Back in January, when Chair Powell unexpectedly U-turned on months of hawkish policy and shocked traders when he said that contrary to what he had said just two weeks prior during the December FOMC press conference, the Fed could be “patient”, rate hikes could, in fact “pause”, and the Fed’s balance sheet reduction is not in fact on “autopilot”, the Powell Put finally emerged for the first time, and the result has been a torrid rally ever since, and the best first half market performance in decades.
It also prompted an avalanche of accusations that Powell – who has also facing intense pressure from president Trump to cut rates or else lose his job – folded like a cheap suit, held hostage by traders who pushed stocks low enough to i) test where the Powell Put strike price is and ii) force the Fed to not only halt rate hikes, but launch an easing cycle, something it has now effectively done.
Yet as we noted in January, being held hostage, or captive, by the market is nothing new to Powell; in fact, it was way back when in March 2013, ahead of the Fed’s taper announcement, that the Fed chair first realized that it was not the Fed that controls the market, but rather – after years of ZIRP and QE – the Fed had become a hostage of the market’s every whim.
And now, none other than the world’s biggest incubator of central bankers, Goldman admits as much.
In a note published by Goldman’s chief economist Jan Hatzius, he asks rhetorically “Why Cut?” and provides several good fundamental, economic reasons why there is no reason whatsoever for Powell to announce at the end of this month that the US central bank has commenced an easing process. Some of the key arguments are the following:
- Fears of a sharp labor market slowdown have proven unfounded so far. Following the 224k rebound in June, both the 3- and 6-month averages for nonfarm payroll growth are now back above 170k. This is 50k below the 2018 pace but still 70k above the breakeven rate consistent with stable unemployment.
- While there has been a sharp slowdown in various manufacturing surveys, Goldman continues to believe that “much of this weakness reflects the ongoing inventory adjustment, which is likely to subtract 1.7pp from Q2 GDP growth” and adds that “we are now probably near the end of this process, as the level of inventory investment seems to have fallen to a below-trend pace and the economywide inventory/sales ratio appears to be peaking.” According to Hatzius, “these observations typically set the stage for a rebound in orders and employment before too long.”
- The US Consumer has rarely been stronger: according to Goldman, prospects for final demand look good, as private domestic final sales probably grew almost 3% in Q2, “and even beyond Q2, we are relatively optimistic, because the easing in financial conditions implies that the FCI impulse to growth should go from about -1pp around yearend 2018 to a modestly positive number around year-end 2019.”
- Inflation is far from recessionary: while core PCE inflation remains at 1.6% year-on-year, significantly below the Fed’s 2% target, in Powell’s May 1 FOMC press conference, he characterized the weakness as “transient” and emphasized the stability at 2% in the Dallas Fed’s trimmed-mean index, and to Goldman this still looks like the right take on the issue: “In fact, both the core PCE and the trimmed-mean PCE remain at the same year-on-year levels as two months ago, and each has risen at sequential rates of more than 2% since then.”
- Trade war has taken a step back: with most dovish Fedspeak over the past several weeks emphasizing the increased uncertainty (especially with regard to trade policy) around a fairly optimistic central case as a reason for potential rate cuts, while the trade uncertainty has not gone away, the decision by Presidents Trump and Xi to return to the negotiating table and suspend the next tariff increase has reduced it, at least in the near term.
This reveals the key question – if the economy, both domestic and international – are not pushing the Fed to cut, then what is? According to Goldman, the answer is simple – the market. To wit, despite the recently encouraging news on jobs, growth, inflation and trade, “the bond market is still priced for nearly 50bp of cumulative cuts over the next two meetings, even after Friday’s selloff. Whether or not this is “justified” by the fundamentals, it probably matters for the near-term monetary policy outlook because it raises the cost of doing nothing.”
By pricing in so much easing, the market has basically trapped the Fed: according to Goldman estimates of the link between monetary policy shocks and financial conditions imply that failing to deliver 50bp of cuts could tighten our FCI by 50bp as well, via a combination of higher bond yields, lower stock prices, wider credit spreads, and a stronger dollar. Translation: the market would tumble and prompt the Fed to cut rates anyway to avoid a crash.
Additionally, the combination of a hawkish Fed surprise and falling stock prices would undoubtedly trigger another bout of criticism from President Trump. Besides, it would play into the perception by many market participants that the Fed’s policy and communications since last October’s “long way from neutral” comment have been unusually unpredictable. Although Fed officials likely view this criticism as unfair, at the margin it probably makes them more eager to avoid yet another major policy surprise. So 25bp cuts in July and September remain our base case.
What is even more challenging is the divergence between the Fed’s longer-term forecasts and the market, which continues to price in rate cuts well beyond 2020. By contrast, if Goldman’s economic forecast of renewed declines in unemployment and a rebound in core PCE inflation to 2%+ proves correct, “Fed officials would normally be looking to reverse any near-term cuts, as they did following the 1995-1996 and 1998 “insurance“ episodes.” That said, hikes in the runup to the 2020 presidential election are unlikely as Hatzius concedes, but his forecast remains a rebound in the funds rate to the 2½-3% range in the medium term
Which brings is the punchline – the same punchline that Powell uncovered back in 2013 – that the Fed is now a slave to the market. As Hatzius concludes, “ultimately, the uncertainty around the future path of policy probably revolves as much around the Fed’s reaction function as around the economic outlook.” But what is most stunning is Goldman’s own admission that “bond market pricing may be playing a bigger role in driving policy decisions than in the past, via the cost of not delivering on near-term policy expectations, the slope of the yield curve, and the signal contained in breakeven inflation compensation.”
In short, Powell is now terrified to disappoint the market!
This is a disaster for the future of the Fed for two reasons – first, here is Goldman’s explanation, noting that while “such reliance on the “wisdom of the crowds” has some potential advantages for policymakers, it also raises the risk that monetary policy—in the words of former Chair Bernanke—“degenerates into a hall of mirrors” and takes the funds rate far away from the level justified by economic fundamentals.”
This is Goldman’s way of admitting the Fed may be blowing a massive asset bubble.
But wait, don’t take Goldman’s word for it – here is Powell’s own shocking observation from March 2013 on what it would mean if the Fed has now lost control and is “now a captive of the market.“
I have one final point, which is to ask, what is the plan if the economy does not cooperate? We are at $4 trillion in expectation now. That is where the balance sheet stops in expectation now. If we have two bad employment reports, the markets are going to move that number way out. We’re headed for $5 trillion, as others have mentioned.
And the idea that… we ’re now a captive of the market — is somewhat chilling to me. I think we need to regain control of this, or we will be moving out on that if the economy doesn’t cooperate.
There’s some material part of the probability distribution that is not covered by a plan, in my view. The way to get at it is to increase flexibility, starting now, around the plan for the existing prongs: the costs and the risks, and what constitutes a substantial improvement. I think both of those need to be communicated better to the public in a way that increases our flexibility to do something, because if the economy doesn’t cooperate, I don’t know what we do.
The problem has been, and is, the open-endedness of the plan. And I would say , in closing, that the risks may be manageable at $4 trillion, but at $5 trillion , you’re in a different league. There has to be convexity in this.
And so, almost six years after Powell first defined precisely how the Fed is now a captive of the market in March 2013, and a few months after Powell got to experience it first hand, Goldman admits that the worst case scenario is now in play – one where the Fed no longer has control over the market, and as such the final asset bubble is now in play, one which Powell will never dare to burst over fears of how he would go down in history as the man who burst the world’s largest bubble. Of course, the flip-side is that with the bubble only growing bigger, by the time it finally does burst, it will wipe out the entire financial system with it – and is also why several weeks ago BofA first warned that if the Fed cuts now, it would be a “huge risk.”
Well, in just three weeks the market expects – with 100% certainty – that the Fed will indeed cut rates at least once. Ironically, as even Goldman now admits, by doing so Powell will start the countdown to not only the final reflationary phase of what will be the last asset bubble, but also a financial, economic and social crash that will make the Global Financial Crisis seems like a dress rehearsal.
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