Fed's data-dependence deceptive?

Outlook:

When we get the US inflation data today—headline forecast down 0.6-0.7% and core up 0.1% or 1.6% annualized--markets will presumably respond in a knew-jerk fashion even though we all know perfectly well that the numbers are “wrong” because of oil prices.

We all know that simple arithmetic means that a few months from now, inflation will appear vastly higher because it will be compared to periods when oil was extremely low, whether the quarter or the year. Using core inflation ex-oil doesn’t really help all that much because pricing of all goods is influenced by oil, even if the connection is so indirect as to be invisible. Drugs, for example, are lightweight and shipping costs should be a fraction of total price. But wait and see—when inflation looks 2% higher, drug prices will rise by more than 2% and the cost of transportation will be named. Drug companies hope we won’t notice that prices didn’t fall at all when transportation costs were low.

In any case, see the inflation projection below, from www.forecast.org (1982-84 = 100). It doesn’t matter whether 1982-84 is a reasonable index base. It matters that inflation will be back to “normal” levels this year. Here’s the rub—every economist knows that inflation must rise unless oil continues lower all the rest of the year. Again, it’s simple arithmetic. And Yellen, of course, knows it as well as anyone. So uncertainty about when inflation will qualify for Fed action is (1) not true and (2) a deceptive stance. Yellen might as well come right out and say that the Fed will raise rates when oil returns to some price (like $85). But that would overvalue the role of oil in an institution that pretends to view oil as just one factor among many and the current price issues a “temporary aberration.” Poppycock. Oil is not just one more factor—it’s the single biggest factor in the formation of inflation expectations. As for “temporary aberration,” bah. Oil prices have been gyrating wildly for over a century—by hundreds of percentage points in short periods of time. The effects of price changes are non-trivial and pervasive. Ask the railroads when trucking became the effective competitor. The American suburbs and auto industry relied on cheap oil during the 1950’s and 1960’s. The American West would not be home to actual cities without cheap oil. For the Fed to say oil is not the central factor is disingenuous, to be charitable.

Bottom line, the Fed is feeding the bond market with enough uncertainty about the date of the First Rate Hike that the divergence between the Fed member dots and market prices is growing wider. The FT has a handy chart. The member dots and market prices should be coming closer together, not father apart.

This means the Fed’s data-dependence is deceptive. The bond guys don’t see inflation rising to anything interesting anytime soon and therefore do not believe in the June date. The equity and bond markets believe the absence of inflation means the Fed’s hands are tied—the target is not going to be reached this year. Therefore, if the Fed does move in June, the markets will not be ready. This is the utter failure of communications policy. If the Fed is serious about June, it has to start changing some minds or face exactly the kind of taper tantrum that Bernanke caused, also by mistaking sentiment.

In a nutshell, the Fed is creating the conditions for an accident to happen.

We don’t like it when central banks set out to deceive. Next week we have four central bank policy meetings—Australia, Canada, UK and the ECB. Australia and to a lesser extent Canada have been engaging in verbal intervention and as the AUD approaches 80¢ again, should we not expect talk of a too high exchange rate? Never mind local conditions or even the seeming improvement in Chinese conditions. If the RBA says anything about the AUD, or pointedly declines to say anything about the AUD, that’s what moves the AUD. Analysts are expecting a rate cut but a few pointed references to the AUD would work equally well.

Canada was equally tricky. Poloz could have said in Jan when rates were changed that it was only an “insurance policy.” He had to know perfectly well that the market was pricing in another cut or at least some dovish noises. Waiting until a week before the next meeting to talk about the insurance policy, as though it was a one-time thing, reveals an intent to deceive.

What is real is the €60 billion per month the ECB intends to buy starting after next week’s meeting. If anyone knows the exact date, we haven’t seen it. Also real is UK GDP up 2.6% y/y in Q4, and can inflation be far behind—oil notwithstanding? We are not so sure the consensus is correct that the US will hike first and the UK second. In recent years, the BoE leads.

The general outline of central bank positions is that only the US and maybe the UK are done with recession and deflation, and higher rates are coming, while all the rest of the world, aka Europe and Japan but also the Other Dollar Countries, are still struggling with sub-par growth and more likely to cut than anything else. This picture is turning out to be wrong. We have significant green shoots in Europe. Canada and Australia look more to their trading partners, the US and China, than to most domestic conditions. The CAD and AUD move on some data, like employment and retail sales, but realistically, the Big Picture lies elsewhere. An under-recognized factor is the “currency war” effect that drives some of this data longer-run. Whether those central banks cut or just talk about an overvalued currency, the effect is the same.

At some point we have to acknowledge that recession/deflation is receding and normalization is the right policy. We believe in June and we think central banks that remain focused on backward looking data that scares them are just plain wrong. Here’s a bet: by yearend, we will be talking about when the ECB will drop QE. It’s supposed to last through all of 2016. We say it will be ended early. In other words, the dollar rally will be ending early, too.