Tuesday, February 13, 2018

Traditionally Hawkish Loretta Mester Signals "Stay the Course"

Cleveland Fed President Loretta Mester, in speaking to the Dayton Area Chamber of Commerce this morning, signaled a "stay the course" attitude regarding the Fed's current interest rate policy.  Her speech follows a week of extremely turbulent price action in the markets, raising speculation that volatility in the DOW would influence the Fed's pace of interest rate hikes through the remainder of the year.

The market has currently priced in three interest rate hikes for 2018, and sentiment shows a 77.5% chance of a 25 bps increase following the March 21 FOMC meeting.  Mester, one of the hawkish members of FOMC, said today that she supports a rate increase pace similar to what the Fed pursued in 2017 when they raised interest rates three times over the course of the year. 

Mester dismissed the current market action as little more than the normal correction one would expect after the explosive run-up in stock prices experienced over the past year.  “For now," she said,  "I expect the economy will work through this episode of market turbulence and I have not changed my outlook. In my view, the underlying fundamentals supporting the economy are very sound.”

 Historically, Mester has supported an aggressive interest rate policy, citing fears of a run-up of inflation should the Fed not raise rates quickly enough.  While she expects inflation to rise at an increasing rate, she does not foresee a need to increase the rate at which the Fed raises rates.  It's noteworthy that her remarks come a day before the February release of the closely watched CPI numbers.  Tomorrow's numbers should be a strong signal both for inflation's rate of change and for the aggressiveness the Fed is likely to take for the remainder of 2018.

The consensus for tomorrow's CPI release, according to Econoday is as follows:

PriorConsensusConsensus Range
CPI - M/M change0.1 %0.3 %0.3 % to 0.4 %
CPI - Y/Y change2.1 %2.0 %1.9 % to 2.3 %
CPI less food & energy- M/M change0.3 %0.2 %0.1 % to 0.3 %
CPI less food & energy - Y/Y change1.8 %1.7 %1.7 % to 2.0 %

Numbers that come in stronger that the consensus will add pressure to an already jittery market since it will increase speculation that the Fed will add a fourth rate increase into 2018.  That fourth increase is not currently factored into prices.

Mester also addressed the impact the 2018 tax cuts may have on the economy as a whole.  In her view, she expects the cuts to add between a quarter and a half of a percent to economic growth.  This, she expects, will support an inflationary rate just above the Fed's target of 2.0%.  It should also, in her view, support continued hiring in the private sector.  That will spur an increase in wage growth, the primary factor driving inflation.  (Wage growth in January increase 0.3% over December, and is showing an already strong annual 2.9% hourly rate.)

Scott Anderson, chief economist at Bank of the West in San Francisco, doesn't share the view that inflationary growth is under control.  “The acceleration in average hourly earnings growth punches a hole in the narrative that wage growth remains lackluster.  The Goldilocks view of inflation is being sorely challenged right now.”

Wednesday and Thursday provide a series of economic releases that will signal Fed's direction.  Definitely watch tomorrow's CPI release.  If there's surprise to the upside, expect the market to react negatively in anticipation of a more aggressive interest rate schedule.  But it doesn't end with the CPI.  Watch these releases tomorrow and Thursday for a more complete picture:
  • Wed - 8:30 AM - CPI
  • Wed - 8:30 AM - Retail Sales
  • Thu - 8:30 AM - Jobless Claims
  • Thu - 8:30 AM - Philadelphia Fed Business Outlook Survey
  • Thu - 8:30 AM - PPI FD
  • Thu - 9:15 AM - Industrial Production
 We share Mester's view that the fundamentals of the economy remain strong.  The question, however, is "how strong."  By market open on Thursday, we should have a good idea as to whether the economy is too strong or if it's proceeding at a healthy pace.

Happy Trading.

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