Sunday , 25 September 2022

An Assessments of Powell’s Favorite Indicators Say…

Powell has three jobs at the Federal Reserve: (1) ensure the U.S. Treasury market functions; (2) price stability and (3) employment. [Below is my assessment of how each is evolving and what we can expect from the Fed over the next 3 to 6 months and the effect on the U.S. economy.] 


1) Ensure the U.S. Treasury market functions

The US Treasury (UST) market is how the U.S. funds its deficits. A deficit is the short fall between income and expenses. The UST market must trade each day and the market must be liquid to allow capital to enter and leave the market freely. Currently, liquidity is under stress as there is an oversupply versus demand, therefore higher interest rates are required to attract buyers. The question remains, “Can the U.S. with its debt to GDP over 120% afford higher interest rates?” Powell is busy maintaining U.S. Treasury market liquidity so if a liquidity crisis eventuates then Powell will be forced to be the buyer of last resort via Fed balance sheet expansion. The indicator says currently the U.S. Treasury market stress is very high.

(Click on image to enlarge)

2) Price Stability

Powell is concern with two economic indicators:

  1. the unemployment rate and
  2. core personal consumption expenditure (PCE) index, or CPI without food and energy.

These two indicators can be made into a powerful inflation and deflation indicator. The red line in the chart below is the unemployment rate flipped upside down and then added to the core PCE. When the red line is rising, this is a period of inflation (or reflation), when the red line is falling this is a period of deflation (or disinflation). If you notice when the red line falls below zero a official U.S. recession is called, when this is the case the red line is saying deflation forces are strong.

The light blue line is the yield curve between the 2 yr and the 10 yr treasury interest rate, when this line falls below zero this means the 2 yr rate is higher than the 10 yr rate, or a yield curve inversion. This inversion signals with a high conviction that deflation forces are near…Typically there is about 18 months between the initial yield curve inversion and a confirmed deflationary period (or recession). Therefore, in the chart the light blue line has been moved forward 18 months. Currently, the light blue line is forecasting a strong deflationary period near 2023/24. Therefore, there is a recession warning for late 2023 or early 2024. The indicator says recession risks are growing and Powell should consider a pause in hiking rates to avoid a strong deflationary period (or recession). This is best way to get a a soft landing, act now and pause.

2024 is a presidential election year and it is never good for the sitting president to have a recession in the year of the election. Hmmm, is Powell and Trump working together (ha)!

(Click on image to enlarge)

3. The Rate of Inflation

The above chart includes the unemployment rate. Therefore if you can forecast this indicator you can determine the likely hood of how deep the coming deflationary period may be. In the chart below the red line is the unemployment rate inverted (upside down). The red line trends very well with consumer sentiment (grey line) and the housing units for sale ratio (dark blue line) and, as such, these lines suggest the red line forecast is for a rapid rise in unemployment. Higher unemployment means deflationary forces will show up very quickly. The indicator below is very bearish for employment, suggesting Powell will have to consider the accelerating deflationary forces in his monetary policy measures to avoid a hard landing.

(Click on image to enlarge)

Conclusion: Deflationary forces will accelerate over the next 3 to 6 months. The Fed will have to change course from tight to loose monetary policy very soon, or they will allow the U.S. to enter a deep recession in 2023/24.

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