Data Dependent: Interest Rates Have Nowhere To Go

Dudley was at that moment, however, undaunted. His eye was cast toward the unemployment rate and that was nothing but encouraging no matter the “transitory” factors increasingly lining up against it.

I see more pressure on resources. I see a linkage between pressure on labor market resources and my confidence in inflation.

If that was true, meaning slack and inflation tied together through wages, the reverse must also be true. In other words, if inflation failed to materialize as the unemployment rate fell further, we would have to conclude less or not enough “pressure on resources.” It’s a powerfully contrary economic possibility.

Just about one year ago, in August 2016, Mr. Dudley was again opining on the topic of conforming inflation and the Fed’s exit ostensibly due to it. He said yet again, “the labor market continues to tighten” and that wage data, though only rising by 2.5%, “suggests we are getting closer to full employment.”

US Employment Cost Index, Jan 2001 - Aug 2017

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We do expect as the labor market continues to tighten, to see firmer wage gains and that will ultimately filter into inflation moving up towards our 2 percent objective.

Because of this, Dudley anticipates the Fed will begin unwinding its balance sheet and press through another “rate hike” later this year. The reaction in markets was pretty much non-existent, perfectly describing so-called data-dependent monetary policy. Eurodollar futures and US Treasury yields pay very little attention anymore to what the Bill Dudley’s of the world have to say (apart from the occasional Draghi comments from which reactions to them, or other things, get blown way out of proportion), a far different proposition than how the world is described.

China and U.S. Consumer Price Index and Eurozone Harmonised Index of Consumer Prices, Jan 2007 - Aug 2017

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No matter where you look, inflation stands out for all the wrong reasons (from the policymaker perspective). The US CPI as its PCE Deflator has disappointed and in very predictable fashion; in Europe, the pattern for EU HICP is eerily similar; and in China, the CPI continues to undershoot significantly despite in local terms anyway huge and sustained RMB injections.

China Consumer Price Index and PBOC Balance Sheet, Jan 2007 - Jun 2017

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Productivity Recovery Circular

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Real Gross Domestic Product and WTI, Mar 2012 - 2017

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China Fixed Asset Investment, Jul 2013 - 2017

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Even if it was only due to predictable oil price base effects, the risks that it was more than that, that it was indeed wages and resources as Dudley suggested long ago in October 2015, were viewed as then slightly more than trivial. That’s why the disappointing results from Europe to China to America in inflation have been so important in 2017. Markets are back to wondering why Fed officials even bother to speak, accomplishing little more than pull back the curtain on the wizard that much further.

Running Out of Reflation, Apr 2013 - Oct 2016

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The jury’s out of whether there is sort of structural, secular changes in place that are holding inflation lower on a sustained basis. The next four to six months I think are going to be important to see whether the readings that we’ve had over the last few months are mainly due to one-off factors, such as the big decline that we’ve seen in cellphone prices, or whether there’s something more fundamental going on.

No, the jury’s verdict was read into the record a long time ago, the “rising dollar” providing all the necessary evidence as to what really sets the “more fundamental going on.” If it was the other way, Dudley wouldn’t still be talking about wage pressures in the future tense. Transitory doesn’t count if the word still lingers in the official vocabulary year after year after year.

These markets have noticed, forcing even the formerly recalcitrant orthodoxy to notice, too. In still another “interest rates have nowhere to go but up” article published today, also in Bloomberg, the author admits there might be more than Korea holding down yields:

Of course, it’s not just escalating tension on the Korean peninsula that’s pushed yields toward their lowest levels of the year. U.S. inflation missed estimates yet again last week, adding to doubts about the likelihood of a third Federal Reserve rate hike in 2017. Traders are pricing out that possibility. They’ll get further insight into officials’ thinking when the Fed releases minutes of its July meeting Wednesday.

Those last two sentences are really the central thesis, just not in the way the article or even the narrative is written. Markets (outside of stocks) don’t care anymore if or by how much the Fed might “raise rates.” As noted last week, what truly matters is why they might be doing so. Reviewing Dudley’s speech history, or Yellen’s, it is instructive in that regard. The most that can be concluded given economic as well as inflation data is that they intend to “raise rates” because they intend to raise rates.

It is why UST yields and eurodollar futures prices have moved this year in the “wrong” direction, just as they did three years ago. Policymakers and economists are still seeking the economy that “should be” when by now it is obvious there is no such thing. What’s really out there is one “unexpected” lost decade turning “unexpectedly” into two. That scenario justifies lower rates and higher eurodollar futures prices no matter what the empty suits at the FOMC do about wage pressures that never seem to materialize.

Running Out of Reflation, Apr 2013 - 2017

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