Author: Rebekah Stovall

Asset Allocation Weekly (October 27, 2017)

Posted on by Rebekah Stovall

by Asset Allocation Committee

It is expected that over the next two weeks President Trump is going to appoint a new Federal Reserve Open Market Committee (FOMC) chair and vice chair.  In this report, we will build scenarios of how policy could change depending upon whom the president appoints.

This spreadsheet details our estimate of policy preference, with one being the most hawkish and five the most dovish.

(Sources: Federal Reserve, CIM)

The first column shows the members of the FOMC with the chair in green and vice chair in blue.  We have Fischer still on the roster even though he is now leaving.  The “all” column lists our estimates of policy bias.  The Fed has eight permanent voters—the seven governors and the New York Federal Reserve Bank (FRB) president.  The other 11 regional FRB presidents rotate into a voting position roughly every two to three years.  The last row shows the average of our hawk/dove rankings.  The current voting roster is more dovish than the FOMC as a whole.  Scenario #1 assumes no changes to the chair and vice chair roles, although we know that Fischer is leaving so this scenario is purely hypothetical.  This is to show that even with no changes at the governor level, next year’s voting roster would have been markedly more hawkish regardless, with an average ranking of 2.70 compared to the current ranking of 3.20.

Scenario #2 assumes Jerome Powell, a current governor, is appointed to chair with John Taylor as vice chair.  Powell’s seat is assumed to remain vacant for the foreseeable future, which leads to an even more hawkish FOMC, with an average of 2.33.

Interestingly enough, the FOMC voters are just about as hawkish under the next most likely scenario, with John Taylor as chair and Kevin Warsh as vice chair (Powell remains as a governor).  Finally, if Trump re-appoints Yellen but adds Taylor as vice chair, the average is 2.40; again, not a significant change in policy stance.

So, what is the most likely outcome?  Currently, Powell is considered the front-runner[1] and would be the safest candidate.  He is a moderate like Yellen and would probably maintain the current arc of policy.  According to reports, President Trump had a good meeting with John Taylor and he might select him for vice chair.  There is no indication at this point who would be selected to fill out the rest of the three open seats if Powell is appointed.  It’s possible that Kevin Warsh could be offered one as a consolation prize but, for now, we would not expect the remaining vacancies to be filled until much later in 2018.

The bottom line is that next year’s FOMC will take on a decidedly more hawkish stance due mostly to the hawkish lineup of regional bank presidents.  This is a factor that will affect our outlook for next year.

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[1] https://www.predictit.org/Market/3306/Who-will-be-Senate-confirmed-Fed-Chair-on-February-4%2c-2018

Asset Allocation Quarterly (Fourth Quarter 2017)

Posted on by Rebekah Stovall
  • Our inflation outlook remains benign and economic data continues to be modestly positive.
  • We do not anticipate a recession in the near term.
  • Though the composition of the Fed will change over the next four months, we expect policy to continue toward tightening through increases in the fed funds rate and a reduction in the size of the Fed’s balance sheet.
  • The larger allocation to intermediate-term investment grade bonds remains intact. However, we reduce exposure to speculative grade bonds due to spreads grinding to their tightest post-recession levels.
  • Our growth/value even weight of 50/50 remains unchanged.
  • We increase our exposure to non-U.S. developed and emerging market equities, the former with a tilt toward Europe, due to expectations for continued U.S. dollar softness and attractive valuations overseas.

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ECONOMIC VIEWPOINTS

There are a number of potential pending changes to the policy and complexion of the U.S. Federal Reserve as of this writing. First, there are currently three, and soon to be four, open positions on the Board of Governors, the most important of which is the Fed chair. Though we are not expecting a dramatic near-term shift in the trajectory the current Fed has taken, the new arrangement could alter its policies as it is absorbed over the next few quarters. Second, the process of normalizing the nearly $4.5 trillion balance sheet is expected to commence in October as the Fed begins to slowly stop reinvesting the proceeds it receives from maturing bonds. Though the Fed stated it will start with a reduction of just $10 billion a month, over the next year the Fed’s current intention is to increase the amount to $50 billion each month. As this chart illustrates, a level of $50 billion each month will soon have the effect of shrinking the balance sheet.

With the recent publication of the Fed’s minutes from the September meeting, the near-term trajectory seems fairly certain with expectations for another hike in the fed funds rate in December already priced into the market. Fed fund futures currently have an implied 80% probability of  a December rate hike. However, the prospect for increases in the rate through 2018 as well as further implementation of quantitative tightening through the reduction in the balance sheet are dependent upon the composition of the Fed’s board. Given the Trump administration’s desire to strike a more populist appeal, it would not be surprising if the Fed adopts a more dovish posture in 2018. Such a pose would imply an extension of softness for the U.S. dollar versus other currencies.

Regarding other domestic economic themes, inflation and unemployment remain at low levels, while consumer and business sentiment are elevated. Although the effects of the disastrous hurricane season and wildfires in northern California will likely weigh on GDP and employment over the next several quarters, we believe the dislocations will prove temporary.

Outside the U.S., the European Central Bank (ECB) announced its intention to begin tapering the amount of its bond purchase program, but also indicated it would be extended further by nine months. We view this as the ECB maintaining its accommodative positioning while recognizing the strength in the underlying economy. It also underscores the ECB’s caution toward the myriad political developments in Europe, including Brexit, German and Austrian election results, the separatist movement in Spain and Italian elections in early 2018. The consequent economic impact holds a large degree of uncertainty, leading the ECB to lengthen its stimulus timeline.

In the realm of geopolitics, though concerns attract headlines, we do not think the current issues hold meaningful implications for asset prices. Naturally, the prospect of armed conflicts with North Korea and/or Iran, or a complete revision of NAFTA, would have tremendous economic impact, but at this stage we do not find reason to be less than sanguine. Accordingly, our allocation of assets among each of the strategies currently reflects an accommodation of risk.

STOCK MARKET OUTLOOK

The benign inflationary environment has been a positive backdrop for equity valuations and our expectations are that it should remain favorable. Though this year’s equity market advances thus far have been stronger than many experts expected,  we remain positive on the outlook for equities over the forecast period absent an exogenous event or a surprising change in inflation expectations. While we recognize that equity pricing, particularly in large caps, remains close to historical highs as measured by traditional valuation metrics of Price/Earnings, Price/Book and Price/Cash Flow, we remain optimistic over the near term. Moreover, we harbor some concerns that equity markets could exhibit a “melt up” over the next 1-2 years as investors who have remained on the sidelines since the beginning of this bull market capitulate and put their excess cash to work, thereby fueling demand for equities and inflating prices further.

As we recently published in our Asset Allocation Weekly (10/13/17), the parameters surrounding long-term S&P 500 trends remain supportive. Although a recession or geopolitical event would carry consequent risk to equity prices, the regression trend lines on the accompanying charts indicate that the S&P 500 is trading within one-half standard error of the 6% average yearly trend. For context, the top chart displays log-transformed weekly Friday closes of index data since 1929, while the lower chart shows a more recent period beginning in 1990. The same regression trend lines are used on both charts.

The Confluence Asset Allocation Committee recognizes that the U.S. economy is well advanced in terms of the economic cycle. In fact, the end of October will mark the 100th month for the current economic expansion, making this the third longest on record. However, economic conditions and associated market values fail to conform to the rigor of a calendar. We remain cognizant of the length of the expansion and are wary of the potential of a slowdown in economic growth over the forecast period.  Nevertheless, as equity markets continue to advance, the Confluence Cyclical Asset Allocation strategies retain their historically high allocations to equities, inclusive of non-U.S. equities. It should be noted that this quarter’s rebalance further increases non-U.S. equity exposure, owing to the committee’s prevailing view that there is a likelihood of continued softness in the U.S. dollar coupled with favorable non-U.S. equity valuation metrics as compared to U.S. counterparts.

Within U.S. large caps, we favor energy, health care, industrials and materials and underweight telecom, utilities and consumer staples. We maintain a neutral growth/value style bias.

BOND MARKET OUTLOOK

Despite the Fed’s decision to leave the fed funds rate unchanged at its September meeting, the probability for a 0.25% hike in December has increased. Over the forecast period, we envision the terminal rate of fed funds to be between 1.75% and 2.50%, with the differential dependent upon the make-up of the Fed’s Board of Governors and overall economic conditions. Given these expectations, there is the increased likelihood of a continued flattening of the Treasury yield curve due to tighter monetary conditions. Among corporate bonds, spreads for both investment grade and speculative grade bonds versus maturity equivalent Treasuries have tightened to post-recession lows.

Considering current conditions and expectations, we lengthen the overall duration slightly, though with an increase in Treasury exposure and a continued concentration in the intermediate segment of the yield curve. In addition, we decrease the overall exposure to speculative grade bonds, a position we find appropriate given tighter spreads and as the Fed embarks upon normalizing its balance sheet.

OTHER MARKETS

Similar to last quarter, we determined that commodities do not hold near-term appeal. Commodities can be helpful to a diversified portfolio in an environment of faster economic growth and/or a surge in inflation expectations; however, as these conditions remain absent, commodities are not currently represented in the strategies.

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Weekly Geopolitical Report – North Korea and China: A Difficult History, Part II (October 23, 2017)

Posted on by Rebekah Stovall

by Bill O’Grady

Last week, we examined the Minsaengdan Incident and the onset of the Korean War.  This week, we will discuss the final phase of the Korean War, the ceasefire, the introduction of Juche and the impact of the Cultural Revolution.

The Korean War: The Latter Stages of the War and the Ceasefire
Among the issues that caused tensions between China and Korea was the management of the railroads during the war.  Chinese troops encountered difficulties when using roads to supply their forces.  The roads were not in good shape and their war materials were vulnerable to American air attacks.  Given that most of the rolling stock and crews were Chinese, Chinese Volunteer Army (CVA) Commander Peng Dehuai wanted to gain control over the railroads to deliver war materials.  However, Kim Il-sung didn’t want China to take over North Korea’s rail system for two reasons.  First, the regime was trying to start reconstruction and didn’t want to divert rolling stock for war materials, and second, Kim was offended by the loss of sovereignty.  Nevertheless, China and the U.S.S.R. coerced the North Koreans into giving up control of their railways to China for the duration of the war.

The final indignity the Kim government had to face was the ceasefire determination.  Stalin and Mao wanted to keep the war going.  Both wanted to keep the U.S. occupied with the fighting in Korea as this would reduce America’s ability to defend other parts of the world.  In addition, Mao was receiving military aid from the Soviets and feared that the war’s end would end the flow of aid.  On the other hand, Kim wanted a ceasefire.  His country was being steadily bombed by the U.S. and North Korea couldn’t really begin reconstruction without an end to hostilities.

A second issue involved prisoners of war (POWs).  Chinese troops didn’t aggressively capture POWs.  Their military experience was mostly derived in the Chinese Civil War where they didn’t pursue POWs and they continued that behavior during the Korean War.  On the other hand, the Korean People’s Army (KPA) tried to capture as many prisoners as they could with the idea that they would be used as forced labor for reconstruction.[1]  Thus, the sides couldn’t agree on how to resolve the return of POWs; it wasn’t important for China, but it was critical for the Democratic People’s Republic of Korea (DPRK).

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[1] Zhihua, S. (2004.) Sino-North Korean Conflict and its Resolution during the Korean War. Cold War International History Project Bulletin, Winter/Spring (Issue 14/15), page 20.

Asset Allocation Weekly (October 20, 2017)

Posted on by Rebekah Stovall

by Asset Allocation Committee

The Financial Accounts of the United States (formerly known as the Flow of Funds Report) is published by the Federal Reserve and provides data on the level of financial assets and liabilities by sector.  Using this data, we can approximate the average asset allocation of American households over different periods.  This accounting of assets is broad; for example, the equity portion includes equities held in defined benefit plans and insurance policies.  In addition, the Federal Reserve includes non-profits in its data.  In our view, non-profits are not material to the overall calculations.

The data goes back to the 1950s.  On average, 50% of household assets are held in some sort of fixed income, while equity assets average 16% and non-financial assets average 34%.  A casual observation of the data suggests that allocations to fixed income and non-financial assets (likely housing) are favored during periods of high levels of inflation and elevated nominal interest rates.  On the other hand, equity allocations are higher during periods of low inflation and low nominal interest rates.  The allocation to non-financial assets rose sharply after 2000 as part of the housing bubble.  After the Great Financial Crisis, non-financial asset holdings declined; initially, fixed income rose and equities fell, but since 2010, that trend has steadily reversed as equities have taken a large share of assets.

Some of the gains in the various asset classes have come from price appreciation and other parts from reallocation of assets.  It isn’t completely obvious how much is coming from which part, although in future reports we will examine this issue more fully.  However, the chart does suggest that equities have benefited from being “the only game in town.”  Historically low interest rates and the aftermath of the housing crisis have undermined allocations to fixed income and housing.  Historical patterns suggest that allocations to fixed income don’t increase until 10-year Treasury rates exceed 6%.

This chart shows a scatterplot of the percentage of total assets held in fixed income and the 10-year T-note yield.  We have plotted a nearest neighbor fit study to the data.  We have seen high fixed income levels along with low rates (shown in the circle), but these mostly occurred during the Great Financial Crisis.  Although the current level of fixed income is low (shown by the arrow), a consistent rise above 50% generally has been seen with interest rates in excess of 6%.  Thus, history suggests that it would take a more significant rise in interest rates to trigger a flight to fixed income.

Of course, recessions or geopolitical events could trigger a move out of equities.  At 25%, the current allocation to equities is elevated.  This level is similar to where it was in Q3 1999 and not far from the peak of 27% in Q1 2000.  At the same time, the liquidity does need another place to go.  After the 2000 tech crash, the primary beneficiary was housing.  We don’t expect that pattern to repeat itself.  Thus, without an event to scare households out of equities or a sizeable rise in interest rates, equities should maintain their favored status for the time being.

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Weekly Geopolitical Report – North Korea and China: A Difficult History, Part I (October 16, 2017)

Posted on by Rebekah Stovall

by Bill O’Grady

The U.S. and North Korea have had a difficult history.  The two countries were the primary combatants during the Korean War and still have not established a peace treaty.  However, in the late 1970s, the Kim regime and the Carter administration considered normalizing relations.  Carter’s national security team concluded there was little value in talking directly to North Korea[1] and, ever since, the U.S. has essentially “outsourced” North Korea to China.[2]

On its face, this decision makes sense.  China is critically important to North Korea’s economy; more than 80% of North Korea’s foreign trade is with China.  Mao described relations between the two countries as “close as lips and teeth.”  However, relations are more than just economics.  A review of historical relations between China and North Korea indicates a deep animosity that inhibits China’s ability to control the policies and decisions in Pyongyang.

In Part I of this report, we will begin our study of the historical relationship between North Korea and China, including a review of the Minsaengdan Incident and a broad examination of the Korean War.  Part II will complete the analysis of the war, discuss the Kim regime’s autarkic policy of Juche and outline the impact of the Cultural Revolution on North Korean/Chinese relations.  Part III will cover the controversy surrounding North Korea’s Dynastic Succession, the end of the Cold War and the ideological issues with Deng Xiaoping.  Finally, we will recap this history and its impact on American policy toward the Democratic People’s Republic of Korea (DPRK) along with market ramifications.

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[1] Carter was worried about being seen as weak by GOP critics.  Creekmore, M., Jr. (2006). A Moment of Crisis: Jimmy Carter, The Power of a Peacemaker, and North Korea’s Nuclear Ambitions (chapter 7). New York, NY: Perseus Books Group.

[2] http://www.38north.org/2017/09/jperson092617/ This report borrows heavily from Mr. Person’s analysis and his reference material.

Asset Allocation Weekly (October 13, 2017)

Posted on by Rebekah Stovall

by Asset Allocation Committee

With the S&P making new highs almost daily, it is probably a good time to look at long-term trends to build some parameters.

This is a simple trend chart of the S&P 500 Index.  We have log-transformed the weekly Friday closes of the index data and regressed it against a time trend.  The chart on the left shows the index from 1929 while the chart on the right shows the index from 1990 (same regression trend lines for both charts).

Equities clearly trend higher over time.  The yearly trend shows an average return for the S&P 500 Index of just over 6%.  However, as the charts show, there is a fair degree of variation over time.  The trend data shows that two standard errors above the trend is a dangerous area.  One standard error above the trend is a concern.  We are currently just below one-half standard error above the trend.  That level by itself isn’t a big worry.  In the 1950s into the early 1970s, we saw the index vacillate between the trend and one standard error above trend.  These are not inconsequential market moves; in the current context, the trend line for the S&P 500 Index is 2090.26, meaning a pullback from current levels to the trend line would be a decline of about 17.6%.

Simply put, barring a recession or geopolitical event, equities are not seriously extended on a trend basis.  We also note that the last two bear markets dropped a full two standard errors from peak to trough.  The bear market that began in 2000 fell from two standard errors above the trend to the trend line (the bold red line on the chart), and the 2008 bear market ran from one standard error above the trend to one standard error below.  Thus, a recession-triggered bear market would be a significant market event.

So, what does this tell us?  Although there is a rather elevated sense of concern among investors, overall, the path of least resistance is to grind higher.  Equities are not cheap but alternatives are even more expensive.  The other insight this research offers is that a “melt-up” would take us well above 3000.  If investors were to become “irrationally exuberant” we would expect a move to this level.  At this point, there appears to be enough caution to prevent that from occurring.  However, if a dovish Fed chair is nominated or a major tax cut appears likely to pass, a rise to these levels might be triggered.  A recession is a clear worry; falling to one standard error below the trend line, which would be a drop of lesser magnitude than normal, would be to 1454.81 by year’s end.  Obviously, because the trend line moves higher over time, the longer it takes to have a correction, the higher the expected bottom.  For now, equities, based on this analysis, are not at levels that would usually signal a major bear market.  At the same time, this doesn’t mean that there are no risks.  It just means that, in terms of trend, we are not at extremes.

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Keller Quarterly (October 2017)

Posted on by Rebekah Stovall

Letter to Investors

In my last letter I wrote of the tendency of investors to think of the economy and the markets as linear phenomena, rather than cyclical phenomena.  In other words, an inclination to think that a good economy will continue its upward path forever unless some villain intercedes and causes a recession.  However, at Confluence we believe that both the economy and markets are cyclical because they are the products of human behavior, which always tend toward extremes, extremes which sow the seeds of their own reversals.  This quarter I’d like to call your attention to another fallacy of thought that many investors fall prey to: “fighting the last war.”

If you left the gate to your backyard open and your dog ran away, it’s natural for you to fear that that might happen again.  Thus, you’ll worry greatly about it and be extraordinarily vigilant about locking the gate ever after, such that it’s most unlikely your dog walks out of your open gate again.  It is more likely, however, that he gets out of the yard some other way that you haven’t thought of.

Investors are unusually well attuned to how the last bear market unfolded, and take measures to make sure they are not injured in that manner again.  Usually, however, the next bear market unfolds in an entirely different fashion and catches most investors unaware.  Citizens and politicians also take measures to “cure the ills that led to the last recession,” which unfortunately often leaves them unprepared for the next recession that unfolds quite differently.

As investors, it’s important to study the history of the economy and markets, not just that of the last ten or twenty years, but of the last several centuries.  There are many ways that recessions can unfold and there are many types of bear markets.  The same type of recession rarely strikes twice in a row and two identical bear markets usually don’t occur back-to-back.  One must be vigilant to all the possible ways the economy can get into trouble and look for all kinds of impending trouble.

I mention these things because in my recent travels visiting many clients in all parts of the country, I’ve been hearing a constant theme: fear of a return to the travails of 2008-09, when the economy hit a major recession and stock indices fell more than 50% over 18 months.  While I believe it’s inevitable that we’ll have a recession again in the next several years, I’m fairly certain it won’t look anything like 2008-09.  Why?  The last recession was driven by a liquidity crisis of the highest order, i.e., almost nobody, individuals or businesses, had any cash.  The real estate bubble of the preceding decade had led everyone to believe that property prices would never decline, thus, “Why hold cash?  Put all that money to work!”  In fact, legions borrowed lots of money to buy all the property they could.  When real estate prices finally fell, everyone (well, almost everyone) was cash poor.  People scrambled to sell assets (stocks, bonds, property, you name it!), raise cash, and pay down debt.  This led to a recession as people stopped buying other stuff all at the same time.  And, debt reduction has continued for most of the last eight years, which has led to very slow growth since.

Today, even though both real estate and stock prices have recovered, few investors are cash poor.  In fact, both data and anecdotal evidence show that investors and institutions (especially banks) are still sitting on “big piles” of cash (that’s not a technical term).  In other words, people are not going to let 2008 happen to them again.  They have padlocked the backyard gate.  Whatever sort of recession occurs next, it’s most unlikely to be similar to the last one.

In fact, fears by so many that a recession and bear market are just around the corner is good evidence that they are not.  Recessions and bear markets are usually the product of complacency, not fear.  Our economic analysis leads us to conclude that the precursors of recession are not yet visible.  And while this bull market is getting old, it doesn’t appear to us to be ready to reverse course.  Of course, bad things can go bump in the night and unsettle the world, and we watch for those.  But inasmuch as everyone seems to be ready to fight the last war, that last enemy is not likely to show up.

Thank you for your confidence in us.

 

Gratefully,

Mark A. Keller, CFA
CEO and Chief Investment Officer

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Weekly Geopolitical Report – The Four Horsemen of Leveling: A Book Review (October 9, 2017)

Posted on by Rebekah Stovall

by Bill O’Grady

Occasionally, we find a book that has such an interesting message that we dedicate a Weekly Geopolitical Report to reviewing it.  This week, we will look at The Great Leveler by Walter Scheidel.[1]  The book is an extensive historical analysis of inequality and the factors that reduce it.

In this report, we will discuss the premise of the book, the “four horsemen” of income leveling and the future it portends.  As always, we will conclude with potential market ramifications.

The Basic Premise
Inequality has become a critical issue.  In 2013, President Obama said the following about inequality:

And that is a dangerous and growing inequality and lack of upward mobility that has jeopardized middle-class America’s basic bargain—that if you work hard, you have a chance to get ahead.  I believe this is the defining challenge of our time: Making sure our economy works for every working American.[2] 

Interestingly enough, Scheidel’s historical analysis makes it clear that the current level of inequality is hardly unique.  And, a certain degree of inequality has been with us since the early stages of human existence.  Archeologists note that even early gravesites of hunters and gatherers show distinctions of wealth and status.  These differences steadily became more widespread as civilization developed.

In theory, society could take steps to prevent or reduce inequality.  However, history suggests the opposite usually occurs.  As agriculture developed, Scheidel’s analysis shows that wealth became increasingly concentrated.  Scheidel’s key insight is that civilization and peace tend to bring rising income and wealth inequality.

However, a casual observation of history also suggests that wealth and income distributions are not permanent.  Sadly, Scheidel’s conclusion is that massive societal disruption reduces inequality.  He refers to these as the four horsemen of equality.

The Four Horsemen
The “Four Horsemen of the Apocalypse” comes from scripture.[3]  The biblical reference is widely debated but, in general, it refers to tribulations.  Scheidel suggests that his four horsemen refer to events that cause inequality to decline.  Here is his list: Mass Mobilization War, Transformative Revolution, Societal Collapse and Plague.

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[1] Scheidel, W. (2017). The Great Leveler: Violence and the History of Inequality from the Stone Age to the Twenty-First Century. Princeton, NJ: Princeton University Press.

[2] Ibid, page 2.

[3] Rev. 6:1-8

Asset Allocation Weekly (October 6, 2017)

Posted on by Rebekah Stovall

by Asset Allocation Committee

The latest FOMC meeting and subsequent comments from Chair Yellen have increased the likelihood of a December rate hike.

(Source: Bloomberg)

This chart shows the implied likelihood of a rate hike compared to steady policy from fed funds futures for the December meeting.  In early December, the projected odds of a hike were just above 30%; those odds have recently jumped to over 70%.  Although the core personal consumption deflator remains well under 2%, which is considered the target of the central bank, Chair Yellen indicated that tight labor markets raise the chances that inflation might rise quickly and force the Fed to boost rates sharply, potentially triggering a recession.  By raising rates when inflation is below the inflation target, the FOMC hopes to avoid a rapid increase in rates.

Most members of the FOMC base their policy decisions on the Phillips Curve, which postulates that there is a relationship between unemployment and wages, and if the latter rises, inflation tends to follow.  This idea has become increasingly controversial as the relationship between wages and inflation has weakened over the past two decades.

This chart shows the yearly change in core PCE and wage growth for non-supervisory workers.  Note that the correlation broke down after 1995.  We believe this is because the full impact of deregulation and globalization has put a lid on inflation and thus wage changes have less impact on price levels.

The key concept for the Phillips Curve is the Non-Accelerating Inflation Rate of Unemployment (NAIRU), which is the unemployment rate that is the lowest possible rate an economy can achieve without triggering inflation.  The idea is that if unemployment falls below NAIRU, the labor markets become too tight, triggering excessive wage growth and inflation.  The above chart shows the Greenspan-Bernanke-Yellen Federal Reserve.  We have put vertical lines where tightening cycles began.  Note that Greenspan began two tightening cycles while the unemployment rate was above NAIRU (1994, 2004) but waited to raise rates until 1998 when the unemployment rate was well below NAIRU.  The latter tightening cycle was a rather famous one; Greenspan held that rising productivity would keep inflation under control and thus waited to raise rates.  Notably, Janet Yellen, a Fed governor at the time, lobbied hard for raising rates sooner due to the drop in unemployment.

The current tightening cycle began with the unemployment rate very close to NAIRU, which is consistent with Chair Yellen’s thinking on inflation.  So far, wage growth has remained subdued.  Since the early 1980s, wage growth has usually exceeded 4% when the unemployment rate falls below NAIRU.  It is currently 2.3%.  It is unclear why wage growth is so weak relative to what appears to be a tight labor market.  That is what makes boosting the policy rate risky.  Since the meeting, we have seen the dollar strengthen and bond yields rise.  However, the odds of a policy mistake, though currently low, are rising.  This is an issue we will be monitoring closely in the coming months, especially as the president chooses not only a new Fed chair but also a vice chair and two other open governor positions.

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