A SHORT MACROECONOMIC DISCOURSE

Equities rose on light volume as all focused upon the Fed’s surprise decision.  I will continue to argue that unless external risks rise, the central bank will be forced to change its stance in the immediate future.

I ask what happens if China’s economy turns up in the second half of the year, a trade deal is signed and the UK does not crash out of the EU without a trade deal?  The above is very plausible and in fact is the consensus view.

The largest cost of production is labor.  Currently wages gains are offset by gains in productivity.  But how long will this last given the dearth of qualified workers.

While most will admit the Fed has been wrong for the last ten years as its forecasts overestimated expected growth by almost 100% from 2010-2016 and underestimated growth in 2017 and 2018 by 50%, I will focus on the Fed’s official outlook for my next comments.

The FOMC is projecting a 2.1% 2019 growth rate, down from 2.3% from its previous forecast.  The unemployment rate is expected to the end the year at 3.7%, a tenth percent below the Q418 level and the core PCE forecast was left unchanged at 2.0%.

This means the Fed expects real interest rate to end the year at just 0.4%, well below estimates of neutral.

I was schooled that the Phillips Curve was sacrosanct to inflation. It states high unemployment dictates low interest rates and low unemployment dictates high interest rates.  To remind all interest rates and unemployment were at double digits forty years ago and today unemployment is around record lows as are interest rates.  Obviously there is something amiss.

However with the above written, wages are now rising and are projected to be up about 4.2% over the next 12 months.  Will these wages morph into a “cost push” inflationary environment that catches the Fed flat footed and is forced to again change direction in three months?  Cost push inflation was the bane of the late 1970s, the inverse of the expected environment.

Wow!  This is not in the mantra but should be the expected outcome if wages do rise at the expected rate.

Change is the only certainty   I am an ardent believer in the phrase “it is not what you do but rather why you do it.”  This has been completely lost in the markets as everything is all about style not substance.

Thirty years ago in a room of 100 analysts there was one technical analyst and ninety nine fundamental analysts.  Today it is the inverse amplified by the extreme influence of computer based trading models utilizing technical/algorithmic analysis.

If the Fed again changes directions, how will markets react?

Perhaps more significantly what happens if the above environment does materialize and the Fed does not again change course?  Will the markets begin to lose confidence in the Fed and inflationary expectations will begin to rise?  As evidenced by yields, inflationary expectations are nominal at best.

Last night the foreign markets were mixed.  London was down 0.92%, Paris down 0.89%  and Frankfurt down 0.39% . China was up 0.09%, Japan up 0.09% and Hang Sang up 0.14%.

The Dow should open moderately lower as German manufacturing data was greatly disappointing sending the yield on Germany’s 10 year bond—Europe benchmark—to zero. The 10-year is up 13/32 to yield 2.49%.

 

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