As Fed’s Daly Frets Over ‘Self-Fulfilling Prophecy’, Goldman Warns Fed Is Caught In ‘Hall Of Mirrors’

San Francisco Fed President Mary Daly is worried about a self-fulfilling prophecy between markets, sentiment and the economy.

“I don’t think we’re headed towards a recession right now. When I look at the data coming in, I see solid domestic momentum that points to a continued economic expansion”, she wrote, in a post on Quora Tuesday, adding that “the labor market is strong, consumer confidence is high, and consumer spending is healthy”.

All of that is true with one caveat: Consumer sentiment, while high, just plunged to the second-lowest read of the Trump presidency in the University of Michigan’s survey.

As we’ve repeated ad nauseam in these pages, that speaks to the idea that the Fed’s July cut (and Donald Trump’s amplification of monetary policy) risks backfiring by spooking a consumer that just carried the economy to a solid second quarter performance and continues to shop.

“The main takeaway for consumers from the first cut in interest rates in a decade was to increase apprehensions about a possible recession”, the University of Michigan’s Richard Curtin said Friday, underscoring the point.

For her part, Daly seems cognizant of the possibility that trade policy and the ongoing ex-US manufacturing slump have the potential to feed back into sentiment stateside and manifest themselves in, for example, dramatic moves in the US bond market, where the 2s10s curve inverted last week, leading directly to a steep selloff on Wall Street. Earlier that day (Wednesday, August 14), lackluster activity data out of China and confirmation of a second quarter contraction in Germany set the mood.

“Considerable headwinds, like weaker global growth and trade uncertainties, have emerged — and they’re contributing to this fear we see in the markets that a downturn is right around the corner”, Daly wrote Tuesday, warning that “one thing I’m looking closely at is whether the mood gets so out of sync with the data that the fear of recession becomes a self-fulfilling prophecy”.

That is entirely possible and, as alluded to above, the Fed may be contributing to that, in part by following the bond market for fear of the tightening impulse that would accompany disappointing expectations. That’s the “hall of mirrors” effect, which Goldman revisits in a new note.

After reviewing the economic backdrop in the US, the bank writes that when it comes to explaining the “remarkable rally” in US Treasurys, the trade story is important, but the “hall of mirrors” concept is potentially more so.

“It starts from the observation that Fed officials now seem to put greater weight on bond market pricing in making monetary policy decisions than in the past, partly because they worry more about the consequences of disappointing market expectations for cuts and partly because some of them put a significant amount of weight on bond market signals in gauging the outlook for growth and inflation”, Goldman’s Jan Hatzius writes, before sounding his usual cautious tone on this dynamic. To wit:

This can lead to a positive feedback loop between more dovish bond market pricing and more dovish central bank decisions. This feedback loop might not be broken until the economic data signal very decisively that further easing is inappropriate. Partly for this reason, we now forecast 25bp cuts at the next two FOMC meetings, with risks tilted toward more and/or bigger cuts.

(Goldman)

If you’re wondering whether this has the potential to distort the signal from the yield curve, the answer is obviously yes.

“After all, the predictive power of the yield curve works in part through expectations for monetary policy–e.g. ‘the market says sharp rate cuts are necessary so the outlook must be bad’–and if these expectations become circular, they will be less informative about the economic outlook than they might have been in the past”, Hatzius goes on to write.

When you throw in the fact that more than half of the action in bonds in August was technically-driven, you end up with some pretty muddy waters thanks to a series of circular dynamics and what amounts to overlapping Venn diagrams.

Daly doesn’t see a recession. “Speaking only for myself, I do believe [the July rate cut] was an appropriate recalibration of policy in response to the headwinds we’re facing”, she wrote Tuesday, being careful to stress that her “support for this cut is based around my desire to see our economic expansion continue — not because I see an impending downturn on the horizon”.