Central Banks

Dallas Fed President and voting member Robert Kaplan was particularly hawkish today. This is just a few weeks after he said he was ‘lightly penciling in a rate hike’ next month.

He reiterated the Fed view that the “US economy is at or near full employment” but also said “While real wage growth has been sluggish, we are beginning to see welcome signs of increasing wage pressures which are consistent with removal of remaining slack from the labor market.” He also said that lower inflation might be “due to structural forces, which are limiting the pricing power of businesses and are likely having a muting effect on wage pressures for certain types of workers.” Therein lies the inflation trade off in his mind but he’s leaning toward tightening to deal with the cyclical factors.

I give Kaplan credit today in acknowledging the side effects of aggressive monetary policy. Not many talk about unintended consequences. He said “I have argued that monetary policy accommodation is not ‘free’, there are costs to accommodation in the form of distortions and imbalances in consumer decisions as well as in investing, hiring and other business decisions.” He then said of course its “possible that ‘this time will be different’, but as I assess the condition of the US economy, I am carefully monitoring evidence that might suggest growing risks of real imbalances, which could threaten the sustainability of the current economic expansion.”

He talked about a continued tightening of the labor market from here that “would likely add to excesses and imbalances accumulating in the economy.” He then went on to discuss the growing “potential of financial excess.” He lists the market cap/GDP ratio which “now stands at approximately 135% of GDP, the highest since 1999/2000.” Also, “commercial real estate cap rates and valuation measures of debt and other markets appear notably extended.” He then talked about the historically low volatility and that we haven’t had a 3% correction in a year. “This is extraordinarily unusual.”

He also acknowledged record high corporate debt levels and record stock margin debt levels.

While he doesn’t vote next year, if he was, he’d be voting for more rate hikes: “even though we are not meeting our inflation objective, the size of the expected full employment overshoot is growing and should be taken into account in assessing appropriate monetary policy actions.” It is the cyclical inflation pressures that he thinks are building that for now offset the structural pressure on inflation. His neutral rate forecast is 2.5%. The FOMC is only half way there and you’ll see an inverted yield curve if they get there.

Bottom line, Robert Kaplan is sounding a bit like former Fed Chairman William McChesney Martin who in 1955 said “The Federal Reserve is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.” The problem now though is the party has been going on for 9 years with all the coincident excesses that have built up (can you say $450mm for a freaking painting that we don’t even know for sure is real). What happens next? To reiterate, in addition to more rate hikes, the Fed will be removing $420b of liquidity next year and the ECB will be buying $500b less of assets vs its current run rate. Simply stated and in the context of valuation excesses, be bullish if you think $1T of liquidity that will be essentially disappearing next year doesn’t matter. Be worried if you think it does.