Fed: “Unknown Unknowns” matter more than the data – RBC CM

Research Team at RBC Capital Markets, suggests that while the economic data may very well cooperate in satisfying the FOMC doves over the next few months, it is financial stability risks that could very well derail rate increases—again!

Key Quotes

“In terms of the relevant dataflow, what struck us about the Conference Board’s consumer confidence report was not that top line confidence is back at a cycle high, but that the labor differential (jobs plentiful minus hard-to-get) jumped to the best reading since August 2007 (to +6.3 from an upwardly revised +4.0 last month and just +0.9 in July). This is just one of a plethora of metrics that suggest an economic downturn is still out of the forecast horizon. Note that it typically falls below its 2-year trend a few months ahead of a recession. Thus far, the trend is still well in the other direction.

This number also matters for the internal debate at the Fed regarding the assessment of the labor backdrop. As the relationship this cycle suggests, the current reading on the labor differential is consistent with a u-rate in the low-4% zone. In other words an improvement in the unemployment rate, which has been elusive this year, is seemingly in the pipeline.

But we will still need to see this translate into a lower unemployment rate in the months ahead of the December confab in order for the dovish Fed camp to become comfortable with the idea that we have shed enough slack to push us comfortably into the full employment zone. We will get more concrete evidence of this in the week ahead with the employment report.

But maybe it’s not that simple. The market has been lulled into thinking that Fed decisions were subject to an economic metric here and there in the past. We know better than that. What we need to consider is that even if the data cooperate fully over the next few months, it still might prove difficult for the committee to raise rates. If the concerns about recent bank stress continue to linger through year-end, this will bring the Fed’s “third mandate” back into focus (i.e. financial stability).

Recall that our view that the next rate increase probably won’t come until the middle of next year is based on the premise that concerns about global financial conditions will outweigh a relatively constructive economic backdrop. The “known unknowns” when we made that call back in June were the money market fund reform, US election, Italian referendum, French election, and Brexit aftermath among others. The bank stress concern is an example of the “unknown unknowns” that have tended to crop up now and then and have stayed the Fed’s hand, at least in recent years.”