The FX market thinks Yellen will be dovish

Outlook:

The FX market thinks Yellen will be dovish, hence the dollar dip yesterday. And yet we have other markets moving on the idea that the Fed will act sooner than expected, like gold. Bottom line, whatever you want to do, blame the Fed. Note that the equity gang believes Yellen will remain dovish, and thus we have a new record high in the S&P and some chatter about the glorious round number 2000.

Before speculating about what Yellen may say and why, let’s get one thing out of the way. The majority Fed stance is that “Persistent labor market slackness and low inflation suggest it is appropriate to main-tain accommodative monetary policy for some time,” as one analyst told the FT. This is the base case. Degrees of dovishness or hawkishness are what is on the table, not an announcement of an outright poli-cy change.

We wish Yellen would propose some more sophisticated measures to modify forward guidance and oth-erwise give us benchmarks to estimate the First Rate Hike. But another possible outcome is that Yellen sways with the hawkish crowd or at least gives them a nod, on the grounds that monetary policy has done as much as it can for jobs and now it’s someone’ else’s turn. Yellen may also wish to push back against the scurrilous accusation the Fed is behind the curve.

Or Yellen may wish to acknowledge the “behind the curve” charge and defend it in an explicit rebuttal of the economics behind the hawkish point of view. Yesterday a gauntlet was thrown down Philadelphia Fed Pres Plosser, who said making wages the centerpiece of monetary policy is not smart—wages are not a good predictor of inflation. The Fed needs to be responsive to data and the data indicates the tim-ing of the First Rate Hike should be brought forward. The risk is high that the longer we wait, the more rates will have to rise in the end.

Krugman points out in the NYT today that Plosser and other inflation hawks have been saying the same thing since 2008. They have said it every year for six years. Every economist makes mistakes but hon-estly, “The inflation hawks… show no sign of learning from their mistakes.” Why the inflation obses-sion? “Inflation obsession is as closely associated with conservative politics as demands for lower taxes on capital gains. It’s less clear why. But faith in the inability of government to do anything posi-tive is a central tenet of the conservative creed. Carving out an exception for monetary policy…. may just be too subtle a distinction to draw in an era when Republican politicians draw their economic ideas from Ayn Rand novels.” Bam! Right in the kisser.

In any case, the minutes are official and Jackson Hole is not. Yellen may wish to point out that the effect of wages on inflation is not her central point about wages, anyway. She is concerned with job quality and income inequality as Big Picture policy challenges, not the inflation aspect. The first paper to be presented today at Jackson Hole, for example, is a data-heavy analysis of the 25% loss of job “fluidity” in the US, previously a key advantage. The US economy is less flexible and dynamic as a result.

Proposing a new way of looking at the employment data is not the same thing as hinting at a change in policy. It’s also irrelevant to the inflation hawk scenario. Besides, we still have the output gap to fall back on as the inflation generator, and so far, the output gap is still pretty big, $900 billion to over $1 trillion, according to the CBO. We may be getting improved housing numbers and a few other good bits of data, but if you want to measure recovery from recession, the output gap is the single best number. The output gap does NOT suggest an early tightening.

So what does? Yellen needs to tell us, and the speech today will probably contain clues. Remember that the minutes earlier this week stated clearly that the Fed needs to communicate the conditions for normal-ization. “Participants agreed that the Committee should provide additional information to the public re-garding the details of normalization well before most participants anticipate the first steps in reducing policy accommodation to become appropriate.” The minutes also “stressed the importance of communi-cating a clear plan while at the same time noting the importance of maintaining flexibility so that adjust-ments to the normalization approach could be made as the situation changed and in light of experience.”

Again, Jackson Hole is not the right venue for this particular communication, but we will likely get clues. We expect markets to misinterpret whatever Yellen says and to miss the key points. Traders don’t like real economics, let alone nuance. They prefer stockbroker economics—quick and dirty. Overall, the US has growth and some recovery while the rest of the world and especially Europe does not. Whenever the first US rate hike comes, it will be long before any hike by the ECB or BoJ (even if the BoE pre-cedes the Fed). Therefore, we imagine the net effect will be to see the dollar as continuing to gain sup-port from tightening coming ever nearer. We are left with traders holding opposing ideas in their poor little heads at the same time—Yellen dovish, and for good cause, but the US still on a faster track to tightening than anyone else, so buy dollars. Got that?

Note to Readers: We will take off next Thursday and Friday, Aug 28 and 29. These dates precede Labor Day on Monday, Sept 1, which is a national holiday in the US. There will be no reports on Thurs-day, Friday or Monday. We return Tuesday, Sept 2. In any case, the minutes are official and Jackson Hole is not. Yellen may wish to point out that the effect of wages on inflation is not her central point about wages, anyway. She is concerned with job quality and income inequality as Big Picture policy challenges, not the inflation aspect. The first paper to be presented today at Jackson Hole, for example, is a data-heavy analysis of the 25% loss of job “fluidity” in the US, previously a key advantage. The US economy is less flexible and dynamic as a result.

Proposing a new way of looking at the employment data is not the same thing as hinting at a change in policy. It’s also irrelevant to the inflation hawk scenario. Besides, we still have the output gap to fall back on as the inflation generator, and so far, the output gap is still pretty big, $900 billion to over $1 trillion, according to the CBO. We may be getting improved housing numbers and a few other good bits of data, but if you want to measure recovery from recession, the output gap is the single best number. The output gap does NOT suggest an early tightening.

So what does? Yellen needs to tell us, and the speech today will probably contain clues. Remember that the minutes earlier this week stated clearly that the Fed needs to communicate the conditions for normal-ization. “Participants agreed that the Committee should provide additional information to the public re-garding the details of normalization well before most participants anticipate the first steps in reducing policy accommodation to become appropriate.” The minutes also “stressed the importance of communi-cating a clear plan while at the same time noting the importance of maintaining flexibility so that adjust-ments to the normalization approach could be made as the situation changed and in light of experience.”

Again, Jackson Hole is not the right venue for this particular communication, but we will likely get clues. We expect markets to misinterpret whatever Yellen says and to miss the key points. Traders don’t like real economics, let alone nuance. They prefer stockbroker economics—quick and dirty. Overall, the US has growth and some recovery while the rest of the world and especially Europe does not. Whenever the first US rate hike comes, it will be long before any hike by the ECB or BoJ (even if the BoE pre-cedes the Fed). Therefore, we imagine the net effect will be to see the dollar as continuing to gain sup-port from tightening coming ever nearer. We are left with traders holding opposing ideas in their poor little heads at the same time—Yellen dovish, and for good cause, but the US still on a faster track to tightening than anyone else, so buy dollars. Got that?

Note to Readers: We will take off next Thursday and Friday, Aug 28 and 29. These dates precede Labor Day on Monday, Sept 1, which is a national holiday in the US. There will be no reports on Thurs-day, Friday or Monday. We return Tuesday, Sept 2.