Although the stock market is giddy from President Trump’s pro-growth policies, there is another constituent not quite so enamoured with recent developments. Although a few years ago Fed officials were begging for some help from fiscal policy, with employment now running at a “perceived” tight pace, FOMC participants have switched to viewing fiscal stimulus as a potential inflationary concern that needs to be offset with tighter monetary policy.
Case in point - have a look at the comments from the most dovish member of the FOMC - über dove Lael Brainard (all quotes from Bloomberg):
September 16, 2016
“The case to tighten policy preemptively is less compelling” in an environment where declining unemployment has been slow to spur faster inflation, Brainard said Monday, according to the text of her prepared remarks in Chicago. She made no reference to a specific meeting of the policy-setting Federal Open Market Committee.
Brainard’s comments are the last before the Fed enters its quiet period, during which officials abstain from publicly speaking about monetary policy in the run-up to an FOMC meeting. Policy makers will gather in Washington Sept. 20-21 to discuss their monetary policy stance. Recent comments from the committee’s voters have not projected a cohesive signal about whether they will lift interest rates or stay on hold.
“Asymmetry in risk management in today’s new normal counsels prudence in the removal of policy accommodation,” Brainard said, arguing that with interest rates near zero, it’s easier for the Fed to react to faster-than-expected demand than to a negative surprise that upsets the economy. “I believe this approach has served us well in recent months.”
January 17th, 2017
Federal Reserve Governor Lael Brainard said the U.S. central bank may accelerate interest-rate increases and measures to shrink its balance sheet if Congress approves a sustained, material increase in fiscal stimulus that pressures inflation without lifting productivity.
“Based on recent spending indicators, we might expect progress to continue to be gradual and steady,” Brainard said Tuesday in Washington. “However, if fiscal policy changes lead to a more rapid elimination of slack, policy adjustment would, all else being equal, likely be more rapid than otherwise.”
Brainard is the most dovish member of the Federal Open Market Committee, yet she is openly warning about higher rates. Other FOMC members are even going so far as to signal upcoming balance sheet reductions and even higher rates than the market has currently priced in.
Chair Yellen is also making some hawkish chirping noises. Have a look at the first paragraph from her recent Stanford speech:
In my remarks today, I will review the considerable progress the economy has made toward the attainment of the two objectives that the Congress has assigned to the Federal Reserve–maximum employment and price stability. The upshot is that labor utilization is close to its estimated longer-run normal level, and we are closing in on our 2 percent inflation objective. I will then discuss the prospects for adjusting monetary policy in the manner needed to sustain a strong job market while maintaining low and stable inflation
“Labour utilization is close to its estimated longer-run normal level, and we are closing in on our 2 percent inflation objective” is the key line. In this speech, Yellen then goes on to sketch out the basic formula for setting rates. It’s a boring econometrics discussion, but the important point is that she is setting out how the Federal Reserve will go about raising rates.
Make no mistake - rates are going higher. Probably a lot higher than the market realizes. Just look at this comment buried in Yellen’s speech:
That said, I think that allowing the economy to run markedly and persistently “hot” would be risky and unwise. Waiting too long to remove accommodation could cause inflation expectations to begin ratcheting up, driving actual inflation higher and making it harder to control. The combination of persistently low interest rates and strong labor market conditions could lead to undesirable increases in leverage and other financial imbalances, although such risks would likely take time to emerge. Finally waiting too long to tighten policy could require the FOMC to eventually raise interest rates rapidly, which could risk disrupting financial markets and pushing the economy into recession. For these reasons, I consider it prudent to adjust the stance of monetary policy gradually over time–a strategy that should improve the prospects that the economy will achieve sustainable growth with the labor market operating at full employment and inflation running at about 2 percent.
In the coming quarters, the Federal Reserve will march rates higher. But more importantly, the more Trump pushes on the fiscal accelerator, the harder the Fed will lean on the brake.
The stock market has risen on each pro-business executive order Trump signs. In fact, this latest push to new highs is the direct result of Trump’s following through with his promised plans.
Although the stock market is screaming higher, the bond market is not at all happy. Not only does the bond market need to deal with the threat of increased inflation from Trump’s policies, but also a Federal Reserve intent on tightening monetary policy to offset the fiscal stimulus.
I think the Federal Reserve is too eager to raise rates (and also reduce the size of the balance sheet). They continue to fight the last battle and don’t realize that in a balance sheet constrained global financial system, inflation is not the main worry. They run the risk of becoming another Japan with an economy littered with false starts. I don’t know if it is a political bias, or they would have been just as quick on the trigger for a Democratic President, but it really doesn’t matter. Nor does my opinion about the Fed being better off letting the economy run hot for a while mean two shits. All of these thoughts should just be discarded in the dustbin of not worrying about what should be and instead focusing on trading what will be.
It seems obvious the Federal Reserve is intent on withdrawing monetary accommodation until something breaks. There is no sense fighting it.
And it is also clear President Trump will follow through with his fiscal stimulus plans. Many pundits thought Trump’s actions might not follow his rhetoric, but the market is quickly realizing that Trump means what he says.
These two different forces are on a collision course. More fiscal stimulus translates into more monetary tightness. And Trump isn’t going to back down anytime soon, so all that is left is an expanding fiscal environment with a Federal Reserve desperately trying to apply some brakes.
This economic expansion is already running long in the tooth, and there is a pattern of recessions occurring in the first year of office for newly elected Presidents, so an overly aggressive Fed is a worrisome development. Ironically, Trump’s fiscal stimulus might be the trigger that ushers in the next economic slowdown.
Many strategists believed Trump might ask Yellen to step down and appoint someone more hawkish. They mistakenly confused Trump’s campaign complaint about low interest rates killing the economy as future policy.
Well, Trump will do no such thing. In fact, I suspect before Yellen’s term is complete in 2018, Trump will be blaming her for all his problems when the economy rolls over. I am not sure if Trump is this smart, but keeping Yellen around for exactly this task would be the wise move.
In the mean time, Trump will keep pushing forward with more fiscal stimulus, and Yellen & Co. will push back with tighter monetary policy.
This interplay between Trump and Yellen makes for a shitty environment for bonds, and also as real rates head higher, gold and other commodities. Eventually this giant debt disaster will need to be inflated away, but I am afraid this FOMC is not yet scared enough to let that happen.
As this plays out, be careful with your precious metals and other commodity long positions.
Higher real rates are not conducive for precious metal bull markets. As long as the Fed keeps pressing on the brake, it will be tough for these commodities to get up off the mat. It won’t be until something breaks in the financial system that you want to own them. But at that point, you should be buying with both fists.
Thanks for reading,