Yellen Defends Fed Rate-Rise Plan Despite ‘Mystery’ of Low Inflation

(…) Although Ms. Yellen said she expects inflation to gradually move up to the target, she acknowledged the uncertainty surrounding that prediction. (…)

“How should policy be formulated in the face of such significant uncertainties? In my view, it strengthens the case for a gradual pace of adjustments,” Ms. Yellen told a National Association for Business Economics conference in Cleveland. “It would be imprudent to keep monetary policy on hold until inflation is back to 2 percent.” (…)

New York Fed President William Dudley, argue that the strong economy will soon push up inflation, suggesting a need to continue raising interest rates.

”I expect inflation will rise and stabilize around [the Fed’s] 2% objective over the medium term,” he said Monday. “In response, the Federal Reserve will likely continue to remove monetary policy accommodation gradually.”

Others, such as Charles Evans of the Chicago Fed, see no indication that inflation is about to turn higher.

Speaking in Michigan on Monday, Mr. Evans said he believed weaker inflation reflected structural changes in the economy rather than a temporary phenomenon. “I think we need to see clear signs of building wage and price pressures before taking the next step in removing accommodation,” he said. (…)

Still, the Fed’s understanding of inflation is “imperfect,” she said, calling the shortfall in inflation “a mystery.” “We recognize that something more persistent may be responsible for the current undershooting.” (…)

“We will monitor incoming data closely and stand ready to modify our views based on what we learn,” she said.

Bloomberg Briefs adds this:

The underlying theme of Yellen’s speech was that the Phillips curve still works. While some recent Fed research has suggested that the model — which describes the inverse relationship between the jobless rate and inflation — may no longer be useful, she is not subscribing to that notion.

The Fed is risking a policy mistake by turning a deaf ear to continued inflation weakness and proceeding with both balance-sheet unwind and rate hikes. (…)

Atlanta Fed President Raphael Bostic said an interest rate increase may be appropriate in December given clear signs of growing inflation pressures. “The contacts we have on the ground are telling us that they are starting to see far more pressure from a wage perspective and a pricing perspective,” he said. “I am starting to see those much more clearly and consistently than when I started in June.”

Robert Eisenbeis, Ph.D., Vice Chairman and Chief Monetary Economist at Cumberland Advisors:

(..) The more interesting information from this last FOMC meeting is the insights we gleaned after the meeting, both from the SEP [the Fed’s staff’s Summary of Economic Projections] forecasts and from Chair Yellen’s press conference. The picture we get is the FOMC’s view is that the economy is growing steadily and the labor market continues to improve, but the response of inflation has the Committee totally puzzled.

Consider the Committee’s GDP forecasts. The highest median forecast is for 2.4% growth for 2017, followed by a gradual decline year by year to 1.8% in 2020. Labor markets are projected to remain tight, with the median unemployment rate declining even more, from 4.3% to between 4.1% and 4.2%. Finally, the median PCE inflation measure is expected to move up to 1.9%, within striking distance of the Fed’s 2% target.

The problem is that GDP is weaker and labor markets are not significantly different in these new forecasts from what has happened in 2017. So where do the inflation pressures come from?  The question is especially interesting when we look at the distribution of the federal funds rate target that FOMC participants argue is most consistent with their forecasts. For example, the median outcomes are realized with a policy rate for 2018 ranging between 1.9 and 2.6%. (We are ignoring here the 1.1% number submitted by one participant.)

The range of assumed target rates for fed funds in 2019 is between 2.4% and 3.4%, while median GDP growth is even lower, at 2%, from that projected for 2018. All the while, inflation is seen as pushing close to the Committee’s 2% objective. This view of inflation dynamics implicit in the SEP forecasts simply doesn’t comport with what has happened and implies that substantially different underlying forecast models and inflation dynamics are being utilized by FOMC participants.

Is there an alternative, understandable explanation for the inflation path we have seen? Simple Econ 101 supply and demand analysis may hold the answer. The picture we have right now is of a real economy in which GDP growth is slow both because of slow growth in the labor supply and low productivity. If, in such a world, aggregate demand is essentially in balance with production and there is no excess demand, then there can be no upward pressure on prices. People are simply not running around trying to spend but failing to find goods and services. If producers can’t raise higher prices in the face of non-existent excess demand pressures, then prices will not move up. Moreover, there will be no need to bid up wages.

If this simple explanation works, then the FOMC’s clinging to a 2% inflation objective that is inconsistent with demand and production becomes a risky policy. This likely explains the wide range of policy rate assumptions FOMC participants are making and reflects the widely differing views within the FOMC as to what is appropriate policy going forward.

So when Yellen says that “It would be imprudent to keep monetary policy on hold until inflation is back to 2 percent”, one has to wonder “imprudent for who?”. “How should policy be formulated in the face of such significant uncertainties? In my view, it strengthens the case for a gradual pace of adjustments”. But if policymakers were focused on the man on the street, “such significant uncertainties” could also strengthen the case for a wait and see policy, given that the economy is rather weak as the Chicago Fed National Activity Index of 85 data series reveals:

In fact, the FOMC itself has the economy slowing from a current rather slow +2.4% growth rate for 2017 to +1.8% in 2020. Knowing that the Fed has consistently been too optimistic, prudence should be not to give more headwind to an economy almost totally dependent on the consumer.

The fact is that we are all going blind into the most important period of the year with data blurred by the hurricanes, a Fed convinced that the economy is steadily improving and that a mysteriously weak inflation still needs to be contained.

U.S. New-Home Sales Declined in August

Purchases of newly built single-family homes fell 3.4% to a seasonally adjusted annual rate of 560,000 in August, the Commerce Department said Tuesday, the second straight monthly decline and hitting their lowest level since December. More broadly, new-home sales were up 7.5% in the first eight months of 2017 compared with a year earlier. (…)

The agency said survey responses were lower than usual in areas of Texas and Florida affected by Hurricanes Harvey and Irma, potentially affecting the latest data. (…)

Note that all regions were flat or down in the last 2 months.

Citi Says Get Ready for an Oil Squeeze

(…) Five countries in the group — Libya, Nigeria, Venezuela, Iran and Iraq — may already be pumping at their maximum capacity this year, Ed Morse, the bank’s global head of commodities research, said in an interview. Rather than a surge in output, there’s a risk of a market squeeze emerging as early as 2018, driven by those nations because of weaker investment in exploration and development, he said. (…)

US oil producers lock in prices after crude’s rally Futures data suggest hedging is at levels not seen since oil began its slide in 2014

(…) Hedging could embolden US producers to raise volumes after putting the brakes on drilling in recent weeks. (…)

Few S&P 500 Companies Have issued EPS Guidance Since Harvey Hit U.S.

(…) Nearly all of the S&P 500 companies that have issued EPS guidance to date for the third quarter issued the guidance before the hurricanes hit the U.S. Of the 118 S&P 500 companies that have issued EPS guidance for Q3 2017, only six (or 5%) have issued EPS guidance since Hurricane Harvey first hit the U.S. on August 25.

One reason is normal seasonality. Over the past five third quarters, 101 S&P 500 companies on average have issued EPS guidance for the third quarter. Of these 101 companies, 88 on average issued EPS guidance prior to September 1. Only 13 S&P 500 companies on average have issued EPS guidance for the third quarter after September 1. Only 6 S&P 500 companies on average have issued EPS guidance for the third quarter during the month of September. Thus, many S&P 500 companies may be continuing their normal practice of not issuing EPS guidance for the third quarter after September 1.

S&P 500 companies may also still be trying to quantify the impact of the hurricanes on their bottom line. Three of the six companies that have issued EPS guidance since August 25 directly addressed the hurricanes. However, two of these three companies (Hewlett Packard Enterprise and Best Buy) stated that it was too early to provide an estimate of the impact. Thus, S&P 500 companies may provide more EPS guidance at a later time once the impact of the property damage and lost business can be quantified. (…)

But as I wrote Monday:

But amid these positive pre-announcements, analysts were busy reducing their estimates on many other companies. Since September 1, 63% of the 1416 earnings revisions for S&P 500 companies were downward.

Thomson Reuters says that the estimated earnings growth rate for the S&P 500 for Q3 2017 is 6.2% (+4.3% ex-Energy).

SENTIMENT WATCH

• Here’s why the stock market is still the ‘cleanest dirty shirt’

Think the stock market is overpriced or maybe even in a bubble? Think again, say analysts at Barclays.

In the note, entitled “Uncomfortably Bullish,” they argued that global equity valuations remain in line with longer term averages and below the previous cycle peak, while the outlook for global earnings per share remain the best in nearly five years. Compared with other pricey assets, equities remain the “cleanest dirty shirt” available to investors, they argue (…).

• “This Is Not A Time To Buy Anything” – Sam Zell Warns Retail Real Estate Market Is A “Falling Knife”

“Like a falling knife…the U.S. has 4 or 5 times the amount of square footage per person of retail as anywhere else in the world… not an area where I would want to deploy capital at this time.”

Lenders Continue to Ease Mortgage Credit Standards

Facing constrained mortgage demand and a negative profit margin outlook, more lenders say they have eased rather than tightened home mortgage credit standards, according to Fannie Mae’s third quarter 2017 Mortgage Lender Sentiment Survey^®. Across all loan types – GSE Eligible, Non-GSE Eligible, and Government – the net share of lenders who reported easing credit standards over the prior three months reached a new high since the survey’s inception in March 2014, after climbing each quarter since Q4 2016.

On net, lenders’ profit margin outlook has remained negative for four consecutive quarters. “Competition from other lenders” was again cited as the primary reason, reaching a new survey high for the third consecutive quarter. In addition, the net share of lenders reporting growth in purchase mortgage demand over the prior three months has fallen for all loan types year over year, reaching the lowest third-quarter reading in the past two years. However, the net share of lenders expecting an increase in mortgage demand over the next three months remains relatively stable for the same quarter year over year.  (…)

INFLATION AND CENTRAL BANKS

The Fed’s rift on rates and inflation is on full display. New York President William Dudley signaled the likelihood of one more hike this year, calling factors holding down prices temporary. Chicago’s Charles Evans demurred, saying tightening before seeing “clear signs” of wage and price pressure would be a mistake. Janet Yellen may give her take when she speaks Tuesday in Cleveland.

Chicago’s Evans said he’s “a little nervous” that some inflation weakness may be structural, given changes to technology and “the nature of competition.”

Mario Draghi emphasized that the euro area will get as much stimulus as needed, even as the ECB adjusts its 2.3 trillion-euro ($2.7 trillion) bond purchase program this year. Cautioning against “hasty moves,” the central bank chief cited uncertainties over inflation as continuing to require “a very substantial degree of monetary accommodation.” (BloombergBriefs)

• BIS Says Globalization Is Answer to Inflation Puzzle

Globalization is the most likely explanation for surprisingly low rates of inflation, suggesting that central banks should be patient in seeking to meet their targets and avoid providing too much stimulus, a senior official at the Bank for International Settlements said Friday. (…)

The BIS has advanced this view with increased confidence over recent years, citing a mounting body of evidence from its own research and that of other economists. Some leading central bankers are now giving it greater credence. In a speech Monday, Bank of England Gov. Mark Carney said globalization has weakened the link between spare capacity in national economies and their inflation rates.

Mr. Borio said the influence of globalization on inflation has implications for central-bank policy.

“To the extent that disinflationary pressures result from forces such as globalization or technology, they should be generally benign: They would reflect favorable supply side developments as opposed to damaging demand weakness,” he said. “At a minimum, this suggests lengthening the horizon over which it would be desirable to bring inflation back toward target.”

In the current context, that would mean providing less stimulus to the economy than many central banks are now offering. (…)

And this from the San Fran Fed:

• Demographic Transition and Low U.S. Interest Rates

(…) Population aging is a natural possible explanation for the declining trend in real interest rates because of its effects on household saving and consumption over peoples’ life cycles. (…)

Our model projections regarding the substantial effects of population aging suggest that future economic policy will have to adjust to operating in a low r-star world. In such an economic environment, interest rates would hover not too far above their lower bound. This implies that central banks could be more limited in their ability to further lower the policy rate to respond to recessionary shocks and stimulate the economy.

Nestlé Gives Loeb What He Wants: New Margin Targets, Faster Buybacks Nestlé set a new profit-margin target and said it would accelerate share buybacks amid pressure from activist investor Dan Loeb.

The announcement Tuesday, ahead of a much-awaited investor day in London, comes after Mr. Loeb’s Third Point LLC built a 1.3% stake in the Swiss consumer-goods giant and has pushed for a formal profit-margin target and other shareholder-friendly moves.

The Vevey-based company said it would strive for a trading operating profit-margin target of 17.5% to 18.5% by 2020 on an underlying basis, or stripping out restructuring, impairment and other one-time charges. In July, Nestlé reported an underlying trading operating-profit margin of 15.8% for the half year, flat from a year earlier on a reported basis and up 10 basis points at constant currency. (…)

GOP’s New Effort to Repeal Health Bill on Verge of Collapse The Republicans’ latest effort to repeal large parts of the Affordable Care Act this year suffered a likely death blow when Sen. Susan Collins’s declared opposition left it without enough votes to pass.

Republican’s Latest Tax Plan Has Little Room to Maneuver Republicans face a daunting challenge as their tax plan comes into sharper focus: They are trying to fit more than $5 trillion of cuts inside a $1.5 trillion box.

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  Tax Plan Could Leave High Earners With Little to Gain

(…) The 2016 House GOP blueprint called for a 20% corporate tax rate, a 25% tax rate on pass-throughs and a 33% top individual rate. In April the White House proposed a 35% top rate for individuals. President Donald Trump has said he might not cut taxes for the wealthiest Americans, and recently Republicans have talked a lot less about the importance of reducing the 39.6% top tax rate on ordinary income. In the end that rate might not come down much and some deductions could go away.

With GOP senators agreeing to, at most, $1.5 trillion in tax cuts over the next decade, there is a limited amount to go around. Republicans are focused on cutting business taxes and offering a larger standard deduction for middle-income households. (…)

Keeping the top tax rate on wages near 39.6% would be a way for Mr. Trump to defend his argument that he isn’t prioritizing tax cuts for the rich, even if other pieces of the tax plan favor wealthy business owners, investors or heirs of large estates. (…)

The proposed lower pass-through rate wouldn’t help the large share of business owners who don’t generate significant high income, because their top rates are below the 25% proposed rate in the House plan. The biggest winners are high earners who can classify their earnings as business income. (…)

FYI from The Daily Shot:

Apple (and to some extent the US stock market) remains dependent on the iPhone revenues. Will the public pay nearly $1,000 for the latest product?