Daily Comment (August 27, 2020)

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT] | PDF

Good morning.  After hitting another new high yesterday, S&P futures are consolidating this morning. There is a lot to get through today; the first revision to GDP is out and is covered below.  We lead off with Chair Powell speaking this morning at a “virtual” Jackson Hole symposium (which will stream to the public).  His speech will commence just about the time we finish our comments so we will offer a recap tomorrow, but it is widely expected the Fed will announce changes to its reaction function regarding inflation.  Next, an update on Hurricane Laura.  China news follows with general economic and market updates.  Foreign news is next, and we close today with a pandemic update.  It’s Thursday, so a new Weekly Energy Update is available.  Let’s get to it:

The Fed:  Since Volcker, one of the key features of monetary policy has been to suppress inflation expectations.  To do this, the Fed has signaled it would react to preemptively contain any rise in inflation.  Over the years, the Fed has become increasingly transparent in its policy, setting an explicit inflation target (2% yearly growth in the core PCE deflator), for example.  However, it is arguable the Fed has been too successful.  In the last business cycle, the core PCE deflator was above or equal to 2% only 10.6% of the time.  Inflation is a complicated variable;[1] the Fed may have much less impact on it than the conventional wisdom suggests.  Regardless, we expect Chair Powell to make a somewhat explicit announcement today that preemption is likely over, and the Fed will be content to allow inflation to run over the target.  The market wants an explicit statement of the reaction function. For example, the Fed will target the three-year average of inflation.  We doubt it will be this clear; after all, the Fed wants policy flexibility,  but it also wants to signal that rates will stay low for a long time. Therefore, we expect Powell to disappoint on clarity but reassure nonetheless.

  • Although we don’t expect Powell to address this issue, there are growing concerns about how much the Fed is doing in the financial markets. Sebastian Mallaby, one of our favorite commentators,[2] recently wrote about the tensions from the Fed’s ever-widening mandate.  Greg Ip has written a piece this morning.  Much of the Fed’s recent policy moves come close to fiscal policy; as it does so, the bank is brushing ever closer to politization.  Although the Fed has been joined at the hip to the Treasury in the past (it fixed the yield curve rate during WWII), its recent forays into areas of the corporate and municipal bond markets along with direct lending mean it is making choices about who gets credit.  We are starting to research the central bank digital currency area (look for this in an upcoming WGR), which could put the central bank squarely in the political arena.  As long as inflation is low, such broadening will be acceptable. However, once the Fed is required to tighten policy, tensions will become difficult to contain.

Laura:  The hurricane reached category 4 status before making landfall overnight.  It has weakened to a category 2 storm, and its current path looks like most of the Houston area, home to much of the U.S. refining industry, won’t take a direct strike.  However, Louisiana, also with significant refining assets, is in the direct path.  It is not uncommon for gasoline prices to jump in the aftermath of major refinery disruptions, so drivers should expect a temporary rise in prices.  The other concern is the storm surge and Laura was expected to deliver a massive one; we will be watching in the coming hours for the extent of the damage.

China news:

Economics and Markets:

Foreign news:

COVID-19:  The number of reported cases is 24,203,260 with 826,418 deaths and 15,825,921 recoveries.  In the U.S., there are 5,823,923 confirmed cases with 179,743 deaths and 2,523,771 recoveries.  For illustration purposes, the FT has created an interactive chart that allows one to compare cases across nations using similar scaling metrics.  The FT has also issued an economic tracker that looks across countries with high frequency data on various factors.  The weekly Axios map by state shows a definite improvement as the pace of infections decline.


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[1] After years of studying it, we have concluded that the most unappreciated part of inflation is expectations, followed by income distribution.  Under conditions of low inflation expectations and high levels of income inequality, inflation tends to remain low.

[2] His biography of Allan Greenspan is a must read.