When the going gets tough, the tough ignore their mandates

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      By Stewart D. TaylorInvestment Grade Fixed Income Portfolio Manager, Eaton Vance Management

      Boston - The Federal Reserve (Fed) has begun an easing cycle - despite unemployment at a 50-year low, financial asset prices near record highs and inflation trending upward. How did the Fed go from targeting stable prices to cutting rates while inflation pressures are building?

      How the Fed got its mandates

      The high inflation, high unemployment environment of the 1970s led the U.S. Congress to codify the Fed's three economic objectives: "maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote the goals of maximum employment, stable prices, and moderate long-term interest rates." This became known as the Fed's dual mandate, with the logic that by focusing on inflation and employment, long-term rates would stay controlled.

      For the vast majority of central bankers in those days, stable prices meant no inflation. In their view, inflation represented an unseen tax on the hard-earned savings and investments of their citizens. After seeing the terrible damage high inflation could inflict, these inflation hawks found the courage to protect the nest eggs of savers and the portfolios of investors.

      Why 2% inflation became the target

      Over the past 50 years, as the Fed's fear of deflation increased, so did their preference for higher inflation. During the 1980s and 1990s, their focus shifted from the headline Consumer Price Index (CPI) to the typically lower core CPI, which excludes goods with greater price volatility like food and energy. Core CPI gradually supplanted headline CPI as the preferred metric to assess the trend of inflation.

      In January 2012, the Fed formally established an explicit 2% inflation target using core personal consumption expenditures (PCE), with the comparative weightings and index construction ensuring that core PCE would generally be lower than core CPI. More recently, the target was made "symmetrical" around 2% - that is, when inflation fails to meet the 2% target, the Fed can let inflation run higher for a period to bring the average rate back up to 2%. With inflation below 2% now viewed as "disappointing," the inflation-hawkish Fed of past decades has become extinct.

      Where we are now

      Now, global growth is weak and fixed income yields are plunging. Bloomberg estimates that USD 17 trillion of the Bloomberg Barclays Global Aggregate Index is trading at a negative yield. The U.S. Treasury yield curve has inverted. As a signal that the Fed needs to cut rates, inversion has been a reliable precursor to a recession.1

      Which brings us back to that dual mandate to balance employment and inflation. While the jobless rate is the lowest in 50 years and core PCE inflation is below target, core CPI has been above 2% for 17 straight months. Changes in collection methodology in both apparel and used car prices have created volatility in recent reports. At 2.88% in July, the Cleveland Median CPI, which removes the influence of the most volatile outliers, had the highest print since August 2008. At the same time, core goods inflation has turned convincingly positive.2 With core services inflation already near 3% for most of the last seven years, higher core goods prices will become additive to core services.

      Wage pressures are also building. The recent revision to the national income and product accounts (NIPA) reveals that labor's share of corporate profitability has been much higher than previously thought.3 Because wage trends are sticky, wage gains are likely to continue even as the economy slows.

      Fixed income markets are demanding that the Fed keeps easing, with federal funds futures market-based forecasts suggesting another 50-75 basis points (bps) of rate cuts by the October 30 meeting. But within the context of the legislated dual mandate, the Fed has little room to maneuver, particularly this late in the economic cycle - an environment typified by growing wage pressures and rising inflation. Add the inflationary impact of tariffs, declining globalization and the soon-to-be-implemented IMO 2020,4 and inflation could move considerably higher.  

      Bottom line: For our central bank, we suspect the first casualty will be the inflation portion of the mandate. Over the past two decades, we believe the Fed has shown more interest in supporting financial markets and bowing to political pressure than in fighting inflation. In our view, this time will be no different.