James Bevan: Uncertainty, disinflation and monetary caution

Rob Evans and I were discussing Fed Chair Janet Yellen’s speech before the Economic Club of New York yesterday, and agreed that in the speech titled, The Outlook, Uncertainty, and Monetary Policy, she strongly suggested that she is in no rush to raise the Federal Funds rate again anytime soon.

By emphasizing uncertainty, she basically said that she (and her dovish allies on the FOMC) don’t have much confidence in their relatively upbeat outlook for the US economy, so it might be best to do nothing for a while.

They clearly had more confidence when they hiked the Federal Funds rate at the end of last year – but global financial markets then tumbled after a couple of Fed officials said that four more rate hikes were likely by year end.

The key parts of Mrs Yellen’s speech covered important topics.

1) Volatile markets.

At the start of her speech, Yellen said that “global economic and financial developments since December” … “at times have included significant changes in oil prices, interest rates, and stock values.” She reiterated that “global developments have increased the risks associated with” the Fed’s outlook.

She continued to stress the market risks and uncertainties as follows: “Looking forward however, we have to take into account the potential fallout from recent global economic and financial developments, which have been marked by bouts of turbulence since the turn of the year.

“For a time, equity prices were down sharply, oil traded at less than $30 per barrel, and many currencies were depreciating against the dollar.

“Although prices in these markets have since largely returned to where they stood at the start of the year, in other respects economic and financial conditions remain less favorable than they did back at the time of the December FOMC meeting.”

2) Risks to growth.

Mrs Yellen is clearly concerned that by raising rates again, the Fed could destabilize the global economy and financial markets, which certainly would have an adverse impact on the US.

She mentioned that while China is certainly slowing, there is much uncertainty about the pace of the slowdown. She didn’t say so directly, but she implied that Fed actions could destabilize China’s financial markets and exchange rate.

Rather than focus on the recent rebound in oil prices, Mrs Yellen chose to say that if they start falling again, that could renew the risk of an adverse “financial tipping point” for some oil-producing countries and companies.

3) Risks of disinflation.

Mrs Yellen was also extremely dovish about the inflation situation. She noted that the PCED inflation rate was 1.0% y/y through February and that the core rate was 1.7%, up from a recent low of 1.3% during October.

In other words, the core rate is getting close to the Fed’s 2.0% target. Yet she chose to minimize this development as follows: “But it is too early to tell if this recent faster pace will prove durable. Even when measured on a 12-month basis, core inflation can vary substantially from quarter to quarter and earlier dollar appreciation is still expected to weigh on consumer prices in the coming months.”

Consequently, she expects inflation will remain below 2.0% this year, though it should be up there in 2017 and 2018.

She continued to accentuate the risks of lower inflation, saying: “The inflation outlook has also become somewhat more uncertain since the turn of the year, in part for reasons related to risks to the outlook for economic growth.

“To the extent that recent financial market turbulence signals an increased chance of a further slowing of growth abroad, oil prices could resume falling, and the dollar could start rising again.”

4) Uncertainty begets caution.

The conclusion was obvious: The Fed should do no more harm as it had at the start of the year.

Yellen put it this way: “Given the risks to the outlook, I consider it appropriate for the Committee to proceed cautiously in adjusting policy.

“This caution is especially warranted because, with the federal funds rate so low, the FOMC’s ability to use conventional monetary policy to respond to economic disturbances is asymmetric.

“If economic conditions were to strengthen considerably more than currently expected, the FOMC could readily raise its target range for the federal funds rate to stabilize the economy.

“By contrast, if the expansion was to falter or if inflation was to remain stubbornly low, the FOMC would be able to provide only a modest degree of additional stimulus by cutting the federal funds rate back to near zero.”

Just another year

It looks as if this all adds up to another year like last year of either none-and-done or one-and-done for Fed rate hikes.

We can lean toward the first choice. There could be more global uncertainty this summer if Brexit happens. In early November, there could be more domestic uncertainty if Donald Trump happens. Then there’s China, Europe, and the US domestic economy making part of the determination of the way forward deeply data-dependent.

For those that want a longer assessment, by way of context, investors are always data-dependent but in recent years, investors also have become dependent on how Fed officials interpret the data they depend on.

Of course, Fed officials have been saying that they are data-dependent for several years now, and their focus was on the unemployment rate and the inflation rate.

With the unemployment rate under 5% and the inflation rate approaching 2%, the Fed has basically achieved its dual mandate.

Yet Fed officials are hesitating about raising interest rates again because they’ve recently decided that US monetary policy should also depend on global economic and financial developments, as confirmed by Mrs Yellen’s speech yesterday.

Meanwhile, the latest batch of US economic indicators has been a mix of strong and weak data. In no particular order, the Atlanta Fed reported on Monday that their latest “GDPNow model forecast for real GDP growth (seasonally adjusted annual rate) in the first quarter of 2016 is 0.6 percent on March 28, down from 1.4 percent on March 24.

“After this morning’s personal income and outlays release from the U.S. Bureau of Economic Analysis, the forecast for first-quarter real consumer spending growth fell from 2.5 percent to 1.8 percent.

“The forecast for the contribution of net exports to first-quarter real GDP growth declined from -0.26 percentage points to -0.52 percentage points following this morning’s advance report on international trade in goods from the U.S. Census Bureau.”

Inconceivable

On Monday, Jeffrey Gundlach, the widely followed investor who runs DoubleLine Capital, said that an interest-rate increase by the Federal Reserve in April is “inconceivable,” given lower forecasts for first-quarter GDP growth. It became even less conceivable after Mrs Yellen’s speech yesterday.

On the other hand, the Fed’s regional business surveys picked up smartly this month. This suggests that Friday’s M-PMI will show that the US manufacturing sector is coming out of its slump.

Also on Friday, another solid employment report for February is likely to be released. Focusing on the muddled mix of data:

1) Regional business surveys.

Debbie and I closely follow the monthly regional business surveys compiled by five of the Fed district banks (NY, Philly, Richmond, KC, and Dallas).

Their composite indexes tend to be quite volatile – but their average is highly correlated with the national M-PMI. It was below zero for seven consecutive months through February, when it was -8.8. But it shot up to 6.5 during March. The average of the orders indexes jumped from -11.1 to 8.5. However, employment remained below zero for the ninth consecutive month.

The dramatic rebound in the regional orders indexes into positive territory was led by NY (-23.5 in Jan to 9.6), Philly (-5.3 in Feb to 15.7), and Richmond (-6.0 in Feb to 24.0). Turning less negative were KC (-27.0 in Jan to -2.0) and Dallas (-17.6 in Feb to -4.8).

2) Employment.

While the regional employment index remained weak this month, it tends to reflect the trend in manufacturing payrolls.

Last year, payroll employment rose 2.7mn, with manufacturing jobs rising just 26,000. The household measure of employment rose 2.5mn over the same period.

Interestingly, over the past three months through February, the payroll measure is up 685,000 while the household measure is up 1.6mn.

The improvement in the labour market has certainly lifted the Consumer Optimism Index (COI), which can be calculated by averaging the Consumer Sentiment Index and the Consumer Confidence Index.

Interestingly, the present situation component of the COI remained around the recent cyclical high during March, while the expectations component has lost some ground over the past 14 months, falling from a cyclical high of 97.0 to 84.7 during March.

According to the survey used to compile the Consumer Confidence Index, the percentage of respondents who said that jobs are hard to get ticked up in March to 26.6% from a recent cyclical low of 21.7% during August 2015. However, the percentage saying that jobs are plentiful rose to a cyclical high of 25.4%.

3) Consumers saving more.

Despite the optimistic survey readings, consumers seem to share some of Mrs Yellen’s caution about the future, perhaps unnerved by the recent volatility in financial markets, or the ongoing presidential campaign.

During February, the personal saving rate rose to 5.4%, up from a recent low of 4.9% during November 2015. The 12-month sum of personal saving rose to $681bn, up from a recent low of $597bn. That increase suggests that all of the windfall from lower petrol prices has been saved.

On an inflation-adjusted basis, the three-month average of personal income through February rose at a solid 3.3% annualized pace compared to the previous three months, led by a 4.0% increase in wages and salaries.

However, real personal consumption spending rose only 2.0% over the most recent comparable period, with services up 2.8% while durable goods outlays edged up just 0.5% and nondurable goods outlays were flat.

By the way, I recently spoke to Tom Keene who went to Mrs Yellen’s lunch, and he reckoned that the most important thing he’d ‘learned’ was in a chat we’d had earlier in the day when I reminded him that the gap between the dividend yield and the real bond yield remains at extremes and dividends are very important, providing 67-85% of long-term returns.

We went on to agree that the key for dividend income is identifying sustainability, requiring a focus on companies with high cash flow return on investment, high cover (on free cash flow) and a decent start yield, so more than 3% in today’s markets. That’s what the GEIFs do and are a core part of the investment funds too.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla

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