Dear Valued Clients and Friends,
I was fully prepared for the possibility of writing a Dividend Cafe today about a surprise rate hike from the Fed this week. In fact, when I selected this as the topic earlier in the week, I basically did so because if the Fed had done so, I didn’t want to miss the opportunity to capture the excitement in Dividend Cafe.
The Fed did not raise rates this week, but it was a fascinating week in monetary policy for a lot of reasons. I understand that many may like what the Fed did (or didn’t do) and many may not, but I believe it is very important for investors to comprehend what is going on inside the Federal Reserve. I am going to try and do two things today in the Dividend Cafe, neither one of which is particularly easy, and the two put together may represent a small miracle: (1) I am going to try and provide cogent and coherent commentary on what the Fed is up to, and (2) I am going to try and make it fun and enjoyable.
If I can pull this off, who knows what else I am capable of?
Let’s jump into a Fed-filled Dividend Cafe …
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The Base Case (for a Hike)
Made as simple as possible – those arguing for Chairman Warsh to hike rates this week would basically say: “Your inflation target is 2%. You have been running above 2% for over four years. Therefore, you should raise rates until you see inflation get to your target.” For many, it is that simple, and if nothing else, the argument’s logical structure certainly works.
But it really isn’t that simple. If there are other nuances to the premises or additional premises altogether, the conclusion itself may very well change. For example, some may argue (none of these may be true, or all of them may be true, or something in between, but my point is merely that they are all potential counters to the above argument):
- The inflation rate is headed to our target without the Fed hiking rates
- The factors keeping inflation above 2% are not likely to be addressed by a higher interest rate
- There are other things we can do that will be more effective in reducing the inflation rate
- Right now, the cost of running inflation above 2% is less than the cost of what higher rates would do to the economy
So while the base case seems cut-and-dry, there are other potential beliefs that would allow one to logically conclude something other than “we need to hike rates to get the inflation rate lower.”
Debating About the Wrong Why
One of the problems with monetary policy for a long, long time is that there has been a huge difference between stated priorities and concerns and what is actually driving monetary policy decisions. Certain Fed regimes may have said, “today we made the decision to hold rates at 0% due to concerns about weakness in the labor market,” and people would then have a real debate about whether or not there were concerns in the labor market, or whether or not a 0% fed funds rate was an appropriate solution. But if the real reason they made a 0% rate decision was “we are worried about dollar funding in emerging markets” or “until we see housing recovery in this foreclosure glut we can’t raise the cost of capital” or “government borrowing is skyrocketing and we need to facilitate a low cost for Treasury to accommodate rising deficits for a period of time” – any one of which could have been a legitimate reason or a horrifying reason – but if we were debating about the merits of what they said was their reason versus understanding the real reason we were spinning our wheels.
It was, I suggest, the predominant fallacy of monetary debate for the last 18 years. Too many allowed the cover the Fed provided to actually work as a distraction to a policy debate about what was really happening. I can disagree with plenty of what past chairs Bernanke, Yellen, and Powell did, but I still acknowledge that each of them was masterful at sticking to the script, knowing what should be said, and knowing what could never be said. There has been too much policy debate in the post-GFC regime about whether or not the Fed was right to do something based on the public rationale for such an action, when the debate needed to be about the actual rationale for various actions. This requires the Fed to harmonize the public and actual rationales, and I will suggest that it represents the biggest regime change to come.
The Base Case (for Not Hiking Rates)
Before we get into why the Fed did not hike rates this week, which may or may not be aligned with the most common arguments against doing so, it will be helpful to understand what the major argument is against doing so. While there may be different strands of this argument, I suspect the base case would be a combination of the above bullet points (not merely one of them) … In essence, if one believes the inflation rate is dropping without Fed tightening, and that the factors impacting the price level (oil/geopolitical volatility, tariff impact on goods prices) are largely outside the touch of monetary policy, anyway, then the cost of hiking rates (potentially suppressing hiring and economic growth) would not be justified. Once again, this argument may be flawed or even entirely wrong, but it is structurally logical.
Peter Boockvar shared the drop in inflation expectations in 2-year, 5-year, and 10-year TIP spreads on Wednesday. As you see here in this Bloomberg chart, all three have seen market expectations for inflation drop closer and closer to that 2% target.
The argument basically is: Why add medicine to something getting better on its own? It is a why argument from the other side of this policy debate (versus those arguing for a rate hike).
It also, though, happens to be quite different than the why behind the Fed’s decision function.
The Fed’s Case for Not Hiking Rates
What Chairman Warsh more or less said on Wednesday was that:
- Markets have done their tightening for them this meeting. In other words, yes, we’d like to tighten to help expedite a move closer to the 2% inflation target, but with the entire yield curve both in real and nominal rates having moved higher over the last six weeks, a Fed Funds rate hike was not needed. The 10-year is up 23bps since the last FOMC meeting, and the 2-year is up 19bps.
- If monetary policy is part of the reason the inflation rate has stayed above 2%, there is another culprit on the side of excess accommodation that is a more logical thing to target than the overnight borrowing rate: The balance sheet. In other words, the Fed adding $200 billion to its balance sheet in recent months has to stop before we even consider hiking rates
The chairman was asked several times (at varying degrees of eloquence and rhetorical competence) by reporters in Wednesday’s press conference “what markets were telling him if he preferred for markets to speak versus central bankers” and he forcefully made the case that he believes capex is strong, that productivity is strong, and that labor markets are at least steady, and that the bond market itself is telling us this. He is not presupposing that a ten-year around the “nosebleed” levels (tongue in cheek, believe me) of 4.6% means “inflation” – but rather that it potentially means “enhanced productivity and a stable economic backdrop.”
Chairman Warsh is not a dove. He is not going to tolerate an inflation rate above 2% for years on end. But his case, for now, is basically: Nominal and real rates up 25bps across the curve over the last six weeks is a rate hike we didn’t have to do.
The retort to this, actually offered by one reporter in the press conference, is that the bond market did so in anticipation of a Fed hike – that it was a self-fulfilling prophecy. Of course, markets weren’t ever really assuming a rate hike this week, but even if they were, if bond markets were playing the referee and not the ball, why did rates move up across the yield curve the next day, after the Fed announced they were NOT hiking?
Warsh believes in market signals, and he is content, at least for now, to let markets do their job without Fed intervention. The softer-than-expected June CPI report may not have driven the non-decision, but I am sure it helped. If the Fed got a peek at today’s PCE report, I suspect that helped. But I don’t think either thing was dispositive.
His other point regarding the balance sheet was not as heavily discussed on Wednesday, but it was addressed with such simplicity and plainness that it almost seems embarrassing that others would miss it. If one believes the Fed is too accommodative, so accommodative, in fact, that it needs to tighten via a market-shocking rate hike, why in the world are they still adding to their balance sheet (increasing financial reserves and system liquidity to the tune of $200 billion in recent months?
In other words, why is someone talking about adding a whole new alarm system to their house when they right now still keep the front door and back patio door not just unlocked but wide open? (I made that analogy up myself right now, and I am sticking with it.)
Summary:
- Hawks believe the Fed should hike because we are above the target inflation rate.
- Others believe they should not because we are headed there anyway.
- The Fed believes we do need to tighten, but markets are doing it for us with higher real and nominal rates, and we can do so ourselves by stopping new asset purchases.
Regime Change at the Fed
The biggest takeaway I had this week was not in what the Fed did and did not do. It is in two themes across Chairman Warsh’s rhetoric that I found very compelling. He has more or less stated since he got the chairmanship that he wants to see a Fed that has a smaller footprint in the economy, that financial markets become more interested in economic data than in guessing how the Fed might respond to or act on a given economic data point. The analogy he has used on multiple occasions is:
“Play the ball, not the referee”
I suspect you will see this become the dominant theme of the Warsh Fed, and I think it will frustrate a wide array of reporters and a wide array of hedge fund managers to no end. Warsh is 100% right that forward guidance has been used as a tool of distortion and manipulation and that the unintended consequences have been to de-emphasize productive economic activity and overly emphasize that which is non-productive (betting on what the referee will do rather than the players).
I have already written and spoken at great length about Warsh’s rejection of Phillips Curve folly, but this week he took it to another level. When Powell-lover, Nick Timiraos of the Wall Street Journal, flat out asked him what his transmission mechanism would be for managing the trade-off between price stability and full employment, Warsh replied:
“Price stability and full employment are not at war. I do not accept that these things work against each other … In fact, I believe the most harm done to labor markets is cause by high inflation [as price uncertainty impedes hiring, investment, and risk-taking].”
I could have cried (tears of joy). Instead, I took notes.
Where Are We Now?
Odds of a rate hike (implied by the fed funds futures market) went from 95% by September to just 63%. The odds of one (or more) hikes by the end of the year fell from 100% to 84%. I will not be surprised to see those odds drop in the weeks to come, though any number of data points could change that.
Warsh seems very encouraged by a surge in AI investment and the expectations of greater productivity from such investment. I do have to wonder if or when concerns of excess or froth in that space will provoke monetary intervention, but it is clear to me (for now) that he is content to let markets prick that asset bubble, and not the Fed, itself (and indeed, looking at July action in semiconductors and hyper-scalers, one may conclude markets won’t end up needing the Fed to do just that; we shall see).
I am more convinced than I was before that the various task forces he has at work are not pretextual or cosmetic, and that serious people doing serious analysis about the Fed’s data processes, use of balance sheet, and other key objectives will be quite telling about where the Fed is headed under Warsh.
Warsh seems to share my view that supply shocks alone can not dictate monetary response to price action – that there are many moving parts beyond those inherently volatile and non-monetary catalysts. That said, if you get a month or two of bad data in these fronts, I suspect Warsh does end up hiking. Inversely, if the data stays reasonably level, and the thrust of his arguments from this week remains intact, I doubt you will see much change from the status quo this year.
The other thing that needs to be quickly said: There were three (out of twelve) members who voted for a hike at this meeting. A 9-3 vote is not a mutiny, and both Powell and Warsh were on the 9-side of that, but I bring it up to point out that Warsh has very little wood to chop if he wanted or needed to move the FOMC majority to the hike side.
Warsh and Trump
A very legitimate argument some made for a Warsh rate hike (or two) this week was to firmly establish Warsh’s credibility and independence as it pertains to the influence of the President. That is all fair enough. But of course, to do something just because the President doesn’t want you to do it is just as incoherent as doing it just because the President does want you to. My view is that:
- Whether or not Warsh’s action (or non-action) was liked by President Trump, he did not do it to appease the Trump – and, in fact, didn’t consider that at all; and …
- He explicitly called out tariffs and higher oil prices from the Iran war as factors in upward price pressures.
It hardly seems that calling out the two most unpopular things in the administration would be in line with doing the President’s bidding. Again, people can agree or disagree with what Warsh does or does not do, but the assumption that is Presidentially driven is, in this case, just wrong.
Conclusion
I am not among the people wondering “when Warsh is going to come in and blow things up.” I believe he can be a transformational Fed chair without being a lunatic or revolutionary. I certainly understand that sometimes very bold actions are needed, and I hardly consider an interest rate hike lunatic or revolutionary. But reform-mindedness being needed at the Fed (Warsh’s view) does not negate temperate, even slow, methodical processes. The task forces are a good example of the institutionalism that guides Warsh. I believe he is playing the long game, and no one can play the long game if they break their leg in the first minute of the first quarter. There is a lot, and I mean, a lot of time left in Chairman Warsh’s tenure. His changing posture around forward guidance, and hopefully some effect in stopping the increase on the Fed’s balance sheet, represent sizable moves in the first 45 days on the job.
As for rates, well, markets are digesting PCE data, TIP spreads, oil prices, and muted GDP growth, all underneath the largest capex boom in a single sector in human history. Warsh doesn’t know what he is doing next for the same reason I don’t – because markets can’t even know. The beat goes on, and the more it goes with market forces driving things versus central bank interventions, the better.
Quote of the Week
“Critics are always correct, because they don’t have P&L’s to remind them how wrong they actually were.”
~ Lloyd Blankfein
More to Chew on
- Gen Z has a different prism on politics than the rest of us
- An entrepreneurial approach to hiring – out of the box, meritocratic, and fascinating
- If government can sell groceries, why can’t they …
* * *
July comes to an end today, and we move into August, where questions will continue about labor markets, the price level, capex, and more. Investors continue to face a variety of tug-of-war contests right now (markets unpacking where they like capex and where they don’t has become another fascinating one – put differently, where they like depleting free cash flow and where they don’t). I am excited to devote a lot of time in August to what I believe is the most evergreen, defensible, and sensible solution to the various unknowns and uncertainties of the economy and markets: dividend growth. To that end, we work.
This Dividend Cafe is dedicated to the loving memory of Elaine Rothman, who I will miss dearly.
With regards,
David L. Bahnsen
Chief Investment Officer, Managing Partner
The Bahnsen Group
thebahnsengroup.com
This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet
