Powell paints rosy picture, but Senators not convinced.

US Federal Reserve Chairman, Jerome Powell under Congress scrutiny on 17 July 2018.

US Federal Reserve Chairman, Jerome Powell under Congress scrutiny on 17 July 2018.

One day after, and in the ‘collusive’ shadow of the Helsinki meeting between Trump and Putin, US Federal Reserve Chair Jerome Powell presented the Fed’s semi-annual monetary report as he testified to the US Senate Banking Committee.

His testimony comes at a pivotal time in light of the trade war which is driving the Global economic agenda for the time being.

Despite Powell’s upbeat presentation of the US scorecard and the Fed’s commitment to continue with gradual rates hikes and normalisation, he swaggered along a thin line to carve out some wriggle room for the Fed to respond, should things get ugly.

The Fed’s scorecard on employment and price stability.

  • The US economy is pretty much at full employment, with June’s 4% unemployment expected to gradually fall into the mid 3% range and stay there for some time.
  • Monthly average job creation was higher than the same time last year.
  • Wages up 2.7% this June over last June, whilst CPI 3% (meaning no real growth). Powell’s view is that periodically higher gasoline/oil prices had inflated the result but would work through the system, so therefore moderate growth if that was taken out.
  • Inflation was a little over 2% with core inflation (a better long term predictor) of 2.0% in May, versus 1.5% a year ago.
  • FOMC is targeting 2% inflation to fulfil its price stability mandate, with Powell again pointing out that the target is symmetric. Symmetric because FOMC would be concerned if it was consistently above or below the 2% target rate.

Many Senators suggested the Fed remove its rose coloured glasses.

A number of Senators challenged the reality of a ‘broadly based’ strong economy and that the so-called benefits unfortunately had not flowed to all sections of the population, with stagnant wages particularly for non-supervisory employees.

This was clearly repugnant to Democrats given corporate profits had increased by 8.7% as a result of the tax cuts.

What’s worse is that US$2.2 Trillion in tax cuts has been added to the national debt, and with a reported 27% (or US$600 Billion) used by corporations to pay for dividends, buy-backs and executive bonuses, mainly in the banking sector.

It was also suggested that 1/3rd of that amount was likely to have gone out to foreign holders.

Powell did not think that the tax bill had contributed to an increase in wages, however he did say that anticipation of tax cuts/reforms probably did have an effect on GDP growth in 2017.

The Fed now expects the tax/spending bill to provide meaningful support for demand over the next 2-3 years, and there might be some effect on the supply side (i.e., more investment and productivity leading to rising wages). Broadly, Powell's view was that the tax cuts were likely to have a positive effect this year and possibly next year.

Not all the Senators were convinced. Powell was challenged again on his outlook.

The suggestion was that this year’s medium term growth forecast of 1.8% was the same as last year and that there was in fact no real year on year contribution to growth – the implication being that the Fed had to be careful about painting too much of a rosy picture – and that real hourly earnings had been flat and pay had actually dropped.

The link between productivity and wage growth.

When asked about his views on what was contributing to generationally stubborn wage growth, Powell suggested that deep societal problems were at the heart of the wages issue.

Key elements in his mind included stagnation of educational attainment/achievement, plus a number of years of weak capital investment following the GFC. Both were casting shadows over productivity, and were deep and hard to shift thematics that will take some time to solve. The opioid crisis and a non-mobile work force were also sited.

Counter to that view, Senator Cortez Masto (Democrat, Nevada) pointed out that some studies show that since the mid 1970’s, productivity had increased at a significantly faster rate (over 5 times) than wages.

Still, Powell was of the view that in the long term, wages cannot sustainably increase without productivity and there is a dire need to invest in education and skills to boost long-term productivity.

Clearly, these are fiscal policy levers that rest in the hands of Congress (not the Fed). True, if not convenient for him.

Powell’s views on tariffs.

Broadly, Powell believes that countries that go down the protectionist route (i.e., tariffs) do worse than countries that are open.

In principal, open trading is good. In a perfect world you do not want barriers in either direction, with an international rules-based system the preferred option.

Over the years and up until recently, US tariffs had come down to an all-time low. His view is that lower tariffs are OK and even good. However, higher tariffs would not be a good outcome and he acknowledged that the situation would be very bad if higher tariffs stood for, say 2 years.

Tariffs also lead to trade uncertainty and in turn, lower capital investment plans, with these probably leading to lower productivity and stagnant wages.

Clearly, this would not be a great outcome and some Senators expressed the view that whilst tax cuts probably did boost growth in areas, the trade uncertainty was likely to undo it.

Powell’s response was that whilst that view might play out over time, there was no evidence in the numbers as yet (in terms of taxes and tariffs).

Again, he walked the line between monetary and fiscal policy, stating that tariffs are a fiscal tool and in the power of Congress, not his.

This Powell side-step not only shifts the onus back to fiscal policy makers but avoids the key at-the-minute issue that would otherwise pit him directly against the President, who as we know nominated him as Fed Chair.

As for those pesky bank stress tests…

Whilst described by Powell as the most stringent stress test yet, the three banks that failed the 2018 Comprehensive Capital Analysis and Review (CCAR) stress test were also a hot topic.

In the latest CCAR test round, almost all firms finished above the required levels. 2 firms failed and had to restrict capital distributions to past year levels. The third firm was asked to conduct a management analysis of counterparty exposures under stress.

You may or may not be surprised to know that the three firms were Goldman Sachs, Morgan Stanley and State Street.

Given the monster profits recently made and the size of the recent tax cuts, there was a view that now would be the perfect time for such firms to be bolstering their capital reserves, not paying them out.

Moreover, instead of failing those firms, the Fed gave them ‘conditional non-objects’ – which basically only restricts capital distributions to past year levels. Even in light of that, these firms were able to still pay out in the vicinity of $5 Billion in distributions.

Senator Elizabeth Warren (Democrat, and vocal opponent to relaxing the Dodd Frank reforms and the Volcker Rule - see ‘Volting Volcker’ for a refresher) felt this to be a failure on the part of the Fed, which in her opinion had irresponsibly turned a blind eye.

Other Senators asked Powell to again commit to not providing exemptions to foreign controlled banks and to not supporting further relaxation of the supervisory rules.

On balance, no change to Fed balance sheet run-off, nor interest rate normalisation.

The Federal Open Market Committee (FOMC) is still of the view that gradually raising the Federal Funds rate is the best path for now, but future actions will depend on the economic outlook.

In turn, this will according to Powell depend on a wide range of relevant information, not just inflation and unemployment.

So, despite tariffs and the shadows they are casting over world growth expectation, and despite growing uncertainty over capital expenditure plans (not to mention the Russia meddling backflip, confirmed by Trump hours after Powell's testimony), plus moderate wage growth that is not broad-based, FOMC is still committed to its path - but with a little wriggle room in the days and months ahead.

Now what?

No surprises here (other than for Trump backflipping on his Russia medalling comments), US rates remain low, alternative investments to equities and bonds remain scarce and threats to global growth as a result of tariffs remain real to the extent high tariffs remain for a long period.

This year’s gains in copper have been almost totally wiped out and 3 month copper, zinc and tin are all down.

After Powell’s testimony, the USD strengthened against the AUD (good for our USD exporters), US equities were up, US dollar gold was down 1% (not so good for Australian based gold producers) and the VIX (volatility index) was down nearly 6.6% to under 12.

Nothing to see here? Not so.

Tariffs and trade wars are driving the economic agenda for the time being and despite Powell’s rosy testimony, he has carved out some wriggle room for the Fed to respond should things get ugly.

WA.

Here in WA, the small exchange rate benefit for US dollar exporters is unlikely to outweigh the larger drop in precious and base metal commodity prices and trade uncertainty.

That said, BHPIO and RIO are reporting record output (subject to shipping constraints) and LNG exports are booming. Major 'bulks' players and support industries will benefit while this lasts.

Broader basing the WA economy will take time, but it is critical. Investment in downstream processing of battery/EV minerals, waste management, defence and other sectors discussed in previous blogs would go a long way.

Mike


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