Daily Comment (August 22, 2016)

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] There are two items of note this morning.  First, talk coming from the FOMC is that of two minds.  On the one hand, several members are taking great pains to suggest that all meetings are “live.”  Today’s weakness in equities and dollar strength is being attributed to comments from Vice Chair Fischer who said the economy is “…close to our targets” for raising rates further.  Fischer appears to be in the camp that believes recent economic sluggishness is not a permanent feature but a series of temporary headwinds.  This position is different than what we have heard from the San Francisco and St. Louis FRB presidents, who have suggested that sluggish growth may be more persistent and that the FOMC may need to have a much lower terminal rate target or tolerate higher than 2% inflation.

Chair Yellen will speak later this week at Jackson Hole, WY, at the annual gathering sponsored by the KC FRB.  The markets do not expect Fischer and Yellen to contradict each other; if Fischer’s comments are hawkish, the fear is that Yellen will reflect similar sentiments on Friday.

We do note that WSJ Fed whisperer Jon Hilsenrath has an article today in which he admits his earlier opposition to raising the inflation target was probably wrong.  Raising the inflation target solidifies the “lower for longer” position but it also assumes that central banks can control inflation, which we think is incorrect.  The intersection of aggregate supply and demand sets inflation.  Monetary policy tends to affect aggregate demand but only if banks circulate the reserves (which they have not done).  In a globalized and deregulated world, aggregate supply is ample, leading to a mostly flat supply curve, meaning that the economy can take lots of stimulus before price levels start to rise.  That is why we have been watching the populist uprising in the West; if anything could upend the current regime of globalization and deregulation, it would be nationalism and populism.  But, as long as centrists continue to control government, the current regime will probably stay in place.

To some extent, the FOMC probably wants to inject a bit of uncertainty into the financial markets.  This is a fool’s errand—financial markets are calling the Fed’s bluff and we doubt the FOMC will raise rates because of an elevated P/E.  Thus, even if they do raise rates, we would expect a parade of Fed speakers to make it clear that a hike at one meeting doesn’t necessarily signal a series of hikes.  This gets us to the “two minds” problem.  On the one hand, the Fed would like to raise rates a bit; on the other hand, it’s becoming clear that more members are buying into the secular stagnation idea, which means the terminal rate will be lower.

In foreign central bank news, the Reserve Bank of India announced its new governor.  He is Urjit Patel, a former Yale economist who spent time at the IMF in the early 1990s.  He replaces Raghuram Rajan, who had fallen out of favor with the Modi regime.  Patel is said to be an inflation hawk, so we don’t expect much change in policy.  We also note that BOJ Governor Kuroda said over the weekend that there is “sufficient chance” of further easing at the next policy meeting.  It is unclear how much more could be done, absent of direct fiscal financing.

Second, we are seeing lower oil prices this morning.  The latest commitment of traders’ data confirms that the rally over the past two weeks has been nothing more than massive short covering.  In Nigeria, the rebel group that has cut the nation’s output by about a third has agreed to a ceasefire and is “ready for dialogue.”  We suspect that the government will have to pay off these rebels in order to lift output; that was the strategy of the former government.  In addition, Iraq has announced a deal with the Kurds to lift Iraqi oil exports by 5% in the next few days.  The Northern Iraqi Oil Company owns the oil but uses pipelines that move through Kurdish territory.  There was a payment dispute but that has apparently been resolved.  Finally, Reuters is reporting that Chinese refiners are boosting exports to record levels.  Diesel exports are up 182% from last year and gasoline shipments are up 145%.  We expect to see oil prices ease back toward recent lows in the coming weeks as the summer driving season in the U.S. comes to a close.

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