The CFNAI index (Fed Chicago) indicates in September that the Fed’s decision to ease monetary policy is not linked to a risk of recession. An index close to -0.7 generally reflects a risk of recession & intervention by the Fed. It is -0.24 in September. More details here
The possibility of a 50 basis point interest rate cut by the US Federal Reserve is on everyone’s lips. The dots chart published at the end of the June 19 meeting indicated that rates would remain at the current level in 2019, but it showed that 7 members suggested a 50 bp decrease in 2019 (stability is calculated on the median of the results). That was all it took for observers to switch to a similarly sharp decline at the July 30-31 meeting. The explanations given are those of Donald Trump’s pressure on the central bank either through threats relayed on Twitter or by the members appointed by Trump to the FOMC.
Such an interpretation raises several questions The first is that at the Fed, the president always has the last word. Jerome Powell’s recent comments do not give this sense of urgency about lowering rates. This implies that the July rate cut, if it were to take place, would be more than a palace revolution since its president would be outvoted.
The second point is that the macroeconomic data also do not reflect the urgency of a change in the central bank’s strategy. To gauge the economic situation I used the CFNAI index calculated by the Chicago Fed. It includes 85 indicators of the federal economy (from industrial production to retail sales, employment and orders for durable goods). The calculated indicator is centered on 0, and a value below -0.7 (on the index on average over 3 months as shown in the graph) suggests a risk of recession.
Since 1985 (the beginning of the great moderation), I have then measured the changes in the pace of the Fed’s monetary policy. The first graph shows the fed fund rate and the points used to mark the shift towards an accommodative monetary policy.
The second graph shows the dates of monetary policy changes and the CFNAI index. Since 1985, monetary policy changes have taken place when the CFNAI index is close to -0.7, i.e. when the risk of recession becomes clearer. The only exception is 2007 when the issue of liquidity on many financial structures was raised. This is a special case. The current level of the index is not consistent with a decline in Fed rates unless we imagine a deep break in all US indicators for June and July. This is not our scenario.
This means that, in the absence of economic or financial justification, a reduction in the Fed’s rates and a defeat of its President would first reflect a collapse in the credibility of the US central bank due to its loss of independence. As the world’s most powerful financial institution, it is likely to cause significant turmoil in financial markets. Should we take this kind of risk? I don’t think so.
ISM index dropped: a healthy adjustment. In the USA, the fall of the ISM may reflect a return to a more normal situation? For many months, this indicator for the manufacturing sector was well above the CFNAI index which is a measure of 85 indicators of the economic activity (prepared by the Chicago Fed). This situation, which has been a regular occurrence since 2004, always ends with a sharp and brutal adjustment of the ISM to the CFNAI. The adjustment always takes place in this direction. Finally, the overly optimistic expectations contained in the ISM index adjust to the “real economy” which does not present excessive optimism. This adjustment is rather healthy.
The ISM index for the manufacturing sector is, in August, at its highest since May 2004. It was then at 61.3 versus 61.4 in May 2004.
The reading of this index is puzzling for different reasons
1 – Since 2011, the average growth in the US is 2.2% but the trend was 2.7% between 2000 and 2007. But the ISM index was, on average, higher since 2011 than before the crisis. Its average was 54.1 from January 2011 to August 2018 but only 52.1 from January 2000 to December 2007. A higher ISM index doesn’t not reflect a stronger growth momentum. We can see that also when looking at the manufacturing production index. On the same periods, the annual growth rate was 1.8% from 2000 to 2007 but 1.15% from 2011 to July 2018.
In other words, the index is higher than in the past while growth is lower.
2 – There is a robust index calculated by the Federal Reserve of Chicago. The CFNAI (Chicago Fed National Activity Index) is the synthesis of 85 indicators (industrial production, employment, personal income,….). It’s reading is easy with an average at zero and a standard deviation of one.
The CFNAI is an accurate measure of the business cycle based on observed variables. Usually the two profiles are consistent as the graph shows.
Recent data show a persistent divergence between the two. The CFNAI is close to 0 while the ISM is at a high historical level. It is probably too high giving a wrong signal of the US growth strength.