Trending
Written by: Tim Pierotti
There is an old saying that I remember from my early days on Wall Street that “Only Fed Chairs who defeat inflation go to Heaven”. Given Chair Powell has allowed inflation to run above the 2% target for over four years, I’m not confident about his future ethereal direction of travel. In my experience over the years, at almost every FOMC press conference, Powell has sounded more dovish than I thought he would and has proven time and again to mistakenly underestimate the persistence of inflationary pressures.
But for some, specifically the President, he has been far too cautious and should be lowering rates far more aggressively. Over the past week, betting markets have priced-in the very likely nomination of Kevin Hassett who currently serves as the Chair of the National Economic Council to be Chair Powell’s replacement next year. Whether the next Chair is Hassett or one of the other auditioning candidates, that person is going to be someone who believes in an “active third mandate” policy.
The President’s recent nominee to the Fed Stephen Miran said purposefully during his Congressional testimony, “Congress wisely tasked the Fed with pursuing price stability, maximum employment and moderate long-term interest rates.” You don’t hear much about that third piece because it has generally been seen to be the outcome of getting the first piece of the “dual mandate” right. When asked about the idea that it is within the Fed’s responsibilities to ensure “moderate” long-term interest rates Chair Powell said, “So we haven’t thought about that for a very long time as a third-mandate that requires independent action.”
Miran clearly sees things differently from Powell and so will all future nominees of the President. When Miran gave his testimony and invoked the idea of a third mandate, he was signaling to the market that he will not only strive to cut rates, but also he’s saying: don’t worry about the long-end getting away from us. So far, it has worked. The 10 yr is trading just over 4% with little volatility despite solid economic growth, CPI at 3%, and profligate deficits that will only look worse if the Supreme Court invalidates the IEEPA tariffs, which appears likely.
The presence of the third mandate is critical if the Fed really wants to run the economy hot. Let’s say for a moment that Fed becomes extremely dovish relative to expectation and lowers interest rates over 100 basis points over the next six months as Governor Miran has recommended. It is extremely likely that the long-end of the yield curve would weaken (rates up) as markets would discount higher long-term inflation. The discussion of an active third mandate solves for that problem by suggesting to the market that some form of future intervention is possible.
The good news of suppressed long-term rates is that it is stimulative to all industries, but none more than the all-important housing market. Lower long-term rates means lower mortgage rates and better housing affordability and there is no more important issue for the US consumer and voter as we head into the mid-terms next year. It also means more housing turnover, more construction and more cash-out refi’s.
It is also of course possible we get our cake and eat it too. It’s possible that inflation begins to soften and the Fed won’t even have to further discuss the third mandate. Perhaps the benefits of the current technologically driven productivity boom will offset the inflationary policy. The housing market continues to provide an important disinflationary force without being outright weak in most of the country. Labor isn’t creating much push inflation and the rollback of tariffs on many food items may also provide some sequentially softer inflation data.
The bad news would likely be seen in dollar weakness. That alone isn’t all bad of course when you are running the kind of massive trade imbalance the US manages. Dollar weakness is viewed as generally stimulative. The problem is not so much the weaker dollar, but the potential perception that the US has an explicit and active weak dollar policy. The risk is that we see a repeat of the all US asset sell-off from this spring where we had dollar weakness, weakness in Treasuries and weakness in equities. The US, for good reason, enjoys massive foreign investment and invariably some of that capital is going to make the decision that maybe an overweight position in a country seeking devaluation is less than prudent.
All that said, markets are pretty good at discounting the future and I’m not the only one making the textbook observation that lowering interest rates to below the rate of inflation and signaling a willingness to intervene at the long-end would be an overtly weak dollar policy. And yet, here we are and the dollar has been essentially sideways for the last couple months riding just above the bottom of a four-year trading range. So far, it would be hard to argue that the dovish direction of the Fed has manifested negatively on the currency or the will of foreign investors to keep pushing their chips onto the US. However, should inflation accelerate and the Fed is viewed as too dovish and they do intervene in the long-end, I would expect the dollar to break to new lows and to see a selloff in risk assets. In other words, be careful what you wish for.
Related: The Fed Is in Zugzwang: Why Any Move Now Risks Breaking the Economy