economic projections saw the FOMC trim its "longer run" Federal Funds target rate expectations, while the nearer-term core PCE projections were also trimmed, and GDP estimates were raised.

With that in mind, here is what Wall Street expects from the minutes to be released at 2pm ET today, courtesy of RanSquawk.

RBC suggests that the “debate surrounding the drop back in core inflation this year was particularly lively. The bounce-back in CPI inflation appears to have convinced the centrists that the earlier weakness was partly due to transitory factors, whereas the doves are still worried about potential structural factors or lingering cyclical slack.”  This was reflected by the fact that 12 of 16 officials that submitted projections still anticipated at least one more rate hike this year.

In the press conference that followed the decision Fed Chair Janet Yellen noted that “low inflation this year, despite a substantial improvement in labour market conditions, created uncertainty for monetary policymakers.” Although she did note that low inflation may be “transitory” and as a result it does not negate the need for gradual policy tightening.

Since the decision, Fed rhetoric has increasingly cited structural headwinds for inflation, while some of the more dovish members have continued to highlight the need for a pickup in inflation before they are willing to vote for a hike (including 2017 voter Robert Kaplan, who was previously of a hawkish disposition).

Markets still lag the FOMC in terms of rate hike projections, pricing circa two 25bps hikes through the end of November 2018, will the median FOMC projection looks for four 25bps hikes through the end of 2018.

Focus has switched to the race to be the next FOMC Chair, with four notable frontrunners in contention at present (a primer is available here), with Barclays outlining their perceived monetary policy stances in the image below.

Deutsche Bank provided the handy crib sheet seen below, summarising what a victory for each respective front runner would mean across for Fed policy.

What The Bank Desks Are Saying: –

Barclays: Given the outcome of the September FOMC meeting, in which only four participants indicated no further rate hikes this year was appropriate, we expect the FOMC minutes to show that most participants see recent disinflation as largely driven by transitory factors. We expect the discussion to remain focused on inflation and its shortfall relative to what the Fed’s Phillips curve framework would suggest, but we believe most participants will view the unexplained weakness as dissipating over time, thereby permitting a return of inflation to the target. The minutes may indicate that members preferred to reduce their estimate of the longrun neutral rate of interest as opposed to halting the normalization process. Elsewhere, we expect the minutes to include discussion as to why it was time to begin balance sheet runoff and how members see the balance of risks to the outlook for the US economy.

Deutsche Bank: Inflation will likely be a heavily debated topic, but given the recent Fedspeak, it appears that most voting members are looking through some of the recent weakness and prefer to continue the “gradual” removal of monetary accommodation.

HSBC: The FOMC announced in September that it would initiate its balance sheet normalisation programme in October, as described in the June 2017 addendum to the committee’s “Policy Nomalization Principles and Plans”. The operational parameters of the programme had been communicated to financial markets in advance and did not come as a surprise. We will look through the September minutes to see if there was any further discussion regarding the expected impact of balance sheet disinvestment. Inflation was likely a major topic of discussion at the September FOMC meeting. In the conference following the meeting and in a subsequent speech, Fed Chair Janet Yellen noted that low inflation this year, despite a substantial improvement in labour market conditions, created uncertainty for monetary policymakers. In the end, the Chair concluded that low inflation may be “transitory” and that it had not persisted long enough to negate the need for gradual policy tightening. However, some other FOMC policymakers have indicated a preference for allowing inflation to pick up before raising policy interest rates any further. The FOMC minutes are likely to show a range of views on inflation, financial stability, and the implications for policy.

Morgan Stanley: The FOMC minutes are often revised nearly all the way up until the release and can be edited to stress important points. We look for the Fed to resume its gradual path of rate hikes again in December.

Goldman's Clients Are Confused About Inflation: Here's Why

In his latest weekly kickstart, Goldman"s chief equity strategist David Kostin (who has maintained his year end S&P price target of 2,400 of -3% from current levels), says that the one topic most confusing (and important) to Goldman"s clients in the past week, was what happens to inflation next: "the US inflation outlook and its equity investment implications were key topics of discussion during recent visits with clients in Boston, Chicago, and New York. Core Personal Consumption Expenditures (PCE) data released [on Friday] showed a year/year inflation rate of 1.5% in 2Q. Wednesday’s Fed statement acknowledged that inflation was running “below” its 2% target, a revision from the “somewhat below” description used previously."

Kostin points out that while fixed income managers have always had to take a view on inflation, now that the Fed"s "reaction function", to use an IMF-ism, is entirely driven by concurrent and future inflation expectations, and as a result "equity investors must also take a stand and position portfolios accordingly. The anticipated path of inflation is an important determinant of the trajectory of Fed policy tightening. Bond yields will be affected in turn via expectations of future hikes and the term premium, and stock prices by extension will be influenced through the equity risk premium."

As for why Goldman"s clients are "confused", Kostin points out something we have discussed on several occasions recently: depending on what indicators one uses, inflation can be expected to rise, drop, or stay the same: 

"Looking forward, will the rate of inflation in 2018: (a) decelerate, (b) accelerate, or (c) stay about the same? The answer depends on the information source. Treasury Inflation Protected Securities (TIPS) imply inflation will decelerate; Goldman Sachs economics forecasts an acceleration (to 1.9%); while corporate pricing varies both across and within industries. For example, branded pharmaceutical prices are rising by 9% (offset partially by rebates) while generic drug prices are falling by 9%."

Some more details behind these perplexing numbers:

• The TIPS market implies inflation will average 1.3% annually during the next two years and 1.8% annually through 2027. As a result, fed funds futures currently imply just a 50% probability the FOMC will hike once more by year-end 2017 and expect just two hikes in total through the end of 2018.


• In contrast, Goldman Sachs economics believes underlying inflation will trend towards the Fed’s 2% objective. Specifically, our economists forecast core PCE will reach 1.6% by year-end 2017 and climb to 1.9% by the end of 2018. The trend in inflation will prompt steady policy tightening starting with a 25 bp hike in December followed by four hikes in each of 2018 and 2019 that will lift the funds rate to 2.4% and 3.4%, respectively.
  

In a humorous swipe at his own economics team, Kostin writes that "we have met no equity investors who subscribe to this forecast."  So much for Goldman"s once legendary ability to shape and sway investor sentiment. 

Then there are the government"s own measurements of inflation:

The components of measured PCE inflation are split 25% in Goods and 75% in Services. The goods category has shown consistent deflation for several years and our economics team forecasts that trend will persist in 2017 and 2018 (see Exhibit 5). A leading driver of disinflation has been the Video, Audio, and Computer category where prices dropped by 5% in 2015, by 10% in 2016, are declining at an average pace of 7% YTD, and we forecast will fall by 4% and 7% in 2017 and 2018, respectively.

However, Services PCE inflation is the more important category and the trends are mixed, which is why market participants have such divergent views on the underlying pace of inflation. The four largest Services categories account for 65% of core PCE inflation and include Medical Services (19%), Housing (19%), and Financial Services (9%).

Separately, what inflation information can investors glean from corporations and the equity market?

Confirming what the latest Census data showed last week, namely that asking rents across the nations just fresh all time highs...

... Goldman flags that apartment owners suggest rental inflation remains above the Fed’s overall inflation target of 2%. Six public apartment REITs own 357,000 multifamily units (AVB, ESS, EQR, AIV, CPT, UDR). Same-store rental growth in REITs has been a leading indicator of the change in owner’s equivalent rents (OER) in the government’s housing inflation measure (Ex. 3).

Average rental growth for these REITs equaled 5.6% in 2015 and 4.8% in 2016. More notably, Kostin writes that "because analysts forecast rental growth will slow to 2.9% this year and 3.1% in 2018, housing inflation represents a fading tailwind to core PCE inflation." To be sure that would be great news to a middle class that has never had to pay more out of pocket for the monthly rent...

On the other hand, a conflicting picture emerges from the deflation observed in certain parts of Financial Services. The Investment Company Institute (ICI) reports that average fees for active equity management have dropped from 108 bp in 1996 to 82 bp today, although we doubt that one can seriously claim with a straight face that there is delfation because millionaire LPs are paying not 2 and 20 any more but 1 and 10 or less.

Meanwhile, inflation and interest rates affect equity valuations. The gap between the S&P 500 earnings yield and ten-year Treasury yield represents a short-hand measure of the equity risk premium. The gap in the “Fed Model” currently equals 320 bp (5.5% less 2.3%), below the average of the past 10 years (460 bp) but above the average of the past 40 years (250 bp).

Which brings us to Goldman"s summary: based on all the initial assumptions, Kostin"s S&P 500 price target of 2400 suggests the yield gap will narrow to 300 bp by the end of 2017. The yield gap has narrowed by 300 bp since February 2009.

Our economists forecast the Treasury yield will rise by 50 bp to 2.75% at year-end. Higher interest rates coupled with a slightly lower risk premium is consistent with our S&P 500 year-end target of 2400 (-3%). However, if inflation remains subdued and the bond yield hovers near the current level, the Fed Model would imply a S&P 500 fair value of 2650 (+7%) (see Exhibit 4).

Finally, and going back to the original underlying confusion, Goldman concludes that "whether they are bullish, bearish, or neutral, every equity investor is implicitly or explicitly taking a view on the inflation outlook." That... or simply taking a view that no matter how this latest inflation vs deflation debate plays out, the Fed and central banks will always be there, ready to bail out the wealth effect that they have so carefully cultivated over the past 9 years with $15 trillion in liquidity injections, and which nobody seriously thinks they will let go to waste just to make a statement that the market can levitate on its own without constant central bank manipulation.

RBC Explains The Market's Sudden Regime Shift

There"s a clear change in the air as growth stocks are pummeled, bond yields spike, and central bankers wax hawkish.

Here is RBC"s head of cross-asset strategy Charlie McElligott to explain what"s happening...

The selloff in USTs & duration / concurrent ‘bear steepening’ is further-set to act as an ‘accelerant’ on both my equities ‘rotation’ call and the unwind of the broad ‘slow-flation’ narrative overshoot and its key trade expressions.

And just to get this question out of the way: as we have mentioned many times in the past 5 years, equities can handle higher nominal rates to a certain extent before becoming ‘too violent,’ at which point we’d have to become concerned about the potential for risk-parity deleveraging flows across what have been recently ‘low vol’ assets, which has allowed for greater leverage deployment on said ‘risk allocations’ which would then be taken-down.  This could be exacerbated by recent ‘longs’ into USTs tapping, as some faster money late-comers get stung here.  However in the ‘now,’ the recently higher realized vols in rates isn’t bleeding into a gamma repricing yet (Jenny Xiao—“It’s pretty incredible that a 15bps selloff couldn’t muster anything more than a 1 annual bpvol move in gamma”).  And FWIW too, with ‘real rates’ chopping along here and unable to break meaningful higher (= “tighter” financial conditions), I don’t expect this to be a headwind for awhile either.

Currently, it’s the same ‘higher nominal rates’ catalysts which I’ve been noting that are continuing to push yields around.  Hawkish rhetoric from global central bankers (most recently BoE’s Haldane this morning stating they “need to look seriously at raising rates”) is certainly a large dynamic right now, catching the ‘slow-flation’ crowd--who had recently piled-into duration and flatteners on account of slowing data trajectory and what had been a collapse in inflation expectations / inflation proxies—‘wrong way.’  More ‘higher rates’ right-sizing as the ‘narrative excess’ is corrected.

Further playing into my hands on the “slow-flation narrative & positioning overshoot” theme at the core of the equities factor-rotation trade I’ve been pushing are two key commodity inflation proxies reversing course:

Crude ‘capitulatory’ flows from ‘lazy OPEC longs’ seemingly reached peak ‘tap-out’ over the past 3 weeks (with net manager length at 11-month lows and all-time highs in ICE Brent spec shorts)….which allowed for a ‘stabilization’ off the 50dma and pivot ultimately higher.  Now it seems ‘less bad’ inventory data  is helping to fuel a modest squeeze higher, with WTI +7.7% in one week….although there are some notable ‘production decline wins’ worth-noting here too: our Energy equities team is highlighting that the ‘lower 48 states’ production saw the largest drop in 10 months, and has declined twice now this month.

And even more importantly from an ‘inflation expectations’ key price ‘sensitivity’ input, Qingdao Iron Ore pivoted MASSIVELY-HIGHER off the lows mid-month, as the Chinese ‘flinched’ on liquidity (3 weeks of powerful injections via OMOs and MLF beginning late May) began to ‘pay off’ in the form of a 16.8% rally in 10 sessions (and for the broad industrial metals complex as well).  And mind-you…this rally has continued despite the PBoC liquidity withdrawals of the past week, as money market rates in aggregate have moved lower. 

Take a look at said ‘easing’ of tighter financing conditions as per overnight SHIBOR over the past week alone…it’s like a steroid-shot for the global commodities complex: 

Bloomberg Global Commodities Index and Overnight SHIBOR:

Overnight SHIBOR and Qingdao Iron Ore:

In turn, look at the counter-trend move across inflation proxies—pivoting HIGHER / WIDER for the first time in months--everything from US 5y5y inflation fwds to breakevens to the aforementioned iron ore and crude:

It’s still the same story we’ve been grinding over for the past three years:

...the entire global macro trade continues to hinge on the perceived ‘binary’ direction of ‘inflation’ (‘reflation’ vs ‘disinflation’ debate)

...which then dictates everything from the rates ‘flatteners vs steepeners’ trade to US equities factor rotations (‘value’ and ‘size’ factors vs ‘momentum,’ ‘growth,’ ‘quality,’ and ‘anti-beta’) to CCCs vs high-grade in credit. 

Why?  Because every asset class in the post-GFC era now possesses a heightened sensitivity to ‘interest rates’ on account of ZIRP & QE monpol.

Four Reasons Central Banks Are Wrong To Fight Deflation

Authored by Jorg Guido Hulsmann via The Mises Institute,

The word “deflation” can be defined in various ways. According to the most widely accepted definition today, deflation is a sustained decrease of the price level. Older authors have often used the expression “deflation” to denote a decreasing money supply, and some contemporary authors use it to characterize a decrease of the inflation rate. All of these definitions are acceptable, depending on the purpose of the analysis. None of them, however, lends itself to justifying an artificial increase of the money supply.

The harmful character of deflation is today one of the sacred dogmas of monetary policy. The champions of the fight against deflation usually present six arguments to make their case. One, in their eyes it is a matter of historical experience that deflation has negative repercussions on aggregate production and, therefore, on the standard of living. To explain this presumed historical record, they hold, two, that deflation incites the market participants to postpone buying because they speculate on ever lower prices. Furthermore, they consider, three, that a declining price level makes it more difficult to service debts contracted at a higher price level in the past. These difficulties threaten to entail, four, a crisis within the banking industry and thus a dramatic curtailment of credit. Five, they claim that deflation in conjunction with “sticky prices” results in unemployment. And finally, six, they consider that deflation might reduce nominal interest rates to such an extent that a monetary policy of “cheap money,” to stimulate employment and production, would no longer be possible, because the interest rate cannot be decreased below zero.

However, theoretical and empirical evidence substantiating these claims is either weak or lacking altogether.

First, in historical fact, deflation has had no clear negative impact on aggregate production. Long-term decreases of the price level did not systematically correlate with lower growth rates than those that prevailed in comparable periods and/or countries with increasing price levels. Even if we focus on deflationary shocks emanating from the financial system, empirical evidence does not seem to warrant the general claim that deflation impairs long-run growth.

Second, it is true that unexpectedly strong deflation can incite people to postpone purchase decisions. However, this does not by any sort of necessity slow down aggregate production. Notice that, in the presence of deflationary tendencies, purchase decisions in general, and consumption in particular, does not come to a halt. For one thing, human beings act under the “constraint of the stomach.” Even the most neurotic misers, who cherish saving a penny above anything else, must make a minimum of purchases just to survive the next day. And all others—that is, the great majority of the population—will by and large buy just as many consumers’ goods as they would have bought in a nondeflationary environment. Even though they expect prices to decline ever further, they will buy goods and services at some point because they prefer enjoying these goods and services sooner rather than later (economists call this “time preference”). In actual fact, then, consumption will slow down only marginally in a deflationary environment. And this marginal reduction of consumer spending, far from impairing aggregate production, will rather tend to increase it. The simple fact is that all resources that are not used for consumption are saved; that is, they are available for investment and thus help to extend production in those areas that previously were not profitable enough to warrant investment.

Third, it is correct that deflation—especially unanticipated deflation—makes it more difficult to service debts contracted at a higher price level in the past. In the case of a massive deflation shock, widespread bankruptcy might result. Such consequences are certainly deplorable from the standpoint of the individual entrepreneurs and capitalists who own the firms, factories, and other productive assets when the deflationary shock hits. However, from the aggregate (social) point of view, it does not matter who controls the existing resources. What matters from this overall point of view is that resources remain intact and be used. Now the important point is that deflation does not destroy these resources physically. It merely diminishes their monetary value, which is why their present owners go bankrupt. Thus deflation by and large boils down to a redistribution of productive assets from old owners to new owners. The net impact on production is likely to be zero.

Fourth, it is true that deflation more or less directly threatens the banking industry, because deflation makes it more difficult for bank customers to repay their debts and because widespread business failures are likely to have a direct negative impact on the liquidity of banks. However, for the same reasons that we just discussed, while this might be devastating for some banks, it is not so for society as a whole. The crucial point is that bank credit does not create resources; it channels existing resources into other businesses than those which would have used them if these credits had not existed. It follows that a curtailment of bank credit does not destroy any resources; it simply entails a different employment of human beings and of the available land, factories, streets, and so on.

In the light of the preceding considerations it appears that the problems entailed by deflation are much less formidable than they are in the opinion of present-day monetary authorities.

Deflation certainly has much disruptive potential. However it mainly threatens institutions that are responsible for inflationary increases of the money supply. It reduces the wealth of fractional-reserve banks, and their customers-debt-ridden governments, entrepreneurs, and consumers. But as we have argued, such destruction liberates the underlying physical resources for new employment. The destruction entailed by deflation is therefore often “creative destruction” in the Schumpeterian sense.

Goldman: The Fed Will Hike This Week, But Here Are "The Two Most Interesting Questions"

On Wedensday the FOMC will hike rates by another 25 bps - an event which the Fed Funds market prices in with near virtual certainty, while Goldman calls the rate increase "extremely likely" - and only a "tail" event like an extremely weak CPI report on Wednesday morning, hours ahead of the Fed announcement, has any chance of preventing  this outcome. So with the next rate hike virtually inevitable, questions are focused on not only the Fed"s exit strategy for balance sheet normalization and what the "dots" or funds rate path will look like, but how the Fed squares rising rates with the recent string of inflation misses.

As Goldman"s Jan Hatzius writes, data since the March meeting has sharpened the dilemma that both sides of the mandate are sending increasingly different signals about the urgency of further tightening. "The unemployment rate has fallen 0.4pp since the March meeting and our current activity indicator and real GDP estimates signal that above-trend output growth will produce further labor market improvement. But the year-over-year core PCE inflation is now 0.2pp lower than at the March meeting."

While conceding that a hike is guaranteed, Goldman notes that two issues should make this meeting particularly interesting.

• First, will Fed officials alter their policy views in response to the increasingly different signals that both sides of the mandate are sending about the urgency of further tightening?


• Second, will the press conference provide some clarity on what the next tightening step following the June hike will be?

As a result of the weaker than expected inflationary prints, Goldman believes the recent data do not call for a major change in the Fed’s policy outlook. While Hatzius expects the FOMC to lower its estimate of the structural unemployment rate by a tenth next week, even with that assumption, the new data have broadly offsetting implications for the policy outlook in standard Taylor rules. Highlighting recent Fed communications, Goldman believes the Fed will follow "a balanced approach in dealing with the dilemma."

It also means that the statement will likely characterize economic activity as "picking up but recognize that inflation slowed since earlier this year." On the other side, Goldman sees a signal of heightened inflation concern as the main dovish risk and an upgrade of the balance of risks as the main hawkish risk.

Previewing the Fed"s Summary of Economic Projections (SEP), expect a modest downgrade to GDP growth for this year, coupled with declines in the unemployment rate to 4.3% this year and 4.2% next year. At the same time, projections for core PCE inflation are likely to fall to 1.8% this year and probably 1.9% in 2018. Reflecting the offsetting data news, expect the “dot plot” to show relatively stable funds rate projections.

On to Yellen"s press conference, which should provide some clarity on whether the next tightening step after June will be balance sheet normalization or a third funds rate hike. Goldman, as well as much of the street, expects balance sheet adjustment to start in September and the Fed hiking cycle to resume in December. With respect to the balance sheet, the Fed will initially cap the amounts of securities that can run off in any given month of $10bn for UST and $5 billion for MBS, that rise over four quarters to caps of $40 billion and $20 billion, respectively.

* * *

Some more details. Here is Goldman on the current economic situation, and how it will be (mis)read by the Fed.

Another rate increase from the FOMC next week is now extremely likely. Only an extremely weak CPI report on Wednesday morning or another tail event would prevent the committee from hiking. The committee probably also still expects a total of three hikes and the start of balance sheet adjustment in 2017.  

But two issues should make this meeting particularly interesting.

• First, will Fed officials alter their policy views in response to the increasingly different signals that both sides of the mandate are sending about the urgency of further tightening? We expect both lower unemployment and inflation paths in the Summary of Economic Projections (SEP) but relatively stable funds rate projections as the labor market and inflation data surprises, in the words of San Francisco Fed President John Williams, roughly “wash out”.


• Second, will the press conference provide some clarity on what the next tightening step following the June hike will be? We expect a detailed balance sheet announcement in September and a third rate hike in December but the reverse order is also plausible.

We believe both labor market and growth data in hand make a strong case for a rate increase next week and to remain upbeat about the outlook. Both our current activity indicator —down from 4.0% in February to 3.0% in May— and real GDP estimates—up from 1.2% in Q1 to our 2.3% Q2 tracking estimate—signal above-trend output growth (Exhibit 1, left panel). The medium-term growth outlook is also decent despite the lower odds of significant fiscal easing. The more important reason why growth should stay firm is the easing in financial conditions. Our FCI is at the easiest level since early 2015 and has  eased by 50bp since the March FOMC meeting. As the right panel of Exhibit 1 shows, the expected effect on GDP growth from changes in financial conditions for 2018H1 is now more than 0.3pp higher than at the March meeting.

Spare capacity continues to diminish, and the unemployment rate has fallen 0.4pp since the March meeting to a 16-year low of 4.3% (Exhibit 2, left panel). While nonfarm payroll growth has recently softened a bit, the average monthly gain of 162k year-to-date is still double our 85k estimate of the “breakeven” rate needed to keep the unemployment rate unchanged. While slack measures have declined more than expected, weak inflation data in April and especially March pushed the year-over-year pace of core PCE inflation 0.2pp lower than at the March Meeting (Exhibit 2, right panel). Both a Taylor rule framework and recent Fed communications suggest that the new data have broadly offsetting implications for the policy outlook.

Exhibit 3 translates the labor market and inflation surprises into changes in the appropriate funds rate via a standard Taylor rule framework. The original Taylor rule implies that a 0.2pp decline in inflation lowers the appropriate funds rate by 30bp while a 0.4pp reduction in the unemployment rate raises the appropriate funds rate by 40bp. In a modified “Taylor 1999” rule, the impact of employment is doubled  relative to the original version. This means that the impact of a 0.4pp reduction in unemployment rises from 40bp to 80bp. The left panel of Exhibit 3 thus suggests a 10-50bps higher appropriate funds rate.

But the decline in the unemployment rate may overstate the surprise if some decline was expected. Similarly, the decline in inflation can understate the surprise if some firming was expected. The middle panel of Exhibit 3 therefore compares actual unemployment and inflation moves to our expectations as of the March meeting and has less hawkish implications than the left panel. Finally, a lower estimate of the structural unemployment rate also reduces the decline in the unemployment rate gap. On net, we estimate the new data—combined with a 0.1pp downgrade of the structural rate—would have an exactly neutral effect in the Taylor 1999 rule that Chair Yellen has discussed repeatedly.

What has the Fed communicated in recent week.

Recent Fed communication suggests that the committee will also consider surprises on both sides of the mandate as roughly offsetting. As Exhibit 4 shows, several Fed officials have emphasized that there is now little labor market slack left. The inflation language in the May minutes was quite balanced as ”most participants viewed the recent softer inflation data as primarily reflecting transitory factors, but a few expressed concern that progress toward the Committee’s objective may have slowed.”

Since the May meeting, inflation for April has been weak for core CPI (0.9% annualized) but roughly in line for core PCE (1.8% annualized). The April inflation reports and recent comments by some Fed officials including Chicago Fed President Evans suggest that additional signs of heightened inflation vigilance are a dovish risk relative to our expectations. Governor Powell said that “there are good reasons to expect that inflation will resume its gradual rise but it is important to demonstrate a strong commitment to achieving our symmetric 2 percent objective” while Philadelphia Fed president Harker said that “we’re still on track for inflation” and that he is “looking at the trend.”

In light of these developments we expect to the committee to make three key changes to its post-meeting statement next week. First, we expect the committee to replace “consumer prices declined in March” by “inflation slowed since earlier this year” reflecting the core CPI miss in April. Second, we expect the statement to upgrade the growth assessment with verbiage along the lines of economic activity “appears  to have picked up” and to note that household spending “appears to be accelerating”. Third, we expect the committee to tacitly signal balance sheet run-off later this year by adding the qualifier “for the time being” to the description of its existing reinvestment policy.

A signal of heightened inflation concerns is the key dovish risk. The committee may, for instance, drop the “somewhat” from “inflation continued to run somewhat below 2 percent”. In terms of hawkish risks, an upgrade of the balance of risks is possible through the removal of “roughly”, reflecting improved domestic and international growth. We also expect Minneapolis Fed President Neel Kaskhkari to dissent as he recently described the move of inflation in “the wrong direction” as “concerning”.

What about the revised Summary of Economic Projections

The June FOMC meeting will include the quarterly update to the SEP. We expect significant changes to the unemployment and inflation projections but relatively stable funds rate forecasts, reflecting offsetting job market and inflation news.

1. Slightly lower GDP growth: Assuming our Q2 GDP tracking 1. estimate of 2.3%, GDP growth will average 1.7% annualized over the first half of 2017, so it would take a 2.4% growth rate in H2 to meet the policymakers March SEP estimate of 2.1%. We expect the 2017 median to fall to 2.0%, with risk tilted to the upside. We forecast that the median estimates for GDP growth in 2018-2019 and in the longer-run will remain unchanged.

2. Lower unemployment rate. The unemployment rate fell 0.4pp since the March meeting when the median unemployment rate projection was 4.5% for the forecasting horizon. We expect the median to fall to 4.3% in 2017, 4.2% in 2018 (with risks of 4.3%) and 4.3% in 2019. The estimate of the structural unemployment rate is quite likely to fall further from 4.7% to 4.6% in response to large declines in the actual rate and recent news on prices and wages. The decline in NAIRU would limit somewhat the projected employment overshoot but is a close call.

3. Lower core PCE inflation. We expect the 2017 median core PCE projection to fall to 1.8% and perhaps 1.7%. To reach 1.8% by year-end, monthly core PCE inflation would need to accelerate to an annualized rate of at least 1.9%. We believe the 2018 forecast also drops a tenth to 1.9% as some members now likely feel a bit less confident about the inflation outlook.

 

4. Relatively stable median dots. We expect most participants, especially those in the center of the committee, to stick to their March dots reflecting offsetting inflation and unemployment moves. We also believe that the committee probably still expects a total of three hikes in 2017. The retirement of Tarullo lowers the numbers of participants to 16 from 17 in March and is likely to move up the median 2018 dot from to 3 to 3-1/2 hikes next year. As the FOMC is extremely likely to hike for the second time this year next week, we expect that the 2017 one-hikers will shift to projecting 2 hikes in total for this year. We also assume that the new Atlanta Fed President Bostic votes like his predecessor Lockhart and that the new Richmond Fed President Mullinix lowers the Richmond Fed dots a bit.

Finally, how will the Fed "renornalize" its Balance Sheet.

We expect to get some more clarity next week on balance sheet runoff at the press conference and possibly also with an augmented Policy Normalization Principles and Plan. We continue to look for normalization to be announced in September. Here we update our projections for balance sheet runoff:

1. Start Date: We expect a detailed announcement in September  but would not be surprised if it came in December as guidance has been mixed. The May minutes suggest a start in September as an announcement at the December meeting would leave little time to “begin reducing the Federal Reserve’s Securities this year”. But guidance on the start of runoff by Governor Brainard after the funds rate gets midway to its long-run value of 3.0% and by New York Fed President Dudley “sometime later this year or next year” supports December. We think that announcing the start of balance sheet adjustment in September and keeping open the option of foregoing the third 2017 hike is the more prudent course of action given the mixed recent data and the potential for fiscal turmoil in Washington in Q3 related to the need for a debt ceiling hike and an extension of spending authority. We think the detailed announcement in September will be followed by the actual start of runoff of assets in October.

2. Process for phasing out reinvestment: The May minutes signaled that the committee will preannounce a schedule of gradually increasing caps to limit the amounts of securities that can run off in any given month. Our assumption is that that the initial caps are $10 billion a month for UST and $5 billion a month for MBS. The caps would rise each quarter by $10 billion and $5 billion to $40 billion and $20 billion respectively. Exhibit 7 shows that caps allow for a gradual runoff and deal with the variability associated with MBS prepayment and the irregular monthly schedule of maturing assets. The caps will remain in place after the phase-in but then only bind in roughly a third of the months for Treasuries until mid-2020 when the balance sheet reaches its projected terminal size.

3. Terminal size: We expect the Fed to maintain a balance sheet that 3. is relatively large by historical standards given several advantages of a large balance sheet related to monetary policy implementation and regulatory needs. Our calculations suggest that a monetary policy implementation through a floor system implies a terminal size of roughly 15.5% of GDP. While support from the New York Fed for the large balance scenario makes this outcome quite likely, there is no urgency yet in deciding on the size and on the composition of the terminal balance sheet.

Goldman"s conclusion:

A third consecutive quarterly rate increase next week is now extremely likely, in our view. Only an extremely weak CPI report on Wednesday morning or another tail event would prevent the committee from hiking. The data news since March has sharpened the dual mandate dilemma policymakers are facing. Our own view is that the inflation and unemployment surprises have been roughly offsetting but that the range of outcomes has widened somewhat. While the inflation outlook is uncertain, the dilemma will most likely resolve itself as inflation gradually accelerates. We therefore expect policymakers to remain focused on tightening mostly with the funds rate but also soon with the balance sheet tool.

And while we agree with Goldman in theory, one thing the bank has omitted in principle is that according to the Fed"s own commercial loan data, the US economy may be just 4-6 weeks away from posting its first negative C&I loan print since the financial crisis: a virtually failsafe indication of an imminent (or concurrent) recession.

Which means that, as we explained yesterday, the Fed is about to hike in not only a disinflationary phase of the economic cycle (which is largely a function of the slowdown in the Chinese commoity bubble, and the collapse in the Chinese credit impulse), but also into what may be an outright recession in the US. If so, look for the yield curve to do what it has always done in the past after the Fed hikes rates: flatten, then flatten some more, than go horizontal, and eventually invert.

Central Bank Hubris Bubbles To The Surface

Authored by Mike Shedlock via MishTalk.com,

Albert Edwards at Societe General commented yesterday on Central Bank Hubris, deflation, and the flattening of the US yield curve. Here are some email snips.

How’s this for Grade 1 central bank hubris?

Peter Praet, the ECB’s chief economist said in a recent interview that, “Since the crisis, we have had serious concerns about deflationary risks on several occasions in the euro area, but now we can say they have disappeared.”

Really? Has he seen the chart above, which shows core CPI in the Eurozone heading sharply lower and now approaching its all-time low seen at the start of 2015! Not only that, but Eurozone inflation expectations are also declining again, after surging in the aftermath of Donald Trump’s election. To be fair, Praet was focusing on the rise in headline inflation in the Eurozone, which touched 2% in February before dropping back in March to 1½%. After some 18 months bobbing around the zero mark, I can understand why central bankers might be heaving a sigh of relief, but for them to take credit for a recovery in headline inflation is totally disingenuous given it has been entirely driven by a recovery in the oil price.

Similarly, Janet Yellen was quoted saying the Fed is “doing pretty well” in meeting its congressionally mandated goals of low and stable inflation and a full-strength labor market. It’s this sort of comment that has led Marc Faber to want to short central bankers, the only way being to buy gold. The increasing volume of central bank hubris may even explain the recent breakout of gold to the upside!

It is not just eurozone inflation expectations that seem to be in retreat. The same thing is happening in the US too (see chart below). I am always surprised how dominated 10y inflation expectations are by short-term movements in the oil price and headline inflation, but it was noticeable just how rapidly inflation expectations ran up in the wake of Trump’s election – way in advance of what might have been expected by the bounce in the oil price.

One might have thought the surge in the oil price from its trough some 12-18 months ago might have had more impact on wage inflation, but so far that does not seem to be the case.

Despite the euphoria in the markets about the “reflation trade”, survey inflation expectations have continued to drift downwards. One thing is certain: for central banks to call victory over deflation may prove very premature indeed. Nemesis awaits.

Reflation Trade Is Over

The reflation trade is over. It is fitting central banks now brag about oil-related and Trump-related phenomena over which they had zero control.

What The Jobs Report DIDN’T Tell You Last Week

Ever since the gold report was published, the gold price moved up. This caught several investors by surprise, as some of them even continued to dump gold, scared by what appeared to be a good jobs report.

‘Appeared to be’, because?

Yes, 227,000 new jobs were created, and we can’t deny that’s a positive evolution. However, the increased job number is also the only positive thing in the jobs report, and there are two other issues that haven’t really been highlighted.

Two issues that could, and probably will, have an impact on the interest rate decisions later this year.

First of all, the unemployment rate in the USA actually increased from 4.7% to 4.8%, despite the job growth.

How is that possible?

Simply put, due to the way the Bureau of Labour Statistics is gathering its data, almost 700,000 people have been ‘removed’ from the civilian population. The total size of the civilian population is rebalanced on a yearly basis, in January.

Source: Bureau of Labor Statistics

The smaller size of the civilian population caused the labor force participation rate to increase by 0.2%, and this by itself caused the unemployment rate to increase as well, despite the job creation number.

And as the unemployment rate is one of the key factors the Federal Reserve is looking at to determine whether or not a rate hike is appropriate, this small increase could have an impact on the decision making process. And keep in mind this is the second consecutive increase in the unemployment rate as the December unemployment rate also came in higher than the unemployment rate in November (and this did not include any population rebalancing exercise).

But perhaps even more important is the extremely disappointing update on the average hourly earnings (‘AHE’). The AHE increase fell to just 0.1% in January on a month/month comparison, but the real catch is in the details.

Exactly because the 0.1% increase is focusing on a monthly update, the revision of the wage increase in December is actually telling you something more serious is going on. The December wages have been revised down by 0.2%, so if that would NOT have happened, the average hourly wage would have DECREASED in January.

Source: tradingeconomics.com

And that’s a horrible conclusion, considering the official inflation estimates are currently hovering at around 2.3-2.5% by the end of 2017, it’s pretty easy to see and understand the inflation will eat a lot of the wealth of the lower income class and middle class people away. Indeed, let’s have a look at the expected five year forward inflation rate, as expected by the Federal Reserve:

Source: St Louis Fed

After all, the salaries are remaining relatively stable, whilst the inflation rate is eating away 2% of the families’ purchasing power. You don’t have to be a genius to see this could go terribly wrong as a declining purchasing power will reduce the so-called  ‘disposable income’, causing the demand for non-essential goods to increase. We aren’t just ‘inventing’ this. Just have a look at the next chart which shows you the consumer confidence level in the USA.

Source: tradingeconomics.com

Indeed, despite the job growth in January, the consumer confidence level was decreasing and this should tell you the common man in the street doesn’t feel too confident about the ‘job growth’ numbers and the economic prospects for the middle class man.

The numbers don’t lie, and even though the Bureau of Labour Statistics was proud to announce yet another increase in the job numbers, the data that wasn’t shouted from the rooftops is far more important. The US Consumer Confidence is decreasing, and the wages are stalling. This means inflation is eating away the people’s purchase power ànd savings.

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Pssst... Wanna See The Best-Looking Chart In The World?

Submitted by Kevin Muir via The Macro Tourist blog,

Happy Groundhog day! Instead of writing about yet another macro economic topic, I am going to break with tradition, and just present what I think could be the best looking chart in the whole world.

Without further ado, I present Cotton:

And in case you think you might have missed the move, scale back and have a look at the longer term picture:

I know just enough about the fundamentals of various “soft commodities” to get myself into some serious trouble. I won’t insult you with any sort of attempt to explain the recent price action. I don’t have a clue, but it sure seems bullish.

Yet I remind you that for too long, many of these “soft commodities” have been overlooked. Decades of persistent disinflation will do that.

But what if the trend has finally turned? What if the next great bull market will not be in stocks, or bonds, but “soft commodities?” Remember, nothing offers better opportunities than “Shit no one trades”.

Sometimes you need to find new territory. Spread your wings. Trade different stuff. Venture to the other side of the road… Much like this other Canadian groundhog did almost a decade ago at a different F1 race.