Cheshire Cat’s Smile: ‘What Is The Fed Worried About?’

I used to spend quite a bit of time imbibing at local watering holes – both dive bars and the type of granite-topped edifices to pretentiousness that are anathema to the dive bar crowd.

The conversations I had at less “reputable” establishments differed materially from those I found myself engaged in at the nicer joints, with the former centering around sports and drugs and the latter revolving primarily around niceties that can generally be summed up as follows: “What line of work are you in and how is it that you came to live on this island?”

One thing I learned pretty quickly when I moved here from New York is that exactly no one wants to talk about finance, irrespective of bar pedigree.

I no longer drink, but I have been venturing out to the same spots again recently and substituting coffee (at the dive bars) and espresso (at the nicer places) for Jim Beam and Blanton’s (respectively). As it turns out, nothing has changed in terms of the locals’ willingness to entertain discussions centered around finance in my 18-month absence.

Last night I had a guy (a real estate agent) ask me for my take on Bitcoin and I thought I might be able to luck up and parlay that into a discussion about the Fed. But that segue effort crashed and burned in spectacular fashion when he became disinterested and, while turning around to talk to the person on the other side of him, spilled his IPA all over the goddamn place. That’s a true story.

But if Fed meetings and finance more generally are taboo in “polite” island bar company, I imagine trying to discuss the shape of the yield curve and/or debate whether the Phillips curve’s demise has been greatly exaggerated is a good way to get yourself kicked out of the bar altogether.

So while I don’t imagine I’ll be debating those issues here, there are presumably a lot of economists having drinks together across the country and the discussions that accompany those drinks almost invariably center around the two curve debates.

Most readers are undoubtedly apprised of the basics here and in fact, I’d go so far as to say that my audience is well-versed in this. The yield curve (which collapsed to new cycle lows following the Fed statement this week) is the subject of vociferous debate and while one can argue whether it’s still a reliable indicator when it comes to predicting imminent economic doom, it’s still an indicator of something that’s presumably important – even if no one knows what in the post-crisis world.

If you want some in-depth discussion around the first signs of curve inversion in the U.S., you can check out “Inner And Outer Limits: Resolving An Inconsistency And What It Means For Risk” and if you want a more plain vanilla post on this complete with a Richard Pryor video, (more) liquor references and some charts, you can check out “‘We Got No More Liquor!’ These Yield Curve Inversion As A Recession Predictor Probabilities Are Sure To Be A Hit At The Bar“.

As for the Phillips curve debate, the question can (basically) be summed up in Monty Python terms. Is the Phillips curve “just resting” or is it, like the Norwegian Blue, “deceased”, “expired and gone to meet its maker.”

Obviously, this is a critical debate for the Fed at a point when reality is forcing upgrades to the unemployment outlook in the SEP while that same reality is forcing officials to acknowledge that inflation remains stubbornly subdued considering how low unemployment has fallen.

Presumably, piling fiscal stimulus atop a late-cycle economy operating at full employment should lead to wage inflation and that’s pretty much the heart of the debate.

So that’s the backdrop for the latest note from Deutsche Bank’s Aleksandar Kocic who asks “what is the Fed worried about?” in the context of recent hawkish rhetoric and policy leans.

“We believe that Phillips curve is the central point which provides the context for the recent changes in Fed rhetoric and actions,” Kocic writes, before elaborating as follows:

In the context of a single cycle, Phillips curve typically exhibits a hysteresis: Linear decline in a recession is followed by a nonlinear recovery starting with a slow rise in wages/inflation during the initial stage and their accelerated rise towards the end. As the economy approaches the full employment, wages tend to become more responsive. This is the inflection point that the Fed is monitoring.

Ok, so why is the Fed concerned about this inflection point? Is it realistic to think that with all the purportedly “structural” headwinds to inflation at work that things are going to suddenly accelerate meaningfully and catch them behind the curve (figuratively and literally)? Here’s Kocic to explain, as only he can (note the artistry in the writing):

Through the last four cycles, Phillips curve has asserted its importance in an unorthodox way and, as such, attained a special status; it inhabits a space different from other macroeconomic frameworks and metrics. In each cycle, it falls apart, but after every annihilation, it re-composes itself and continues to play an important role. It appears “indestructible”, but not in a conventional way, more like a survivor of one’s own death. Phillips curve functions like an organ without a body, an equivalent of Cheshire cat’s smile (in Alice in Wonderland) that persists alone, even when the cat’s body is no longer present. This time is no different in our view. The figure shows the Philips curve through several cycles starting in mid-1980s. Each cycle has a different color which implicitly marks their beginning and end. The first thing one observes is that this is more of a “spaghetti” then a curve. The main reason is that it captures different cycles — a testimony to its falling apart and recomposing itself after each.


What you’re looking at there are the vertical lines at the end of recoveries. As Kocic goes on to write, “in the past, this stage always exhibited a dramatic (practically straight line) rise in wages in response to infinitesimal improvements in economic activity.”

Here’s the current cycle:


Clearly, the worry is that we’ll abruptly catapult into the upper-left quadrant. That would could mean the Fed gets caught flat-footed by the suddenly not flat curve. Next up: stagflation.

“If we enter the goldilocks region (upper left corner) too fast, the Fed could be caught behind the curve and might be forced to hike aggressively which could have a negative impact on growth while leaving only inflation behind,” Kocic cautions.

So there’s something to watch or to at least be cognizant of.

Just don’t try and talk about it at a bar.



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7 thoughts on “Cheshire Cat’s Smile: ‘What Is The Fed Worried About?’

  1. Great post H. The wage inflation is perhaps one of the most important metric variables at this point.

    “Clearly, the worry is that we’ll abruptly catapult into the upper-left quadrant. That would could mean the Fed gets caught flat-footed by the suddenly not flat curve. Next up: stagflation.”

    As you and Kocic write, it’s once again the rate of the move towards that upper left quadrant, and the subsequent Fed response. We are clearly in uncharted territory, given 9 years of extensive QE. I think this “historical baggage” (QE) needs to be considered when attempting to model reflexivity of wage inflation to unemployment and real GDP.

    Asset bubbles can divert corporate capital in very strange ways.

  2. Interesting that the previous and current cycles show flatter and flatterer late cycle curves — participation rate related? Also, FRED suggests the yoy change in corporate pretax profits leads (by a quarter) yoy change in nonfarm business unit labor costs. Q4 17 and Q1 18 pretax profits were each down 6% yoy. More to come? Q2 and Q3 17 are rather difficult base periods.

  3. Notice each vertical line is both depressed towards the x-axis and is lower down than the preceding spike. This seems to suggest successive recoveries are resulting in diminishing returns for wage growth. In other words, each recovery is seeing less and less wage growth. That “goldilocks” quadrant may be arbitrary since its pegged to earlier cycles that had higher baseline wage growth. Ergo, this may already be the goldilocks period.

  4. I wish you would have posted this over @ SA. I enjoy the wackiness of (some) comments over there so much.

    Nicely assembled essay by the way, and even I can grok it. That’s not frequently the case with much of your stuff but I’m catching on.

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