A hike at the Dec 15-16 is all but certain

Outlook:

Today the US data includes PPI, the University of Michigan consumer confidence and retail sales. Three guesses which one counts. We know retail sales should be pretty good because we already have auto sales and some other components, but the headlines are driving a gloomy mood—big retailers like Macy’s and WalMart are stuffed with inventory and already discount-ing like crazy. By Black Friday, the day after Thanksgiving, stores will be hysterically offering deals. It’s not a pretty sight.

Before launching into the Fed outlook, we were distracted by a very long, data-studded story in the FT Alphaville about why the eurozone was a failure (“pointless” from the day it began. A common currency does not promote rising living standards and productivity. Convergence has been weak. In fact, you can get good results among non-common currency pairs and sets (US-Canada, Australia-New Zealand, E. Europe and Germany, et al.).

We like a good rant as much as the next guy, but this article is misguided in a dozen ways. If you want a critique, see Connolly’s Rotten Heart of Europe. It’s a little outdated but the key economics and institu-tional analysis remains valid, especially the part about the eurozone favoring The Establishment, includ-ing oligopolies. The FT article concludes that “In retrospect, it’s clear the euro simply shifted risk from exchange rate fluctuations to defaults (for foreign creditors) and nominal income (for domestic workers and businesses). This wasn’t sufficiently obvious at the time, however, or we wouldn’t have seen such massive growth in cross-border banking and portfolio flows within the currency bloc before 2008. “Contrary to what the euro’s founders believed, it now appears the absence of monetary union is what’s needed to channel capital flows most productively across borders. That’s the real tragedy of the single currency: it was pointless from the start.”

Well, no. The eurozone has promoted convergence in important ways, including inflation rates. It has ended beggar-thy-neighbor currency wars. For that matter, it has ended shooting wars among members. The eurozone has promoted labor mobility, one of the US’ top strong points, despite the language barri-er. It has brought marginal economies into a mainstream (Hungary, the Baltics), removing them from the Russian sphere of influence. We are not going to go on to recount all the advantages of a common cur-rency, but the economics profession has gathered a ton of evidence over the decades, a good portion of which was used to convince the EMU members to join together in the first place. This article puts forth some interesting data but does not make the case. It would be really interesting to know the author’s hid-den agenda—there must be one. Something to do with Brexit, maybe, the worst idea ever out of Down-ing Street.

To return to the US, yesterday was a festival of affirmation of the Dec rate hike. We had one speech af-ter another, with the star being the NY Fed’s Dudley, who told the Economic Club of NY “I think it is quite possible that the conditions the committee has established to begin to normalize monetary policy could soon be satisfied.”

A hike at the Dec 15-16 is all but certain unless something disastrous comes along. Now the question is the pace of increases after the First One. Chicago Fed Pres Evans said it’s not the liftoff that concerns him but rather the rate of increase. He would like to see the Fed funds rate at no higher than 1% by this time next year. Not only that, he would prefer the Fed to say so. He wants the Fed to get rid of its new aversion to dates. “It is critically important to me that when we first raise rates, the F.O.M.C. also strongly and effectively communicates its plan for a gradual path for future rate increases. If we do not, then market participants might construe an early liftoff as a signal that the committee is less inclined to provide the degree of accommodation that I think is appropriate for the timely achievement of our dual mandate objectives. I would view this as an important policy error.”

Richmond Fed Lacker, our one true hawk, had said the day before “I think there’s a chance we are be-hind the curve, but it will be a year or two before we figure that out. We have room to accelerate if we find out that we wish we’d started earlier.”

Vice Chairman Fischer came right out and said delay in September was the right course of action as the “appropriate response to dollar appreciation.” But that’s over now. “While the dollar’s apprecia-tion and foreign weakness have been a sizable shock, the U.S. economy appears to be weathering them reasonably well. Monetary policy has played a key role in achieving these outcomes through defer-ring liftoff relative to what was expected a little over a year ago.” We don’t know what to make of Fischer’s remarks. Does he mean that the 10-15% rise in the dollar was too fast and that justified delay? It wasn’t all that fast. And does it mean that if “foreign weakness” returns, the Fed will retreat? Fischer doesn’t say.

And yet the speech is very interesting. The press clearly doesn’t have a clue what he was really saying—that narrowing our focus to a single thing, the inflation aspect of the strong dollar, the Shock was actually a big one. Fischer said the dollar played "an appreciable role" for inflation running below the 2% target, but the exchange rate effect on inflation is more “transient” than its effect on growth. This seems a little confusing at first but remember, his topic is “transmission” effects. A 10% appreciation of the dollar cuts exports and thus growth proportionately in ways the Fed researchers have modelled. “Real exports fall about 3 percent after a year and more than 7 percent after three years. The gradual re-sponse of exports reflects that it takes some time for households and firms in foreign countries to substi-tute away from the now more expensive U.S.-made goods.” Meanwhile, foreign exporters to the US manage prices to maintain market share, reducing the imported inflation effect.

Fischer also said "Some of the forces holding down inflation in 2015 -- particularly those due to a stronger dollar and lower energy prices -- will begin to fade next year…. [And] overall PCE inflation is likely on this account alone to rebound next year to around 1.5 percent," rising toward the Fed’s 2 per-cent goal in the longer term.

Can this imply that Fischer thinks the biggest portion of the dollar’s rise is now over? If we are reading his speech correctly, the answer is yes. The alternative explanation would be that somehow the economy has suddenly become more adaptive, not a reasonable assumption. If you are in policy wonk mode.

What we don’t get from the speech is whether and in what ways the Fed is now valuing the dollar factor that it was not previously considering. We are hungry for a Fischer analysis of the merchandise trade effects vs. capital flow effects on the dollar and not just from the dollar. This is the central puzzle of FX economics that has never been properly explained. If we are not going to get a coherent explanation out of the ivory-tower gang, maybe a usable explanation can come from a central bank practitioner.

And we hate to say it, but coming on the same day General Motors reports it will import Buicks from China makes Fischer more relevant to guys like presidential candidate Trump. There are a ton of policy implications in the Fischer speech. You have to wonder if anyone will make hay out of them.

For the immediate future, we see the euro trapped in a narrow range of about 1.0678 to 1.0805. If we are going to get a breakout, we’d bet on the downside, standard ideas about the necessity of opposite-direction corrections notwithstanding. Something can lways happen on a weekend, but we would not advise going short dollars into the Sunday open.