Regime shift at the Fed, Trump signals tariffs, Mexico to retaliate

I was reading Tim Duy’s second account of Federal Reserve Chairman Jerome Powell’s testimony before Congress. And what he wrote made a lot of sense. Tim is talking about a regime shift at the Fed that will see interest rates go higher. That’s the first subject I want to take on in today’s daily. But there’s also trade because of an expected tariff announcement by US President Donald Trump. Mexico says it will retaliate if the US imposes tariffs on Mexican steel. And that has me thinking about a trade war.

There’s a lot to unpack. So let’s get started!

Lael Brainard as the catalyst for Fed regime shift

The thing that caught Tim’s eye regarding a Fed regime shift was Lael Branaird. She always seems to be at the center of policy shifts. Back in late 2015, she and Fed Governor Dan Tarullo expressed caution about raising interest rates. And as the Fed increased the Fed Funds rate, their cautious stance became Fed policy. Then in mid-2017, as Powell laid out the rules for quantitative tightening, Brainard favoured rate hikes. That signalled the Fed moving in a hawkish direction.

Now she is teeing up the latest regime shift. In a speech echoing Powell’s Congressional commentary, her next speech is entitled “Navigating Monetary Policy as Headwinds Shift to Tailwinds.” Powell’s optimism on the economy took the same phraseology in testimony before Congress. He said:
“While many factors shape the economic outlook, some of the headwinds the U.S. economy faced in previous years have turned into tailwinds”

So clearly Powell’s Fed colleagues ‘signed off” on his remarks. And having Brainard, who is usually considered more dovish, give a talk on economic tailwinds speaks volumes. The speech title alone is hawkish. A regime shift is at hand.

The Fed’s move to a rules-based approach

What kind of regime shift should we expect? Fed watchers talked a lot about a rules-based approach to monetary policy in 2013, when Yellen became the Fed Chair. The Fed had undercut its credibility by moving the goalposts every time it lowered its employment threshold. And so the communications strategy was chaotic. I saw Yellen as someone who would move more in the direction of ‘rules’. And that meant that she based her then-dovish policy stance only on what was appropriate given the macroeconomic conditions. Indeed, she has repeatedly stressed that the Fed’s policy stance depends crucially on the prevailing macro conditions. Powell has taken on this same language, albeit in a more boilerplate way.

But Yellen’s approach was not really a strict rules-based approach. Fed policy was a more coherent adhockery than during the quantitative easing regime days. Nevertheless, it was still adhockery. In particular, even now, the Fed’s forecasts are not credible. As I wrote in December:

The only way we get the Fed’s projected 2.5% real GDP growth for 2018 and year-end unemployment of 3.9% is by a whole lot of people coming back into the labor force. Without a migration of hidden unemployed people to active labor force participants, the unemployment rate is going to 3.6 or 3.7% with growth as robust as the Fed projects.

Unemployment at 3.6 or 3.7% means more than just three rate hikes. All of the speculation about a fourth rate hike in 2018 owes to this inconsistency.

Jay Powell has said right from the word go that he wants to change this. On Tuesday he told Congress: “In evaluating the stance of monetary policy, the FOMC routinely consults monetary policy rules that connect prescriptions for the policy rate with variables associated with our mandated objectives. Personally, I find these rule prescriptions helpful.”

Adhockery is over.

The Taylor Rule

One very prominent rules-based approach is the Taylor Rule. It says that an increase in inflation of 1% requires the Fed to raise its interest rate target by more than 1%. That means that when inflation rises, the real interest rate must rise too, not just the nominal rate. That means that, adjusted for inflation, interest rates will be higher, if inflation is higher. Policy makers want the increase in real rates to slow an overheating economy without causing recession.

The talk of headwinds turning to tailwinds evokes a Taylor Rule thinking of the economy. And if the Taylor Rule is really driving the conversation now, that’s a regime shift. The Yellen regime was one of caution because of low labor force participation and high broad measures of inflation. The Powell regime could be one of rising real interest rates.

I think the market is starting to digest this. Because rising real rates make future earnings less valuable, this is negative for equities. And the selloff on Powell’s comments make sense in this context.

Equity market, bond market and currency market reaction to a new Fed Chair

Source: Reuters

Trade War?

Real quick now to the tariff issue. I mentioned on Tuesday that President Trump could be making a speech in Pennsylvania and announce a new tariff policy. Steel and aluminum are the targets. There are three options on the table, according to Bloomberg News:

  • A global tariff on all steel imports of at least 24%.
  • A tariff of at least 53% on steel from select countries: China, India and Brazil. Other countries would have imports capped at last year’s level.
  • A quota on all steel products equal to 63% of shipments from each country to the US in 2017. And that includes big US allies Canada, South Korea, Mexico and Germany.

Bloomberg says today is the big day. And Mexico has got wind of this policy. With a Mexican election coming, the talk is of retaliation.

I believe the tariffs are more geared toward China than Mexico. But the fact that Mexico has reacted shows you the issues are multilateral. Moreover, given a North American Free Trade Agreement, I don’t know how Trump plans to implement this. On its face, a steel tariff that affects Canada and Mexico is negative for NAFTA. Let’s see what Trump has to say.

UPDATE 1300 EST: Trump has now told industry executives that he will impose 25% tariffs on steel and 10% tariffs on aluminum. The details will be released next week.

Negative news flow

For me the news flow today is negative for risk assets. A Fed regime shift to faster tightening and a potential trade war raise interest rates and lower growth. Now hedge fund manager Paul Tudor Jones thinks a 3.75% 10-year yield in 2018 is a “conservative” bet. And that is certainly a headwind for risk asset prices.

Nevertheless, I am in the camp that says rates that a steep rise in interest rates eventually sows the seeds of its own destruction. That would risk recession. At the same time, the Powell regime shift, if it happens, won’t transmit policy equally across the curve. Unless inflation or growth increases, we are unlikely to get 3.75% here because the yield curve will flatten. 3.75% is 90 basis points more than today and that assumes front end movement equivalent to four rate hikes plus only 10 basis points of flattening. I don’t see it.

Right now the breakout to 3% growth is tenuous. Global growth is accelerating. And that is a tailwind for the US. But I think we have to be cautious about extrapolating positive fundamentals forward.

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