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Dovish Daly? - November 13, 2018

“The FOMC is not on Autopilot”

Yesterday, San Francisco Fed President Mary Daly, a voting member of the FOMC, gave a speech in Idaho entitled “A Strong Economy – But We Can Aim Higher”. Her speech contained the usual boilerplate about how the Fed doesn’t control the economy and “Monetary policy... can’t do everything”. The effort to shift some of the focus away from the Fed will come as no surprise considering the recent exchanges between past and present Fed members and the Whitehouse, as we covered in October. However, likely more important to bruised market participants were Daly’s dovish comments.

First, Daly assured the crowd that the Fed is “not on autopilot”, offering a glimmer of hope to those looking for a reprieve in the gradual hiking of Fed Funds. In fact, Daly assured those present that, “We’re constantly looking at the data and adjusting the monetary policy path as needed in response”. This could come as welcome news for market observers and participants who share Jim Cramer’s view that, “If we’re lucky, falling energy and housing prices will convince the Fed to take a pause”. Indeed, Daly declared in her speech that, “policymakers must plan ahead but need to be ready to adjust if the data or the environment change”. So the Fed will adjust in time if things go wrong? Not quite. In addition to the Fed’s poor record of forecasting problems, hinted at in this September tome by Ben Bernanke himself, even Daly admits, “monetary policy acts with a significant lag”. This is understood, and is part of the Fed’s process where, they “take a policy action, wait, learn about the economy’s response, and repeat”. This is good in theory, but rather than following Wayne Gretzky’s aphorism of skating to where the puck is going, this causes the Fed to drive staring at the rear-view mirror. Why? The paper that Daly cites regarding the lagging nature of monetary policy points out that in developed economies, the transmission lags are 25 to 50 months. At any point it may be too late to pump the brakes, the Fed may have already hit the proverbial deer.

The second ray of hope was Daly’s assertion that “inflation numbers are very encouraging” and low rates of labor force participation may mean that the economy is not quite at full employment. Superficially, this would seem to imply that the Fed will be able to remain gradual and won’t be forced by inflation to adjust their path. This too may be somewhat disingenuous. Daly herself admits that “the U.S. economy is in very good shape” and wonders if “we are at the point where growth will be increasingly constrained by bottlenecks and other supply factors”. Today’s Small Business Optimism numbers imply that the answer to the latter question may be a resounding yes. As the NFIB highlights in the summary of the data, “With reports of increased compensation running at record levels, there is more pressure to pass these costs on in higher selling prices. If the pace of price hikes (inflation) picks up, the Federal Reserve will find even more reason to hike rates in December”.

Since Compensation Plans roughly lead the Atlanta Wage Growth Tracker, and the Wage Growth Tracker roughly leads Core CPI, barring any major developments, inflation may be just over the horizon.