Fed Officials Come Looking for a Fight

Incoming data continues to support the narrative that the US economy is not, I repeat, not, slipping into recession. Instead, the US economy is most likely continuing to chug along around 2 percent year over year. Not exciting, but not a disaster by any means. Indeed, for Fed officials thinking the rate of potential growth is hovering around 1.75 percent, it is enough to keep upward pressure on labor markets, pushing to economy further toward full employment.

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And if you think you want to hit the inflation target from below, then you need to hit the employment target from above. Which means a non-trivial contingent of the Fed does not want to leave June off the table. That is a message that came through loud and clear today.

Industrial production surprised on the upside, gaining 0.7 percent. Still down on a year over year basis, but it is worth repeating that the weakness is narrowly concentrated:

In a recession, the weakness is broadly concentrated. Hence, the softness in manufacturing is still best described as a sector-specific shock, not an economy-wide shock.

Housing starts for April were also above expectations. The upward grind since 2011:

Notably, the housing market is transitioning from multifamily to single-family construction:

Plenty of room to run in that direction, providing underlying support for the US economy. See Calculated Risk for more.

Inflation rose on the back of higher gas prices. Headline CPI gained 0.4 percent, although core rose a more modest 0.2 percent. Core CPI inflation is hovering just above 2 percent:

Fed hawks will be nervous that rising gas prices will quickly filter through to core inflation; doves will remind them that the Fed's target is PCE inflation, which remains well below 2 percent.

Fedspeak was decidedly hawkish today, with both Atlanta Federal Reserve President Dennis Lockhart and San Fransisco Federal Reserve President John Williams insisting that market participants are wrong in assuming the Fed will pass at the June meeting. Via Greg Robb at MarketWatch:

Atlanta Fed President Dennis Lockhart and San Francisco Fed President John Williams, in a joint appearance at a lunch sponsored by the news site Politico, said that the decision on whether to raise rates at the June 14-15 meeting depends on the data.

June “certainly could be a meeting at which action could be taken,” Lockhart said.

He said he assumes there will be two to three rate hikes this year...

...Williams said he agreed with Lockhart and said he thought the economy was “doing great.”

“I think the incoming data have actually been quite good and reassuring in terms of policy decisions, so, in my view, June is a live meeting,” Williams said.

He added that there will a lot more data reported before the meeting.

In an interview with the Wall Street Journal prior to the Politico lunch, Williams said raising rates two or this times this year “makes sense.”

Separately, Dallas Federal Reserve President Robert Kaplan argued for a rate hike in June or July. Via Ann Saphir at Reuters:

"Whether that’s June or July, I can’t say right now," Kaplan told reporters after a speech. He said would prefer to pause after that first 2016 rate hike to assess conditions, and while he would "hope" to continue to normalize rates thereafter, the pace of rate hikes will depend on incoming economic data.

None of these three are voters. Still, there is a message here—many FOMC participants want to go into the June meeting with a reasonable chance that they will hike rates. They don't want the outcome of this meeting to be a foregone conclusion. Two other thoughts:

1.) The more hawkish Fedspeak could be foreshadowing that the minutes of the April FOMC meeting will have a hawkish tilt.

2.) Kaplan puts July on the table. I had thought that July was off the table due to the lack of a press conference. That said, I should be open to the possibility that they use the June press conference to clear the way for July.

Market participants raised the probability of a June rate hike to 15% today. Still probably less than the probability assigned by the median FOMC participant. Meanwhile, the yield curve flattened further—signaling that the Fed needs to move very cautiously. At the moment, the Fed doesn't have much room before they invert the yield curve. In my opinion, the bond market continues to signal that Fed's expectation of normalizing short rates in the 3.0—3.5 percent range are wildly—and dangerously—optimistic.

Bottom Line: Today's Fed speakers came looking for a fight with financial market participants. They don't like the low odds assigned to the June meeting. I don't think June is a go; the data isn't quite there yet. But odds are greater than 15%, in my opinion.

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Professor of Economics