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Welcome to Indicators and Insights. Every Friday, I write about what I find to be the key financial market topics, charts, and stories of the week, often challenging the conventional wisdom.

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Today I highlight what I found to be the most critical development during a week full of important influences. Hint: it wasn't earnings, data, China, or Covid.

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As I look back on this past week, I'm reminded that it was eventful. A number of key developments stand out:

• Q2 earnings season kicked off on Tuesday with the big banks reporting generally better than expected results, led by a stellar quarter of revenues in Fixed Income, Currency, and Commodity trading (FICC). Market volatility breeds this kind of success although the results far surpassed expectations in most cases. That trading success will be difficult to replicate, however, plus the banks had to set aside a combined $33bln in provisions for impending loan losses related to the pandemic that are sure to come.
• The U.S. economic data was mostly better than expected with June CPI, July Empire mfg, June IP, June CPU, June retail sales, July Philly Fed, and July home builders sentiment all beating expectations.
• The weekly claims for unemployment disappointed, however, raising concerns that the stubbornly high level of filings (1.3m) is indicative of the slow bleed of layoffs and small business closures, particularly now that states have had to shut down sectors of their economies that only recently were allowed to reopen.
• The upside surprises in the data continue to be viewed through the lens of an economy that is moving from lock down to partial reopening. These snap backs are to be expected. A high level of skepticism remains, however, as to whether this kind of progress can be sustained once the pent-up demand and re-ignition of the economy have filtered through. With 32.0m people still on some form of employment benefits, it's not likely.
• The rhetoric and actions between the U.S. and China continued to heat up, and the tensions are high. China is facing this on multiple fronts, with the U.K. and Australia engaged in their own Sino-tussles (Huawei, Hong Kong) and Australia leading a large group on the international community against China for its negligent handling the coronavirus. The U.S. is squeezing China on a bilateral basis on the virus, Hong Kong, human rights, Taiwan, cyber-security, TikTok, and the South China Sea.
• Covid-19 continued to fester throughout the United States and around the globe. The U.S. reported a new daily record of cases on Thursday (77k+), up from the previous record of ~68k. The number of deaths are now ramping higher and hospitals are being overrun in the hardest hit states. Moreover, CA, TX, and FL, representing ~28% of U.S. GDP, have rolled back/restricted some of the previous reopenings.

The Big Takeaway

There was a negative shift in the commentary from Fed officials. Wednesday's remarks were particularly downbeat from three voting members of the FOMC - Fed Gov Brainard, Philly Fed Pres Harker, and Dallas Fed Pres Kaplan.

It wasn't only that, either. Brainard and Harker voiced a clear desire to let inflation run HOT, if they ever get the chance.

The depth of concern expressed by Brainard, an opinion leader at the Fed, really caught my eye. In a webinar speech on Tuesday hosted by the National Association for Business Economics and titled Navigating Monetary Policy through the Fog of COVID , she stated

"A thick fog of uncertainty still surrounds us, and downside risks predominate."

Fed Gov Lael Brainard, July 14, 2020

In her speech, Brainard echoed remarks from Harker and Kaplan, acquiescing "the pandemic remains the key driver of the economy’s course." A few other highlights included:

• "Even if the virus spread flattens, the recovery is likely to face headwinds from diminished activity and costly adjustments in some sectors, along with impaired incomes among many consumers and businesses."
• "Fiscal support will remain vital."
• "With some of the fiscal support measures either provided as one-off payments or slated to come to an end in July, the strength of the recovery will depend importantly on the timing, magnitude, and distribution of additional fiscal support."
• "In the consumer sector most services categories have remained quite depressed."
• "A similar concern may apply to the commercial real estate (CRE) sector and to equipment investment. Some parts of the CRE market—most notably, the lodging and retail segment—are experiencing significant distress and have seen sharp increases in delinquency rates along with tighter bank lending standards."
• "In downside scenarios, . . . A wave of insolvencies is possible."
• "Already this year, we have seen about $800 billion in downgrades of investment grade debt and $55 billion in corporate defaults—a faster pace than in the initial months of the Global Financial Crisis."

Overshoot

What I found to be of utmost importance was her suggestion that the "Fed Should Abandon Policy of Preempting Inflation" as it was interpreted by this Dow Jones - Wall Street Journal headline (via Bloomberg). This would be a significant shift in addressing the inflation side of the Fed's dual mandate.

Brainard expressed concern "with inflation coming in below its 2 percent objective for many years, the risk that inflation expectations could drift lower complicates the task of monetary policy."

Referring to the June FOMC meeting, the Fed Governor said "A majority of FOMC participants indicated that they expect core inflation to remain below our 2 percent objective and employment to fall short of its maximum level at least through the end of 2022."

She went on to say,

Looking ahead, it will be important for monetary policy to pivot from stabilization to accommodation by supporting a full recovery in employment and returning inflation to its 2 percent objective on a sustained basis. 

To get there, the Fed will "be guided by . . . our evolving understanding of the key longer-run features of the economy, so as to avoid the premature withdrawal of necessary support."

This remark was a clear acknowledgement that the Fed must learn from and not repeat the policy mistake from 2018 when it tightened four times (+100bps total), choking off any chance of stoking inflation and having to reverse -75bps of that tightening from July-Oct'19.

It is also the line that framed up the WSJ's reaction (and mine) that Brainard thinks the Fed must no longer tighten policy preemptively to keep inflation in check, as it has done in the past.

In point of fact, Brainard said as much: "it is important that monetary policy support inflation expectations that are consistent with inflation centered on 2 percent over time. And with inflation exhibiting low sensitivity to labor market tightness, policy should not preemptively withdraw support based on a historically steeper Phillips curve that is not currently in evidence."

She has lessened the significance of the Phillips Curve which, for years, has argued inflation and the level of unemployment are inversely related. Actually, the Phillips Curve theory has been neutered ever since the Great Financial Crisis of '07-'09.

Instead, Brainard is a proponent of allowing inflation to overshoot the 2.00% target. Now "research suggests that refraining from liftoff (raising rates) until inflation reaches 2 percent could lead to some modest temporary overshooting, which would help offset the previous under performance."

Philadelphia Fed President Harker supported this view in a Bloomberg TV interview on Tuesday. “We’ve been saying for a long time that the 2% inflation goal is symmetric, which means we should overshoot it. We were having a difficult time doing that, like all developed economies,” Now he's “supportive of the idea of letting inflation get above 2% before we take any action with respect to the fed funds rate.”

He also holds these negative views:

"we remain mired in a crisis the likes of which none of us has ever experienced."

and

“We are in a downturn that is both exceptionally painful and stubbornly long-lasting.”

Harker then told the WSJ this on Wednesday: "I think the most important tool in our tool kit, as we start to emerge out of this, is forward guidance that says 'we are going to act in such a way that we bring the economy back and let inflation run above our target'...We are not going to act prematurely until we see real movement back to the target."

Which brings me back to Brainard who also shared "forward guidance constitutes a vital way to provide the necessary accommodation." and "Balance sheet policies can help extend accommodation by more directly influencing the interest rates that are relevant for household and business borrowing and investment." 

"Forward guidance and asset purchases were road-tested in the previous crisis, so there is a high degree of familiarity with their use."

In essence, Brainard and Harker have laid out the road map for monetary policy going forward. Expect to hear other Fed officials incorporate this language into their communication going forward.

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This article is part of my LinkedIn Newsletter Series: Indicators and Insights – Perspectives on the Top Financial Market Movers with a View of What's to Come.

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