The Taylor rule calls for adding GDP

We have plenty of US data today, including the usual jobless claims and June retail sales, plus more earnings reports and several Fed speakers, including dove Waller, who earlier wanted a July cut. Yesterday NY Fed Williams “refused to comment on Powell's position but said monetary policy is in the right place and warned the impact of trade tariffs is only just starting to hit the economy,” according to Reuters.

We also get the TICS report showing foreign purchases/sales of US Treasuries across the board. So far it has not shown the exodus of disgusted investors that so many have expected, although to be fair, it’s a lagged report. This one is for May.

Food for thought:  As we await Trump’s nominee for shadow fed chief , we need to contemplate the effect of lowering rates on inflation and other matters. In practice, firing Powell would result in a court case that would take until May next year when Powell’s term ends, anyway, so does not actually work.

Even if Trump gets one of his toadies in the chair, the other 11 members of the Committee can still outvote the chairman. So then Trump would have to replace them, too. As we saw yesterday, the stock market would not like any of this, so for the moment, the only course is naming a shadow Fed chairman who can try to make headlines.

As a practical matter, we should not expect rate cuts from this brouhaha. That’s not the problem.  The problem is the loss of the Fed’s independence and the resulting financial market turmoil. As we just saw, none of the markets like Trump’s stance. Maybe Trump was just trying it on for size, and of course is unhappy about the outcome. Maybe he was trying to distract attention from his stance on the Epstein files, as liberal TV commentators are enjoying.

But back to the economy. Big companies don’t have debt, so won’t care if rates go down. That won’t stop the S&P from rejoicing; when the Fed cuts, the equity market almost always goes up. Smaller companies that do have debt get some relief, which may result in fewer job losses. In the current environment of supply cost uncertainty, no other effect can be detected. 

The big effect is on housing, which has an outsized portion of the inflation calculation. Presumably banks become more willing to lend to builders and home buyers are more comfortable with mortgage rates. But in each case, the cost of debt is minor compared to the cost of materials for builders and the selling price of the house for buyers. We don’t see an inflationary effect from rates alone.

So what would be so bad about cutting rates? Conventional thinking. The interest rate “should be” the rate of inflation plus a premium for future inflation. If inflation is (say) 3% (the one year out forecast) plus 1.5-2.5% premium, the result should be 4.5-5%. Well ,that’s about where the 10-year is now.

The Taylor Rule calls for adding GDP to the mix. If it’s falling, a rate cut should lift it back up. As it happens, if we believe the Atlanta Fed, GDP is not falling, or not by much. It’s 2.6% for Q2 (we get a new version today). Trading Economics says the average rate of growth of GDP is 3.15% from 1948 to 2025.

Bottom line, the true economic effect of a rate cut would not be bad. It might even be good if it helps housing and jobs. What is bad—terrible, horrible, disgusting—is politicization of the Fed. There has always been some interference from the White House to the Fed in the form of verbal pressure (remember Volcker resigned because of it), but never before has the president taken the reins. And nobody with more than a dollar in his pocket trusts this guy to do it right.

So, would the bond market raise the inflation premium it needs to make the Taylor Rule the proper measure? Maybe by a hair on the current economic data but by a far wider amount on the inflation expectation. The public may see 3% one year out but the economists see 4-4.5%. Now add Trump distaste and we could see 4.5% inflation + 2.5% premium + 1% for Trump and we get the 10-year at 8%. Is such a thing possible? Probably not, but be worried.

Bottom line: Powell is not leaving the job. We will get a shadow Fed chairman who can make noise but not decisions. Even if the Fed is cowed into an early cut knowing full well tariff-induced inflation will force hikes later, the economic effect will likely be minor.. 

What will be noticeable is the sense of instability and political dissonance, and that can’t be good for the business decision-makers or consumers. They would sense that instability is coming from within, unlike natural disasters and pandemics. Inflation is supposedly attached to unstable economies. In the US, we can imagine spending halted and savings going way, way, up. Since the US economy is two-thirds the consumer, that means recession. Since we also have those tariffs, stagflation becomes the best-case scenario.

Tidbit: The current thinking is that Trump is holding an Apprentice TV-like contest for shadow Fed chief, with the front-runner the budget guy Hassett. He is prone to lying about the books and can be expected to start cooking them. He said inflation was only about 1% when it was 2.4% and now 2.7%. Hassett is a genuine PhD economist but a believer in supply-side economics, a demonstrably failed idea that he is not letting go. His professional qualifications have been entirely corrupted by political ambition and he is now what Krugman names a lapdog.

Forecast

The dollar is getting propped up by its cousin, the bond market. The macro data is not actually all that bad yet, but everyone knows it’s going to be. We are waiting for a tipping point event to set the dollar back on its downward slide. It has to be a pretty big event to overcome the mighty US bond market.

Besides, it’s the change in US rates vs. the change in foreign rates that makes the difference. The UK, C$ and A% yields are falling as their economies stumble. The EU economy is not stumbling, yet, but the Bund is lower. Japan financial conditions are a hopeless tangle.

It would take a collection of super-evil events to overcome the bond situation. We already have the too-high deficit, a worsening labor shortage because of Trump policies, and Trump messing with the Fed. There will be something else any day now. We expect the shadow Fed chief today, tomorrow or over the weekend. Then it’s tariff deadlines. The stock market gang thinks Trump will chicken out again. We don’t agree. 

At the same time, as long as the dollar is getting some forward momentum, we have to stick to our intraday trading advisory signals and hold off switching signals in this report, which lags on purpose. But we don’t have to like it and we do have to be ready to reverse.  

This is an excerpt from “The Rockefeller Morning Briefing,” which is far larger (about 10 pages). The Briefing has been published every day for over 25 years and represents experienced analysis and insight. The report offers deep background and is not intended to guide FX trading. Rockefeller produces other reports (in spot and futures) for trading purposes.

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