What does it mean for Fed policy if RGDP & NGDP diverge?

The May 2016 post, The Dollar and Treasury Yields in Limbo: Three Possible Scenarios, sought to work through potential scenarios involving the US dollar and treasury yield curve. The three possible outcomes were:

1) Global Reflation and Currency Convergence

The 10 year yield breaks above 2% and tests 2.5% or greater.
The dollar index definitively loses $93 support in a downtrend that marking $100 as at least an intermediate term top.

2). US growth rebounds relative to the rest of the world

The 10 year yield remains near the current range or breaks below 1.55%.The dollar either continues to consolidate between $100 and $93 or trades above $100.

3). Risk aversion and Panic

The 10 year yield trades below 1.55% as it trends towards the 2015 low of sub 1.4%.
The dollar index remains range bound or breaks $93 support in a correction before resuming the prior uptrend.

Although 2016 began with a fit of risk aversion, once this mood past the trend for a majority of year was very much US dollar strength based on US growth outperformance relative to other developed market economies (scenario #2). The US dollar bottomed for the year in May before topping following the Fed's December rate hike. Unlike the dollar, treasury rates remained subdued the fall where yields started their climb in October. At least initially, the treasury yield curve was exhibiting similar behavior to the end of 2015 when market participants were seeking to front run the Fed's rate hike decision. However, the major difference this time being that optimism surrounding the potential for expansionary policy under President Trump (Trumpflation) caused treasury yields to accelerate to the upside (scenario #1).

Seeing as treasury yields have languished to start 2017 after an explosive end to 2016, there are signs that a reversal must be considered over the intermediate term. This post will attempt to explore a fourth potential outcome where treasury yields and the US dollar weaken simultaneously. With a Fed intent on tightening until prove otherwise and the euphoria surrounding Trumpflation subsiding of late, downtrends in the dollar and long term treasury yields could signal that US growth and real rates for the remainder of 2017 may disappoint. Where 2016 began with fear, Fed delaying further hikes, and ending in optimism, 2017 is setting up to be the exact opposite.

As a reminder, the following is not a prediction but an exercise in thinking through a conceivable outcome given present policy, market, and macro conditions.

4). US growth lags the rest of the world

The 2.6% highs set in December 2016 that were tested in March 2017 mark an intermediate term top in the US 10 year yield. The breakdown below 2.3% is the start of a downtrend.
Similarly, $103.8 proves to be at least a temporary top for the US dollar index.

Market participants expect the Fed to continue increasing policy rates at the present pace especially as inflation approaches the Fed's 2% target. The bias is toward the hawkish side of possibly more hikes than advertised unless the Fed is forced to refrain due to poor data that can't be ignored.
Trump's economic plan fails to meet what once were lofty expectations as real growth flounders at around 2.5%.

What to look for:

The dollar weakens against a broad range of currencies.
Short-term treasury rates rise faster than long-term rates
Inflation expectations continue to trend higher
Longer dated US real rates fall as nominal interest rates lag inflation
EM securities outperform their US counterparts
Commodities led by gold and precious metals trend up after bottoming
Global banks and financials underperform as a result of a flatter yield curve

At the beginning of 2016, a wave of risk off and slowdown fears provided the Fed cover to proceed with caution for the rest of the year. This enabled RGDP growth to bounce back after Q2 2016. In contrast, a lack of financial markets volatility has meant that the Fed has already been able to hike once in 2017 with a minimum target of two more to follow. This has been the case despite RGDP stalling at a sub 2% pace for the last two quarters. On the other hand, nominal GDP registered another year-over-year increase where it is now approach 4% because the GDP-deflator (broad measure of inflation) accelerated to 2%. Since the Fed is an inflation targeting central bank, if RGDP growth doesn't pick up to match the pace of NGDP, the Fed will have to choose between lackluster real growth or rising inflation. This is the inherent disadvantage of targeting an inflation rate and employment objectives instead of a nominal GDP level.

Should stalling RGDP correspond with falling long-term treasury yields amid rising or stable 2% inflation, the Fed policy would have to confront falling LT real rates. If the latter is synonymous with a declining natural or neutral rate, a Fed intent on tightening risks entrenching this tepid real GDP growth or worse provoking a further slowdown. Furthermore, falling long-term real rates corroborate the weak productivity dynamics currently in play. Absent an actual fiscal and monetary regime change that focuses on directly improving the output capacity of the economy through greater spending on productive investments, the US economy may be approaching growth limits. How the Fed reacts to rising or stable 2% inflation, stalling RGDP growth, and falling real rates could prove crucial to the life span of this post-GFC cycle.

It was thought that president Trump with a Republican controlled government allowed for a greater scope for a fiscal expansion that would position the economy to be less reliant on the monetary policy. Seeing how the first 100 days have evolved, any possible fiscal expansion seems much more like a 2018 story at best and at worst not forthcoming. If anything, certain aspects of the policy stance emanating from Washington are just as likely to detract from future economic activity as they are to elicit a positive desired effect.

As John Hussman recently summarized:

The policy menu currently under discussion threatens to materially worsen the arithmetic of U.S. economic growth. Limiting immigration, for example, will further constrain the component of labor force growth. Attempts to forcibly narrow the trade balance will torpedo gross domestic investment. Appeals to the economic impact of tax reforms in the 1950’s and 1980’s conflate the effect of tax reductions with the impact of factors, already in place at those points, that have regularly created the conditions for rapid economic growth.

Though a great deal of hope is being placed on corporate tax reform, the effective tax rate of U.S. corporations (taxes actually paid as a fraction of pre-tax profits) is already lower than at any point in the post-war era prior to the 2008-2009 economic collapse. Even cutting the statutory rate in half from here would result in a likely bump to corporate profits of less than 10%. As for repatriation of cash held overseas, a similar tax holiday in 2004 resulted primarily in bonuses and stock repurchases, while the corporations that benefited most actually cut employment and decreased research spending. Meanwhile, foreign cash holdings pose virtually zero funding constraints. As I've noted before, major corporations already have ample access to funding for any project they could reasonably consider. Even if cash is held overseas, it’s rather easy for corporations to effect interest-rate swap transactions that effectively make the funds available domestically.

There are many actions we can take as a nation to improve our capacity for long-term economic growth, including an emphasis on productive, sustainable and non-duplicative infrastructure; greater investments in education and workforce training; increased immigration of high-skilled workers (who have a multiplier effect on both national income and employment); a substantial increase in the number of H1B visas; expansion of training, incentives and even immigration of workers in fields such as home and community health (where an aging population is likely to pose substantial demands); increased incentives for research and development; and substantially enhanced funding of scientific research through the NIH, NSF and other agencies.

Therefore, the current path from monetary policy coupled with underwhelming fiscal prospects requires that a pick up in domestic private or foreign sector spending occur in order for upcoming US real GDP not to disappoint. Barring greater spending and output deriving from either of these two sectors, intermediate and long-term US real rates are at risk of declining which complicates the Fed's monetary stance. With the Eurozone having possible averted another political upheaval in the form of the French elections, stagnant US RGDP growth should bode well for the Euro and negatively for the USD. That is of course until the Eurozone faces its next existential crisis (see Scenario 3*).

Conclusion:

Since Q3 2016, improving nominal GDP has successfully offset languishing real GDP due to the rise in the GDP-deflator. During this period, long-term real rates have matched this trend in real growth. Were these conditions to hold for the immediate future where real GDP growth and real rates decline while broad based inflation and NGDP diverge to the upside, this could complicate matters for the US monetary policy. Is the Fed more likely to aggressively tighten in order to avoid an inflation overshoot even at the expense of real aggregate output or will they hesitate until the latter shows further signs of strength? Importantly, how would president Trump react should economic performance fail to meet the expectations that he set forth during his campaign? Could a battle between the Fed and Trump loom ahead?

*Also see the post, Is this a case of Dollar Déjà vu?, for a view on the dollar under a late-cycle risk-off environment.

**The anemic performance in productivity in this cycle has understandable been explained ad nauseam from a supply side lens. Refreshingly, James Montier and Philip Pilkington of GMO present the (endogenous) demand side case that measured productivity is being damped by the post-GFC low growth dynamic. Were the present policy mix to cause weakening RGDP growth going forward, depressed productivity could remain for a bit while longer.

Looking at the more recent period, we can see in the US that Gross Domestic Income (which has to equal GDP) has been low since the financial crisis because labour income has been low (Exhibit 21). In turn, Exhibit 22 indicates that labour income has been low because earnings have been low.

Hence, we can say that output is lower because labour income is lower, and labour income is lower because of earnings. Thus low productivity looks to have a strong demand component to it. The important thing to note here is that productivity is not some exogenous concept that has a life of its own.

That said, it seems to us that real productivity – however we would actually measure the concept – is highly likely to be negatively affected by the neoliberal policy platform. This is because real productivity is probably driven by the investment in new research and development, machines, and so on. If investment is negatively impacted because aggregate demand for goods and services is low and unstable, then it is likely that actual productivity will also take a hit.

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