Last week was the annual Economic Policy Symposium hosted by the Kansas City Fed in Jackson Hole, Wyoming, which is attended by economists, central bankers, academics and policy analysts from around the globe. This year’s topic was Financial Innovation: Implications for Payments and Policy. Timely, given the increasing proliferation of blockchain technology within the global financial system and growing adoption of AI within the broad economy with their potentially transformative impact on not just digital payments but currencies, financial markets, labor and prices. There are lots of interesting papers and presentations if you are so inclined[1].
As the head of the U.S. central bank, Kevin Warsh gave the Keynote address, his first as Chair of the Federal Reserve. His speech offered few surprises relative to expectations. He did share a mostly positive view on the current state of the U.S. economy. Regarding the labor market, he noted a low and stable unemployment rate and cited real consumer spending up 2% over the last four quarters. Conversely, he was less sanguine about elevated inflation (PCE price index up 3.7% and 4.1%, respectively, over the past twelve and six months[2]). Importantly, he offered clarification on a key market question by definitively reinforcing the Fed’s 2% Core PCE inflation target. Warsh spent a good deal of time discussing broad policy philosophy and long-term plans for the Fed’s topical research focus. The most notable takeaway, from my perspective, was his discussion of forward guidance, a practice he vowed to do away with upon taking the reins based on his belief that it boxes the Fed in on short-term decisions and clouds the signals between financial markets and the Fed that are critical to arriving at the right decisions. There is much more in the speech, but the following quote captures the essence of his message:
The economic literature has long described the distorting effects: a hall-of-mirrors problem. If markets rely materially on the Fed’s guidance and the Fed relies on market prices, we are all more likely to be blinded to new developments . . . more likely to be caught unprepared for a turn of events . . . and more likely to commit errors in policymaking. Perversely, market participants are unlikely to bear the biggest costs of the hall-of-mirrors problem. The most serious harm is likely to befall those without financial assets. If the Fed gets inflation wrong and judges the economy wrong, who gets the worst of it? Not the financial high-fliers. Hard-working Americans are the ones left to deal with inflation that is too high or jobs that suddenly appear less secure. So, if forward guidance is ill-suited to normal times, then how about the new Fed chief commits—at the very least—to an explicit reaction function? Surely, he should tell us his interest rate path—if, say, the data were to come in hot or cold. I wish our understanding of the economy were so precise as to provide a mechanical, tried-and-true answer—that some simple function like a Taylor rule could be rigorously relied upon. But our knowledge just doesn’t extend that far—at least, not yet—and the factors most relevant to the proper conduct of monetary policy change over time[3].
The bond market immediately decided the comments regarding inflation were hawkish and almost as if on cue interpreted it as guidance, pushing the odds of a September rate hike above 60%. The argument is that unless the inflation data reported over the next two weeks is “cool” then the Fed will be forced to raise rates. I am not so sure the consensus interpretation is correct, mostly because Warsh has been clear that, while data-driven, the Fed is unlikely to react simply to one set of numbers. One the other hand, the trend in PCE inflation is currently up[2] so, directionally, the Fed’s bias should be towards tightening. According to Warsh "We must be confident that underlying inflation is moving to our objective, clearly and at sufficient speed. Otherwise, we have work to do[3].”
The 10-Year U.S. treasury yield was basically unchanged in August (4.75% vs 4.73% on July 31), despite some volatility[2]. Corporate credit spreads were unchanged and remain near multi-decade lows[2]. The Aggregate Bond Index rebounded in August after a tough July bringing the YTD total return close to flat[2]. Inflation survey data came in a little hot in the early part of the month with ISM Price Paid indexes for both goods and services above 70[2], but core inflation measures (PPI, CPI, PCE) were in line with or slightly below expectations[2]. Core Capital Goods Orders (non-defense, ex-transportation) for June were ahead of forecasts, but total Factory Orders were down slightly MoM[2]. The weak spot was the labor market. Initial Jobless Claims, though still low, ticked up a bit with the 4-Week Moving Average crossing back above 200k[2]. Nonfarm Payrolls fell -23k in July compared to a consensus for +82k while the Two-Month Revision was -103k[2]. This week we get to see another set of employment numbers, which the market will closely scrutinize for clues as to what the Fed is likely to do at the September 16th meeting. As usual, the data does not offer an unequivocal signal one way or another. However, Fed Chair Kevin Walsh indicated in his Jackson Hole speech that in his view the economy “appears to have strengthened[3].”
One area of the economy is unequivocally strong, however. Business Fixed Investment (capital expenditures, or Capex) is lending substantial support, much of it driven by spending on AI, data centers and power infrastructure. This is a point we have belabored, but currently it is the critical marginal driver of activity. Spending on equipment is growing at a double-digit rate this year. Industrial and Information Processing equipment (excluding computers and peripherals) accelerated in the second quarter to well over 25% annualized growth and contributed nearly one-half of total Fixed Investment and almost 40% of total 2Q GDP[2]. This is why the Technology Sector trade remains robust and why Large Cap Growth stocks rebounded in August after getting hit in July on a big semiconductor correction[2]. Rotation into Large Caps led Small Caps to lag in August and they are struggling QTD but remain among the top performing benchmarks YTD due to strong outperformance in the first half[2]. REITS were hardest hit in August on a combination of profit-taking, rate volatility and some modest curve flattening driven by higher short-term rates[2].
After the Labor Day holiday we enter the final election push to the mid-terms. I will spare you the punditry other than to say that the track record of pre-election polling data has become increasingly unreliable over the last decade. Have a great long weekend and enjoy the waning days/weeks of summer.
|
Bloomberg Catholic Values Indices[2]
|