By my friend David Kotok.
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New Fed Policy & Markets
December 15, 2012
My colleague Bob Eisenbeis will address the Fed’s new policy and what it means for “Fed watching.” Let me address what I think it means for markets.
We expect market agents to focus on the numbers. 6.5% has become the targeted unemployment rate for the headline unemployment statistic. That is now the “Evans rule,” named for Chicago Fed President Charles Evans, who pushed for this numerical standard as a threshold for the Fed to change its policy from the present expansive and stimulative one. Evans argues that the Fed should stay the course until the unemployment rate falls to this level or lower.
The number itself is an unambiguous reference. It is computed and published monthly. It is released at 8:30 AM on the first Friday of each month. Most of the time there is controversy about its computation. Media coverage has evolved into a game of forecast roulette on each month’s “employment Friday.” Surveys of economists’ estimates coalesce to a single number as the Friday draws near. Then the pre-employment-Friday ADP release on Wednesday is a forerunner in forecasting the actual unemployment rate. ADP’s record is mixed, but it is now part of the circus activity. Speculation about the employment report has no penalty for error among forecasters. Out comes the number and all the pre-release commentary is forgotten.
Most important are the revisions to prior numbers, since the first set of releases is composed of initial estimates and the refined numbers are more accurate. But the revisions get less attention than the roulette game of forecasting. Oh, well.
Over longer periods of time, the headline unemployment rate is an indicator of the health of the US economy. From the Fed’s viewpoint it is the single best-understood labor-related number to watch. Of course, market agents will now try to anticipate the Fed. Watch the market start to adjust when the unemployment rate falls below 7% and stays below it for several months. Watch the bond market attempt to project when the rate will reach 6.5%. We will be seeing that in the shape of the yield curve. Forward rates can be expected to move quickly every month as the employment number is released. The closer we get to 6.5%, the more volatility we will see.
Bob Eisenbeis will also discuss the use of “core PCE” again. He and I have been examining this change in Fed policy since Bernanke revealed it in the Q&A session. Bob notes the work of St. Louis Fed President Jim Bullard regarding the reasons why “core PCE” is a preferred indicator of inflation. The selection of this indicator and its use are very important for market agents to consider.
Market instruments do not easily trade on the “core PCE.” For markets, the reference is the headline CPI. It is the CPI which determines the pricing of TIPS and rents and social security payments and pension indexing and income tax brackets, etc. There is a vast difference (30 to 50 basis points) between the CPI and the PCE and more difference between the headline CPI, which includes food and energy, and the “core PCE,” which uses different component weights than the CPI and does not include food and energy. Markets are now going to have to estimate the gap between CPI and “core PCE.” This is like estimating the difference between “apples and oranges” (or maybe I should say the difference between the prices of apples and oranges). Both grow on trees; both make juices. Oranges make lousy pies.
The computational details of the PCE and CPI are a large topic, but there are references to watch for each of them. Jim Bianco publishes a comprehensive list of inflation measures each month as the data becomes public. Many others examine the data with different statistical approaches. Good work is available on the Cleveland Fed website (median CPI) and on the Dallas Fed website (search under “trimmed mean PCE”).
The bottom line is that there is a lot of variability between the “core PCE” and the headline CPI. They can be as much as 100 basis points apart and heading in different directions. Markets will be looking at market-based pricing by examining how the CPI-based TIPS market and TIPS forward rates adjust to each month’s releases.
The danger here is that expectations can and, in our view, will be over-reactive. We expect that the new Fed policy of predicating policy change on a threshold of 2.5% for “core PCE” will invite more volatility in the bond market, not less. In fact, the Fed’s action to include this inflation reference may end up being counterproductive to the Fed’s policy objective. Don’t be surprised if the headline CPI is over 3% and rising on an energy price spike while the core PCE may be simultaneously 2% and falling. The opposite construction is also possible. This will be the market’s new conundrum with Fed policymaking.
For market agents, the whole business of managing money has now become much more complicated. We already have the Fed actively engaged in targeting two points on the yield curve instead of one. The Fed policy now focuses on both the short-term rate and the longer-term rate. It has been hard enough for the Fed to get one of them right; now it is trying for a twofer.
Add the fact that the Fed is now focusing on references and thresholds to determine when it will make a policy shift. It is using the unemployment rate, but it has introduced a conditional inflation rate. The unemployment rate number is firmly identified; the inflation number is derived from an abstract notion and is questionable and controversial. Again the Fed has to get two things right, and both are very difficult.
So the Fed now has a two-by-two matrix. Two interest rates (short-term and long-term) and two economic indicators (inflation and unemployment) need to align for the Fed to make a shift. And each of them has a mean and standard deviation; and one of them, the “core PCE,” is viewed by market agents as a proxy that reflects itself in the CPI.
It is going to be an interesting few years.
Meanwhile, the near term is quite predictable. The inflation rate is well below the Fed’s target. The unemployment rate is well above the Fed’s target. The Fed has committed itself to several more years of the present low interest rates as a policy. At the same time, the deleveraging of the last five years is intensifying as financial repression continues to crush the yields of savers when they encounter maturity rollover. And fiscal stimulus has certainly peaked in the United States and most other major economies, so various forms of austerity are acting as a global agent of compression.
Bottom line: Interest rates are likely to be low for quite some time. It is too soon to sell your bonds. We like spread product and particularly tax-free Munis of higher credit quality. The bond bull market is not over.
David R. Kotok, Chairman and Chief Investment Officer
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