Cumberland Advisors Market Commentary – The FOMC: Whatever (and However Long) It Takes

To no one’s surprise, the FOMC in its June meeting reaffirmed its 0–25 basis-point target for the federal funds rate. Markets did not react well, especially since the announcement came on the heels of a fairly downbeat assessment by Chairman Powell regarding the expected slow path for the recovery and the problems in the labor market. The statement itself had little useful information.

Market Commentary - Cumberland Advisors - The FOMC Whatever (and However Long) It Takes

It focused on the pandemic, the sharp decline in economic activity, and the risks posed to the economic outlook. The Committee indicated that it will keep rates at the present level until the economy has weathered the downturn and is on track to achieve the Committee’s statutory goals. It went on to indicate that it will use its tools to support the economy, and to that end it will continue to support the flow of credit and the smooth functioning of financial markets through continued asset purchases in support of accommodative financial conditions. These broad statements were remarkably short on specifics.

We received more substance during Chairman Powell’s post-meeting press conference, which had several themes. He focused on the pandemic as both a domestic and an international external shock that had essentially shut down the US economy almost overnight. He painted the Fed’s responsibility to cushion the blow by facilitating the smooth functioning of the economy, and he said that he viewed the current policies as appropriate at this time. He noted that the Fed has deployed its full array of tools to meet the challenge by quickly setting its policy rate to between zero and 0.25%, by using forward guidance and asset purchases, and by creating emergency lending facilities. It is also, he said, considering other actions, such as affecting the shape of the yield curve. Powell emphasized that the Fed would use its powers aggressively and proactively, and he noted pointedly that the majority of the emergency programs put in place were lending activities, not spending policies, for which the Fed has no authority. He asserted that as soon as the crisis is resolved, those emergency actions will be terminated. But for the time being, he saw policy as accommodative.

One piece of evidence on policy accommodation can be gleaned from the Chicago Fed’s Index of Financial Conditions, shown below from December 2019 through last Friday.

We can see that policy accommodation was gradually tightened from January of this year, but then conditions eased as the FOMC cut rates to zero and accelerated its asset purchases and other support policies. Noteworthy is the fact that, despite these actions, the index is still not where it was in mid-January.

The second major theme in the press conference was Powell’s focus on the labor market. He emphasized the improvements in labor market conditions reflected in the May employment report. But his discussion failed to recognize the impact that misclassifications had on those data. Had the data been properly considered, the unemployment rate for May would have been much higher than the cited 13.3% number and actually would have been higher than April’s number, not lower, as Powell suggested. Powell’s discussion also included a deep dive into various indexes, concerning the people impacted, including furloughed workers, those out of work, and those who might have extreme difficulties getting back into the labor force. One noteworthy point that Powell made was that the Fed had learned the economy could tolerate a much lower unemployment rate than the Fed had thought it could without engendering an increase in inflation. He gave the impression that this experience will likely condition the Fed to pursue accommodative policies until the labor market recovers, and that the Fed’s inflation objective will likely take a back seat until that objective is achieved. Not only did Powell discuss the employment situation, but he also devoted significant attention to the challenges that workers with different skills and in various industries will face as they try to get back to work. Those who lost their jobs as their firms went under will face a much longer and more challenging task than those who can simply go back to their old jobs. The picture Powell painted for the labor market was one of slow recovery, with different recovery speeds for different industries and for displaced workers.

A third major theme related to widely published reports that the FOMC will be on hold with its policy rate for two years (https://www.france24.com/en/business/20200611-us-federal-reserve-to-keep-interest-rates-near-zero-for-two-years). That inference was not drawn from the FOMC’s statement or from any commitment made by Chairman Powell but rather from the information contained in the FOMC’s summary of economic projections (SEP) that accompanied the policy press release. The SEP had the federal funds rate target at 0.1% through 2022, and the dot plots showed that all of the participants had the funds rate at 0.1% through 2021 and only two had a higher rate in 2022. But Powell made it abundantly clear that the SEPs were not the result of an FOMC decision but rather they were an input to their discussions. More broadly, the SEPs, shown below, anticipated negative GDP growth through the end of 2020, a large pickup in 2021, and slightly slower growth in 2022.

But there was no change in participants’ expectations that the longer-term growth path for the economy is about 2%. Commenting on the pace of the recovery, Powell continually and appropriately focused on the pandemic and the uncertainties it creates for assessing and preparing economic forecasts. We should remember that, to economists, uncertainty is a technical term (attributed to Frank Knight) that means it is not possible to assess the probabilities of possible outcomes. Uncertainty is, then, distinct from risk, for which we do have the ability to assign confidence intervals for given probabilities around outcomes. In response to these uncertainties, Powell said the Committee would just have to wait for more data to see whether, for example, a resurgence of cases occurs this fall or whether we are able to continue our gradual climb out of the current shutdown. When pressed on when the Fed would reverse course, Powell responded that they were “not even thinking about thinking about raising rates.”

There were two other areas touched upon in the press briefing. Powell expressed concern about racial inequality and the need to address it. In addition, he implied the need for additional fiscal responses to COVID-19 but carefully sidestepped giving specific advice to Congress. But when pressed, Powell repeated – and the point was reiterated by Robert Kaplan on Sunday – that additional fiscal stimulus might be required and appropriate for the future, even as he clarified that this was an issue for Congress and not the Federal Reserve. Both of these discussions were atypical of what we normally see after FOMC meetings.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


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Cumberland Advisors Market Commentary – To Pass or Not to Pass (Part 3)

The FOMC decided to throw a pass by cutting rates; but given the market’s response, it looks like they were tackled for a loss. In Woody Hayes’ parlance, the one positive of a forward pass turned into a negative.

Market Commentary - Robert-Eisenbeis - To Pass or Not to Pass (Part 3)

Powell attempted to offer three justifications for the policy move: to insure against downside risks, to counter global weakness and trade uncertainty, and to help push towards the Committee’s 2% inflation goal. These explanations appeared to be greeted with some skepticism by the media. But, more importantly, there were really two significant moments in the press conference, one of which has gotten little attention so far.

In response to a question, Powell first suggested that the way to think about the cut was as a mid-cycle adjustment. Markets initially interpreted this during the press conference as “one and done,” which was not what markets had hoped for, and the Dow dropped 478 points. But it recovered somewhat to close down 325 after Powell appeared to walk back the inference to suggest that future cuts would be dependent upon incoming data.

But the interesting takeaway from the press conference concerns the policy formulation process and related communications and may represent a significant change with important implications. It raises all sorts of questions about non-meeting meetings, speech coordination, etc. In particular Chairman Powell responded in a very telling way to a question of whether the FOMC felt market pressures for a rate cut, which I paraphrase below:

He first said, What we did was well-telegraphed.

He went on to add, What we did was consistent with what we had said we would do; our reasons were well-telegraphed; and we believe we will achieve our goals.

Finally, he indicated, We know that policy works through communications and actions consistent with those communications.

That interchange raises all sorts of questions about how closely markets will need to monitor and process speeches and other communications by FOMC participants. Chairman Powell strongly implied in his monetary-policy testimony before Congress that a rate cut was likely. President John Williams, for example, spoke before the blackout period leading up to the meeting and clearly implied that it would be better to take preventative measures than to wait for a disaster. These are but two examples of the “telegraphing” to which Chairman Powell referred. But were these communications coordinated? How could rate cuts be “well-telegraphed” if there had been no advance discussions and agreements? Are certain Board members and FOMC voting members discussing policy with each other before the meetings? All these questions not only deserve answers but also suggest that, going forward, Fed watching will be heightened and markets will respond to the possibility that they are getting advance information on policy moves. This is not the way the policy should be conducted.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio

Read Part 1 here: To Pass or Not to Pass? (Part 1)
Read Part 2 here: To Pass or Not to Pass? (Part 2)
Read Part 3 here: To Pass or Not to Pass? (Part 3)


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.




Cumberland Advisors Market Commentary – Hope Is Not a Strategy

On Wednesday, the FOMC left its policy stance unchanged. This decision was consistent with the message sent after the previous meeting and was not contradicted by speeches given by FOMC participants in the intermeeting period.

Federal Reserve - FOMC

This action was also consistent with the consensus view of economists who follow the Fed. Indeed, of the 39 economists responding to the April 23–25 Bloomberg poll, only two had forecast a rate cut in 2019 while the rest had the funds rate target steady through 2020.[1] Despite this data, the stock market declined after the FOMC statement was released, indicating that a rate reduction had been expected but not delivered. The market continued to decline over the next two days. In contrast, on Wednesday, May 1, the ten-year Treasury rate rose at about 10 AM and then jumped even higher just before the release of the FOMC statement at 2 PM, then dipped slightly before the meeting, as the Bloomberg chart below indicates. It then recovered to pre-10 o’clock announcement levels after Chairman Powell’s press conference. How can we explain these reactions to the information flowing from the FOMC meeting? Why was the stock market’s reaction more prolonged than the Treasury market’s was?


Source: Bloomberg

 

In the case of the stock market, rhetoric from some politicians and even a now-former Fed nominee argued that the FOMC had made a mistake in raising rates in December 2018 and that time was ripe for a rate cut. Economic growth appeared to be slowing through 2018, with Q3 growth below Q2 growth while Q4, at 2.2%, was below Q3’s 3.2%. Participants were expecting a modest number for Q1 2019, especially since first-quarter growth had been slow for the past five years and we had a full government shutdown for a full one third of the quarter. Everyone expected the shutdown to subtract from Q1 growth. Finally, in addition to expected slow growth, part of the rationale on the part of those expecting a possible rate reduction lay in the fact that inflation had been running persistently below the FOMC’s 2% target, and thus at some point a rate cut would be necessary to further stimulate inflation via extraordinary monetary accommodation until the target was achieved.

Of course, we learned that this scenario did not match the view of the FOMC. Chairman Powell, in his press conference, countered the idea that inflation was “persistently below target” when he stated that the decline in inflation in 2019 was not only expected but also was viewed as being due to “some transitory factors.”[2] If markets had assumed that inflation below target was persistent and hence would soon require a rate increase – especially if the FOMC was as committed to its inflation objective as it was to the other leg of its dual mandate – then Chairman Powell, when questioned by an astute reporter, effectively shut down the possibility of a near-term rate cut to achieve the FOMC’s inflation objective. Nancy Marshall-Genzer asked, “You were saying if inflation does stay low and these low inflation rates are not transient, you said a couple of times you’ll take that into account with monetary policy. How, specifically, will you take that into account?” Chairman Powell’s response was extremely vague. He stated, “It’s hard to say, because there’s so many other variables. Ultimately, there are many variables to be taken into account at any given time, but that’s part of our mandate. Stable prices is half of our mandate and we’ve defined that as 2 percent, so we’d be concerned and we’d take it into account.” The reporter pushed further asking whether an interest-rate cut would be possible, and Powell responded that he could not be more specific.

That interchange, combined with Powell’s use of the word transient, was interpreted by markets as indicating – as the economists’ Bloomberg predictions had implied – that policy was on hold for the foreseeable future. There would be no rate cuts to satisfy stock market investors’ desire for more stimulus; and as far as the Treasury market was concerned, the meeting was a blip, as it returned to its pre-meeting position. If there was any doubt, the 3.2% Q1 preliminary growth estimate, coupled with Friday’s CES report of a 3.6% unemployment rate and over 263,000 jobs created in April, clinched the fact that no rate cuts are on the horizon. Interestingly, if the FOMC meeting had been a week later, there would have been no shock to the stock market. The lesson here for stock market investors is that hoping for a rate hike as a substitute for considered analysis is not a good strategy.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio





The Fed Decides (Radio Podcast): Bob Eisenbeis on Bloomberg Markets

Federal Reserve officials left their main interest rate unchanged and continued to pledge patience as they grappled with conflicting currents in the U.S. economy. Discussing the decision and Fed Chair Powell’s press conference are Bloomberg Markets Editor Joe Weisenthal, Bloomberg News Stocks Editor Dave Wilson, Former President of the Minneapolis Fed Gary Stern, Ira Jersey, Bloomberg Intelligence Chief U.S. Interest Rate Strategist, Bloomberg News Bond Reporter Alex Harris and Bob Eisenbeis, Vice Chairman and Chief Monetary Economist at Cumberland Advisers. And we Drive to the Close with Ryan Detrick, Senior Market Strategist for LPL Financial. Hosts: Carol Massar and Jason Kelly. Producer: Paul Brennan

Running time 41:10

.

Cumberland Advisors on Bloomberg Radio
Radio

LISTEN HERE (or click the graphic above): Bloomberg Markets with Robert Eisenbeis Ph.D.

If you like this podcast, you may enjoy the June 22, 2018 Bloomberg Daybreak interview with  David Kotok, Chairman and Chief Investment Officer at Cumberland Advisors. He discusses the Dow’s eight day drop and possible trade war with China. He also discussed bonds and treasuries with Bloomberg.

NOTE: Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.


This podcast from 2015 features David Kotok talking about his background and Camp Kotok with Barry Ritholtz. They also talk about the history of Cumberland Advisors since its founding, and delve into fundamental principles of investing and valuation.


Links here
https://itunes.apple.com/us/podcast/masters-in-business/id730188152?mt=2

And here
http://www.bloomberg.com/podcasts/masters-in-business/




The Interview: David Kotok on GSIBs, Markets & Central Banks with Chris Whalen

My friend Chris Whalen was kind enough to use an interview he did with me in his weekly publication on financial and banking issues, The Institutional Risk Analyst. Chris has had a distinguished career, and it was a pleasure to interact with him again.

Market Commentary - Cumberland Advisors - The Interview David Kotok on GSIBs, Markets and Central Banks

This summer Chris and I are cohosting the June gathering at Leen’s Lodge in Maine. We’ve decided to invite some new participants and, for my part, to include readers who follow these conversations. If you are interested in joining us for the weekend after Father’s Day, email me your full contact information and we can see if a space is open. Spaces and guides are limited, so there are no guarantees.

I will insert the interview text below but want add a detail first. As I mention in the interview, we used SOFR to estimate a financial distortion that, we believe, exacerbated the December market selloff. We cited a 60-basis-point anomaly in pricing and a spike in certain interest rates that coincided with the stock market selloff and the widening of bond market spreads.

The direction of causality is never perfect. Coincidence isn’t proof of causation. But last December there were no other new elements that coincided. Also note how certain riskless rates were stable while others spiked. That oddity gives us high conviction in the view we articulated in our writings and in our interview with Chris.

We’re happy to discuss more in Maine and elsewhere. Here’s the full interview text with some minor edits for compliance purposes.

-David R. KotokSan Francisco | In this issue of The Institutional Risk Analyst, we feature a conversation with David Kotok, Chairman and Chief Investment Officer of Cumberland Advisors in Sarasota, Fl. David is an investment advisor, an observer of the evolving American political economy and an experienced fly fisherman. He and his colleagues at Cumberland publish commentaries on the markets and the world which may be found at www.cumber.com.


The IRA: David in your commentary last week (“Jay Powell, GSIBs, Christmas Eve Massacre”) you refer to December as a “massacre.” We concur. In fact, we are gathering more and more data that suggests our friends on the Federal Open Market Committee almost ran the proverbial ship aground in December. New issuance in the bond market went close to zero for several weeks and the flow of new home mortgages also cratered and has not yet recovered. There seems to be a lot of collateral damage here. Tell us what you see.

Kotok: I am in agreement. What I did in the commentary last week was to go through the estimates of the “global systemically important banks” or “GSIBs,” some 29 banks, and looked at the capital cost of a rule which came together in a perfect storm in December. Under the radar, except for those who looked for it, was a multi-hundreds of billions or even trillions of dollars in liquidity contraction. Why? Because the big banks pulled back from the markets at year end in compliance with the GSIB rule. A mispricing of whole segments of the so-called riskless market was triggered and resulted in a massive cost to the markets that we can estimate. Trillions of dollars in meltdown of market value were triggered because of billions in reallocations. This occurred because of the cost of a rule regarding the 29 designated large banks or GSIBs. Note that this is a rule which is totally unnecessary. Fed Chairman Jay Powell has said that he is satisfied with the capital structure of the big banks. I agree with him.

The IRA: The tightening of the REPO markets was very visible in December, long before the end of the month. Customers with collateral were shunned by the big banks, benefiting the smaller desks.

Kotok: The GSIB rule caused the big banks to step back from the market. On December 31st, the SOFR rate which is supposed to reflect a risk free overnight rate for funds was 60bp over referenced Treasury yields. The cost came because the big banks were incented to shrink, to convert assets into cash and other risk-free exposures. You can see the spike in REPO rates and the change in holdings. Any Bloomberg terminal demonstrates the visual spike. People who have expertise in the money markets saw it. You saw it. We saw it. But 99% of investors had no idea why the money markets were seizing up. They didn’t see that this is a temporary liquidity crunch that has nothing to do with default risk or credit risk. The risk is derived from the imposition of a rule, a regulatory provision called GSIB. But investors did not see that. They saw markets shifting violently and volatility spiking. They saw the spread on the credit default swaps of the United States rise by 50%. They didn’t understand that the Credit Default Swap is a hedging device used when such spikes happen.

The IRA: To add another datapoint to your analysis, in Q4 2018 the securities holdings of all US banks fell modestly, but there was a huge surge in Treasury holdings roughly equal to the runoff of the Fed’s portfolio. And there was continued erosion in certain types of deposits. This may be why Chairman Powell had to back off on further shrinkage of the Fed’s balance sheet.

Kotok: Individual banks around the world were acting rationally to protect their institutions. Can’t blame them for that. Collectively the 29 GSIBs imposed a temporary liquidity crunch on the entire system. And the result was that at one point the Treasury REPO rate shifted to a five hundred basis point spike. If riskless paper spikes in one day by hundreds of basis points, what is the cost? I computed what one basis point costs per trillion of market move in SOFR. The 29 GSIB banks represent hundreds of trillions of dollars in balance sheet and derivatives. And they wonder why the equity markets almost melted down? By the way, that may explain the bizarre December phone call that Treasury Secretary Mnuchin made to the biggest US banks. He was just “checking in to see if they were okay” According to press reports. Since the reason for his call was never fully explained, the reports of the call only worsened the market sentiment which was already based on faulty understandings.

The IRA: Agreed David. We think that the accumulation of evidence suggests that the Fed and other prudential regulators came dangerously close to running the global economy aground. This is a terrible refutation of the whole idea of “macro-prudential regulation.” Monetary policy goes one way, prudential rules go another and none of the agencies involved have any idea as to the net effect on the markets.

Kotok: Well, they sure were focused on a lighthouse or what they thought was a lighthouse but it turned out to be a pile of rocks.

The IRA: We have this strange confluence of monetary policy, where the FOMC is reversing past policy, and prudential rules. The Treasury is issuing and the Fed is now buying short-term paper again, essentially unwinding “Operation Twist.” And then, on the other hand, we see prudential policies that restrict liquidity. And nobody seems to understand what it all means for the markets or the economy. When they close the door of the Fed’s boardroom, are they focused on the markets or on the DSGE models? If we cannot rely on the numbers we see on the screens every morning to govern market risk allocations, isn’t the FOMC doing more harm than good?

Kotok: Yes. Those who are looking at DSGE models and those who are in the throes of the debate over whether the Philips curve is reliable need to answer a question. If we know that these tools are unreliable, then why are the dot plots used by the FOMC still measuring two of the main Philips Curve components? This reminds me of the General Eisenhower story about D-Day. In January 1944, Eisenhower was planning the invasion of Europe. And he asked his staff advisors for the long range weather forecast of weather for June, 1944. The experts replied that long range weather forecasts were notoriously inaccurate. But General Eisenhower’s staff insisted on a forecast because they needed it for planning purposes. We can put the Fed’s “dot plots” and long range Fed forecast models in the same category. The only thing we know about them is that they are wrong at the time they are created.

The IRA: Since we are talking about WWII history and General Eisenhower, our next book is tentatively titled “False Mandate” and goes back to the origins of the Humphrey-Hawkins law. Do you remember Rep Augustus Hawkins? He was the first African American from California in the United States Congress and co-authored the 1978 Humphrey-Hawkins Full Employment Act. Hawkins never lost an election in 58 years of public service. Rep. Maxine Waters (D-CA) inherited his seat in Congress. Speaking of long-term economic forecasts, can you tell us when the FOMC decided that zero and two are the same number when it comes to inflation? The Humphrey-Hawkins statute of 40 years ago says zero is the definition of price stability.

Kotok: Ha! May I invite a corollary? Two percent inflation means that the real value of your wealth will be cut in half in forty years. A person born today under the current Fed 2% policy who inherits $1 million at birth will have a quarter million worth of buying power remaining when they die, if they fulfill their current life expectancy. If the Fed is successful with their current policy objective, they will destroy three quarters of the real wealth of the average young person living today. Sounds rather harsh doesn’t it?

The IRA: No, you are quite right. The Humphrey-Hawkins statute says pursue full employment, then seek price stability which is defined as zero. Because of what has changed over the past forty years, the Fed staff in Washington has come up with this convoluted construction whereby zero = two. Two is really “price stability” because the system cannot tolerate deflation, which means that savers will never get a chance to buy a stock or distressed property and create future wealth. All of the bias of US monetary policy is on the side of the debtor (by using inflation as a hidden tax) and on transferring wealth from savers to debtors. Don’t we make a mockery of Thomas Piketty’s assertion that the return on wealth is greater than nominal growth?

Kotok: Precisely. Now if the Fed were to say listen, we are incapable of handling monetary policy affairs at zero. Let’s admit our frailty. And, by the way, I think this would be a fair statement. One needs only to look at the Bank of Japan and ECB to see the mess that can be created if you stay at zero long enough. And we are witnessing both the BOJ and the ECB at the point where there is zero probability of a policy change that leads to extraction. The BOJ balance sheet size is about equal to that nation’s GDP. And the assets are yielding near zero percent. Imagine a Fed balance sheet of $20 trillion size. That would be a similar metaphor. The ECB will soon roll €700 billion in TLTRO. What they must wrestle with is that if, they do not increase the amount to €900 billion or €1 trillion, then they will have done zero stimulus.

The IRA: Well, that is because they call QE stimulus. There are many people who see QE as an engine of market distortion and eventually deflation – unless it is made permanent and indefinite.

Kotok: Of course, but whatever the impact, it will be nothing if the amount is not increased. We will have neutralized an already neutered neutrality.

The IRA: Agreed. But what the FOMC has learned over the past few months is that you cannot withdraw the liquidity provided by QE without destroying the system. You can maintain neutral and have economic stagnation. But you cannot withdraw the liquidity once it is put into the system. In Europe, even the cessation of new asset purchases has put the EU economy into a tailspin. Without the constant heroin drip of QE, the enfeebled European economy has started to contract. And the US is not much better.

Kotok: Yes. But we are not as bad off as the ECB or BOJ. There is still a chance in the US to get this right. The current FOMC, in my view, has ignored Chairman Ben Bernanke’s warning, which he repeated several times, that if we shrink the balance sheet we will only be taking it back up in due time. He very politely said “why shrink it?” And no one can answer that question. There is at least discussion now of a $3.5 trillion baseline for the Fed balance sheet as a target. We both have friends in the Fed System who believe that the balance sheet should be reduced back to the pre-crisis level, but that it not going to happen. In my view that would be a horrible mistake. I would size the balance sheet at close to $4trillion target to meet all upper thresholds for required reserves, survey-based (ask the banks what they want and need) desired excess reserves , Treasury operating balances, special items and currency. That mix today requires a balance sheet size of about $3.5 to $4 trillion and will require balance sheet growth of between $100 and $200 billion a year.

The IRA: Our friends represent a more tradition view of the world, a more prudent view. But when the Treasury, which is the dog in this story, is borrowing $100 billion per month, traditional views about taking the balance sheet down to required reserves and whatever is required to accommodate Treasury issuance misses the point. Once the FOMC under Bernanke made the decision to pursue QE, there was no way to take it back. The Fed cannot ignore the reaction of the markets that we saw in December. The markets have subsumed everything. So the FOMC must obviously allow the balance sheet to grow to keep pace with Treasury debt issuance. The alternative is political suicide. The Fed’s first priority is whether the Treasury issues debt tomorrow, correct?

Kotok: Yes. We cannot afford anything that introduces a risk perception about the US Treasury’s ability to finance itself. May I add a second priority? Can the Fed grow its balance sheet so that the Treasury may enjoy $100 billion addition each and every year in seigniorage? This keeps the US banking system stable and the lender of last resort status of the Fed intact. Can we maintain the status as the least worst major reserve currency in the world and thereby finance $1 trillion in deficits every year? That is the unspoken truth. My stump speech now has four charts that focus on what a $1 trillion deficit and a four percent unemployment rate means year after year. We are less than a decade away from a $1 trillion interest bill for the United States.

The IRA: Thank you David.


The original commentary that launched this conversation can be seen here: https://www.cumber.com/cumberland-advisors-market-commentary-jay-powell-gsibs-christmas-eve-massacre/

Cumberland Advisors, USF Sarasota-Manatee and the Global Interdependence Center are pleased to invite you to our third annual Financial Literacy Day, Financial Markets and the Economy event. The date this year is Thursday, April 11, 2019 and it runs from 8:00 A.M. – 5:00 P.M. It’s only 50 bucks and includes a full interactive day of talks, panels and Q&A, plus a catered lunch.

Panel discussions will include:
* Outlook for the US Stock Market & Global Economic Outlook
* Special Session: Health, Hunger and Philanthropy
* How the World Looks in Economics and Geopolitics
* Keynote Speaker: Gretchen Morgenson, The Wall Street Journal: Senior Special Writer, Investigations Unit
* A Conversation with Susan Harper, Canada’s Consul General in Miami

Full information and cost available at: http://USFSM.edu/FinancialLiteracy

Please join us.

-David


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

Sign up for our FREE Cumberland Market Commentaries

Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.




Mnuchin tweets Trump denial as Republicans warn against firing Fed chairman

By BURGESS EVERETT, BEN WHITE and VICTORIA GUIDA
12/22/2018 03:50 PM EST – Updated 12/22/2018 08:21 PM EST

Cumberland-Advisors-David-Kotok-In-The-News

Financial markets have cratered in recent days amid a partial
government shutdown, rising interest rates and signs of a slowing
economy. Shelby said Trump did not bring up the prospect of firing
Powell at a lunch with congressional Republicans on Saturday.

Wall Street traders and money managers argue that the president would
inject chaos and uncertainty into already fragile markets if he fired
the Fed chair because he doesn’t like his interest rate decisions,

“Market agents may disagree on the policy but they respect the
person,” David Kotok, chief investment officer at Cumberland Advisors,
said of Powell. “The nation is best served if the president avoids the
personalized attacks. Markets want an independent and skilled Fed chair,
not a Trump patsy.”

It’s unclear what specifically Trump can do to Powell. The president
can remove a member of the Fed board only “for cause,” which does not
include policy disagreements.

Read the full story at POLITICO.




Federal Reserve Independence – Under Attack Again?

The last few days, President Trump has made inflammatory and in some instances misguided remarks as to the nature of current Fed policy, its impact on the stock market and potentially on the economy.

Federal Reserve - Independence

Examples follow:

  • “It is a correction (the decline in the stock market) that I feel is caused by the Federal Reserve.”
  • “I think the Fed is making a mistake. They are so tight. I think the Fed has gone crazy.”
  • “I think the Fed is far too stringent and they are making a mistake.”
  • “The Fed is going loco and there’s no reason for them to do it.”
  • “I think the Fed is out of control.”
  • “I think what they are doing is wrong.”
  • The Federal Reserve is “my biggest threat,” President Donald Trump says.[1]

In the face of these comments, Larry Kudlow, director of the National Economic Council, tried to walk back the idea that the President has been attempting to influence Fed policy and indicated that the President was merely expressing an opinion.

Presidential effort to influence Fed policy are not new, nor are they unique to the present administration, especially during an election season. For example, the Reagan administration tried but failed to get Chairman Paul Volcker to commit to not raising interest rates in the midst of the 1984 presidential election. Similarly, with a slow economy in the election year 1992, President George H. W. Bush called on the Fed to cut interest rates, discounting concerns the Fed might have about inflation. Chairman Greenspan’s Fed did not cut rates and was seen by the President as the reason for his election loss and one-term presidency.

While these presidential attempts to influence have largely played out behind the scenes, the most egregious breakdown in Fed independence involving presidential pressure involved President Nixon and Chairman Burns in the early 1970s and it had significant negative consequences for the US economy, which played out through the end of the 1970s. Leading into the 1972 election, Chairman Burns willingly responded to the President Nixon’s pressure and manipulated FOMC policy decisions to stimulate the economy as it emerged from the 1969–1970 recession. The extent and nature of that pressure has been well documented due to the existence of the Nixon presidential tapes, which are now publicly available.[2]

In the aftermath of the 1969–1970 recession the federal funds rate declined steadily from 8.71% in January 1970 to 4.05% in January 1972, and the Fed’s discount rate was reduced from 6% to 4.5% over that period. However, at the same time, unemployment continued to increase despite an improving economy, rising from 3.9% in January 1970 to between 5.6% and 6% in the late summer and early fall of 1972.[3] Nixon was concerned about being a one-term president; and on October 10, 1971 (Conversation No. 607-11), he quipped, “I don’t want to go out of town fast.” The text of the discussion and tape played recently on national television clearly suggests that Nixon had only a rudimentary understanding of the economy or monetary policy. A month later, in another conversation, Burns reported that earlier that day (November 10, 1971) the Fed had reduced the discount rate, indicating that this stimulus would help buoy the economy. Thereafter, Burns continued to engineer additional policy stimulus and reported to Nixon on December 10, 1971, that the discount rate had been lowered ahead of the upcoming FOMC meeting and that Burns’ intention was to prod the FOMC into even more accommodative action. He stated that he aimed to “put them on notice that through this action that I want more aggressive steps taken by the Committee on next Tuesday.”[4] Burns went on to state that “Time is getting short. We want to get this economy going.”

What these and subsequent conversations clearly document is that in late 1971 and into 1972 the administration continued pressuring the Fed to expand the money supply to stimulate the economy.[5] Burns was a willing participant, effectively subordinating the Fed to presidential pressure and engaging in a rapid expansion of the money supply. Nixon not only employed jawboning but also had George Shultz put Burns on notice that appointments to the Board would be closely controlled.[6]

Burns and his tightly controlled FOMC delivered on an expansionary policy. Not only were policy rates dropped during 1972, but the Fed also engineered a very rapid increase in both the M1 and M2 money supplies. M1 growth increased from 4.51% in 1970 to 6.7% in 1971 and then to 7.56% in 1972, while M2 growth exploded even more, from 7.36% in 1970 to 11.65% in 1972. That growth continued after the election, and quarterly M1 growth was between 6.4% and 8.4% during all of 1972, while quarterly M2 growth, shown in the attached chart, ranged between 11.7% and 13.2% that year.[7]


Federal Reserve Independence – Under Attack Again - M2 Growth Chart
 

While the Burns stimulus clearly helped Nixon win the election in November 1972, the seeds were sown for a disastrous inflation. That inflation occurred with a lag, in part because President Nixon imposed a 90-day freeze on wages and prices in August 1971 that was subsequently extended to April 1974. The result was stagflation; and as the controls were gradually dismantled, prices began a disastrous climb. The money supply increases slowed gradually through 1973 and briefly bottomed out before accelerating again. The ensuing inflation continued until Chairman Volcker engineered a recession and broke the back of inflation.

The common feature of the three presidential attempts to induce the Fed to pursue expansionary policies all occurred a year or so before a national election and followed a recession and slow recovery. None of these conditions exist presently. The economy has been growing steadily, albeit slowly, since 2008. Inflation is at the FOMC’s 2% target, unemployment hasn’t been this low since the 1960s, job openings exceed the number of unemployed and wages have finally started to increase. As for policy, even with eight 25-basis-point increases in the federal funds target range, the Chicago Fed’s National Financial Conditions Index shows that conditions are as accommodative as they have been since the start of the recovery. Finally, with less than a month to the election, there is no action the FOMC could take that would impact the economy before the election.

This president may, as a real estate developer, like low interest rates; but that may not be in the best interests of the economy, despite his recent assertion that he knows more than the Fed does. His claim that the Fed caused the recent stock market decline, cited in the quote at the beginning of this commentary, ignores the fact that this decline and the previous decline early in 2018 followed on the heels of the announcements of the imposition of tariffs and the declines are unlikely to be related to Fed policy moves. Jawboning the Fed but not really interfering with its independence may have an advantage. Kane(1980) argues that by leaving the Fed with a fair amount of “… ex ante discretion, elected officials leave themselves scope for blaming the Fed ex post when things go wrong.” Perhaps in anticipation of the 2020 election, this may be what the President means when he sees the Fed as his biggest threat. Fortunately, in the meanwhile Chairman Powell is secure in his position, and the members of the FOMC understand the dangers of subordinating policy to the political whims of this or any other White House.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


[1] https://www.cnbc.com/2018/10/16/trump-says-fed-is-his-biggest-threat-because-it-is-raising-rates-too-fast.html
[2] What follows relies upon Burton Abrams, “How Richard Nixon Pressured Arthur Burns: Evidence from the Nixon Tapes,” Journal of Economic Perspectives, Volume 20, Number 4, Fall 2006, pp. 177–188.
[3] See Abrams (2006), Table 1.
[4] See Abrams (2006), Conversation No. 16–82.
[5] Edward J. Kane, “Politics and Fed Policymaking: The More Things Change the More They Remain the Same,” Journal of Monetary Economics, Vol. 6,(1980) pp 199-211 argues that as William McChesney Martin departed the Fed and Author Burns became chairman that the money supply assumed greater importance as a tool of monetary policy.
[6]Abrams(2006), Conversation 17-5.
[7] Source: FRB St. Louis FRED database


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FOMC Closes Out Q3 2018

As Treasury markets had correctly predicted, the FOMC raised its target range for federal funds by 25 basis points to 2.0%–2.25% at its meeting on Wednesday, Sept. 26.

Federal Reserve - FOMC

Perhaps more importantly, it also deleted the observation that policy remains accommodative, though Chairman Powell went out of his way in his opening remarks to point out that its removal should not be interpreted as a signal about the future path of rates. Rather, it was simply a reflection of where the Committee saw policy. This so-called clarification, however, didn’t square entirely with his observation that financial conditions remained “accommodative.”

Since the meeting was also one in which the Committee revised its Summary of Economic Projections (SEP), it is worth noting that there were really only three changes or additions worth commenting on. First, both the median GDP growth for 2018 and its central tendency were revised up slightly, which Chairman Powell said reflected the strength of incoming data and robust consumer and business confidence. Second, forecasts for 2021 were added, and GDP for each year after 2018 was projected to be lower than the preceding year’s, with the figure for 2021 showing growth of only 1.8%, equal to that forecast for the longer run. At the same time, there were no significant changes in the forecasts for unemployment or inflation. When asked about that, Chairman Powell simply stated that the inflation dynamics now appear to be different from those of the past, implying that the Phillips curve is essentially flat. Finally, even by the end of 2021, the median federal funds rate is expected to be still almost a half percentage point higher than the longer-run rate.

Looking beyond September to the end of the year and possible rate moves in 2019 and beyond, the dot chart suggests that 12 of the 16 participants think there will be one more hike in 2018. Given that by December the Committee will have an observation on Q3 GDP and a new set of SEP forecasts available, the likelihood is that the rate move will occur at that meeting. Moreover, with regard to the moves that have occurred this tightening cycle, there has been no instance when an increase was approved at a meeting when no press conference was scheduled and no SEP forecasts were available. Note that all meetings in 2019 will be followed by press conferences.

Interestingly, for 2019 the median-rate data suggest three moves that year and two more in 2020, stopping at 3.25% to 3.5%. This policy path would put the funds rate above the Committee’s equilibrium longer-run rate, and that fact triggered questions directed at Chairman Powell as to whether there is likely to be a policy overshoot. His response essentially suggested that people should not take those longer-run rate projections as being firm, since knowing when to stop will be data-dependent. He did observe that the gradual pace of the Committee’s policy moves enables it to monitor how the economy is responding and to minimize the risks of a policy mistake that might trigger a recession.

This observation by Chairman Powell raised the question in the press conference as to what could impact the policy path. Tariffs, deficits, oil shocks, and greater-than-expected growth were all key factors Chairman Powell identified that could impact both the pace of policy and the decision to pause. All in all, Chairman Powell continued his strong performance, exhibiting not only depth and breadth of knowledge but also patience in responding to questions. Given the information flow and the short-term forecast for another rate move in 2018, it would not be surprising to see the term structure move up rather abruptly, by about another 25 basis points, in advance of the December FOMC meeting, as it did leading into this September meeting.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


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It’s in the Stars

As is the custom for Fed chairs, Chairman Powell provided the kickoff address to the Kansas City Fed’s annual Jackson Hole symposium, broadly attended by many of the world’s central bankers.

For those who are unfamiliar with the conference, the papers presented are generally conceptual economic policy documents with a distinctly longer-run, bigger-picture focus rather than a discussion and assessment of currently policy. In that vein, Chairman Powell provided an interesting and thoughtful discussion of the problems that he and the Fed face in setting policy going forward.

Some commentators on the speech focused on missing elements such as Powell’s failure to mention trade and tariff issues or the changing role that international economic integration has on the policy environment of changing policy regimes. These factors are clearly important but weren’t central to Chairman Powell’s thought piece, which really focused on the more abstract conceptual framework upon which the Fed’s current policy is depends.

Before discussing that framework however, Powell first provided a brief, but obligatory, overview of the current economic situation. It proved to be just a restatement of what was noted in the FOMC’s July/August policy statement and subsequent minutes. He noted that growth is strengthening, unemployment is at a 30-year low, and inflation is at the 2% objective. There was nothing new or noteworthy here.

Then Chairman Powell then turned to the more interesting part of the speech – interesting in part because it appears that he is revealing his own discomfort with the current policy framework. He first poses two disparate questions that observers and critics might ask any FOMC participant today, questions that encapsulate the policy conundrum the FOMC now faces. The questions are paraphrased below:

(1) With unemployment so low, why isn’t the FOMC tightening policy faster to head off potential overheating and a rise in inflation?

(2) Or, with inflation so low, why is the Fed tightening, thereby risking higher unemployment and a recession?

The first question is rooted in a Phillips-curve view of the world in which tight labor markets inevitably lead to inflation, while the second question ignores evidence on the lags of monetary policy and reflects the view that inflation isn’t a problem until it is. Powell has structured these questions as a policy problem of balancing two risks: the risk of being behind the curve versus the risk of being too aggressive.

Against this set of policy questions, Powell then goes on in a clear but oblique way to discuss how economists are currently framing policy in terms of (a) the desired rate of inflation, and (b) the two abstract concepts of the natural rate of unemployment and the natural rate of interest. Economists have dubbed the natural rate of unemployment u-star (u*) and defined it as the rate of unemployment that would prevail in an economy growing at its potential, where people would be unemployed only due to friction and structural reasons – that is, unemployed due to skill mismatches, mobility problems, or lack of information. The natural rate of real interest or r-star (r*) is the real rate that would exist in an economy operating at full employment and growing at its long-run potential.

Powell then proposes the simple, effective analogy that policy is like trying to navigate by the stars (u* and r*), where the course of policy is dictated by inferior instruments (ie. models) in which action depends upon the direction and magnitude of the deviations of actual unemployment from u* and of the estimated real rate of interest from r*. But the problem is that neither of the two stars nor the potential rate of growth of the economy are known with any degree of certainty.[1] Thus it is hard for policy makers to know exactly where the economy currently stands in terms of these conceptual anchors. The problem is doubly difficult because the anchors also have moved over time.[2] It is also important to note at this point in the discussion that Powell omits any mention of the policy tools that the FOMC has in its tool kit or how they are linked to changes in the deviations of the actual economy from u*, r*, or potential growth.

So, if policy makers don’t know exactly where the economy lies relative to these key variables, what are they to do? Put another way, a skeptic would say that the models aren’t working – and this is what Powell is indirectly saying. So, in the face of this conundrum, what does a practical policy maker like Chairman Powell do? His answer is to fall back on risk management, which says go slowly, be observant, and be prepared to act. In the current economic environment of steady growth, low inflation, and low unemployment, this means the FOMC should continue with gradual tightening, since policy is still accommodative, but be prepared to change if inflation and, importantly, inflation expectations change.

Overall, this was a speech that was clear, honest, and pragmatic. Some might have wanted more, especially since stargazing isn’t working too well, but Powell has laid out clearly what the conceptual problems are and how the Fed is proceeding.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


[1] Indeed, the error bands around estimates of these parameters are quite wide.
[2] As an aside, this is part of the reason that President Bullard of the St Louis Fed has argued that regime shifts make policy formulation and forecasting very difficult.


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The Fed Decides

As the June FOMC meeting approached, pundits and market participants increasingly expected the Committee to raise rates.

This expectation was realized, as the FOMC raised the target range for the federal funds rate by 25 basis points. Since the FOMC had no new information on GDP, this was a decision that was clearly rooted in the context of a tight labor market and its implications for inflation down the road. Markets have interpreted this move, reinforced by the increase in the median funds rate projection for 2018 from three to four moves, as shifting from an accommodative to a more restrictive policy. There is much to glean from Chairman Powell’s press conference. For example, he announced that the Committee would begin holding a press conference after every meeting but would still prepare SEP forecasts only every other meeting. Before commenting on the press conference, however, let us look at some of the significant changes and potential inconsistencies in the press release.

After describing the continued improvement in labor markets, the statement goes on to characterize economic activity as “rising at a solid rate” and household spending as having picked up. Interestingly, in the Beige Book, only the Federal Reserve Bank of Dallas characterized district growth as solid, while four district banks said growth was modest, and seven said growth was moderate. Additionally, the Beige Book described consumer spending as “soft.” Not one of the district bank descriptions used the word solid, but rather said spending increased “slightly,” “modestly,” “moderately,” or was “mixed.” One wonders if the economy changed between the preparation of the Beige Book and the meeting or whether the descriptions were designed to bolster the policy move.

The major change in the post-meeting press release was deletion of its previous forward-guidance language that stated that the Committee’s policy rate would “remain, for some time, below levels that are expected to prevail in the longer run.” This omission was part of the reason that markets concluded that policy accommodation would be moving toward financial restraint, and this was abruptly reflected in an upward movement in interest rates along the curve.

As for the Summary of Economic Projections (SEPs), median GDP growth was moved up one tenth of a percent in 2018 and was unchanged in 2019 through the Longer Run. The unemployment forecast edged down even further to 3.5% in 2019 and 2020 but remained at 4.5% for the longer run. Finally, inflation, edged up slightly for 2019 and 2020, with the median funds rate now moving up steadily from 2.4% in 2018 to 3.4% in 2020. The anomaly in these SEP forecasts, as we have noted in previous commentaries, is the increase in the Longer Run in the unemployment rate to 4.5% with a drop in the median funds rate by half a percentage point to 2.9%. What might the committee expect to happen to generate this result? Is this an admission that the described policy path for the funds rate risks an overshoot and may cause a recession? When asked about this at the press conference, Chairman Powell simply stated that the figure was just an estimate and could change, but he offered no clues as to precisely what the Committee anticipates or why.

Turning to the press conference itself, there were several takeaways and uses of key words that warrant comment:

Persistent – This word was used in describing the FOMC’s 2% inflation target and the fact that the FOMC endeavors to avoid persistent deviations from that target. What was not explained, however, was how long and how large a deviation would have to be in order to be considered a persistent deviation that requires policy action. Uncertainty – Chairman Powell used the word uncertainty in several contexts, but most revealing was his use of that term when discussing the Committee’s Longer Run unemployment forecast. He clearly viewed that projection as an estimate of the so-called natural rate of unemployment consistent with stable prices. When pushed as to why the 4.5% Longer Rate isn’t closer to the 3.5% value for 2020, he said that it very well might be and that there is a range of uncertainty around that estimate, on the order of plus or minus .75 to 1 percentage points.

Unobservables – Closely related to his discussion of the natural rate of unemployment was his caution that one had to be careful in becoming too attached to estimates of economic variables, like the natural rate, that cannot be observed. The range of “uncertainty” around such values calls for caution when making policy.

Cushion – Powell was asked if one of the motivations for increasing rates was the desire to create an additional cushion so that the FOMC would be able to lower rates should that be necessary. He emphatically said that he did not consider that factor in his decision-making framework. He went on to argue that pursuing a cushion strategy held the risk of overshooting and even causing a downturn. He preferred a strategy of proceeding slowly to avoid overreaction.

So, in summary, Chairman Powell continued on his quest, quite successfully, to communicate with the public in plain English. He conveyed a view that was less “hawkish” than a cursory reading of the statement might suggest. Furthermore, he tried to downplay the significance of the adjustments that were made to the SEP forecasts. Finally, when pushed, he said the Committee was not yet ready to declare victory when it came to its inflation objective.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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