ECONOMIC WEEKLY. Allows More Flexible Policy. Core PCE Inflation Inflation has been under the Fed's target for most of the past 20 years

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1 MARCH 29, 2019 ECONOMIC WEEKLY Fed s New Inflation Thinking Allows More Flexible Policy For fifty years, the Federal Reserve has operated with a conviction all inflation is bad, even cyclical inflation. And it is certain inflation comes from low unemployment rate. Result: the Fed works hard to stabilize or even increase unemployment in the late cycle, in effect not just allowing recessions, but triggering them. This may be changing, however. The Fed is shaking off its anti-inflation bias in favor of a more balanced approach that could encourage some cyclical inflation and increase the odds of longer expansions. This has already freed the FOMC to adopt a more accommodative stance, and it could allow a still more accommodative stance in near future. In 2008, the Fed s Vice Chairman, Donald Kohn, described the Fed s approach to inflation forecasting. A model in the Phillips curve tradition remains at the core of how most academic researchers and policymakers including this one think about fluctuations in inflation. As Real Clear Markets John Tamny explains, Translated, the entity (the Fed) that employs more economists than any other in the world is staffed near unanimously by economists who think too many people working and producing is the cause of inflation. Rethinking this approach is overdue, not least because the Fed s rigid inflation approach when Kohn made his claim eleven years ago exacerbated the Great Recession and global financial crisis in CONTENTS Fed s New Inflation Thinking Allows More Flexible Policy ECONOMICS Chris Low, Chief Economist chris.low@ftnfinancial.com page 1 The Week Ahead page 5 This Week s Numbers page 5 Rebecca Kooshak, Economic Analyst rebecca.kooshak@ftnfinancial.com 6% 5% Core PCE Inflation Inflation has been under the Fed's target for most of the past 20 years 4% 3% 2% Recessions 1% Core PCE Fed target rate 0% Source: Bureau of Economic Analysis In hindsight, Kohn s speech was one of the earliest examples of a series of speeches reexamining the Fed s analysis of inflation. Ben Bernanke, Janet Yellen, Jay Powell, Lael Brainard, John Williams, James Bullard, and Neel Kashkari have all considered and reconsidered Phillips Curve orthodoxy. Kohn s Disclosures are on the last page of this report. FTNFINANCIAL.COM

2 ECONOMIC WEEKLY MARCH 29, 2019 speech was a defense of the Phillips curve, as were Yellen s early inflation-themed speeches. But starting in October 2016, when Yellen suggested the Fed should find a new way of thinking, 1 participants inflation-themed speeches increasingly focused on the Fed s role in the 40-year downtrend in real rates and therefore, the Fed s role in creating the Zero Lower Bound problem. In the past three years, the Fed s inflation thinking has shifted in two important ways: 1. The Fed believes the Phillips curve s influence has diminished. In Powell s words, the Phillips curve is flat, meaning a big drop in unemployment causes only a small increase in inflation. 2. The Fed is contemplating its biggest policy overhaul since If adopted, it would significantly relax its attitude toward cyclical inflation. New thinking made January pivot possible In January, we asked a former Fed governor what he thought about the Fed s chances of pulling off a soft landing. There s no way, he replied. They waited too long and let the unemployment rate fall so far through the NAIRU. There s no point in even trying to get it back up without a recession. The best they can do is try to stabilize unemployment here and pray for a productivity miracle. This, of course, is traditional Fed thinking at its best. It is well meaning, in the sense that even those at the bottom of the economic ladder benefit from the Fed s traditional policy approach because keeping inflation low allows them to keep the expansion alive longer; and it was sincere. Nevertheless, the Fed has strayed from this view lately for several reasons: 1. By overstating inflation risk, the Fed s model encourages the Fed to overtighten. As a result, rather than extending expansions by keeping inflation low, the Fed has since 1991 cut expansions short. 2. By consistently cutting expansions short, the Fed and other central banks created the serious dilemma of rates near the Zero Lower Bound (ZLB). 3. Ending expansions early also means ending the motivation for the late-cycle productivity miracle that Fed officials rightly note is the only means of improving living standards. Double-barreled policy change One of the reasons the March FOMC announcement was so powerful was because the Fed set up to end both of its tightening programs. The SOMA policy change alone reduced 10-yr yields by 10-15bp. See The Weekly Report for more about that. Pivoting to on-hold was bold enough considering most FOMC participants still estimate the neutral rate at or above 2.75%. In other words, the FOMC stopped raising rates despite most participants apparently convinced policy is still accommodative. And, on top of that, the FOMC decided to stop shrinking the Fed balance sheet well before most traders anticipated. The old Fed might have risked one of these changes with the unemployment rate under 4%. But both? Not likely. The Fed already is calm in the face of an extraordinarily low unemployment rate, and that s even before formally changing its policy approach to address the Zero Lower Bound. 1 Yellen s October 14, 2016 speech kindled a revolution in economics. It starts with a call to arms: Extreme economic events have often challenged existing views of how the economy works and exposed shortcomings in the collective knowledge of economists. To give two well-known examples, both the Great Depression and the stagflation of the 1970s motivated new ways of thinking about economic phenomena. More recently, the financial crisis and its aftermath might well prove to be a similar sort of turning point. This speech led to work by Fed economists Kiley and Roberts as well as former Fed Chair Bernanke pushing for lower-for-longer Fed policy rates. Page 2 of 8

3 ECONOMIC WEEKLY MARCH 29, 2019 ZLB talk affects the Fed even before a formal shift occurs As Powell explained in his recent monetary policy testimony, the Fed has not yet shifted its policy approach to address the Zero Lower Bound problem, but it will soon. The fact the Fed s top policy economists are advocates of the change, however, coupled with a strong endorsement from former Chairs Yellen and Bernanke, Powell and the current open market committee will catch all kinds of criticism if they fail to make the change and the FOMC is forced to cut rates to the ZLB. Imagine the following scenario: In early 2020, a year after the yield curve first inverted, the economy slips into recession. The recession is mild at first, as it always is, reflecting moderately weaker consumer demand. The Fed cuts the fed funds rate gradually in response. The recession deepens as companies slash orders and production in an effort to reduce overbuilt inventories. This too is the way recessions always play out, and the biggest surprise is that it always seems to catch policy makers off guard. The Fed cuts rates faster, but with only 175bp in their quiver, the funds rate is back at the ZLB (0-0.25%) by the end of By July 2021, the economy is still contracting and the Fed s balance sheet has grown to $6 trillion under QE4. Inflation has fallen to 0.5% and all signs point to further declines. Deflation looms. Powell heads to Capitol Hill for his semiannual monetary policy testimony. When his turn comes, Senator Pat Toomey reminds Powell that in February 2019, Powell told him the Fed was in the process of changing its approach to inflation to avoid having to cut rates to the Zero Lower Bound. You can imagine his question would likely sound something like, You said you would do it. You said what would happen if you didn t do it. Then you didn t do it. So tell me, Mr. Chairman, how s that working out? What s Powell supposed to say? Senator, you told me to be very careful before making that change? Of course not. First, because telling a Senator it s your fault is never a good idea. More to the point, rate policy and its implementation is the Fed s responsibility. Now the Fed s leadership has acknowledged the need to make this change and has described everything that can go horribly wrong if the change is not made, they will own the consequences if they decide not to make the change and everything falls apart as predicted. A few scenarios The bond market is priced for at least two rate cuts, suggesting the Fed tightened too quickly last year. Yields would likely not have fallen this far if the Fed had not raised rates in December, but that s a moot point now. From here, we can think of three broad scenarios for how things might go. The economy continues to weaken and the Fed capitulates quickly. Market yields rally another eighth of a point or so after the first cut, but stabilize after the second. The economy rebounds post-shutdown and trade negotiations, yields rise a quarter point, then growth fades again, yields fall back and Fed rate cuts are delayed until later in the second half, with market yields falling back to current levels at least. This scenario is predicated on our belief that the shutdown and US-China trade fight hurt the economy, but are not the root causes of economic weakness. The economy continues to weaken but the Fed keeps rates unchanged, as it did in 2007 when Bernanke insisted on more than one occasion there was plenty of time to cut rates if the economy failed to recover. In this scenario, yields grind lower into the recession, and plunge once the recession is well underway. Page 3 of 8

4 ECONOMIC WEEKLY MARCH 29, 2019 It s difficult to imagine Powell repeating Bernanke s 2007 mistake given the change in the Fed s attitude toward inflation in the past decade. In 2007, Bernanke thought he was making a hard choice for the right reason. He risked the economic expansion to keep inflation near 2% because even a small increase above 2% was unacceptable. Were Powell to do the same thing today, he would be risking the expansion to keep inflation below the current Fed s late-cycle optimal. It simply does not compute. As a result, the Fed will likely choose one of the first two scenarios. Chris Low, Chief Economist Page 4 of 8

5 THE WEEK AHEAD MARCH 29, 2019 The Week Ahead This Week s Numbers CONSENSUS PRIOR HIGH LOW MEDIAN FTN Monday, April 1 Retail Sales Advance MoM 0.2% 0.6% -0.3% 0.3% 0.2% Retail Sales Ex Auto MoM 0.9% 0.8% -0.3% 0.4% 0.5% Retail Sales Ex Auto and Gas 1.2% 0.5% 0.2% 0.4% 0.4% Retail Sales Control Group 1.1% 0.5% 0.1% 0.4% 0.4% Markit US Manufacturing PMI ISM Manufacturing Construction Spending MoM 1.3% 1.0% -0.4% 0.0% -0.3% Business Inventories 0.6% 0.6% -0.3% 0.4% 0.2% Tuesday, April 2 Durable Goods Orders 0.3% 1.4% -2.7% -1.2% -1.5% Durables Ex Transportation -0.2% 0.8% -0.3% 0.3% 0.2% Cap Goods Orders Nondef Ex Air 0.8% 0.5% -0.3% 0.3% 0.2% Cap Goods Ship Nondef Ex Air 0.8% % Wards Total Vehicle Sales 16.56m 16.70m 16.50m 16.65m 16.6m Wednesday, April 3 ADP Employment Change 183k 261k 125k 180k 180k ISM Non-Manufacturing Index Friday, April 5 Change in Nonfarm Payrolls 20k 282k 145k 175k 160k Change in Private Payrolls 25k 210k 145k 183k 175k Change in Manufact. Payrolls 4k 18k 5k 13k 10k Unemployment Rate 3.8% 3.9% 3.8% 3.8% 3.8% Average Hourly Earnings MoM 0.4% 0.3% 0.2% 0.2% 0.3% Average Hourly Earnings YoY 3.4% 3.5% 3.3% 3.4% 3.5% Average Weekly Hours All Employees Labor Force Participation Rate 63.2% % Underemployment Rate 7.3% % Consumer Credit $17.049b $18.000b $15.000b $17.500b $17.000b Review This week, US 4Q-18 GDP was revised lower than expected, January personal consumption was weaker than expected, and January core consumer inflation rose less than expected. There s no doubt the US economy hit a wall around the turn of the year, but because most hard economic data are still running about a month behind, there s no way to tell if it was entirely due to the government shutdown. In Europe, a better-than expected IFO survey was a welcome ray of light cutting through a news cycle otherwise obsessed with Brexit gloom. In China, US trade negotiators claim to have found discrepancies in the Chinese translation of the draft US-China trade agreement, suggesting the Chinese team may have surreptitiously omitted and walked back some issues previously settled. The BEA revised US Q GDP from 2.6% to 2.2% on a quarter-over-quarter basis. The downward revision reflects weaker personal consumption expenditures, weaker nondefense federal government spending, and weaker nonresidential fixed investment, all of which rose less than initially reported. Imports were also revised lower, offsetting some of the downward revisions. Page 5 of 8

6 THE WEEK AHEAD MARCH 29, % 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% -1.0% -2.0% -3.0% -4.0% GDP Growth Qtr/Qtr% Annualized w/ Sector Contributions Consumption Res Investment Bus. Fixed Invest Inventories Net exports Government GDP Final Sales Q1-16 Q2-16 Q3-16 Q4-16 Q1-17 Q2-17 Q3-17 Q4-17 Q1-18 Q2-18 Q3-18 Q4-18 Source: Bureau of Economic Analysis and FTN Financial January personal consumption rose just 0.1%, and because the consumption deflator was unchanged, it also rose 0.1% in real terms. The core PCE deflator rose 0.1%, a tenth less than expected, pulling the year-on-year core inflation rate down from 1.9% to 1.8%. 5% 4% PCE Inflation 3% 2% 1% 0% Recessions Core PCE -1% Fed target rate -2% PCE deflator Source: Bureau of Economic Analysis Germany s IFO survey showed business sentiment in March improved more than expected. The index rose from 98.5 to 99.6, beating consensus of 98.5 and lifting 10-year Bund yields (temporarily) out of negative territory. Companies are somewhat more satisfied with their current business situation, and they are decidedly more optimistic regarding business in the coming six months, IFO said. Expectations rose from 93.8 to 95.6 (consensus was 94.0) and current assessment rose from to (consensus was 102.9). ECB President Draghi raised the possibility the ECB could introduce a two-tier deposit rate to provide some relief to banks suffering from negative rates. The two US consumer confidence indices split in March. The Conference Board s confidence index fell from to 124.1, with a 13-point drop in current conditions and a 3.5-point drop in expectations. But, the University of Michigan index rose for a second consecutive month, this time by 4.5 points to Both expectations and current conditions indices improved. The Atlanta Fed revised its Q1 GDPNow forecast from 1.2% to 1.7%. The revision reflected weaker-thanexpected imports and upward revisions to investment following the Q4 GDP revision. The NY Fed barely revised its Nowcast from 1.29% to 1.31%. Page 6 of 8

7 THE WEEK AHEAD MARCH 29, 2019 On Monday, the US February retail sales report will be the first comprehensive look at post-shutdown spending data and the ISM manufacturing report will update US manufacturing conditions. Also Monday, manufacturing PMI reports will be released in Europe and Asia. Preview Note: «= High Impact Event All times Eastern Standard Saturday, March 30 «9:00pm China: CFLP Manufacturing, Services, and Composite PMI Sunday, March 31 7:50pm Japan: Tankan Survey Q1 8:30pm Japan: Nikkei Manufacturing PMI 9:45pm China: Caixin PMI Manufacturing Monday, April 1 «3:45am Italy: Markit/ADACI Manufacturing PMI «3:50am France: Markit Manufacturing PMI «3:55am Germany: Markit/BME Manufacturing PMI «4:00am EU: Markit PMI Manufacturing «4:30am UK: Markit PMI Manufacturing 5:00am EU: CPI Unemployment Rate «8:30am US: Retail Sales «10:00am US: ISM Manufacturing PMI Construction Spending Business Inventories 11:30am US: 3M and 6M Treasury Bill Auctions 3:10pm Canada: Bank of Canada Governor Stephen Poloz speaks on the importance of trade. Tuesday, April 2 «Wards Total Vehicle Sales 4:30am UK: Markit/CIPS Services and Composite PMI 5:00am EU: PPI «8:30am US: Durable Goods Feb P Capital Goods Feb P 8:30pm Japan: Nikkei Services and Composite PMI 9:45pm China: Caixin Services and Composite PMI Page 7 of 8

8 THE WEEK AHEAD MARCH 29, 2019 Wednesday, April 3 3:45am Italy: Markit/ADACI Services and Composite PMI 3:50am France: Markit Services and Composite PMI 3:55am Germany: Markit Services and Composite PMI 4:00am EU: Markit Services and Composite PMI «5:00am EU: Retail Sales 8:15am US: ADP Employment Change Mar 8:30am US: Atlanta Fed President Raphael Bostic speaks. (FOMC voter in 2021) «10:00am US: ISM Non-Manufacturing Index Mar 5:00pm US: Minneapolis Fed President Neel Kashkari speaks. (FOMC voter in 2020) Thursday, April 4 «2:00am Germany: Factory Orders (February s factory orders unexpectedly fell -2.6% m/m and -3.9% y/y.) «1:00pm US: Cleveland Fed President Loretta Mester speaks at banking conference. (FOMC voter in 2020) «1:00pm US: Philadelphia Fed President Patrick Harker speaks at a policy conference. (FOMC voter in 2020) 7:30pm Japan: Household Spending Friday, April 5 2:00am Germany: Industrial Production 4:30am UK: Unit Labor Costs Q4 «8:30am US: Non-farm payrolls and unemployment rate «3:00pm US: Consumer Credit 3:30pm US: Atlanta Fed President Raphael Bostic speaks. (FOMC voter in 2021) Rebecca Kooshak, Economic Analyst Although this information has been obtained from sources which we believe to be reliable, we do not guarantee its accuracy, and it may be incomplete or condensed. This is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. All herein listed securities are subject to availability and change in price. Past performance is not indicative of future results, while changes in any assumptions may have a material effect on projected results. Ratings on all securities are subject to change. The views expressed herein accurately reflect the author s personal views about the subject securities or issuers. No part of their compensation was, is or will be directly or indirectly related to the specific recommendations or views contained in the Notes. FTN Financial Group, FTN Financial Capital Markets, FTN Financial Portfolio Advisors and FTN Financial Municipal Advisors are divisions of First Tennessee Bank National Association (FTB). FTN Financial Securities Corp (FTSC), FTN Financial Main Street Advisors, LLC, and FTN Financial Capital Assets Corporation are wholly owned subsidiaries of FTB. FTSC is a member of FINRA and SIPC FTN Financial Municipal Advisors is a registered municipal advisor. FTN Financial Portfolio Advisors is a portfolio manager operating under the trust powers of FTB. FTN Financial Main Street Advisors, LLC is a registered investment advisor. None of the other FTN entities including, FTN Financial Group, FTN Financial Capital Markets, FTN Financial Securities Corp or FTN Financial Capital Assets Corporation are acting as your advisor and none owe a fiduciary duty under the securities laws to you, any municipal entity, or any obligated person with respect to, among other things, the information and material contained in this communication. Instead, these FTN entities are acting for their own interests. You should discuss any information or material contained in this communication with any and all internal or external advisors and experts that you deem appropriate before acting on this information or material. FTN Financial Group, through FTB or its affiliates, offers investment products and services. Investment Products are not FDIC insured, have no bank guarantee and may lose value First Tennessee Bank. All rights reserved. Page 8 of 8