Economist's View

Fed Watch: FOMC Meeting Begins Tomorrow

Tim Duy:

FOMC Meeting Begins Tomorrow, by Tim Duy: This week's FOMC meeting is shaping up to be quite the event. Not for the actually policy result itself, which is widely expected to be unchanged, but for the subsequent press conference with Federal Reserve Chairman Ben Bernanke. The Fed's communication strategy has clearly unraveled in recent weeks, and Bernanke has an opportunity to regain control. But will he be able to do so, or will he leave even more confusion in his wake?

Start with the basics, the statement itself. The Fed is not going to change the pace of asset purchases this week. Recent Fedspeak has made clear that it remains too early to reduce monetary accommodation. The statement will probably be relatively unchanged. I anticipate that they take note of some moderately weaker data since the last FOMC meeting, as well as lower than anticipated inflation. Neither, however, is sufficient to drive asset purchases higher. It will be interesting to how much they emphasize the fiscal contraction. If the statement shifts to the side of "fiscal contraction appears to be having little impact on private activity," the implication would be that they are looking through the fiscal drag on headline GDP numbers. That obviously sets the stage for reducing asset purchases sooner than later.

Next come the closely watched forecasts. Near-term forecasts for inflation and perhaps GDP growth may be softer, but also watch the longer-term forecasts and especially any change in the expected path of unemployment. The latter, I think, is critical in setting an end to asset purchases - the Fed will want to be draw QE to a close prior to hitting the 6.5% threshold at which point they have said they will evaluate rate policy.

Finally comes the press conference. Here is where the real action should take place. Market participants have become increasingly concerned about ending asset purchases. I believe that market participants are having trouble understanding the implications, or lack thereof, of altering the pace of quantitative easing on interest rate policy. Bernanke will attempt to clear the way for ending quantitative easing while attempting to divorce that decision from any subsequent decision on rate hikes.

This, of course, will be easier said than done. I think a critical problem is that the Fed does not want to be pre-committed to some policy path, but at the same time does not want to surprise markets. They want to avoid a repeat of 1994, with the sharp spike in yields viewed as a communications failure. They believed they would resolve this divide by shifting the focus to the data. They were wrong.

Ylan Mui at the Washington Post describes the nature of the problem:

Investors increasingly have focused on predicting the moment the Fed will start to pull back on its massive stimulus program...

...It’s the type of parlor game the Fed had hoped to avoid. Instead, it has tried to convince the markets that the date is less important than the data.

Fed officials deliberately chose not to attach a time frame to their easy-money policies when developing their forward guidance for the public last year.

Stop right here. I think it is important to note that Fed policymakers are the ones who started the ball rolling on the importance of the date over the data. Specifically, at the beginning of April San Franscisco Federal Reserve President John Williams defined a time line for ending QE given the current path of data. At that point the conversation shifted from data to date. Other policymakers followed suit.

Does that mean that Williams made an error? Not necessarily. I think it is impossible to communicate the path of policy without making market participants aware of the associated timeline. Once you describe your view of the data and your forecast, by default you will define the expected time for the policy change. In effect, the Fed can't have it both ways. They can't jointly pretend the date doesn't matter while at the same time clearly communicating the path of policy. If they don't communicate the path/timing, then the eventual policy move will trigger an overreaction. If they do communicate the path/timing, but don't explain how that path fits in the context of the data, then they also risk an overreaction.

The latter is the position they now find themselves in. Williams let the cat out of the bag, that the Fed had a timeline in mind. But it is challenging to see how the data fits into the time line. Back to Mui:

The goal was to help investors come to better conclusions on their own by revealing the public data that Fed officials use as guideposts. In theory, that means interest rates would hew more closely to incoming data than to Fed pronouncements.

But, as it turns out, there are many ways to parse the numbers.

“They kind of threw out these conditions,” said Michael Feroli, chief U.S. economist at JPMorgan. “They’re telling us something but not telling us something.”

Honestly, it is difficult to make the case for ending asset purchases on the data alone. It is neither clear that the labor market is stronger and sustainable nor that asset purchases should be cut in the face of falling inflation. In fact, I think you can argue that the Fed is moving the goalposts to some less defined objective. As noted above, I think the path of the unemployment rate plays a role. But so too does financial stability concerns. And also general discomfort on the part of policymakers about the size of the balance sheet. Indeed, the December conversion from Operation Twist to asset purchases may have been simply insurance against a fiscal disaster that did not materialize. Ultimately, the shift to tapering talk was too abrupt given the data, and that raises the possibility that some undisclosed factor is at work.

Now, if we don't understand what is driving the decision to scale back asset purchases, then it is likely we also don't understand how the data will impact subsequent interest rate decisions. Again, back to Mui:

Part of the problem has been muddy economic data that do not provide a clear signal of where the recovery is headed. The Fed also has left itself plenty of wiggle room to interpret the data. It did not define what “substantial improvement” would be required to dial back its $85 billion-a-month in bond purchases, and it has suggested that it could leave interest rates untouched even after its unemployment or inflation thresholds are met.

If the Fed's plans for ending quantitative easing are opaque relative to the data, then what is are we to expect when the unemployment threshold approaches. An equally opaque policy response? Is the Fed going to change the goalposts again? When does it shift from unemployment and inflation to concerns about financial stability? And how do they propose to pretend that you can commit to some data dependent path without implying a related time line?

Bottom Line: This FOMC meeting is about the Fed regaining - or further losing - control over its communication strategy. Bernanke will attempt to detail how exactly the data flow is supportive of scaling back asset purchases in the next few months (I believe the Fed prefers September) while at the same time disassociating asset purchases from interest rate policy. I think it is important that market participants believe that the shift to tapering talk was entirely data dependent and not influenced by some other factors. Otherwise, they will doubt the supposed data dependent thresholds for rate policy. And the Fed is going to have to come to terms with the reality that the instant they start to anticipate a change in policy, they start a clock ticking. Making the distinction between date and data is not as easy as it sounds.

Fed Watch: Two For Tapering

Tim Duy:

Two For Tapering, by Tim Duy: Today's data was supportive of the Fed scaling back its asset purchase program sooner than later - although it is important to clarify that "sooner" does not mean next week, but September. Later is December. Data dependent, of course. But the data is not yet taking the kind of downward turn needed to turn talk away from tapering.

Retail sales rose 0.6% in May, slightly ahead of expectations of a 0.5% gain. Excluding autos and gas, the general upward trend of recent months is steady:

That said, the pace of growth isn't exactly something to get excited about:

At best, year-over-year growth is just pulling back into the range seen for most of 2012. We are getting spending growth, just not as much as would normally be seen in an expansion. That lack of growth, however, was evident before the tapering talk emerged, suggesting that the Fed does not see the current pace of activity as an impediment to tapering. Talk about diminished expectations....

Somewhat more optimistic was the drop in initial unemployment claims:

Volatile data, to be sure, but I still don't see reason to believe the downward trend is broken. We are heading into a range generally consistent with solid job growth, a key focus of monetary policymakers as they assess the pace of quantitative easing.

Separately, Zero Hedge is quoting economist David Rosenberg:

From what I hear, Ben Bernanke convinced the FOMC in December that in order to get ahead of a potential 'fiscal cliff' in December, it was a matter of having to 'shoot first and ask questions later'. In other words, take a pre-emptive strike in December against the prospect of falling off the proverbial cliff and into recession in the opening months of 2013. But what happened next was a fiscal deal that was reached in early January and the economy faced a hill, not a cliff. The economy still faces near-term sequestering hurdles, but the reality is that a bold policy move aimed at thwarting off recession is now being reconsidered. Bernanke apparently told the hawks on the FOMC that if the economy was not in contraction mode by now, the 'tapering off' talk would ensue — and that is exactly what has happened.

An interesting anecdote, and, if true, suggests that Federal Reserve Chairman Ben Bernanke is not quite the dove many believe him to be. Moreover, it would be consistent with my belief that Bernanke uses the next press conference to clear the way for tapering.

Finally, Edward Harrison, in his review of global market volatility (behind paywall), worries that the worst is still ahead of us with regards to fiscal contraction:

In North America, the talk is of tapering and the markets are in a tissy. It shows you that QE is really about risk-on risk-off and the markets are moving to risk off because they don’t believe in the Bernanke put anymore. In the real economy, it’s stall speed and I expect it to stay that way until Q4, when the next year of fiscal cuts come. The Republicans are now ready to make serious cuts to defense. Someone I know who does budgeting at Defense told me no one made any real cuts this year because they had budget headroom. The real cuts are coming in FY 2014. I think FY 2014 is going to be ugly.

The Fed is thinking the impact of fiscal contraction will fade as 2013 progresses. Harrison is suggesting this is wishful thinking.

Bottom Line: Today's data appears consistent with Fed expectations that they can begin tapering asset purchases this year. Still a horse race between September and December, although I think the Fed is aiming for the earlier date if data allows.

Fed Watch: Bullard Holds His Ground

Tim Duy:

Bullard Holds His Ground, by Tim Duy: St. Louis Federal Reserve President James Bullard reaffirmed his commitment to the current policy stance. From his press release:

“Labor market conditions have improved since last summer, suggesting the Committee could slow the pace of purchases, but surprisingly low inflation readings may mean the Committee can maintain its aggressive program over a longer time frame,” Bullard concluded.

This is not surprising. Bullard has long been more focused on the implications of inflation for policy, believing that employment is largely out of the Fed's hands at this point. More from Reuters:

"What's not encouraging in this picture is that it's (inflation) just going down and so far it hasn't moved back at all. So I would have expected our very aggressive purchase program to turn that process, inflation expectations would go up and actual inflation would follow behind, which is what happened in the QE2 period," said St. Louis Fed President James Bullard.

I think that Bullard is something of an outlier at this point. Ongoing declines in inflation would eventually cause his worries to spread further through the Fed, and could very well delay any effort to cut back on asset purchases. That, however, is not the baseline case. As a general rule, policymakers are more focused on the path of unemployment, which leads them to expect tapering to begin as early as in a few months. See Robin Harding here.

On the subject of tapering, Jon Hilsenrath had this to say over the weekend:

The hangup for Fed officials is the word “tapering” suggests a slow, steady and predictable reduction from the current level of $85 billion a month at a succession of Fed meetings, say to $65 billion per month, then to $45 billion and so on. And that’s not necessarily what Fed officials envision.

Because Fed officials are uncertain about the economic outlook and the pros and cons of their own program, they might reduce their bond purchases once and then do nothing for a while. Or they might cut their bond buying once and then later increase it if the economy falters. Or they might indeed reduce their purchases in a series of steps if warranted by economic developments — but they don’t want the markets to think that’s a set plan. It is, as Fed officials like to say, “data dependent.”

Which is interesting given that Bullard had this to say regarding inflation and policy:

"Maybe this is noise in the data, maybe this will turn around, but I'd like to see some reassurance that this is going to turn around before we start to taper our asset purchase program," he said.

If the Fed wants us to stop using the word "taper," they will need to take the lead. Or is Bullard just being honest - any reasonable forecast matched against their past behavior suggests the Fed tapers. On financial stability, Bullard adds this:

He noted that the Fed remains vigilant about the potential for financial market excess in the U.S. “An important concern for the FOMC is that low interest rates can be associated with excessive risk-taking in financial markets,” Bullard said. “So far, it appears that this type of activity has been limited since the end of the recession in 2009.” While the Dodd-Frank Act is meant to help contain some dimensions of this activity, “Still, this issue bears careful watching: Both the 1990s and the 2000s were characterized by very large asset bubbles,” he added.

The Fed is keeping an eye out for bubbles, but the bulk of policymakers aren't finding them. Consequently, the issue of financial stability is not a primary driver of policy. At best it is a distant third, far behind unemployment first and inflation second.

Bottom Line: Bullard remains focused on inflation. If his colleagues were to join him, they would stop pointing us toward cutting asset purchases in the next few months. As a general rule, however, for now low inflation is seen as an aberration, not the forecast.

Fed Watch: More of the Same

Tim Duy:

More of the Same, by Tim Duy: Unless you thought the job market tanked in May, the employment report contained little if any new information. The labor market continues to grind upward at a pace that most of us consider subpar, but fast enough that monetary policymakers are willing to consider pulling back on asset purchases as early as September. I don't see anything is this report that will alter the Fed's rhetoric on tapering one way or the other. Expect policymakers to continue to say "Not now, maybe in a few months."

Nonfarm payrolls rose 175k in May, just above the consensus forecast of 167k. March was revised up, April down, for a net loss of 12k compared to previous estimates.  The payroll gain was almost exactly the twelve-month average:

Taken in context of the Yellen indicators, tough to say that much has changed:

The unemployment rate did tick up as the labor force rose. In theory, a rapid rise in labor force participation could dissuade the Fed from tapering as it would push back the expected date of hitting the 6.5% unemployment threshold. But the little gain in this month's report would be considered just noise at this point.  

Other labor market indicators are generally holding their previous trends, for better or worse:

The lack of wages gains is a disappointment and a clear signal that plenty of slack remains in the labor market. That slack is revealed in underemployment indicators, which remain elevated and making only gradual improvement:

A hint of good news in the decline of those not in the labor force, but available for work. Perhaps an early sign of a more general acceleration in labor markets? Too early to tell, but something to watch.

Bottom line:  An unexciting report.  Little to change the view that the economy continues to shuffle forward despite the numerous negative shocks since the recovery began.  At best, some hints of future strength in the labor force gains.  Overall, little reason to believe the employment report will alter thinking on Constitution Ave.

Fed Watch: Falling Inflation Expectations

Tim Duy:

Falling Inflation Expectations, by Tim Duy: I had thought that early iterations of quantitative easing were flawed because they were based on a fixed amounts of total purchases. The size and length of the programs were effectively arbitrary as they were not linked to economic outcomes. This, combined with clear indications that policymakers desired to reduce the balance sheet as soon as possible, meant that the Fed was not able to sufficiently affect longer term expectations about the future price level or inflation to yield sustained improvement in economic activity.

In effect, the Fed was shooting itself in the foot with temporary programs. I had thought that open-ended quantitative easing tied to economic outcomes would resolve the problem of stabilizing expectations of future inflation, thus supporting a "stronger and sustainable" recovery.

The initial gains in inflation expectations seemed to justify such optimism. But a funny thing happened on the way to the show - inflation expectations reversed course:

TIPS-measured inflation expectations began falling in March, and now stand at pre-QE3 levels. Also telling is the Cleveland Federal Reserve Measures of inflation expectations. Longer run expectations remain well below 2%:

and, with perhaps more important policy implications, the term structure of expected future inflation has shifted down over the past year:

 

Arguably, by these measures a lot of policy has gone into accomplishing very little. The Fed, however, will tend to take solace from the Survey of Professional Forecasters:

The median is hovering near 2%, but at the bottom end of the range. So even if financial markets are anticipating lower inflation, professional forecasters are not. But professional forecasters really have not deviated from 2% since prior to the crisis, whereas the Fed has seen sufficient numerous threats to price stability to engage in repeated asset purchase programs. So one wonders how much weight the Fed places on this measure. Or, probably more accurately, they place more weight on this measure when it suits their purposes, such as if they are interested in ending the asset purchase program.

Form the perspective of policy, however, I am not so confident the survey is the best measure of inflation expectations. The Federal Reserve transmits policy through financial markets, and if those markets are not signaling stable or, more importantly, higher inflation expectations, then it is arguable that by itself, quantitative easing has limited impacts on economic activity. It can put a floor under the economy, but not accelerate activity.

Perhaps at best, quantitative easing does not cause higher inflation. At worst, some argue it is actually deflationary. The latter argument, however, will not get much support at the Federal Reserve, at least not yet.

Alternatively, one could argue that the Fed can indeed affect inflation expectations and really what is going on is that the Fed botched policy. Again. This is the "they have some slow learners on Constitution Avenue" story. Inflation expectations turned down in March, just when the Fed started sending signals that tapering was on the horizon. In this story, the Fed extrapolated a handful of data into the future and decided enough was enough. But that data was endogenous to Fed policy, and threatening to remove that policy once again undermined the economic outlook. In short, just by talking about tapering in an uncertain economic environment, the Fed pulled the plug on a successful policy.

But what should the Fed do now? Can they reverse the decline of inflation expectations merely by ending expectations of tapering? I am somewhat doubtful; the cat is out of the bag. They may very well have to expand asset purchases if they want market participants to believe "no, we were just kidding."

Indeed, I suspect that at least one policymaker, current voting member St. Louis Federal Reserve President James Bullard, would push for expanding asset purchases given the inflation and inflation expectations data. It would be interesting if he dissented a "hold steady" statement at the next meeting on that basis.

There will be, however, strong resistance to raising the pace of asset purchases. Yes, I know the Fed said they could move up or down. But I think the idea of "up" would only come after a "down." And clearly, if inflation expectations are any guide, market participants are getting the message that "down" is what is coming. And they are not getting that from just the hawkish policymakers. The doves too have been getting in on the action.

Moreover, I have to imagine that the recent market action in Tokyo has made some policymakers a little bit nervous about the limits to quantitative easing. The Nikkei's rise and fall seems to indicate that at some point asset purchases do in fact become destabilizing.

My view is that asset purchases would be most effective if coupled with fiscal stimulus. Working only through financial markets may be simply too restrictive to yield broad-based economic improvement. It is almost as if the Fed is trying to force a fire hose of policy through a garden hose. Keep turning up the volume, and eventually that hose bursts. And that might be what we are seeing in Japan.

Bottom Line: Inflation expectations are falling, and that by itself should complicate the Fed's expectation that they can start scaling back asset purchases at the end of the summer. But falling inflation expectations may complicate monetary policy more broadly by revealing the limits to quantitative easing. And Japan isn't helping.

Fed Watch: More Tapering Talk

One more from Tim Duy:

More Tapering Talk, by Tim Duy: Despite the soft ISM number this morning, two Federal Reserve policymakers reiterated their expectation that asset purchases will slow in the months ahead. First up is Atlanta Federal Reserve President Dennis Lockhart, who was on the speaking circuit today. Via the Wall Street Journal:

“We are approaching a period in which an adjustment to the asset purchase policy can be considered,” Mr. Lockhart said in the interview. Referring to coming Fed policy meetings, he said of a potential slowing in the purchases: “Whether that’s June, August, September or later in the year, to me, isn’t really the issue,” even as he acknowledged, “It’s the issue for the markets.”

Of course, June is probably out of the question:

It would be too soon to pull back now, Mr. Lockhart said. “I don’t think that as of today we have a set of conditions that absolutely justify an adjustment,” he explained. While the official suggested the most likely direction would be to slow the buying from its current pace, he said he doesn’t have “a fixed sense” of how the Fed should slow down on the buying.

No, June is too early - they are waiting for more jobs data before making a move. Lockhart is also selling the story that less is not really less:

If the Fed does slow the pace of its bond buying, “this is not a decisive removal of accommodation. This is a calibration to the state of the economy and the outlook. It is not a big policy shift, and I would hope the markets understand that,” Mr. Lockhart said.

I know that the Fed does not want market participants to associate a slowing of asset purchases with tighter policy. I am not sure, however, that it will be easy to persuade Wall Street otherwise. After all, if the Fed wanted looser policy, they would increase the pace of asset purchases. If more is "looser," then why isn't less "tighter?" Alternatively, is "less accommodative" really different from "tighter"?

Lockhart adds this:

The central banker acknowledged that markets are struggling with the issue, and he said any perception that the Fed has been sending mixed messages is mainly a function of the complexity of the ongoing debate Fed officials are having about the issue. But he also cautioned market participants not to get ahead of themselves in trying to divine the monetary-policy outlook.

Isn't that one of the jobs of market participants? To engage in various trading strategies based on the expected path of, among other things, monetary policy? After all, that seems to be the primary reason for the intense interest in policy.

Separately, San Francisco Federal Reserve President also reiterated his expectation that policy would be making a shift sooner or later. Again, via the Wall Street Journal:

“If the forecast goes as I hope and we see continuing good signs from the labor market [and] overall economic conditions [and] continued confidence in that forecast of substantial improvement, I could see, my own view is that as early as this summer [there could be] some adjustment, maybe modest adjustment downward, in our purchase program,” San Francisco Fed President John Williams told reporters on the sidelines of a conference here.

The outlook is of course data dependent. At the current pace of data flow, however, policymakers have their eye on tapering. Williams also makes some comments on inflation, via Reuters:

Williams noted that underlying inflation was at 1 percent, below the Fed's target of 2 percent. Speaking on the sidelines of a seminar in the Swedish capital, he said he saw temporary factors as being the main reason inflation was being held low and expected the inflation rate to return to 2 percent.

Still, it was one of the factors the Fed should watch when deciding on policy, he said.

"If we see continued low inflation and, more worrisome, a fall in long-term inflation expectations, well below 2 percent, then those would be factors that argue for, all else equal, greater total purchases for our program than otherwise," he said.

If the employment outlook holds steady, but price trends conspire to put the Fed's inflation forecast in jeopardy, expect the Fed to push back the timing of a policy shift.

Bottom Line: Fed is looking to pull back on asset purchases. They expect the data to give them room to do so.

Fed Watch: Slow Start

Tim Duy:

Slow Start, by Tim Duy: ISM data came in on the soft side this morning, with a sub-50 reading:

I would be a little cautious about saying that "manufacturing is contracting" based on a diffusion index. That said, the headline number suggests overall weakness. What is the source of that weakness? I think once again the external sector is a drag. While new orders were down slightly:

exports orders were down sharply:

But note that import orders held their ground:

Import orders should be a reflection of domestic demand. The steady reading in those suggests that manufacturing weakness in the headline numbers stems from external sources which has not yet filtered broadly into the domestic economy.

That, at least, is the optimistic view. Also more optimistic was the 52.3 manufacturing number from the competing Markit report. But optimism aside, put this morning's ISM report under the "delay tapering" column.

Fed Watch: On September

Tim Duy:

On September. by Tim Duy: We are heading into a big data week, beginning with ISM and culminating with the employment report for May. As I believe the Fed is seriously looking at September to pull back on QE, I will be looking for data that pushes that timing off to December. The employment report is the most important release of course, not just for what nonfarm payrolls tell us about "stronger and sustainable," but also the unemployment rate. The latter is the specific concern of the threshold condition for reviewing the stance of interest rates, but it is also a concern for the pace of asset purchases. The faster we are moving toward 6.5%, the sooner policymakers will want to pull the plug on QE.

Consider the path of unemployment:

Unemployment is declining at a very steady pace, and at that pace will hit the 6.5% threshold in September of 2014. To be sure, past performance is no guarantee of future performance. We may see, for example, the long-awaiting return to rising labor force participation rates. But we could also see an acceleration in job growth, perhaps sufficient to more than offset any increase in labor force participation, and thus the unemployment rate falls faster than anticipated. A safe bet, however, is more of the same steady decline in rates that we have seen since 2010.

The Fed, I suspect, wants to conclude asset purchases well before they hit the 6.5% threshold and have to make a decision about interest rates. That will take at least three months, but they would probably error on the side of caution and shoot for six months out. That suggests they would like to wind down quantitative easing by March of 2014. Assume further that they do not want to go cold turkey, but rather reduce the pace of purchases across multiple meetings, maybe slowly at first, but more quickly later. So you need about 6 months, or 4 meetings, to wind down asset purchases. That pretty much pushes you back to the September meeting of this year.

To be sure, everything is data dependent. But my point is that the calendar is probably a driving force in timing the end of QE. Just estimate when the unemployment rate will hit 6.5%, work backwards, and it becomes evident why so many Fed officials appear to be leaning toward ending quantitative easing sooner rather than later.

But, you wisely say, but what about inflation? Because inflation is clearly not a problem - or, more specifically, high inflation is not a problem. Arguably low inflation is a problem:

Clearly trending down and away from the Fed's definition of price stability, or 2% inflation. Smoking gun, you say. The Fed can't think about backing off QE with inflation trending down.

Perhaps. But let me offer another interpretation. Consider the claim that the failure of inflation to fall further was taken by some as evidence that the economy was near potential output, and that much of the unemployment was structural. The counterargument was that downward nominal wage rigidities keep a floor on wage gains, and thus there is a floor on inflation as well. Thus, the failure of inflation to fall even further, or tip into deflation, tells us little about structural unemployment.

Indeed, the fact that inflation has fallen even as unemployment rates come down is further evidence that structural unemployment was limited. Score one for the importance of downward nominal wage rigidities.

But now those rigidities become a double-edged sword. Policymakers can be relatively confident that deflation will not emerge even when the economy is faced with substantially unemployment gap. Consequently, there is very little chance of deflation, inflation expectations are thus well-anchored, and there is no reason that low inflation should dissuade the Fed from slowing the pace of asset purchases as long as we continue to see "stronger and sustainable" improvement in labor markets.

By extension, policymakers will have an asymmetric response to inflation because they see a lower bound on the downside, but no such bound on the upside. But we can come back to that when rising inflation is a problem.

But what if inflation falls even further? There must be some non-negative rates that prompts additional easing, or, at a minimum, a halt to efforts to reduce asset purchases? Yes, one would be rational to believe that the Fed pushes any policy shift back to December if inflation continues to decline. That said, however, I think you are also still in the world of costs and benefits, and here I will hazard another another conjecture: If I was an monetary policymaker, and I were to look at some of the crazy volatility in Japan, I might reasonably conclude that yes, there may be a point where the destabilizing impacts outweigh the benefits. And the benefits to further action may be very limited considering that the steady decline in the unemployment rate suggests that monetary policy can put a floor under the economy, but may not be able to further lift the pace of activity.

Bottom Line: As always, the data will drive the Fed's next move. My expectation is that data evolves in such a way that policy will shift in September. I think there is currently a bias toward ending QE, so I anticipate a willingness of policymakers to focus on stronger numbers and downplay the importance of weaker numbers. In other words, I think we need to see some reasonably big downside misses to push policy back to December or later. Policymakers will be watching the unemployment rate, realizing that it has steadily declined despite a number of negative shocks since the recession ended. Expectations of continued declines help focus policymakers on winding down by the end of this year or early next year. If they want to meet that goal while not cutting asset purchases abruptly, then they will need to begin sooner than later. Hence why September comes into focus.

Fed Watch: Steady As She Goes

One more from Tim Duy:

Steady As She Goes, by Tim Duy: The BEA released revisions to Q1 GDP numbers today, taking growth down a hair from the original 2.5% to 2.4%. Bloomberg is claiming that the downward revision to GDP and a rise in initial unemployment claims account for today's gain in equities. The idea is that the weaker data will dissuade the Fed from slowing down the pace of asset purchases this year.

It is of course dangerous to assign a cause to every fluctuation in asset prices. In this case, I am hard pressed to see that today's data has any meaningful impact on policy. If anything, a focus on the data over a longer period rather than the month-to-month or quarter-to-quarter movements should convince you that little has changed since 2010. Gross domestic product and income in levels:

Gross domestic product and income year-over-year:

Abstracting from inventory changes, look at the remarkable consistency of real final sales growth:

And as far as initial claims are concerned, you must have pretty sharp eyesight to conclude that something fundamentally changed last week:

Also note the the Fed may discount soft GDP numbers in any event. Recall the words of New York Federal Reserve President William Dudley:

“The important thing to recognize about the U.S. economy is that things are actually improving underneath the surface,” Dudley said in the interview. “We don’t really see that so much in the activity data yet because of the large amount of fiscal drag.”

Policymakers are trying to look past the fiscal drag to see if it is bleeding through to the broader economy. If not, they will conclude that growth is set to jump next year as the fiscal impact wanes. And they want to be ahead of the jump with respect to QE. Hence why the next few months of data are so important.

Bottom Line: Today's data is not likely to have an impact on monetary policy.

Fed Watch: More Uncertainty?

Tim Duy:

More Uncertainty?, by Tim Duy: I was reading this Business Insider report on an analyst's mea culpa on a bad trade when this jumped out:

Last week, we advised investors to add to their 7s/30s and 10s/30s yield curve steepening positions with the view that Chairman Bernanke would calm expectations for tapering by September this year – helping keep rates and volatility low. These curves have since flattened back to the levels at which we suggested investors enter steepeners. Given the uncertainty Bernanke injected into the market, we suggest investors pare down positions to more sustainable levels. At the same time, we keep to our core steepening view. [emphasis added]

I find it curious the analyst believes that Federal Reserve Chairman Ben Bernanke increased uncertainty. I think it was just the opposite. Prior to Bernanke's remarks, opinion on policy was scattered among some looking for the Fed to scale back asset purchases as early as June and as late as 2014. Bernake narrowed that range to September as a likely date, and cleared the way for New York Federal Reserve President WIlliam Dudley and Boston Federal Reserve President Eric Rosengren to point us at September as well. Overall, it looks like more, not less, certainty.

Perhaps market participants are unhappy with the path Bernanke laid out, but that path is more obvious than it was a week ago.

Fed Watch: September Looking Good

Tim Duy:

September Looking Good, by Tim Duy: Boston Federal Reserve President Eric Rosengren, considered to be on the dovish side of the Federal Reserve, had this to say about the outlook for monetary policy:

However, I would also say that it may be undesirable to abruptly stop purchases, so it may make sense to consider a modest reduction in the pace of asset purchases if we see a few months more of gradual improvement in labor markets and improvement in the overall growth rate in the economy – consistent, by the way, with my forecast, which is somewhat more optimistic than that of many private forecasters.

A "few more months" I interpret as June, July, and August, which puts the beginning of tapering at the September FOMC meeting. I think that Fed speakers are sending pretty clear signals to prepare for a September policy change.

Some big names on Wall Street don't agree. Vincent Reinhart at Morgan Stanley believes the data will push the Fed back to December. The view at Goldman Sachs is reportedly similar. To be sure, the data might cut in that direction, but I think that the bar to tapering might be lower than believed by those looking for a shift in December. We may believe the Federal Reserve's dual mandate argues for a longer period of QE at its current pace, but I am thinking that for the Federal Reserve, the dual mandate has more to do with the lift-off date from ZIRP than the end of QE. They have tended to argue for more or less QE on the basis of "stronger and sustainable" improvement in labor markets, and, given the obvious shift in tone among Fed speakers, I think we have reached that benchmark. At this point, they are just looking for a little more confirmation, in their minds erring on the side of being "too easy."

A lot of data will be coming in the door over the next week and a half, culminating in the all-important employment report on Friday, June 5. I think even a moderately positive run of data will further cement a September shift. And I think the Federal Reserve would place less weight on a weak employment report than a strong employment report. The recent pattern of general upward revisions argues for a asymmetrical response. Moreover, I sense they are wary of being trapped by one weak number - I don't think they would have expanded QE last September if they knew that job growth for August was 165k rather than the initially reported 96k. They don't want to make that mistake again.

Bottom Line: I think the Federal Reserve is leaning toward a September policy shift. While it is as always data dependent, I think the data will need to be pretty weak to push the Fed to December.

Fed Watch: More Fed - It Never Ends

Tim Duy:

More Fed - It Never Ends, by Tim Duy: Bloomberg is carrying an interview with San Francisco President John Williams. Williams reiterates the possibility that future policy moves may be up or down:

“Even if we do adjust downward our purchases, it doesn’t mean we’re now in some autopilot of moving in the same direction,” Williams, 50, said in an interview yesterday in San Francisco. “You could even imagine a scenario where we adjust it downward based on good data and then adjust it back” if the economy weakened.

Yes, the Fed can change policy in any direction. But I reiterate what I said earlier: I simply do not believe that they believe that such changes will be likely. First, I don't think they will want to reduce the pace of purchases until they are sure they do not need to reverse course in the next meeting. Second, I think they will want to end asset purchases well ahead of hitting the 6.5% unemployment threshold. And I don't think they can do that if they are fooling around with the pace of purchases over the next year.

That said, we will hear many officials repeat this same line. Why? Williams has the answer:

“Because we have this freedom to adjust, how will people interpret it?” he said. “This is uncharted territory.”

Once the Fed does decide to calibrate its bond-buying, its challenge will be to communicate that “these are just adjustments and not strong signals about things going forward,” he added.

The Fed is trying very hard to ensure that market participants do not overreact to any one policy shift, with the most likely overreaction being to tank Treasury prices and spike yields. The Fed believes that the way to prevent this is to continuously remind everyone that any subsequent moves might be up or down, so don't assume a downward move in the pace of purchases implies anything about the necxt meeting.

But keep in mind that the Fed does not have a forecast that suggests policy will shift up and down randomly. They have a forecast that the first cut to the pace of purchases will be the beginning of the end for quantitative easing and, in all reality, will start the clock on the first rate hike. In other words, they can talk about moving policy up-and-down, but I can't imagine that they really expect such ups-and-downs to be the path of policy going forward.

In other news, New York Federal Reserve President William Dudley reiterates Federal Reserve Chairman Ben Bernanke's position:

“I don’t really understand very well how the tug-of-war between the fiscal drag and the improving economy are going to sort of work their way out,” Dudley said in an interview with Michael McKee airing today on Bloomberg Television. “Three or four months from now I think you’re going to have a much better sense of, is the economy healthy enough to overcome the fiscal drag or not.”

Dudley adds something that I think is important:

“The important thing to recognize about the U.S. economy is that things are actually improving underneath the surface,” Dudley said in the interview. “We don’t really see that so much in the activity data yet because of the large amount of fiscal drag.”

Translation: Fiscal drag will weigh down the GDP numbers. Look underneath those numbers to building momentum in the economy. I think this means there will be extra weight on the jobs data rather than the GDP data as an indicator of the impact of fiscal policy. With that in mind, note that jobless claims reversed last week's spike:

I would say the downward path of claims remains intact despite the fiscal drag. That is what will be meaningful for assessing "strong and sustainable."

Bottom Line: Assuming current data holds, the beginning of the end of QE is coming. But not immediately. Maybe three meetings out in September assuming that the impact of fiscal drag remains largely contained to the GDP data. The Fed does not want us to jump to conclusions about future policy moves based on that initial shift. But I am hard-pressed to see a forecast that would allow for up-and-down moves once the Fed pulls the trigger. Up-and-down moves cannot be their expected policy path.

Fed Watch: Bernanke Saves the Day

Tim Duy:

Bernanke Saves the Day, by Tim Duy: There was some initial consternation yesterday after Federal Reserve Chairman Ben Bernanke gave the clarity we were hoping to see. From Reuters:

"If we see continued improvement and we have confidence that that's going to be sustained then we could in the next few meetings ... take a step down in our pace of purchases," he said.

"Next few meetings" sounds like September at the eariliest. Indeed, September or December are the most likely meetings given both have an associated press conference.

For financial market participants, I would say this was a mixed message. Bernanke is dovish if you expect the Fed to move in June, hawkish if December at the earliest. But imagine the message that would have been delivered to financial markets had Bernanke not spoken ahead of the minutes of the April FOMC meeting:

A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth; however, views differed about what evidence would be necessary and the likelihood of that outcome.

It seems to me that the threat of an imminent policy change would have been taken very poorly had Bernanke not already spoken yesterday morning. So, in a sense, Bernanke saved traders from an even more tumultuous day. Expect Bernanke to use the June press conference to lay the ground work for a reduction in the pace of purchases as early as September.

From a different viewpoint, Bernanke might have just sandbagged his colleagues. Recent comments from Federal officials suggest they reasonably believed they were close to cutting the pace of purchases, and it seems like they received this impression from the discussion in the last few FOMC meetings. Hence, for example, why San Francisco Federal Reserve President John WIlliams felt comfortable suggesting an imminent reduction in the pace of purchases as recently as Monday of this week. Bernanke, however, sets everyone straight. It's not going to happen this summer. Maybe fall.

Notice also the communications challenge. Even as participants coalesced around a policy shift as early as June, they did not have internal agreement on what would justify such a shift. I am not sure how they communicate policy if there is no central view as to what should justify a particular policy. One gets the feeling that the Federal Reserve treats "strong and sustained growth" like the Supreme Court treats pornography: They will know it when the see it.

The communications plot thickens later in the minutes:

A few members expressed concerns that investor expectations of the cumulative size of the asset purchase program appeared to have increased somewhat since it was launched last September despite a notable decline in the unemployment rate and other improvements in the labor market since then. In contrast, a few other members focused on evidence that market expectations about the total size of the program had changed little, on net, since the program was launched or had responded appropriately to incoming information. Members generally agreed on the need for the Committee to communicate clearly that the pace and ultimate size of its asset purchases would depend on the Committee's continued assessment of the outlook for the labor market and inflation in addition to its judgments regarding the efficacy and costs of additional purchases and the extent of progress toward its economic objectives. To highlight its willingness to adjust the flow of purchases in light of incoming information, the Committee included language in the statement to be released following the meeting that said the Committee was prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.

The second sentence in this paragraph is a little bit clunky. But overall it sounds like there is concern among some officials that market participants are not sufficiently responding to incoming information. In other words, the Fed expected that incoming information would trigger a continuous reassessment of the pace of asset purchases, but they are not seeing that continuous reassessment reflected in expectations. Hence the reminder that policy is not a one way street.

I am thinking this morning that the Fed is asking an awful lot from market participants; if policy officials cannot agree on what constitutes sufficient evidence to trigger a change in policy, how can officials expect such knowledge on the part of market participants?

From all of this I am reminded of one important thing: Staying on top of the likely path of monetary policy means tracking Bernanke. Be wary of regional Federal Reserve presidents. What seems to happen is this sequence of events:

1. Bernanke speaks.
2. We all reach a common assessment of the policy path
3. Bernanke drifts into the background amid a cacophony of Fed speakers.
4. Our view of the policy path begins to splinter as each Fed speaker has a different interpretation of the implication of the data flow for policy.
5. Bernanke speaks.
6. We all reach a common assessment of the policy path.
7. Repeat steps 3 through 6 above.

Bottom Line: Assuming the recent pace of activity continues through the summer, it is reasonable to expect the first cut in the pace of QE to begin as early as September. While the Fed will continue to say that they could adjust policy up or down, I don't believe that they really believe this. I think they expect the first reduction in the pace of easing to be the first stage to ending quantitative easing; as such, it is not their intention to start the process until they firmly believe they will not have to backtrack. A good reason to delay through the summer, in my opinion. Finally, there is a very, very simple way to improve communications: Bernanke needs to give more speeches directly pertaining to the policy path.

Fed Watch: And Then There is Bernanke

Tim Duy:

And Then There is Bernanke, by Tim Duy: Lots of Fed chatter in the last week. For openers, some background from Reuters:

It decided on May 1 to keep buying at an $85 billion monthly pace, and many economists say mixed economic data warrants keeping up the purchases through year-end.

But persistent warnings from more hawkish Fed officials had fanned talk that it might start to wind back soon.

The hawkish Fed officials would be Dallas Federal Reserve President Richard Fisher, Philadelphia Federal Reserve President Charles Plosser, and Richmond Federal Reserve President Jeffrey Lacker. These are often colorful voices, but as a general rule are not voices that will hold much sway with regards to the pace of easing. What is much more important is to what extent remaining policymakers are coming along to the same view. In other words, these three can ruffle their feathers all they want, but that ruffling should not be interpreted as consensus movement within the FOMC.

For consensus movement, turn more toward New York Federal Reserve President William Dudley. Great speech today, but I will narrow my focus with a few points I think are relevant for US policy. While Dudley is clearly concerned about deflation, this is important:

Similarly, current circumstances in the two countries are different, with deflationary expectations still in the process of being dislodged in Japan. The BoJ needs to push up inflation expectations, whereas in the U.S. the current level of inflation expectations is consistent with the long-term objective of the Fed.

This speaks to his concerns - or lack thereof - about the current US inflation numbers. My sense is that he will dismiss those low numbers as long as expectations stay anchored at 2 percent. Later he says:

Let me give a few examples of how my own thinking may evolve. In terms of our asset purchase program, I believe we should be prepared to adjust the total amount of purchases to that needed to deliver a substantial improvement in the labor market outlook in the context of price stability. In doing this, we might adjust the pace of purchases up or down as the labor market and inflation outlook changes in a material way. For me, the base case forecast is not the sole consideration—how confident we are about that outcome is also important.

Here he brings inflation back as an issue in determining the pace of purchases. But then in the next paragraph:

Because the outlook is uncertain, I cannot be sure which way—up or down—the next change will be. But at some point, I expect to see sufficient evidence to make me more confident about the prospect for substantial improvement in the labor market outlook. At that time, in my view, it will be appropriate to reduce the pace at which we are adding accommodation through asset purchases. Over the coming months, how well the economy fights its way through the significant fiscal drag currently in force will be an important aspect of this judgment.

Which sounds as if inflation is not the primary determinant in the decision to taper. The labor market is the primary determinant, which might be expected if he believes that low inflation numbers are not a relevant concern in the context of stable inflation expectations. In such a context, Dudley wants to see to what extent the labor market will feel the fiscal drag. In other words, be cautious about how far the low inflation story will travel in the FOMC.

To be sure, you can point to today's speech by St. Louis Federal Reserve President James Bullard as a reason that current inflation is relevant. From Reuters:

"Inflation is pretty low in the U.S.," Bullard told reporters after delivering a lecture in Frankfurt. "I can't envision a good case to be made for tapering unless the inflation situation turns around and we are more confident than we are today that inflation is going to move back toward target," he said.

But is this the consensus view? Robin Harding of the FT smartly tweets:

Re Bullard comments, low inflation has always been the main driver of QE for him. Entirely different for Bernanke, Yellen et al.

— Robin Harding (@RobinBHarding) May 21, 2013

I think Harding is right. With inflation expectations stable, from the consensus FOMC viewpoint tapering will be much more dependent on the labor outlook than current inflation.

Other voices include Chicago Federal Reserve President Charles Evans who raises the prospect of a sharp end to quantitative easing. From Reuters:

"Another approach, which doesn't get talked about that much, we could continue to go with $85 billion a month until we decide that absolutely we've seen enough improvement, and then bring it to a quick conclusion at that time," Evans told reporters after the speech.

"That would be a program going into the fall, I would think, because you can't really have that much confidence to bring it to an end" before that, he said. "I think at the moment the key issue is whether or not it is extremely likely that this (improvement) is going to be maintained over the next few months."

That last line is important - I think it means that if the labor market continues on its current pace through the rest of spring and into the summer (again, assessing the impact of fiscal contraction), then the tapering will begin in later summer or early fall.

In contrast, Minneapolis Federal Reserve President Narayana Kocherlakota argues that policy is still too restrictive:

The FOMC has responded to this challenge by providing a historically unprecedented amount of monetary accommodation. But the outlook for prices and employment is that they will remain too low over the next two to three years relative to the FOMC’s objectives. Despite its actions, the FOMC has still not lowered the real interest rate sufficiently in light of the changes in asset demand and asset supply that I’ve described.

And, at a minimum, he would not favor reducing the pace of stimulus:

...this kind of analysis suggests that, currently, the gains from tightening related to improving financial stability are both speculative and slight. In contrast, the losses from tightening—in terms of pushing employment and prices even further below the Federal Reserve’s goals—are both tangible and significant. I conclude that financial stability considerations provide little support for reducing accommodation at this time.

I don't think he would favor it in three months regardless of the labor data.

So many voices, so many views. Looking through the noise, I think there is strong interest in tapering QE now that we have a string of job reports pointing to substantial and sustainable improvement in labor markets, but, given the fiscal contraction, little willingness to pull the trigger on tapering until we see another two or three similar reports. On net, I think disinflation concerns will move to the back-burner as long as inflation expectations are stable.

Still, at the same time, the Fed wants to keep its options open, as they are very much cognizant that past efforts to pull back on easing have been premature. Hence the talk that future moves could be up or down, which is really just plain confusing because why would the Fed even begin tapering if they thought there was a reasonable chance of having to reverse course the next month? It is even more confusing given that some officials seem to care about inflation, but others labor markets. The former says more purchases, arguably the latter says less. And I am not sure they have a consensus view of what would be the pace of tapering even if they all could agree on the forecast and relevant indicators. No wonder communications is a problem. Back to Dudley:

An important challenge for us will be to think carefully about what combination of actions and communications will best ensure that when we do eventually judge that it is appropriate to begin normalizing policy, the initial tightening of financial market conditions is commensurate to what we desire. There is a risk is that market participants could overreact to any move in the process of normalization.

It seems that lacking a more clear, consistent framework for the exit from quantitative easing, the risk of miscommunication is high. Hence, we are all looking toward tomorrow's speech by Federal Reserve Chairman Ben Bernanke to provide the clarity that appears very much needed.

Fed Watch: 'Dollar Up' and 'Confidence Boom?'

Two from Tim Duy:

First, "Dollar Up":

Dollar Up, by Tim Duy: The Dollar continues to gain despite the supposed "Great Debaser" Federal Reserve Chairman Ben Bernanke bringing us multiple rounds of quantitative easing:

Just sayin....

And second, "Confidence Boom?":

Confidence Boom?, by Tim Duy: The early read on the Thomson Reuters/University of Michigan Consumer Sentiment index jumped to 83.7 in May, up from 76.4 in April. Just a quick reminder before we get too excited - sentiment has tended to be low relative to actual spending. May's sentiment bounce just returns us to trend:

Better than collapsing confidence, but by itself not pointing to an imminent acceleration in consumer spending.

Fed Watch: Lumping Everything into the Wealth Effect

Another from Tim Duy:

Lumping Everything into the Wealth Effect, by Tim Duy: After posting my review of Martin Feldstein's WSJ op-ed, I waded through Dallas Federal Reserve President Richard Fisher's latest speech and found this:

The former outcome is that envisioned by the theoreticians that lead the Fed: According to this plot, by driving rates to historical lows along the entire length of the yield curve, investors will rebalance their portfolios and reach out to riskier assets, providing the financial wherewithal for businesses to increase capital expenditures and reengage workers, expand payrolls and regenerate consumption. Rising prices of bonds, stocks and other financial instruments will bolster consumer confidence. The CliffsNotes account of this play has the widely heralded “wealth effect” paving the way for economic expansion, thus saving the day.

The latter outcome posits that the wealth effect is limited, for two possible reasons. One is that our continued purchases of Treasuries are having decreasing effects on private borrowing costs, given how low long-term Treasury rates already are. Another is that the uncertainty resulting from fiscal tomfoolery is a serious obstacle to restoring full employment. Until job creators are properly incentivized by fiscal and regulatory policy to harness the cheap and abundant money we at the Fed have engineered, these funds will predominantly benefit those with the means to speculate, tilling the fields of finance for returns that are enabled by historically low rates but do not readily result in job expansion. Cheap capital inures to the benefit of the Warren Buffetts, who can discount lower hurdle rates to achieve their investors’ expectations, accumulating holdings without necessarily expanding employment or the wealth of the overall economy.

Is it just me, or is Fisher being explicitly derisive about the wealth effect? And when did we start lumping all the channels of monetary policy into the "wealth effect"? The wealth effect is but one channel of monetary policy. See something like this graphic from Frederick Mishkin's money and banking textbook:

While equity prices do operate through a number of channels, only one of those is the "wealth effect." To his credit, Fisher has a more sophisticated view of those channels than Feldstein, who appears to limit the impact of QE to the strict definition of the wealth effect:

That drives up the price of equities, leading to more consumer spending.

But even if Fisher does see the bigger picture, should he really be lumping together all the channels of monetary policy into the "wealth effect?" Doing so only feeds the bias against monetary easing by perpetuating the view it is about nothing more than creating an artificial boost of equity prices and benefiting speculators rather than stimulating the economy via a number of channels that subsequently enhance the profitability of firms and thus raises equity prices.

Of course, Fisher and Feldstein are deliberately trying to perpetuate a bias against quantitative easing. And even after all these years, I still find it odd that Fisher appears to believe his job is to undermine the institution that provides his employment.

Fed Watch: Dodged That Bullet

Tim Duy:

Dodged That Bullet, by Tim Duy: I was reading Robin Harding's take on the possible nomination of Federal Reserve Vice Chair Janet Yellen for the top job at the Fed, and a chill went down my spine when he reminded me of this:

Mr Bernanke’s own appointment in 2005 was a case in point. There were several candidates that year. According to people involved, then-President George W. Bush leaned towards Martin Feldstein, a former economic adviser to Ronald Reagan.

But fate intervened:

But Mr Feldstein was a director of the insurance company AIG, which restated five years of financial results that May after an accounting scandal. Then in October, Mr Bush ran into a huge backlash after nominating his lawyer Harriet Miers, who later withdrew, to the Supreme Court.

I think we dodged a bullet there. Indeed, it might be proof of a higher power. Martin Feldstein could have been Fed chair during the worst financial crisis since the Great Depression. Consider that in light of May 9, 2013 Wall Street Journal op-ed in which he professes that raising equity prices is the ONLY mechanism by which quantitative easing impacts the economy:

Quantitative easing, or what the Fed prefers to call long-term asset purchases, is supposed to stimulate the economy by increasing share prices, leading to higher household wealth and therefore to increased consumer spending. Fed Chairman Ben Bernanke has described this as the "portfolio-balance" effect of the Fed's purchase of long-term government securities instead of the traditional open-market operations that were restricted to buying and selling short-term government obligations.

Here's how it is supposed to work. When the Fed buys long-term government bonds and mortgage-backed securities, private investors are no longer able to buy those long-term assets. Investors who want long-term securities therefore have to buy equities. That drives up the price of equities, leading to more consumer spending.

As might be expected, Feldstein finds this channel lacking:

...Although it is impossible to know what would happen without the central bank's asset purchases, the data imply that very little increase in GDP can be attributed to the so-called portfolio-balance effect of the Fed's actions.

Even if all of the rise in the value of household equities since quantitative easing began could be attributed to the Fed policy, the implied increase in consumer spending would be quite small. According to the Federal Reserve's Flow of Funds data, the total value of household stocks and mutual funds rose by $3.6 trillion between the end of 2009 and the end of 2012. Since past experience implies that each dollar of increased wealth raises consumer spending by about four cents, the $3.6 trillion rise in the value of equities would raise the level of consumer spending by about $144 billion over three years, equivalent to an annual increase of $48 billion or 0.3% of nominal GDP.

This 0.3% overstates the potential contribution of quantitative easing to the annual growth of GDP, since some of the increase in the value of household equities resulted from new saving and the resulting portfolio investment rather than from the rise in share prices. More important, the rise in equity prices also reflected a general increase in earnings per share and an increase in investor confidence after 2009 that the economy would not slide back into recession.

Oh my. Can Feldstein really believe that only the wealth effect channel is in operation? What about other channels that could boost activity and drive the improvements in earnings and confidence? And does Bernanke believe quantitative easing has an impact only throughthe wealth effect? I don't think that is the conclusion you reach if you read his speeches. Bernanke's description of the portfolio-balance impact is a bit more sophisticated than Feldstein's interpretation. From last year's Jackson Hole speech:

One mechanism through which such purchases are believed to affect the economy is the so-called portfolio balance channel, which is based on the ideas of a number of well-known monetary economists, including James Tobin, Milton Friedman, Franco Modigliani, Karl Brunner, and Allan Meltzer. The key premise underlying this channel is that, for a variety of reasons, different classes of financial assets are not perfect substitutes in investors' portfolios....Thus, Federal Reserve purchases of mortgage-backed securities (MBS), for example, should raise the prices and lower the yields of those securities; moreover, as investors rebalance their portfolios by replacing the MBS sold to the Federal Reserve with other assets, the prices of the assets they buy should rise and their yields decline as well. Declining yields and rising asset prices ease overall financial conditions and stimulate economic activity through channels similar to those for conventional monetary policy.

Quantitative easing acts through a variety of channels - interest rate, credit, exchange rate, etc. - just like traditional interest rate policy. And other channels as well:

Large-scale asset purchases can influence financial conditions and the broader economy through other channels as well. For instance, they can signal that the central bank intends to pursue a persistently more accommodative policy stance than previously thought, thereby lowering investors' expectations for the future path of the federal funds rate and putting additional downward pressure on long-term interest rates, particularly in real terms. Such signaling can also increase household and business confidence by helping to diminish concerns about "tail" risks such as deflation. During stressful periods, asset purchases may also improve the functioning of financial markets, thereby easing credit conditions in some sectors.

So, no, Bernanke does not view quantitative easing as acting only through equity price and related wealth effects, and no, Feldstein shouldn't either. But somehow he does, or wants to trick you into believing that Bernanke's only objective is boosting equity prices. Either way, I don't think this is the intellectual approach we should be looking for in a Fed chair.

With regards to Feldstein's claim that it is impossible to know what would have happened in the absence of quantitative easing, I think Bernanke would have something like this to say:

If we are willing to take as a working assumption that the effects of easier financial conditions on the economy are similar to those observed historically, then econometric models can be used to estimate the effects of LSAPs on the economy. Model simulations conducted at the Federal Reserve generally find that the securities purchase programs have provided significant help for the economy. For example, a study using the Board's FRB/US model of the economy found that, as of 2012, the first two rounds of LSAPs may have raised the level of output by almost 3 percent and increased private payroll employment by more than 2 million jobs, relative to what otherwise would have occurred....Overall, however, a balanced reading of the evidence supports the conclusion that central bank securities purchases have provided meaningful support to the economic recovery while mitigating deflationary risks.

Yes, like it or not, quantitative easing has been a successful policy.

I understand that in the midst of the crisis there was a significant confusion about what monetary policymakers were doing and why. But we are well past that stage. We would hope that any potential Fed chair would by now have come to an understanding about what quantitative easing is and how it works. And we should be relieved that any candidate that has not made that leap did not get the pick for the top job at the Federal Reserve.

Fed Watch: Plosser on the Exit

Tim Duy:

Plosser on the Exit, by Tim Duy: As is well known, policymakers have been coalescing around a QE exit strategy for some time, since at least the March FOMC meeting. Two central issues with the exit are the timing and the communications. Officials do not want to undermine the recovery, knowing full-well that previous flirtations with exits have gone awry. At the same time, however, they fear the cost-benefit analysis may be turning against them. For some doves it is not the potential inflation cost, but the potential financial instability cost. Some policymakers want to begin tapering asset purchases at the next meeting, some are looking to the summer, and others looking to the fall.

Regarding the communications issue, policymakers seem to be taking pains to make clear that the financial markets should not overreact to any one policy move. The tapering process may be smooth, it may be choppy, it may be long, it may be short. It is contingent on the state of the economy, something inherently unknown. Mostly, they want to avoid a 1994-type of miscommunication.

Today's speech by Philadelphia Federal Reserve President Charles Plosser covers nearly all of these elements. In general, although I do not agree with his conclusions regarding timing, I think he makes a what would be viewed by some as a credible argument for tapering to begin sooner than later.

Begin with his base forecast:

My forecast of 3 percent growth should allow for continued improvements in labor market conditions, including a gradual decline in the unemployment rate, similar to the trend we have seen over the past three years, which was a 0.7- to 0.8-percentage point decline per year. Continuing at such a pace would lead to an unemployment rate close to 7 percent at the end of 2013 and a rate below 6.5 percent by the end of 2014.

Indeed, this year we have already seen the unemployment rate fall from 7.9 percent in January to 7.5 percent in April. Employers added 165,000 jobs in April, but the more positive news came in the revisions for February and March. The revised data indicate that firms added 332,000 jobs in February and 138,000 in March. The upward revisions for these two months added 114,000 jobs.

The forecast of a 6.5% unemployment rate by the end of 2014 is important. My thought is that the Fed will want to conclude asset purchases before hitting that target. Moreover, optimally they would like time so that, if necessary, the tapering can be a slow process. That argues for tapering to begin sooner than later. Indeed, Plosser would like asset purchases to end this year:

Based on the stated views of the Committee regarding the flexibility in pace of purchases, I believe that labor market conditions warrant scaling back the pace of purchases as soon as our next meeting. Moreover, unless we see a significant reversal in current trends that jeopardizes my forecast of near 7 percent unemployment rate by the end of this year, then I anticipate that we could end the program before year-end. Let's look at some of the data.

The end of the year is actually fast approaching; if you want to taper off over the course of a hand full of meetings, the calendar is driving you to begin now. Now, back to that data:

In the six months through September 2012, when the decision to initiate the latest open-ended asset purchase program was made, nonfarm payrolls had increased an average of 130,000 per month, and the unemployment rate had averaged 8.1 percent. In the most recent six months, from November 2012 through April 2013, nonfarm payrolls have increased on average 208,000 per month — a 60 percent increase — and the unemployment rate has averaged 7.7 percent. As I noted earlier, April's unemployment rate has now reached 7.5 percent.

Moreover, the average duration of unemployment has fallen, the share of long-term unemployment has dropped, and hours worked and earnings have risen. While further progress would certainly be desirable, I believe the evidence is consistent with a significantly improving labor market. Thus, it is appropriate to begin scaling back the pace of asset purchases.

At this point, I raise my hand and say "But isn't underemployment still too high and being driven by cyclical factors? Aren't you erring on the side of removing stimulus too early?" But that arguement is neither here nor there for Plosser. He has obviously decided these are second-order issues. He does deliver what (I think) is a novel argument for tapering sooner than later:

Indeed, in my view, were the FOMC to refrain from reducing the pace of its purchases in the face of this evidence of improving labor market conditions, it would undermine the credibility of the Committee's statement that the pace of purchases will respond to economic conditions. Similarly, if there were sufficient evidence that conditions in labor markets had deteriorated, I would expect the FOMC to consider increasing the pace of purchases. After all, this is the meaning of state-contingent monetary policymaking. But if we reach the point that markets only expect us to move in one direction — that is, toward more easing — and we become reluctant to dial back on purchases over concerns of disappointing or surprising markets, then we will find ourselves in a very difficult position going forward.

In short, the Fed communicated a particular strategy - one in which the pace of asset purchases would be determined by recovery in the labor market. And, by Plosser's reckoning, the 60% increase in the pace of job growth is evidence of exactly the kind of improvement the Fed was looking to achieve.

Notice that Plosser is not appealing to a fear that the Fed's credibility on inflation is at risk. Instead, not acting to slow asset purchases undermines the credibility of the Fed's communications strategy. This is an argument that might resonate with other policymakers who are already worried that financial markets will misinterpret future policy actions. I suspect Plosser knows inflation concerns are likely to fall on deaf ears. Indeed, he addresses the inflation topic earlier in the speech:

Should inflation expectations begin to fall, we might need to take action to defend our inflation goal, but at this point, I do not see inflation or deflation as a serious threat in the near term. However, I do believe that our extraordinary level of monetary accommodation will have to be scaled back, perhaps more aggressively than some think, to ensure that inflation over the medium term remains consistent with our target.

Convincing others to pull back on easing due to inflation concerns is something of a challenge when your preferred inflation measure is below target and trending down. But where that argument fails, perhaps a credibility/communications argument can succeed?

Plosser is careful to add the now required "not tightening" clause:

I want to emphasize that in this state-contingent framework, reducing the pace or even ending asset purchases need not be the start of an exit strategy or more aggressive tightening. Nor would it indicate that an increase in the policy rate was imminent. Instead, these actions would slow and then halt efforts to continuously expand the level of accommodation by increasing the size of the balance sheet. Given the improving economy, dialing back asset purchases is an appropriate response.

I imagine we will see something like this in every speech going forward. Policymakers do not want market participants to jump to conclusions on the basis of any one policy move.

Bottom Line: While the Fed is moving closer to tapering asset purchases, timing remains an issue. I think that most policymakers will not be swayed to an early end by the "Fed's inflation credibility is at risk" argument. But a subset is likely swayed by the "financial stability is at risk" argument. And another subset may be swayed by the "communications credibility is at risk argument" that is an element of Plosser's speech. In short, the majority favoring continuing asset purchases at the current pace is obviously shrinking. Hopefully this week's upcoming speech by Federal Reserve Chairman Ben Bernanke and the release of the minutes from the last FOMC meeting will help clarify how quickly that majority is loosing ground.

Fed Watch: What Does Japan Mean For The Rest of the World?

Tim Duy once again:

What Does Japan Mean For The Rest of the World?, by Tim Duy: Is Abenomics about boosting exports or domestic demand? I tend to agree with Lars Christensen on this issue:

There has been a lot of focus on the fact that USD/JPY has now broken above 100 and that the slide in the yen is going to have a positive impact on Japanese exports. In fact it seems like most commentators and economists think that the easing of monetary policy we have seen in Japan is about the exchange rate and the impact on Japanese “competitiveness”. I think this focus is completely wrong.

While I strongly believe that the policies being undertaken by the Bank of Japan at the moment is likely to significantly boost Japanese nominal GDP growth – and likely also real GDP in the near-term – I doubt that the main contribution to growth will come from exports. Instead I believe that we are likely to see is a boost to domestic demand and that will be the main driver of growth. Yes, we are likely to see an improvement in Japanese export growth, but it is not really the most important channel for how monetary easing works.

In my view, Abenomics has been remarkably centered on the domestic economy. The impact on the Yen is almost an afterthought, whereas in the past policymakers would have turned to intervention to directly support the economy. This looks like policymakers finally realized that such a policy approach wasn't working and they need to change gears to a frontal-assault on domestic policy levers.

That said, a side-effect of Abenomics is currency depreciation, and this will have an impact on global trade. Investment Week has an interview with hedge fund manager Hugh Hendry:

"Japan's monetary pivot towards QE will not create economic growth out of nothing. Instead it seeks to redistribute global GDP in a manner that favours Japan versus the rest of the world. This is the last thing the global economy needs right now," he said.

So what's right and what's wrong with that quote? What's right is that there will be a trade impact. A story floating around right now is that Japanese exporters are not changing prices, but instead just allowing the impact of the weaker Yen to fall straight through to the bottom line. But they will soon turn their attention to leveraging the weaker Yen to cut prices and take market share. And they have Europe in their sights. They might not be able to compete with Chinese exporters, but they can with German ones.

What's wrong, however, is that this is exactly what the global economy needs right now. If Germany and by extension Europe experiences weaker growth, European policymakers will need to respond. And they are not likely to respond by buying Yen to hold its value up. They are likely to respond by stimulating their domestic economy directly via easier monetary policy and, hopefully, easier fiscal policy.

In other words, successful domestically-orientated policy in Japan will have second-round effects that will induce further policy easing Europe. And a good kick in the pants in Europe is exactly what we need right now. Rather than thinking about Japan's policy as triggering "competitive devaluations," think of it as triggering "coordinated global easing."

What's also wrong is Hendry's usual hedge-fund bias again monetary policy. By altering expectations to lower real interest rates, Japan's monetary policy is in a sense creating economic growth out of nothing. We frequently heard that "uncertainty" was holding back the recovery, but isn't this the same thing as creating a recession out of nothing? If you can create a recession out of nothing, then why not an expansion?

Fed Watch: Fed Notes

Tim Duy:

Fed Notes, by Tim Duy: Gavyn Davies at the Financial Times questions the Federal Reserve's employment target:

On the wider issue of general monetary policy, the behaviour of inflation and unemployment remain the key drivers, and here the Fed has a headache. Its forward guidance on unemployment is in danger of giving misleading signals about the need for tightening, and it probably needs to be changed.

I agree. Davies cites research indicating that recession-driven underemployment makes the unemployment rate a poor measure of resource utilization. The policy implications:

What does this imply for policy? It implies that the Fed will have a bias to keep policy aggressively easy long after the unemployment rate has fallen below 6.5 per cent, and even after it has fallen below the estimated natural rate of 5.25 to 6 per cent, provided that the inflation threshold is still intact. This is because the reserve army of disguised unemployed people will exert a downward force on inflation which will not be correctly picked up by the official unemployment statistics.

See my related piece on structural (or lack thereof) unemployment here. Davies raises a often-forgotten point: Even though the Federal Reserve is turning its attention to ending quantitative easing, the timing of the first rate hike is most likely much farther off in the future.

A challenge for the Fed is that asset purchases are at least in part a communications device that signals commitment to a given policy path. Thus, the Federal Reserve will need to take care to avoid the impression of imminent rate hikes as they scale back asset purchases. Indeed, I thought this was the most important takeaway from Friday's Jon Hilsenrath article in the Wall Street Journal:

Officials are focusing on clarifying the strategy so markets don't overreact about their next moves.

Overreaction can come in many forms:

For example, officials want to avoid creating expectations that their retreat will be a steady, uniform process like their approach from 2003 to 2006, when they raised short-term interest rates in a series of quarter-percentage-point increments over 17 straight policy meetings...An abrupt or surprising end to it could send stocks and bonds in the other direction, but a delayed end could allow markets to overheat. And some officials feel they've ended other programs too soon and don't want to repeat the mistake.

This sounds as if Fed officials are cognizant of this from Davies:

The more precise the forward guidance given, the more the Fed exaggerates the degree of knowledge which the central bank can possibly have about its own future actions, since these actions will depend on many factors which cannot be exactly predicted in advance.

Which also speaks to the inclusion of "increase or decrease" phrase in the last FOMC minutes. Back to Hilsenrath:

The Fed said in its postmeeting statement that it was "prepared to increase or reduce the pace of its purchases" as the economic outlook evolved.

The suggestion that the Fed might boost its bond buying was a change in the policy statement that seemed to some an acknowledgment that more aid for the economy might be needed...

...But many officials believe the recovery is on track and aren't yet concerned about the inflation slowdown. Instead, the most recent statement seems more aimed at signaling the Fed's broader flexibility in managing the programs.

Bottom Line: We need to be very careful in extrapolating the implications of the next policy move to future policy moves. The Fed has only a general strategy for exit, but policymakers lack enough certainty about the future to determine the exact nature of that exit. Still, even given that uncertainty, the current state of labor force utilization and inflation suggest that while the end of QE may occur this year, the first rate hike is not likely until some point well into the future.

Fed Watch: When Will The Divergence Between PCE and CPI Matter?

Tim Duy:

When Will The Divergence Between PCE and CPI Matter?, by Tim Duy: The divergence between PCE and CPI measures of inflation remains in the headlines. Pedro da Costa at Reuters sees a test of the Fed's credibility at hand:

With the inflation rate about half of the Federal Reserve's 2.0 percent target, the central bank is facing a major test and some experts wonder whether it will eventually need to ramp up its already aggressive bond buying program.

The challenge for policymakers is that they are clearly falling short of their dual mandate and that should open the door for additional asset purchases. But, but, but...I think that additional asset purchases is just about the last thing they want to do right now. We will see if their thinking evolved much at the last FOMC meeting, but the minutes of the March meeting clearly indicate that a large contingent of FOMC members are looking to end the asset purchase program by the end of this year. Take ongoing improvements in labor markets, add in concerns about financial stability, mix in some cost-benefit analysis about the efficacy of additional QE, and top-off with a dash of improving housing markets, bake at 350 for 40 minutes, and you get monetary policymakers hesitant to push the QE lever any further.

My sense is that policymakers will thus try to find reasons to dismiss falling PCE inflation as a non-issue. From an email exchange last week, today da Costa quotes me as saying:

"The Fed may view the divergence between the two measures as indicating that worries about deflation are premature," said Tim Duy, a professor of economics at the University of Oregon. "If core CPI was trending down as well, the Fed would be more likely to conclude that their inflation forecasts should be guided lower."

And also last week, Greg Ip at the Economist had this observation:

If CPI inflation were to converge to PCE inflation, that would be a concern. Goldman expects CPI inflation to drop to 1.8% in coming years and PCE inflation to rise to 1.5%. It would be preferable for both to converge to 2%; but so long as inflation expectations remain where they are, it is of little consequence for monetary policy – and a tangible plus for incomes and spending.

Yesterday, Philadelphia Federal Reserve President Charles Plosser had this to add, via the Wall Street Journal:

As of right now, “I’m not concerned” about inflation drifting too far under the central bank’s price target of 2%, Federal Reserve Bank of Philadelphia President Charles Plosser said in response to reporter’s questions at a conference here.

Inflation expectations “look pretty well anchored,” and it’s likely that price pressures as measured by the personal consumption expenditures price index will drift back up to 2% over time and reconverge with the consumer price index, he said.

Today, Chicago Federal Reserve President Charles Evans seemed resigned to low inflation. Again, from the Wall Street Journal:

“Inflation is low, and it’s lower than our long-run objective,” Mr. Evens said in an interview on Bloomberg Television, adding that he would like to see inflation closer to 2% but expects it to stay below 2% for several more years. Inflation, he said, “can be too low” when the central bank’s objective is 2%.

Asked if low inflation should prompt a policy response from the Fed, Mr. Evans said “I think it’s way too early to think like that.” In the debate over how the Fed might exit from the asset purchase program, Mr. Evans, a voting member of the policy-setting Federal Open Market Committee, said he remains “open minded [and] I’m listening to my colleagues.”

The general story seems to be that as long as inflation expectations remain anchored, and CPI inflation does not drift much below 2%, then the Fed will resist accelerating the pace of asset purchases.

Also note that the downward inflation drift is an underlying trend, or so concludes the Federal Reserve Bank of Atlanta's macroblog. The authors use a principle component model to estimate a common trend in the price data, and get these results:

The author's note that by this measure, the decline in PCE is not as ominous as it first seems, but it is clear that inflation by either measure is missing the Fed's target and currently trending away from that target. They conclude:

Does that mean we should ignore the recent disinflation being exhibited in the core PCE inflation measure? Well, let’s put it this way: If you’re a glass-half-full sort, we’d say that the recent disinflation trend exhibited by the PCE price index doesn’t seem to be “woven” into the detailed price data, and it certainly doesn’t look like what we saw in 2010. But to you glass-half-empty types, we’d also point out that getting the inflation trend up to 2 percent is proving to be a curiously difficult task.

Indeed, very curious given that we tend to think that at a minimum the monetary authority should be able to raise inflation rates. You are left with thinking that either the Federal Reserve still had more work to do or that monetary policy can do little more at this point than put a floor under the economy. If the latter, and if you want something more, you need to turn to fiscal policy.

Bottom Line: I suspect that at this point the Fed tends to think the costs of additional action still outweigh the benefits, and thus below-target inflation only induces pressure to maintain the current pace of QE longer than they currently anticipate rather than increase the pace of purchases.

Fed Watch: 'Really? One Basis Point?' and 'Rising Structural Unemployment?"

Two from Tim Duy. Here's the first:

Really? One Basis Point?, by Tim Duy: Bloomberg has a story with an ominous opening paragraph:

Bank of Japan Governor Haruhiko Kuroda’s stimulus policies are backfiring in the housing market, where mortgage rates are rising even as the central bank floods the financial system with cash.

Lions, tigers, and bears, oh my! The next paragraph:

Fixed 35-year home-loan costs rose to 1.81 percent this month, the first increase since February and up from an all-time low of 1.8 percent in April, according to data compiled by the Japan Housing Finance Agency. Federal Reserve Chairman Ben S. Bernanke’s monetary easing almost halved 30-year U.S. mortgage rates since 2008 to 3.35 percent on May 2.

Seriously? The case against Kuroda is that after declining since February, mortgage rates climbed a whole basis point? And Kuroda is expected to accomplish in a few months what took Bernanke five years? And I thought I could be a harsh critic of central bankers!

Hopefully this is just a typo; I can't seem to locate a time series of the 35-year mortgage rate in Japan. Otherwise, one might be tempted to conclude that the reporters were biased against Abenomics.

And here's the second:

Rising Structural Unemployment?, by Tim Duy: This tweet from Andy Harless caught my eye:

HIres-to-openings ratio looking uglier & uglier bls.gov/news.release/j… Looks like rising structural unemployment

— Andy Harless (@AndyHarless) May 7, 2013

The chart:

The ratio of hires to openings fell to the low of the last cycle. Now compare the ratio to the unemployment rate:

Unemployment appears to be too high relative to the hires/openings ratio (caution is warranted, however, as the JOLTS data only extends back to 2001). One would normally associate such a low ratio with low unemployment as the number of hires would be relatively low because of the lack of available workers. In this case, however, the number of hires appears to be low despite a large pool of potential employees, consistent with the concern that available workers lack the skills firms seek. Structural unemployment, as Harless suggests.

That said, recall that Matthew O'Brien pointed us at research here and here suggesting that high unemployment is attributable not to structural factors, but instead to a bias against the long-term unemployed. O'Brien recognizes the insidious nature of this problem:

Circles don't get more vicious than this. The people who need work the most can't even get an interview, let alone a job. It's a cycle that could end with the long-term unemployed becoming unemployable. It's what economists call hysteresis, the idea being that a slump, left untreated, can make us permanently poorer by reducing our future ability to do and make things.

Bias against the long-term unemployed might explain why wage growth remains muted:

One would think that a low hires/openings ratio suggests that wage growth would be accelerating (as employers appear to face a relative shortage of workers), but that is not the case. Indeed, low wage growth is one reason to believe that excessive unemployment is cyclical in nature. How does this fit with the long-term unemployed story above? Perhaps that although firms have a bias against the long-term unemployed, those potential workers still place downward pressure on wages. The newly unemployed don't require higher wages despite demand for their skills because they know there is a large pool of people available with similar skills. If the newly unemployed demand too high wages, they may induce employers to take another look at the pool of long-term unemployed. Consequently, they do not seek higher wages.

Incidentally, this also explains the low quits rate. The consequences of becoming long-term unemployed are particularly severe, raising the expected cost of voluntarily leaving a job.

So I guess the "good" news would be this: If bias against the long-term is simply creating the illusion of structural unemployment, then we are not yet faced with the problem of hysteresis. If the pool of long-term unemployed can place downward pressure on wages, then they must have a valuable skill set. Otherwise, they would not represent a threat to the newly unemployed. Keep the demand up for employees long-enough, and firms will eventually give up their bias against the long-term unemployed (I assume this would be preferable to the alternative of prematurely escalating wages). Eventually, the pool of unemployed would decrease and then wage pressures increase.

Still, the longer we wait for this bias to diminish, the more likely it is that the unemployment does indeed become structural. Then we would expect rapidly rising wages despite elevated unemployment. Another argument for pulling on all the stimulus levers. Alas, that is not the case.

Update: And after I wrote all this, I saw this Harless tweet:

Likely part of the reason 4 low hires/opening is that most applicants r now long-term unemployed, who face a more rigorous screening process

— Andy Harless (@AndyHarless) May 8, 2013

Apparently on the same path.

Fed Watch: Consistency of the Underlying Trends

Tim Duy:

Consistency of the Underlying Trends, by Tim Duy: Calculated Risk comments on this morning's JOLTS report:

Not much changes month-to-month in this report - and the data is noisy month-to-month, but the general trend suggests a gradually improving labor market.

This observation extends far beyond just the JOLTS report to virtually the entire set of labor market data. While we often get caught up in the month-to-month gyrations of various employment reports, the underlying trend of those data have been remarkable consistent:

General, consistent improvement is evident across an array of indicators. The pace of that improvement, however, consistently falls short of what is necessary to rapidly alleviate excessively high levels of underemployment, counter demographic trends impacting labor force participation, or induce significantly higher wage growth. And you can find that generally steady pace of improvement in other indicators as well. For example:

In short, it looks as if monetary policymakers have put a bottom under the economy but are unable to accelerate the pace of recovery. Whether the lack of acceleration is attributable to shortfalls on the monetary side of policy (insufficient quantitative easing, unwillingness to allow inflation expectations to drift higher, etc) or lack of cooperation of fiscal authorities (there seems to be no reason to hasten the pace of deficit reduction) remains a matter of debate. I tend to believe that the economy needs additional monetary and fiscal support, in part because I tend to worry that we will not lift off the zero lower bound in this recovery, setting the stage for even larger policy challenges in the next recession. In any event, regardless of where you think policy should be, right now it looks to be accomplishing something of a minimum by setting a floor for activity.

What does this mean for monetary policy going forward?

First, I think we will need to keep a focus on the trend and not think policy will be swayed (in either direction) by every gyration of the data. The data is inherently noisy, and the Fed will be looking through that noise.

Second, the Fed recognizes the same underlying consistency in the data, and likely concludes that there is little they can do to accelerate that recovery without further substantive changes to policy (dramatically increase asset purchases or changing the inflation target). The costs of those policy shifts are perceived to outweigh the benefits (this is a revealed preference at this point). Hence we should not anticipate the Fed will scale up asset purchases, even though this option was on the table in the last FOMC statement. Scaling up would only happen in the event of a sharp deterioration of the forecast.

Third, they will not scale up asset purchases as long as they expect the impact of fiscal contraction to have largely passed by the end of this year.  If not for the fiscal contraction, the economy would already be accelerating at a more rapid pace, and we would probably be looking at the Fed tapering off asset purchases sooner than later.

Fourth, even if the forecast for 2014 devolves into a continuation of the slow and steady improvement of the past nearly four years (!) since the end of the recession, I doubt the Fed will accelerate the pace of asset purchases. The problem is the 6.5% unemployment threshold for considering the path of short-term interest rates. Slow and steady improvement will place that threshold in sight by the middle of next year, and the Fed will want to be done with asset purchases well before the economy hits that threshold. That helps explain why FOMC members seem to have coalesced around an expectation that they can wind down and end asset purchases by the end of this year. In short, they will be increasingly hesitant to increase asset purchases (and more anxious to begin tapering) as we move closer to the 6.5% unemployment target.

Bottom Line: Pay attention to the underlying trend, discount the month-to-month noise. The farther out we get from the recession, that noise becomes less important. That underlying trend seems to be generally consistent with the unemployment rate coming within sight of the 6.5% threshold by the middle of next year, which explains the interest in ceasing asset purchases by the end of this year. Despite talk of the ability to increase the pace of purchases, I have a hard time seeing the circumstances that would make such a dramatic shift in policy direction. Such a shift will require a substantial negative shock that stalls the pace of activity and brings the threat of deflation back to the front burner - think circumstances that threaten to take out the Fed's current floor under the economy.

Fed Watch: 14,000

Tim Duy:

14,000, by Tim Duy: Seems like just yesterday Japanese policymakers were looking to push the Nikkie to 13,000. It even seemed like a overreaching at the time. Here is Matthew Boesler at Business Insider:

The 13,000 index target implies around 17 percent upside in February and March. The pace may sound ambitious, but then again, Japan is one of the hottest momentum trades in the world right now.

Today the Nikkei pushed past 14,000:

Note too that the 10-year Japanese government bond holds well below 1 percent - fears that aggressive policy would cause rates to skyrocket are once again proved unfounded.

So far, so good for Abenomics. Now the question is will policymakers back off soon after seeing such positive results? We have seen such stop-go policy in Japan in the past when attention turns back toward the size of the deficit. Are Japanese policymakers in it for the long-haul?

Fed Watch: When Deficits Become a Problem

Tim Duy:

When Deficits Become a Problem, by Tim Duy: L. Randall Wray (ht FTAlphaville) thinks that Paul Krugman has made the leap to MMT by acknowledging the ability of the central bank to control interest rates. Wray sees that Krugman was faced with an intellectual roadblock to MMT:

The sticking point has been “crowding out”—the idea that once we get beyond the liquidity trap and return to a more “normal” ISLM world, government deficits will push up interest rates. And that will then reduce private investment, which tends to lower economic growth. Higher interest rates plus lower growth means the government’s deficit and debt ratios grow beyond “sustainable” levels.

Wray argues that ultimately the central bank does not need to fear the bond vigilantes because the Treasury need not issue long-term debt and can instead issue only short term debt. The Fed is assumed to have complete control over rates on short term debt:

But as I explained last week, the short term rate is completely within the control of the Fed....Long term rates depend on the state of liquidity preference plus expectations of future Fed policy. But in any case, the Vigilantes cannot force Treasury to issue long term debt. It can stick to the short end of the maturity structure and then pay whatever rate the Fed targets.

Actually, I would go one step further than Wray and argue that the Fed's expectations tools coupled with large-scale asset purchases allows them to influence the entire yield curve. Wray then explains that this means the danger is not the vigilantes, but the Federal Reserve:

The real danger is not that the Vigilantes go all vigilant on Uncle Sam, but rather that the Fed decides to do a Volcker (raise the overnight rate to 20%). Congress can stop that by legislating that the Fed cannot act like a Vigilante. Or, alternatively, Treasury can stay on the short end. Both of these are policy choices, completely outside the influence of Vigilantes.

Wray takes Krugman's post today as evidence that Krugman believes that crowding out is not a issue either in a liquidity trap or at potential output. The Krugman quote:

the short-term interest rate is set by the Bank of England. And the long-term rate, to a first approximation, is a weighted average of expected future short-term rates. Unless markets believe that Britain is going to default — which it isn’t, and they won’t — this is more or less an arbitrage condition that ties down the long run rate no matter what happens to confidence.

Wray's interpretation:

All he has to do is to carry that analysis beyond the current downturn. This can go on forever, of course. Keep short term interest rates low, or keep Treasury out of long maturities.

Wray seems to believe that this means Krugman has departed from his earlier story:

I could go on, but you get the point: once we’re no longer in a liquidity trap, running large deficits without access to bond markets is a recipe for very high inflation, perhaps even hyperinflation. And no amount of talk about actual financial flows, about who buys what from whom, can make that point disappear: if you’re going to finance deficits by creating monetary base, someone has to be persuaded to hold the additional base.

But I don't see anything inconsistent between the Krugman of the past and that of today. The crowding out argument is a simply a bit more nuanced than in Wray's description. Wray seems to want to overlook the inflation part of Krugman's position. Specifically that in a more "normal" ISLM world, which I would interpret as near potential output, then additional government spending would tend to increase interest rates and crowd out private spending or - and this is an important or - that the Federal Reserve could accommodate the increased government spending and hold interest rates low, but that the end result would be higher inflation.

In other words, I doubt that Krugman fears the bond vigilantes even at potential output, but that he would expect the Federal Reserve to allow interest rates to increase to prevent inflation. Presumably this crowds out private investment, and shifts the mix of demand toward the government sector.

Does this mean that additional debt lowers growth in a Rogoff/Reinhart sense? No, but it does mean that the Fed will not allow output to exceed potential due to inflation concerns. The claim that crowding out leads to lower potential growth in the long-run is generally a supply-side type story in which an excessive level of government spending reduces the rate of resource (labor/technology/capital) growth.

In short, I doubt that Krugman's acknowledgement of the Federal Reserve's control over interest rates implies that he now believes that government deficits do not matter or that he will make such an intellectual leap. Krugman appears to have always believed that the Fed can control interest rates, thus leaving the bond vigilantes impotent. And there is nothing in his blog today to suggest that he no longer believes that at some point (hopefully) inflation - and by extension, interest rates - will once again be a concern. Believe it or not, it is not logically inconsistent to believe that concerns about rising interest rates are not valid today, but might be valid at some point in the future.

Update: I see Ed Harrison is writing on Krugman and the bond vigilantes as well, and sees the difference in not the so much the outcome

Of course running enormous deficits when the economy is operating at full capacity causes inflation to go haywire. Of course it does.

But in the rhetorical approach:

The difference is he straw-manned the deficit as an exogenous policy variable in 2011 when it simply isn’t one. 

Harrison (correctly) views the deficit as largely endogenous. When the economy improves, then the deficit will dissapear (or at least be greatly reduced). So arguing about the deficit's impact on interest rates is pointless:

This could only happen if our politicians went mad and added yet more fiscal stimulus to the economy even after it was overheating.

The key point is inflation:

Wait until inflation starts to creep up. Then the bond vigilantes can get going. But this is a long way off.

Fed Watch: FOMC Leaves Policy Unchanged

Tim Duy:

FOMC Leaves Policy Unchanged, by Tim Duy: The FOMC concluded their two-day meeting by holding policy constant, as expected. The assessment of the economy was largely unchanged. From March:

Information received since the Federal Open Market Committee met in January suggests a return to moderate economic growth following a pause late last year. Labor market conditions have shown signs of improvement in recent months but the unemployment rate remains elevated. Household spending and business fixed investment advanced, and the housing sector has strengthened further, but fiscal policy has become somewhat more restrictive. Inflation has been running somewhat below the Committee's longer-run objective, apart from temporary variations that largely reflect fluctuations in energy prices. Longer-term inflation expectations have remained stable.

Now:

Information received since the Federal Open Market Committee met in March suggests that economic activity has been expanding at a moderate pace. Labor market conditions have shown some improvement in recent months, on balance, but the unemployment rate remains elevated. Household spending and business fixed investment advanced, and the housing sector has strengthened further, but fiscal policy is restraining economic growth. Inflation has been running somewhat below the Committee's longer-run objective, apart from temporary variations that largely reflect fluctuations in energy prices. Longer-term inflation expectations have remained stable.

Notably, recent data has had little impact on the Fed's economic outlook. This includes the last employment report as well. The inclusion of the term "on balance" was clearly intended to downplay the March numbers.

My interpretation is that the Fed is attempting to move away from being pulled this way and that by the monthly fluctuations of the data and instead focus on the underlying trend; presumably, it is that trend that should be guiding policy decisions. Of course, one could argue that that underlying trend should induce them to additional action, but that is neither here nor there at this point. From their perspective, policy is appropriate given that trend. The Fed also strengthened its language on fiscal policy, but again the damage so far is not sufficient to change the course of policy. Or, probably more accurately, the damage is not so great that the Fed is willing to let Congress hit the ball into their court.

The other significant change came latter in the statement. From March:

The Committee will closely monitor incoming information on economic and financial developments in coming months. The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives.

Now:

The Committee will closely monitor incoming information on economic and financial developments in coming months. The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes. In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives.

In the wake of the last meeting, comments from some Fed presidents as well as the minutes themselves seemed to imply that further expansion of the large scale asset purchase program was out of the question. Instead, it seemed the focus had firmly shifted to ending QE as soon as possible, with the end of this year as a goal. With this language shift, the FOMC pulls back on this direction, and instead makes it clear than an expansion of the program is still possible. And possible not only due to a changing employment outlook, but also due to a deteriorating inflation picture.

But isn't the inflation picture already deteriorating? Yes, the latest numbers suggest a worsening disinflation trend. The Fed, however, probably has not adjusted their forecast; they probably do not expect that substantially lower inflation is likely given that inflation expectations remain anchored and economic activity is not deteriorating. In such an environment, they likely are not all that concerned that inflation is running somewhat below target.

Moreover, the Fed has that cost-benefit analysis thing working in the background, and likely believes that any more than $85 billion a month is not likely to have large, positive marginal benefits. Not enough to justify expanding policy further for any small changes to the forecast.

Bottom Line: The urge to taper off quantitative easing has lessened since the last meeting. That pushes the beginning of the end back to the later back of the year. The door is open to additional stimulus as well, but I suspect that it would have to be driven by the employment side of the mandate. Clear evidence of a deflationary threat is likely necessary to drive action on the other side of the mandate; such a threat seems unlikely in an expanding economy.

Fed Watch: What About Inflation?

Tim Duy:

What About Inflation?, by Tim Duy: I find Binyamin Applelbaum's Fed preview to be rather depressing and distressing. Appelbaum begins with a solid insight - reducing the unemployment rate is not the same as maximizing employment:

The Federal Reserve is making modest progress in its push to reduce the unemployment rate. But that is not the jobs goal Congress actually established for the Fed. The central bank is supposed to be maximizing employment. And on that front, it is not making progress.

Applelbaum points to the employment to population ratio as evidence that the Fed is falling short of the mandate. But are Fed officials ready to do more? No:

There is little sign, however, that Fed officials are considering an expansion of their four-year-old stimulus campaign as the Fed’s policy-making committee prepares to convene Tuesday and Wednesday in Washington.

Applelbaum notes that the recent flow of data has forced monetary policymakers to back away from talk of ending large scale assets purchases. But among the reasons to avoid expansion of the program we find this:

Another reason the Fed is not embracing new measures is that it already has tied the duration of low interest rates to the unemployment rate. The Fed said in December that it intended to hold interest rates near zero at least as long as the unemployment rate remained above 6.5 percent, provided that inflation remained under control. The theory is that the economy will get as much stimulus as it needs.

But what if the inflation rate is persistently below the target? Or, worse, trending lower? Clearly then the economy is not getting the stimulus it needs. If we are missing on both targets, then the economy needs more stimulus. And while we can debate the efficacy of monetary policy in influencing the pace of employment growth, surely monetary policy can influence the inflation rate. Correct?

The distressing part of this article is that it reads as if the Fed has given up not only on its ability to influence the pace of employment growth, but also on its ability to influence the inflation rate. Or, possibly worse, that the Fed is simply no longer concerned with the inflation rate now that the obvious threat of deflation has passed. This again feeds suspicion that the Fed's 2 percent target is really an upper bound.

Bottom Line: The Fed is supposed to have a dual mandate. Dual, as in two. Maximum employment and price stability. One would think that failing at the latter would be at least as important as failing at the former. Perhaps we are learning that the Evan's rule is flawed - it should not be about only conditions before which the Fed considers removing stimulus, but also conditions by which the Fed deliberately considers adding additional stimulus. A two-side Evan's rule is needed.

Fed Watch: Just a Few Weeks Makes a World of Difference

Tim Duy:

Just a Few Weeks Makes a World of Difference, by Tim Duy: The minutes of the last FOMC meeting, concluded on March 20, included this passage:

In light of the current review of benefits and costs, one member judged that the pace of purchases should ideally be slowed immediately. A few members felt that the risks and costs of purchases, along with the improved outlook since last fall, would likely make a reduction in the pace of purchases appropriate around midyear, with purchases ending later this year. Several others thought that if the outlook for labor market conditions improved as anticipated, it would probably be appropriate to slow purchases later in the year and to stop them by year-end. Two members indicated that purchases might well continue at the current pace at least through the end of the year.

The center of the FOMC appeared to be shifting toward agreement that large scale asset purchase program would likely be wrapped up by year end. Of course, they included a caveat:

It was also noted that were the outlook to deteriorate, the pace of purchases could be increased.

Since the last FOMC meeting, it has become clear that the economy continues along a suboptimal path, as illustrated by the disappointing 2.5 percent GDP growth for the first quarter; just a few weeks ago, Macroeconomic Advisors was anticipating a 3.6 percent growth rate. In addition, both employment and manufacturing reports have been less than impressive (see Calculated Risk for his take on today's Dallas Fed numbers and the implications for the ISM report). Moreover, fiscal austerity continues to bite:

The end result is that investors have concluded, rightly, that FOMC members looking forward to cutting the pace of purchases by mid-year were overly optimistic. Consequently, the 10-year yield was bid down to just 1.67 percent this afternoon, well below the 2.05 in early March.

Probably more important, at this juncture is that disinflation is again evident, with headline and core PCE up just 1.0 and 1.1 percent, respectively, compared to last year:

In an April 17 Wall Street Journal interview, St. Louis Federal Reserve President James Bullard highlighted the possibility that a deteriorating inflation trend might require additional easing. Other policymakers have joined him in this concern. From Bloomberg:

“I’d of course be giving serious thought” to additional stimulus if disinflation persists, Richmond Fed President Jeffrey Lacker, who voted against the bond program last year, said last week -- while adding he doesn’t think that will happen. The Minneapolis Fed’s Narayana Kocherlakota also said this month weaker inflation may be reason to consider more accommodation.

The important point is that low inflation prompts concern even among policymakers who think the Fed can have little impact on employment growth. For this group, high unemployment is distressing but not actionable. But low inflation is both distressing and actionable. Thus, at a minimum, the low inflation numbers should push the FOMC back to avoiding a premature end to quantitative easing. In addition, it is easy to argue that the Fed should be thinking about additional easing. Not only are they missing on the employment mandate, but increasingly it looks like they are missing on the price stability mandate as well. A policy failure all around.

Bottom Line: The FOMC statement should shift to indicate the softer economy and falling inflation numbers; I am watching for how much emphasis they place on the latter as a signal as to the likelihood of easing further in future meetings. Like most, I don't anticipate an expansion of the program at this juncture. I doubt the FOMC would see the current data as justifying a leap from thinking about ending the program to expanding the program just six weeks later. It would be interesting if Kansas City Federal Reserve President Esther George pulls her dissent. Her objection has been that the Fed's policy stance risks financial stability for little economic benefit. Pulling her dissent in response to falling inflation would signal that disinflation concerns run deep in the FOMC.

Fed Watch: Monetary Policy and Financial Stability

Tim Duy:

Monetary Policy and Financial Stability, by Tim Duy: I think it is difficult to ignore the role of asset prices in the dynamics of the past two business cycles:

If the objective of monetary policy is a combination of low inflation and unemployment, I think it is difficult to argue that the Federal Reserve pursued an overly loose policy stance in the periods of the internet and housing bubbles. Indeed, it is arguable that asset price bubbles were integral in fostering low unemployment.

With this in mind, consider this conclusion from Minneapolis Federal Reserve President Narayana Kocherlakota, speaking at the 22nd Annual Hyman P. Minsky conference:

In this way, unusually low real interest rates should be expected to be linked with inflated asset prices, high asset return volatility and heightened merger activity. All of these financial market outcomes are often interpreted as signifying financial market instability. And this observation brings me to a key conclusion. I’ve suggested that it is likely that, for a number of years to come, the FOMC will only achieve its dual mandate of maximum employment and price stability if it keeps real interest rates unusually low. I’ve also argued that when real interest rates are low, we are likely to see financial market outcomes that signify instability. It follows that, for a considerable period of time, the FOMC may only be to achieve its macroeconomic objectives in association with signs of instability in financial markets.

This sounds like Kocherlakota believes that it is not possible for the Federal Reserve to accomplish its dual mandate in the absence of asset bubbles, excessive credit growth, etc. This leads to issue of how should the Federal Reserve deal with such instability:

To answer this question, the Committee will need to confront an ongoing probabilistic cost-benefit calculation. On the one hand, raising the real interest rate will definitely lead to lower employment and prices. On the other hand, raising the real interest rate may reduce the risk of a financial crisis—a crisis which could give rise to a much larger fall in employment and prices. Thus, the Committee has to weigh the certainty of a costly deviation from its dual mandate objectives against the benefit of reducing the probability of an even larger deviation from those objectives.

In other words, if they raise interest rates, the will clearly deviate from their objectives, but if they don't there is only a chance of suffering a larger deviation. So they should refrain from addressing financial instability (through raising interest rates) until it is clearly evident that it poses a significant risk to the dual mandate.

But how might one measure financial instability? A new paper by Claudio Borio, Piti Disyatat, and Mikael Juselius offers a fresh look at potential output that incorporates information about the financial cycle. Note that traditional measures of potential output focus on the inflationary consequences of level of actual output. If inflation remains contained or falling, then by definition actual output is equal to or less than potential output. Borio et al, however, note that the economy may be on an unsustainable path even when inflation remains contained. Arguably, measures of potential output should incorporate information about financial factors that might signal the economy is on such a path.

Why might be expect that we might be on a unsustainable path even under conditions of low and stable inflation? The authors summarize:

There are at least four reasons for this. One is that unusually strong financial booms are likely to coincide with positive supply side shocks (eg Drehmann et al (2012))....A second reason is that the economic expansions may themselves weaken supply constraints. Prolonged and robust expansions can induce increases in the labour supply, either through higher participation rates or, more significantly, immigration....A third reason is that financial booms are often associated with a tendency for the currency to appreciate, as domestic assets become more attractive and capital flows surge. The appreciation puts downward pressure on inflation. A fourth, underappreciated, reason is that unsustainability may have to do more with the sectoral misallocation of resources than with overall capacity constraints. The sectors typically involved are especially sensitive to credit, such as real estate.

Thus, unsustainable financial booms can be especially treacherous, as it is all too easy to be lulled into a false sense of security. Economic activity appears deceptively robust. Financial and real developments mask the underlying financial vulnerabilities that eventually bring the expansion to an end...

The author's estimate what they describe as "finance neutral" output gaps via an expanded version of an H-P filter. Among their findings is that applying a Taylor rule to their output gap suggests that the Federal Funds rate was set too low during much of the 2000's, and possibly now as well. Still, the authors stop short of advocating that interest rate policy should be used to lean against financial headwinds. Tighter monetary policy might ease financial instabilities, but aggravate recovery from a balance sheet recession.

Arguably, the current environment is a case where it would be imprudent to lean against potential financial instabilities. The Federal Reserve is holding interest rates low for a protracted period and thus fueling fears they are laying the groundwork for the next financial crisis. But raising rates doesn't seem like an appropriate option considering the economy is far from fully recovered from the recession. This speaks to Kocherlakota's comment. And those of Federal Reserve Chairman Ben Bernanke as said in a recent speech:

One might argue that the right response to these risks is to tighten monetary policy, raising long-term interest rates with the aim of forestalling any undesirable buildup of risk. I hope my discussion this evening has convinced you that, at least in economic circumstances of the sort that prevail today, such an approach could be quite costly and might well be counterproductive from the standpoint of promoting financial stability. Long-term interest rates in the major industrial countries are low for good reason: Inflation is low and stable and, given expectations of weak growth, expected real short rates are low. Premature rate increases would carry a high risk of short-circuiting the recovery, possibly leading--ironically enough--to an even longer period of low long-term rates. Only a strong economy can deliver persistently high real returns to savers and investors, and the economies of the major industrial countries are still in the recovery phase.

Admitedly, this is frustrating. It is as if we we are faced with a tradeoff between economic recovery and financial stability. But this begs an even greater question. Why do we have to make this tradeoff? Why is maintaining full-employment dependent on destabilizing asset bubbles? Commenting on this speech, Ryan Avent asks if the current dynamics are a result of the Fed's never-ending pursuit of low inflation:

...one very clear implication...price stability is keeping nominal rates low and is therefore an impediment to financial and macroeconomic stability. One has to weigh costs and benefits, of course, but one cannot miss the trade-off: the more you worry about low rates the less low and stable inflation should look like a good thing...

...It is perhaps premature to declare the existence of a new monetary trilemma, that over the medium-term central banks can choose at most two of the following: low inflation, low unemployment, and financial stability. But if Mr Bernanke continues arguing this effectively in favour of higher inflation, we may need to ask why he isn't pursuing it as an explicit goal.

Has the pursuit of low inflation brought us to a point where we can maintain the Fed's dual mandate only at the presence of financial instability? That unless we allow for somewhat higher inflation, we are making a deliberate choice to follow only "inflation-neutral" measures of the output gap and ignore "finance-neutral" measures? And, importantly, might it not be the case that the costs of somewhat higher inflation are in fact less than the costs associated with the financial instabilities that seem to be part and parcel of the current low-inflation regime?

Bottom Line: If Kocherlakota is correct and monetary policy can only pursue the dual mandate in the context of financial - and, by extension - macroeconomic instability, then we really need to consider which part of the dual mandate needs to be loosened to reduce the reliance on financial instability. My fear is that if Fed policy makers were asked this question, they would unanimously answer that it is the full-employment portion of the mandate that should be jettisoned.

Fed Watch: Three Parts to Macro Policy

Tim Duy:

Three Parts to Macro Policy, by Tim Duy: The G20 has accepted Japan's policy approach. From the Financial Times:

The yen fell sharply against other major currencies on Friday after the Japanese finance minister said Japan’s monetary policies had not met with resistance at the G20 group of nations in Washington.

This interpretation of the meeting helped sink the Yen to almost 100. More specifically, from the statement:

In particular, Japan’s recent policy actions are intended to stop deflation and support domestic demand.

Still, there remains a pro-austerity contingent:

Japan should define a credible medium-term fiscal plan.

I think the only credible medium-term plan for fiscal consolidation first involves higher near-term growth. More broadly than just Japan, but including Japan:

We will continue to implement ambitious structural reforms to increase our growth potential and create jobs.

How do these pieces fit together? I tend to see room for all three policy tools - monetary, fiscal, and structural - in fighting weak growth and outright recessions, although the weighting will vary according to circumstances. For instance, I don't deny the need for structural changes in the European periphery or Japan. Those changes, however, need to be cushioned with expansionary monetary and fiscal policy to yield a positive growth trajectory.

With this in mind, consider this recent post by Ed Harrison. He expands the Reinhart/Rogoff debate to current events in Japan:

This is the takeaway in Japan: stimulus without reform leads to a policy cul-de-sac. Monetary and fiscal stimulus is not a cure-all for economies or Japan would be the model and it most assuredly is not the model. If you want to use stimulus, then you need to have reform policies as well. It’s a three-pronged approach. The supply side matters. And that is the promise of Abenomics, isn’t it: fiscal and monetary stimulus as bridges to sustainable growth due to economic reform. Supposedly, this is what Abenomics is all about. And the Wall Street Journal told us yesterday that this reform, the third leg of this stool is now being put into place. Be sceptical, of course. Let’s just see what happens.

Mixing the RR debate and the Japanese and European experiences leads him to these conclusions:

Take a cue from Japan. The lesson is not to stimulate and deficit spend like mad and hope this succeeds in reflating the economy. That’s just a risk shift onto the public balance sheet. And the Japanese experience shows that people are uncomfortable with these kinds of deficits and will always work to reduce them irrespective of the consequences. You need supply side fixes too.

Take a cue from the euro zone. The lesson is also certainly not to undergo painful – and front-loaded – austerity like the euro zone. The Europeans have tied their hands with the euro. There is no currency sovereignty there and the ECB is legally forbidden to be politically aligned with any national government. The threat of insolvency is real. But Britain doesn’t have to go down this path. They have a lot more policy space. The bond vigilantes are a myth.

Read the post for more good insights.

Fed Watch: Accepting Failure

Tim Duy:

Accepting Failure, by Tim Duy: It is starting to look like European policymakers have given up trying. Bundesbank President Jens Weidmann, via the Wall Street Journal:

"Overcoming the crisis and the crisis effects will remain a challenge over the next decade," he said in an interview from his conference room at Bundesbank's headquarters overlooking Frankfurt's financial district, contrasting recent comments from European Commission President José Manuel Barroso that the worst of Europe's crisis is over.

Also from the Wall Street Journal:

An aging society and the time needed to work through its debt crisis will keep growth in Europe subdued for years to come, German Finance Minister Wolfgang Schaeuble said Friday.

“No one should expect that Europe will deliver high growth rates for years,” he said.

Apparently the new strategy is to keep expectations low. One has to imagine that given the current path of activity and the lack of fiscal support from European nations, the European Central Bank will find itself not only cutting rates but implementing its own version of quantitative easing by year end. The only other option would be to sit back and watch Europe slide from recession to depression And that does not seem like a credible policy path.

Fed Watch: Bullard Concerned About Low Inflation

Tim Duy:

Bullard Concerned About Low Inflation, by Tim Duy: St. Louis Federal Reserve President James Bullard sees inflation as a potential problem, but not in the way you might think. From the Wall Street Journal:

Federal Reserve Bank of St. Louis President James Bullard said Wednesday inflationary pressures may be growing too weakly and if they soften further, the central bank may have to boost its asset buying to bring price pressures back up to more desirable levels.

“Inflation is running very low” as measured by the personal consumption expenditures price index, the Fed’s favored inflation gauge, the policymaker said. “I’m getting concerned about that,” he said.

“If inflation [gains] continues to go down, I’d be willing to increase the pace of purchases” of bonds the Fed is now engaged in, Mr. Bullard said. “This is not what I expected, and I think inflation should be closer to the target than it is,” the official said, adding he considers it just as important to defend the Fed’s 2% inflation target from the low side, as it is to keep prices from going over 2%.

This is the problem:

With the Fed's preferred inflation target trending down, it seems a little silly to start talking about ending the asset purchase program. Indeed, as Bullard suggests, there might be room to expand it further. Note also that Bullard comes to this conclusion despite his concern that monetary policy has limited ability to create jobs, the main point of his speech. See the Wall Street Journal article cited above or Neil Irwin for more.

While everyone is busy watching the labor market for signs that the Fed can wind down asset purchases, we tend to forget that inflation should be part of the equation as well. From the most recent FOMC statement:

The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.

The phrase "in the context of price stability" should cut both ways. The Fed might need to tighten policy even if the labor market is not improving if inflationary pressures start to emerge. But at the same time, it should also mean that the Fed may need to increase the pace of asset purchases even if the labor market is improving. That seems to be the current situation, yet we hear alot of Fedspeak suggesting a widespread inclination to end asset purchases this year regarless of the recent bout of disinflation.

That said, inflation might be set to tick up in the months ahead. From MIT's Billion Prices Project:

Not a worrisome move, but enough to suggest that Bullard's low inflation concern might be short-lived.

Bottom Line: Bullard reminds us the exit from the asset purchase program should not be simply a function of labor markets, but also a function of inflation. And the current path of inflation does not indicate that policymakers should be rushing ahead with a plan to end QE this year.

Fed Watch: Yellen and the Reach for Yield

Tim Duy:

Yellen and the Reach for Yield, by Tim Duy: Federal Reserve Vice Chair Janet Yellen, speaking at the IMF "Rethinking Macro Policy II" conference, notes that Fed policy is intended, at least in part, to increase risky-taking behavior:

Some have asked whether the extraordinary accommodation being provided in response to the financial crisis may itself tend to generate new financial stability risks. This is a very important question. To put it in context, let's remember that the Federal Reserve's policies are intended to promote a return to prudent risk-taking, reflecting a normalization of credit markets that is essential to a healthy economy.

Certainly some reflation of asset prices is helpful in healing household balance sheets and thus But she and other realize that it can go too far:

...Obviously, risk-taking can go too far. Low interest rates may induce investors to take on too much leverage and reach too aggressively for yield. I don't see pervasive evidence of rapid credit growth, a marked buildup in leverage, or significant asset bubbles that would threaten financial stability. But there are signs that some parties are reaching for yield, and the Federal Reserve continues to carefully monitor this situation.

It would be hard not to make this conclusion given the role of asset bubbles in the dynamics of the last two business cycles. Still, what is the right policy response? Yellen:

However, I think most central bankers view monetary policy as a blunt tool for addressing financial stability concerns and many probably share my own strong preference to rely on micro- and macroprudential supervision and regulation as the main line of defense.

The center of gravity at the Fed remains wary of using interest rates to temper suspected asset bubbles, excessive leverage, etc. They prefer the idea of using supervision and regulation. One little problem though:

The Federal Reserve has been working with a number of federal agencies and international bodies since the crisis to implement a broad range of reforms to enhance our monitoring, mitigate systemic risk, and generally improve the resilience of the financial system. Significant work will be needed to implement these reforms, and vulnerabilities still remain.

No, we don't have the tools in place. And, I would add, regulators will be continuously playing catch-up on the regulatory front. Consequently, the ball might fall in the monetary policy court:

Thus, we are prepared to use any of our many instruments as appropriate to address any stability concerns.

Which leaves me a thinking that although the Fed might not want to use monetary policy to blunt any suspected financial stability risks, they may find themselves in a place where they believe they have no other choice because alternative tools are not available.

Not an immediate issue, but one to keep an eye on. The Fed is not likely to be so dismissive of financial stability risks the next time around.

Fed Watch: Another Spring Slowdown?

Tim Duy:

Another Spring Slowdown?, by Tim Duy: While expectations for a solid first quarter GDP report are running high, the most recent data flow has been somewhat sloppy. Sloppy enough that it should raise red flags for monetary policymakers pushing to end QE by the end of this year.

In addition to the weak employment report for March, the ISM manufacturing index retreated:

In contrast, the industrial production report appeared to signal ongoing strength:

But the details suggest a loss of momentum in March aside from a temporary boost from utilities:

Manufacturing output edged down 0.1 percent in March after having risen 0.9 percent in February; the index advanced at an annual rate of 5.3 percent in the first quarter. Production at mines decreased 0.2 percent in March and edged down in the first quarter. In March, the output of utilities jumped 5.3 percent, as unusually cold weather drove up heating demand.

More disconcerting was the retail sales report, which signaled that the recent strength in consumer spending is waning:

Indeed, this is not terribly unexpected as it likely reflects the impact of higher tax this year. But it is a signal that one should be cautious before extrapolating Q1 GDP numbers. On a more positive note, housing starts were higher, with much of the improvement stemming from multifamily construction:

The solid improvement in housing starts seems at odds with waning builder confidence, but that may have more to do with supply constraints than demand. From the news release:

“Many builders are expressing frustration over being unable to respond to the rising demand for new homes due to difficulties in obtaining construction credit, overly restrictive mortgage lending rules and construction costs that are increasing at a faster pace than appraised values,” said Rick Judson, National Association of Home Builders (NAHB) Chairman and a home builder from Charlotte, N.C. “While sales conditions are generally improving, these challenges are holding back new building and job creation.”

“Supply chains for building materials, developed lots and skilled workers will take some time to re-establish themselves following the recession, and in the meantime builders are feeling squeezed by higher costs and limited availability issues,” explained NAHB Chief Economist David Crowe. “That said, builders’ outlook for the next six months has improved due to the low inventory of for-sale homes, rock bottom mortgage rates and rising consumer confidence.”

This suggests the improvement in housing demand is just beginning to have an impact on the overall economy. That impact will accelerate as supply chains rebuild over the next year.

On net, I think the data is telling us a familiar story: The positives in the US economy are difficult to ignore. Housing starts are a very good indicator of the direction of the economy, and that direction appears to be up. But it doesn't pay to get too carried away with any one quarter's worth of data. Underlying growth has been slow and steady since the end of the recession, with positive quarters offset by negative quarters. And the impact of tighter fiscal policy looks likely to produce a similar trend this year. The light at the end of the tunnel, however, is that as the fiscal effect fades toward the end of this year and into next, activity could finally see a more of the sustained improvement we have been looking for.

But, at the moment, that sustained improvement looks ephemeral. That is the message of the bond market as yields plunged back to the 1.7 percent range since the beginning of the year. And the beat-down of commodity prices indicates nervousness on the global outlook as well. If I was a monetary policymaker, I would be paying attention, especially as the inflation numbers are not telling us that imminent tightening is necessary:

Consumer price inflation (not the Fed's preferred measure) posted a -0.2 percent headline decline in March and a slight 0.1 percent core gain. Inflation? What inflation?

Some FOMC members seem to be paying attention to the change in the tone of the data. New York Federal Reserve President William Dudley noted his concerns in a speech today:

In terms of the labor market, we have seen only a moderate improvement in labor market conditions over the past six months or so. After an encouraging pick up in the pace of job creation around the turn of the year, the employment report for March showed a gain of only 88,000 jobs. While I don’t want to read too much into a single month’s data, this underscores the need to wait and see how the economy develops before declaring victory prematurely. I’d note that we saw similar slowdowns in job creation in 2011 and 2012 after pickups in the job creation rate and this, along with the large amount of fiscal restraint hitting the economy now, makes me more cautious....

...In the near term, there is considerable uncertainty about the outlook, particularly because the multiplier effects from fiscal drag and sequestration are still unclear. This uncertainty should gradually decline—for better or for worse—over the coming months, as the sequester’s impact takes hold and more economic data come in, giving us a clearer picture of the forward momentum of the economy....

...I see the current pace of asset purchases as appropriate.

At some point, I expect that I will see sufficient evidence of improved economic momentum to lead me to favor gradually dialing back the pace of asset purchases. Of course, any subsequent bad news could lead me to favor dialing them back up again.

Notice that he does not suggest, as others do, that it would be appropriate to end quantitative easing by the end of this year. Chicago Federal Reserve President Charles Evans expressed his belief that quantitative easing would stretch into 2014:

Mr. Evans told reporters after a speech in Chicago that he expected “with a high probability” that bond buying would continue into the fall. He added he “would not be surprised” if a wind-down carried over into 2014, though offered an upbeat assessment of the economy’s current trajectory and saw no immediate inflation threat.

Prior to the discussion about ending the QE this year, my outlook had been similar to Evans' - the tapering-off procees would begin late this year after the impact of fiscal contration had passed, with a likely end in the first half of 2014. But recent Fedspeak has convinced me that a sizable contingent of policymakers are looking to end QE sooner than later; I suspect that contingent has fallen back to concerns about size of the balance sheet rather than the pace of the recovery.

Bottom Line: The data flow is not as uniformly positive as it seemed just a month ago. Arguably, we are experiencing yet another spring slowdown. This should trigger some monetary policymakers to reassess their predictions that QE could be safely terminated at the end of this year. But there may be a contigent that has dug in its heels on the issue and are asking themselves "how bad does the data have to get to continue assets purchases" rather than "how good does the data need to be to end asset purchases?" Of course, ultimately the answer will depend on which of these two questions Federal Reserve Chairman Ben Bernanke is asking.

Fed Watch: When Can We All Admit the Euro is an Economic Failure?

Tim Duy:

When Can We All Admit the Euro is an Economic Failure?, by Tim Duy: The last month of data flow from Europe is nothing short of depressing. It seems that the history of the Eurocrisis can be summed up as a repeated effort to snatch failure from the jaws of defeat. The Euro and the policy framework that supports it is now clearly inconsistent with anything but sustained recession.

Consider a handful of recent reports. First, unemployment continues to reach new highs. From Bloomberg:

Unemployment in the 17-nation euro area was 12 percent in February and the January figure was revised up to the same level from 11.9 percent estimated earlier, the European Union’s statistics office in Luxembourg said today...The European Commission predicts unemployment rates of 12.2 percent this year and 12.1 percent in 2014. ECB President Mario Draghi said on March 7 that “it is of particular importance at this juncture to address the current high long-term and youth unemployment.”

I don't think that 12.2 percent forecast will hold. Greece remains a complete disaster. Via Aljazeera:

Greece's unemployment rate reached a new record of 27.2 percent in January, new data has showed, reflecting the depth of the country's recession after years of austerity imposed under its international bailout.

The latest figure rose from a revised 25.7 percent in December, the country's statistics service ELSTAT said on Thursday...Unemployment among youth aged between 15 and 24 stood at 59.3 percent in January, up from 51 percent in the same month in 2012.

Meanwhile, the Troika continues to demand further job cuts in return for a drip feed of bailouts that have arguably done little other than ensure Greece remains in recession:

An inspection team of international lenders has finished its review of Greece's reform progress, paving the way for another 10 billion euros aid payment, a source with knowledge of the talks said on Saturday....Under Greece's current bailout plan agreed in November, Athens must overall cut 150,000 public sector jobs from 2010 to 2015, about a fifth of the total, through hiring curbs, retirements and dismissals.

As a consequence, the stage is being set for another political crisis in Greece. Ekathimeri reports:

The head of the main leftist opposition SYRIZA, Alexis Tsipras, called on Saturday for the shaky coalition government to step down and pave the way for new elections, claiming that this was “the only way out” for a country seemingly condemned to endless austerity...

...“The situation has reached the absolute limit,” the leftist leader told supporters. “At this moment, there is no other way out for the country than the resignation of the government and the staging of new elections so a new administration can emerge with the mandate and support of the majority of society to implement an alternative plan to exit the crisis.” Tsipras admitted that his plan entailed risks but was preferable to “certain failure.”

Is the price of staying in the Euro finally now too high? Meanwhile, Ambrose Evans-Pritchard reminds us that both Cyprus have gone from bad to worse:

On cue, Angela Merkel's Christian Democrat base in the Bundestag has warned that there can be no increase in the EU-IMF rescue package for Cyprus.

The Cypriot people alone must carry the extra cost of up to €5.5bn beyond what was already agreed in the €17.5bn deal in March.

"Should that not be possible, the assent of the German Bundestag next week is out of the question," said Christian von Stetten, a key member of the finance committee.

And Evans-Pritchard repeats a point that cannot be repeated enough:

If the eurozone refuses to offer any further help, there must surely be a greater temptation to withdraw from the euro and default on sovereign debt in a classic restructuring deal with the IMF.

That is what the IMF is there to do. Such restructurings have been done countless times across the world over the last 50 years. It is traumatic, but countries usually recover after a couple of years.

Currency depreciation is a critical element of traditional IMF restructurings. The inability of troubled Eurozone economies to depreciate remains a key impediment to their return to growth; there is simply no cushion to offset the never-ending austerity. Speaking of never-ending austerity, Evans-Pritchard reviews the situation in Portugal:

So Cyprus is very far from being solved, and so is Portugal. A fresh Troika leak, this time to the Pink Sheet, has confirmed what anybody following Portugal already suspected. The country is stuck in a debt-compound trap. The economic slump is proving much deeper than forecast. The deficit has been rising not falling, in spite of austerity cuts.

And, increasing, it is not just periphery. From Reuters:

Manufacturing across Europe's major economies endured another month of mostly deep decline in March, dragging down even former bright spots, surveys showed on Tuesday....

Factories in Germany and Ireland, the relative stars of February's PMIs, fell back into decline last month. Everywhere else, the industrial rot extended.

Spanish manufacturing declined at its fastest pace since October, which followed news the government will revise its economic forecasts for 2013 to show a 1 percent contraction, from a 0.5 percent decline previously.

In France, factory activity retreated for a 13th month and car registrations there dived 16.4 percent in March, further underlining the malaise sweeping through the euro zone's second-biggest economy.

"The euro zone's March manufacturing PMIs ... (banishes) the recovery scenario projected by the European Central Bank further beyond the realm of likely probabilities," said Lena Komileva from G+ Economics in London.

The ongoing deterioration in Europe is evident to everyone except European policymakers. Clive Crook wonders at European Commission President Jose Barroso's outlook:

Barroso's optimism on Europe's economic recovery, if you can call it a recovery, was harder to understand. This week the IMF's Christine Lagarde talked of a three-speed world: "countries that are doing well, those that are on the mend, and those that still have some distance to travel.” (In other words, fast growth in many emerging economies, slow growth in the U.S., and no growth in Europe.) The euro area's economy is still shrinking. Yet Barroso still thinks (or says he thinks) that policy has been mostly well-judged and the union will emerge stronger from its ordeal.

He noted early on that Europe's public debts still aren't high by U.S or Japanese standards. True -- and that's the point. The EU is insisting on austerity in its weakest economies even though, in the aggregate, its fiscal problem is manageable. The failure to create effective burden-sharing arrangements -- some form of limited fiscal union to work alongside its monetary union -- has been the euro area's biggest error, not counting the creation of the euro itself. And the consequences are crushing countries such as Spain and Barroso's own Portugal.

Note that fiscal union is not the same as an austerity union. The former allows for internal transfer of the type Crook describes. The latter is simply a joint commitment to austerity. But austerity is the only policy possible within the European framework. Calculated Risk caught German Finance Minister Wolfgang Schauble wallowing in self-delusion:

"Nobody in Europe sees this contradiction between fiscal policy consolidation and growth,” Schauble said. “We have a growth-friendly process of consolidation, and we have sustainable growth, however you want to word it.”

With no depreciation for crisis-stricken economies, no fiscal stimulus, and tight credit conditions through half of Europe as banking consolidates within national boundaries, what exactly is the road forward for Europe? I just don't see it.

Bottom Line: How high does unemployment need to rise, how much output needs to be lost, how much poverty must be endured before European policymakers realize that the framework supporting the Euro politically is an economic failure?

Fed Watch: FOMC Minutes Signal End to QE

One more from Tim Duy:

FOMC Minutes Signal End to QE, by Tim Duy: I usually enjoy the day FOMC minutes are released. It is one of the few releases those of us on the West Coast can read at the same time as everyone else without having to get up in what seems like the middle of the night. So I experienced a mix of surprise and disappointment when I arrived at the office and learned that everyone else had already read the release.

As is now well known, the minutes were inadvertently released early. Robin Harding tells the story:

According to two sources in Congress, the accidental release came from Brian Gross, a special assistant to the Board of Governors who works on government relations...

...“A Fed staffer inadvertently sent an email with the minutes to a group of contacts,” said the Fed. “That group of people was mostly Congressional staffers and trade association members in Washington.”

The distribution list, thought to contain about 100 people, is one that the Fed regularly uses to send out releases.

Sounds like an honest mistake - yes, not all mistakes are of the Zero Hedge "it must be a conspiracy" variety. It happens. In any event, the minutes gave a clear indication that FOMC members were leaning toward pulling the plug on asset purchases by the end of this year (emphasis added):

..Members stressed that any changes to the purchase program should be conditional on continuing assessments both of labor market and inflation developments and of the efficacy and costs of asset purchases. In light of the current review of benefits and costs, one member judged that the pace of purchases should ideally be slowed immediately. A few members felt that the risks and costs of purchases, along with the improved outlook since last fall, would likely make a reduction in the pace of purchases appropriate around midyear, with purchases ending later this year. Several others thought that if the outlook for labor market conditions improved as anticipated, it would probably be appropriate to slow purchases later in the year and to stop them by year-end. Two members indicated that purchases might well continue at the current pace at least through the end of the year. It was also noted that were the outlook to deteriorate, the pace of purchases could be increased....

It seems the center of gravity at the FOMC has shifted toward contentment with the current pace of progress in the labor markets. This seems somewhat odd to me; it is as if they were more interested in putting a floor under the recovery rather than trying to accelerate the pace of activity. The desire to pull the plug on the program as soon as possible also seems odd considering that the majority of policy makers find it to be effective:

In their discussion of this topic, meeting participants generally judged the macroeconomic benefits of the current purchase program to outweigh the likely costs and risks, but they agreed that an ongoing assessment of the benefits and costs was necessary. Pointing to academic and Federal Reserve staff research, most participants saw asset purchases as having a meaningful effect in easing financial conditions and so supporting economic growth. Some expressed the view that these effects had likely been stronger during the Federal Reserve's initial large-scale asset purchases because that program also helped support market functioning during the financial crisis. Other participants, however, saw little evidence that the efficacy of asset purchases had declined over time, and a couple of these suggested that the effectiveness of purchases might even have increased more recently, as the easing of credit constraints allowed more borrowers to take advantage of lower interest rates. One participant emphasized the role of recent asset purchases in keeping inflation from declining further below the Committee's longer-run goal. A few participants felt that MBS purchases provided more support to the economy than purchases of longer-term Treasury securities because they stimulated the housing sector directly; however, a few preferred to focus any purchases in the Treasury market to avoid allocating credit to a specific sector of the economy.

Surely this suggests that some positive fraction of the current activity is attributable to quantitative easing and thus we can expect that some of that activity to fade when the program is brought to an end. Thus even if the economy accelerates further over the course of this year, ending QE will take some wind out of its sails. And taking the wind out of the sails means risking not achieving escape velocity with respect to the zero bound. They might not believe they are actually removing accommodation when QE ends, but they will not be adding to that accommodation. And the first derivative must be important, otherwise there is no point in discussing changing the pace of asset purchases.

I am heartened a bit to see this:

It was noted that, in addition to the standard channels through which monetary policy affects the economy, asset purchases could help signal the Committee's commitment to accommodative monetary policy, thereby making the forward guidance about the federal funds rate more effective.

I have long believed that the Fed failed to appreciate the signalling component of quantitative easing. Indeed, I could be convinced it was the most effective channel of transmission. I am glad to see that policymakers are starting to see that as well.

Bottom Line: The Fed seems content with the current pace of activity. Content enough to believe they can pull the plug on quantitative easing this year. I remain concerned that ending QE will slow forward momentum, thus the Fed is running the risk that they the economy will not achieve sufficient velocity to escape the zero bound. The actual timing is still data dependent, but I am wondering if we should change our framework from "how good does the data need to be end QE" to "how bad does the data need to be to continue QE?"

Fed Watch: Handicapping Labor Data

Tim Duy:

Handicapping Labor Data, by Tim Duy: We know the Fed intends to taper off quantitative easing. We know the timing is dependent on progress in achieving a stronger and sustainable recovery in the labor market. Courtesy of San Francisco President John Williams, we have also know the time they expect to be confident of that recovery - this summer, which could be as early as the June FOMC meeting. Thus June is the earliest we could expect the Fed will begin scaling back the pace of asset purchases, with the expectation that quantitative easing will draw to a close by the end of this year.

June is earlier than I had anticipated. I had expected the Fed would want to be confident that the economy would not experience one of its Spring/Summer swoons. One would think fiscal tightening this year would magnify that concern. Via Bloomberg:

“We could very well in the summertime start seeing the effects of the fiscal tax increase and spending cut slow us down again,” said Joseph Gagnon, a senior fellow at the Peterson Institute for International Economics in Washington and a former Fed economist.

Moreover, given that inflation remains under the 2 percent target and it is likely that significant slack in the labor market will remain deep into 2014, there does not appear to be any need to rush into scaling back quantitative easing. Considering data lags, it would seem prudent for the Fed to wait until the fall or even winter before easing back on purchases.

To be sure, policymakers would probably argue that they could revert to a more aggressive pace of purchases should the data turn south. But even so, that is not likely the desired path. I don't think they would want to increase the pace of purchases just two months after a decrease. I would expect they would want to be sure that they did not have to reverse course.

But that does not seem to be the case. Instead, it is evident that FOMC members anticipate ending asset purchases this year. This I find somewhat puzzling, as they seem to have reached a consensus that they need to be scaling back the asset purchase program on the basis of their own forecast, but that forecast itself anticipates that unemployment - what Vice Chair Janet Yellen described as the “the best single indicator of current labour market conditions”- will remains unacceptably high in the 6.8 to 7.3% range at the end of 2014. Indeed, arguably the Fed has fallen back into the trap of placing an implicit calendar date for the end of quantitative easing, rather than leaving the timing data dependent. It seems they want to end the program by the end of 2013, and are desperately hoping the data cooperates.

Assuming their intention is to end the program this year, to what extent will they color the data in such a way as to ensure it cooperates? For instance, it seems evident that the March employment report should call into question plans to slow the pace of quantitative this summer. Again, from Bloomberg:

“There’s a very strong message to the Fed here, which is that it’s too early to even think about exiting from easy policy,” said Ethan Harris, co-head of global economics research at Bank of America Corp. in New York. “This report suggests that they’re missing on both of their mandates: Inflation is too low and the labor market is too weak.”

This should be correct. The sub-100k nonfarm gain should raise red flags about the strength and sustainability of the labor market improvement. If the Fed holds true to the assertion that policy is data dependent, this should be correct as well:

“It helps that we’ve removed one source of uncertainty which is, how will the Fed react?” said Julia Coronado, chief economist for North America at BNP Paribas in New York. “Instead of asking how bad things need to get for the Fed to do more, it’s how good do they need to be before they stop helping.”

But at the same time, I am watching for signals that policymakers downplay this report or any other similarly weak reports. And lo and behold, today John Williams has an interview with the Wall Street Journal:

The economy could be on a strong enough footing by the second half of the year for the Federal Reserve to begin winding down its bond-buying programs, John Williams, president of the Federal Reserve Bank of San Francisco, said in an interview with The Wall Street Journal.

Mr. Williams said this has long been his view and a disappointing jobs report Friday wouldn’t alter his thinking too much. The Labor Department said Friday that employers added just 88,000 jobs in March, after expanding by more than 200,000 in three of the previous four months.

“We just have to get away from overreacting to one piece of data,” he said.

To be sure, the usual caveat is included:

Of course, his forecast is conditional on how the economy actually performs. “We just have to keep watching all of the economic indicators,” he said.

But how closely is the Fed watching the indicators? Or have they already effectively made a decision on the timing of QE's demise? Be wary that the minutes will have a hawkish tone.

Of course, continue to watch for data that support the case for easing as early as June. With that in mind, February JOLTS report was released this morning. An update of the Yellen charts:

Although the JOLTS data is of second-order importance, notice that the quits rate was revised up for January, a signal that existing employees are more confident of labor market prospects. Put it in the "stronger and sustainable" category.

Bottom Line: I had expected that the data flow would argue for the Fed to postpone tapering off QE purchases until late this year. The Fed seems to have a different view, thinking that the data flow argues for ending QE by the end of this year. My expectation is that the Fed is being overly optimistic and will find that summer is too early to being tapering off QE. That seems to be the message from the bond market as well; yields aren't exactly soaring. But the ease by which SF Fed President John Williams is willing to dismiss the most recent jobs report suggests data may be less important than we have been led to believe.

Fed Watch: Labor Market Hits Air Pocket

Tim Duy:

Labor Market Hits Air Pocket, by Tim Duy: My first thought on the employment report is that, at its core, it was more of the same. For the last two years, nonfarm payrolls growth has shifted between promising and disappointing on the drop of a hat. Underneath the drama, the labor market continues to grind forward at a suboptimal pace - a pace that allows for a slow decline in the unemployment rate, but also suggests more policy action is necessary.

My second thought is that San Fransisco Federal Reserve President John WIlliams was likely far too optimistic in his assessment that the Fed could begin tapering off QE as early as this summer. That is only three months away, and I have trouble seeing how policymakers could be sufficiently confident in the pace and sustainability of the recovery to justify taking their foot off the gas after just three more months of data.

Headline nonfarm payrolls gained by just 88k, with a 95k in the private sector offset by a 7k loss on the public side of the ledger. To be sure, some of the sting was eased by upward revisions to the previous two months, but I think that is cold comfort at this point. Instead, anyway you slice it this report does not signal that momentum is building in the labor market. Notice that the twelve-month average is slowing declining, and stands at 159k/month, down from 202k/month last March:

Arguably, momentum has faded over the past year. Put in context of the Yellen batch of indicators, there is little reason to believe that the Fed should shift policy gears anytime soon [click on charts to enlarge]:

Other indicators were generally consistent with the tenor of the headline establishment number:

Wages, the labor force participation rate, and the employment to population ratio all slipped. On a positive note, aggregate weekly (private sector) hours gained, consistent with what I believe is a more steady underlying improvement in the labor market than suggested by the month-to-month volatility of the headline numbers. There was little evidence of an acceleration in the pace of improvement in measures of underemployment:

Underemployment measures suggest substantial slack in labor markets - plenty of slack to justify ongoing QE at the current pace for most of the year at least, even if the next six reports showed nonfarm payroll growth of 200k+. It makes me wonder what Williams was thinking pushing for the end of QE to begin this summer. Are FOMC members more eager to pull the plug on QE than public statements would suggest? Have they been spending too much time with their European counterparts? Something to mull over.

In any event, bond markets continue to suggest that any Fed officials who want to pull the plug on QE this summer are getting ahead of themselves. The 10-year Treasury yield fell to 1.69% this morning - not exactly a ringing endorsement of the pace of recovery.

Bottom Line: Another in a long line of employment reports that suggests the much hoped-for acceleration in job growth remains out of reach. Nothing to suggest the Federal Reserve needs to slow the pace of asset purchases in the near future. Williams' expectation that tapering off of purchases as early as this summer remains puzzling.

Fed Watch: Initial Jobless Claims Spiked Last Week

Tim Duy:

Initial jobless claims spiked last week, by Tim Duy: Initial jobless claims spiked last week:

As Calculated Risk notes, this could reflect the impact of the sequester. We might also be repeating the pattern of the last two years in which claims decline and then disappoint by plateauing for six months. If that is the case, then we should expect to see less improvement in nonfarm payrolls in the months ahead. If so, San Francisco Federal Reserve President would probably need to push back his expectation that large scale asset purchases are tapered off beginning this summer. Note too that 10-year Treasury rates slipped another three basis points this morning to 1.78 percent. Bond markets do not seem to be signaling that the economy is accelerating at a pace sufficient to justify the Fed taking their foot off the gas this summer.

Fed Watch: Hawkish Dove

Tim Duy:

Hawkish Dove, by Tim Duy: The generally dovish San Francisco Federal Reserve President John Williams sounded relatively hawkish in today's speech. The money quote:

I expect that continued asset purchases will be appropriate well into the second half of this year. In making this assessment, I don’t have a specific unemployment or job-gain threshold in mind for cutting back or ending these purchases. Instead, I’m looking for convincing evidence of sustained, ongoing improvement in the labor market and economy. The latest economic news has been encouraging. But it will take more solid evidence to convince me that it’s time to trim our asset purchases. An important rule in both forecasting and policymaking is not to overreact to what may turn out to be just a blip in the data. But, assuming my economic forecast holds true, I expect we will meet the test for substantial improvement in the outlook for the labor market by this summer. If that happens, we could start tapering our purchases then. If all goes as hoped, we could end the purchase program sometime late this year.

Based on William's current forecast, he expects the Fed will begin tapering off asset purchases this summer, perhaps the June FOMC meeting. He is apparently more optimistic than me, as this puts him at least three months ahead of my expectations - I had not anticipated slowing the pace of purchases until late in the year. Of course, the reality will be data dependent, with the next three employment reports being particularly important. As a recap, three of the last four reports have shown nonfarm payroll growth at or above 200k:

Will Friday's March release make it four for five? Mixed signals from labor market indicators to date make it a tough call. While the downward trend in initial unemployment claims is generally supportive of a solid report, the numbers popped in the second and third weeks of March:

Could the recent increase be the first signs of fiscal contraction working through the economy, or just noise? We get another release tomorrow. The employment number in the ISM manufacturing report was stronger, while the corresponding number from the nonmanufacturing counterpart was weaker. And the ADP release came in below expectations at a 158k gain in private sector jobs, suggesting a weaker report. Altogether, I would tend to expect a number on the low side of the current expectation of 192k gain, but don't see a lot to swing me dramatically away from that number - a number that is more consistent with William's story than not.

That said, I am cautious about extrapolating too much of the recent momentum forward. To be sure, the first quarter is shaping up to be better than the Fed anticipated, with Macroeconomic Advisors tracking forecast showing 3.6% growth. This could be giving Fed officials hope that this year's fiscal contraction is a nonevent. I am not yet convinced that we have dodged that bullet; rumor has it that sales-tax states had a weak March, possibly a delayed reaction to the end of the payroll tax credit. But more important is that the bond market is certainly not acting as if the economy is performing well enough to justify a shift in Fed policy. Notice that today the 10-year yield slumped to 1.81%, a low for the year. It seems as if bond market participants have become less confident of the recovery during the first quarter, even as Williams has become more confident.

Bottom Line: Williams placed a marker for the date that the Fed begins its exit from quantitative easing - summer, assuming that his current forecast holds. I am not so sure the bond market agrees with that assessment.

Fed Watch: Fedspeak on Both Sides of the Atlantic

Tim Duy:

Fedspeak on Both Sides of the Atlantic, by Tim Duy: Federal Reserve Chairman Ben Bernanke and New York Fed President William Dudley both took to the podium yesterday. Dudley spoke directly to the current intersection between the economic outlook and monetary policy, while Bernanke took on the topic of monetary policy in a global context. Despite coming from different directions, both were supportive of current policy.

Dudley first, as it seems journalists are seeing the speech with somewhat different eyes. Jonathon Spicer at Reuters walked away with:

New York Fed President William Dudley, a close ally of Fed Chairman Ben Bernanke, gave a strong and comprehensive speech defending the very easy monetary policies that he said were gaining traction and must not yet be adjusted.

Spicer concludes from the speech, accurately I think, that it is consistent with expectations that the Fed will continue large scale asset purchases at the current pace for the foreseeable future (most of this year, by my expectations). Notable was Dudley's view of the labor market. From the speech:

So how are we doing relative to our objective of a substantial improvement in the labor market outlook?...The unemployment rate is modestly lower and private non-farm payroll growth a bit higher...other important indicators including the employment-to-population ratio and job-finding rates are essentially unchanged...This suggests that the labor market is far from healthy.

Moreover, our policy is based on the outlook for the labor market, not the level of employment or unemployment today. In this context I note that the recent improvement in payroll employment growth, which gets much of the attention, is out-sized relative to the growth rate of economic activity that supports it. We have seen this movie before...As a result, it is premature to conclude that we will soon see a substantial improvement in the labor market outlook.

The implication for policy:

Currently we are falling well short of our employment objective and the restrictive stance of federal fiscal policy is a factor. On inflation, we are also falling short, but by a considerably smaller margin. As a consequence, we need to keep monetary policy very accommodative.

I do not claim that there are no costs or risks associated with our unconventional monetary policy regime. But I see greater cost and risk in moving prematurely to a policy setting that might not prove sufficiently accommodative to ensure a sustainable, strengthening recovery...

Seems to be a clear indication that he is not inclined to alter the pace of asset purchases in the near future. At a minimum, Dudley is looking for evidence that the recent acceleration in job growth is sustainable (in concert with improvement across a broad range of indicators), and I think that will come only after another six months of nfp numbers consistently 200k+.

Other journalists took a different focus. The headline of Victoria McGrane's Wall Street Journal piece is:

Fed Banker Backs Dialing Down Easy Money

Something of a hawkish tone, no? From the article:

A member of the Federal Reserve's inner circle Monday promoted a plan for the central bank to scale back the pace of its bond-buying program as the jobs market improves, though he stressed that a decision on how to proceed is far from imminent.

Similarly, Robin Harding's Financial Times piece is titled:

Dudley gives first hints of slowing QE3

Again, something of a hawkish take. Harding's lead-in:

One of the Federal Reserve’s biggest backers of easy monetary policy said he supported the slowdown of the central bank’s asset purchases once the US economy had enough momentum.

I think these headlines imply that the end of quantitative easing is closer than conventional wisdom holds. I don't think that should be a takeaway. But these articles focus on another takeaway, that the Fed is coalescing around a plan to taper-off asset purchases, not end cold-turkey. From Harding's piece:

The comments by Bill Dudley amount to the first official hint that the pace of a reduction in the asset purchase programme – known as QE3 – is likely to be gradual, and may soothe market worries about the impact of reduced purchases by the Fed.

Back to the speech:

In my view, we should calibrate the total amount of purchases to that needed to deliver a substantial improvement in labor market conditions, by allowing the flow rate of purchases to respond to material changes in the labor market outlook...At some point, I expect that I will see sufficient evidence of economic momentum to cause me to favor gradually dialing back the pace of asset purchases.

Given the current outlook, FOMC members do not anticipate increasing the size of asset purchases. The discussion will thus naturally turn toward the other direction - when and how should we end asset purchases? I think Harding is correct to conclude that a consensus is building within the Fed to taper-off purchases gradually, but only after the sufficient progress is made on the labor market front. But be wary of losing focus on the latter point. Even if the Fed know how they want to end the asset purchase program, that time is still far off given the current forecasts.

Dudley added an interesting footnote to the last sentence I quoted above:

Assuming that the improvement in the outlook is not endogenous to the chosen policy setting to the extent that it would disappear if purchases were slowed.

This suggests that it is not enough that the labor market makes sufficient progress to justify changing policy. The Fed also has to be confident that the progress is self-sustaining in the absence of quantitative easing. It seems to me that this raises the bar for slowing asset purchases.

Separately, Bernanke took on the issue of the so-called currency wars. After a history of exchange rate policy during the Great Depression, Bernanke concludes:

The lessons for the present are clear. Today most advanced industrial economies remain, to varying extents, in the grip of slow recoveries from the Great Recession. With inflation generally contained, central banks in these countries are providing accommodative monetary policies to support growth. Do these policies constitute competitive devaluations? To the contrary, because monetary policy is accommodative in the great majority of advanced industrial economies, one would not expect large and persistent changes in the configuration of exchange rates among these countries. The benefits of monetary accommodation in the advanced economies are not created in any significant way by changes in exchange rates; they come instead from the support for domestic aggregate demand in each country or region. Moreover, because stronger growth in each economy confers beneficial spillovers to trading partners, these policies are not "beggar-thy-neighbor" but rather are positive-sum, "enrich-thy-neighbor" actions.

Obviously, Bernanke rejects the currency war story, at least as far as it applies to developed nations. What about less-developed economies? The story is a bit more complicated. Bernanke notes that developing nations may be relying on an export-based growth strategy and may have underdeveloped financial sectors that leave them vulnerable to capital inflows. Bernanke responds that trade-weighted exchange rates are little changed since 2008, and that stronger developed nation growth helps exporters in developing nations. In addition, with regards to capital flows:

It is true that interest rate differentials associated with differences in national monetary policies can promote cross-border capital flows as investors seek higher returns. But my reading of recent research makes me skeptical that these policy differences are the dominant force behind capital flows to emerging market economies; differences in growth prospects across countries and swings in investor risk sentiment seem to have played a larger role. Moreover, the fact that some emerging market economies have policies that depress the values of their currencies may create an expectation of future appreciation that in and of itself induces speculative inflows.

Notice that at the end he hits the ball back to the currency manipulators? Furthermore, he advocates considering capital controls:

Of course, heavy capital inflows and their volatility pose challenges to emerging market policymakers, whatever their source. Policymakers do have some tools to address these concerns. In recent years, emerging market nations have implemented macroprudential measures aimed at strengthening their financial systems and reducing overheating in specific sectors, such as property markets. Policymakers have also experimented with various forms of capital controls. Such controls raise concerns about effectiveness, cost of implementation, and possible microeconomic distortions. Nevertheless, the International Monetary Fund has suggested that, in carefully circumscribed circumstances, capital controls may be a useful tool.

Again, Bernanke is pushing the conversation back onto his critics. Developing nations have tools to address their concerns. Use them.

Bottom Line: The Fed is not thinking about expanding the pace of asset purchases. Instead, they are thinking about when and how to end those purchases. Policymakers anticipate a gradual end to the program, and they want to communicate their intentions well ahead of the actual timing of the policy change. So expect them to continue to walk a fine line between acknowledging the exit strategy while making clear the exit is not imminent. Finally, Bernanke continues to brush off critics, both home and abroad.

Fed Watch: Do Capital Controls Mean Cyprus Has Already Left the Eurozone?

Tim Duy:

Do Capital Controls Mean Cyprus Has Already Left the Eurozone?, by Tim Duy: Cyprus is in a struggle to save itself, at least the European definition of "save itself," and remain a Eurozone member. But will Cyrpus even use the same euro as the rest of Europe when all is said and done?

After all, banks remain closed in Cyprus, which means a euro in a Cypriot bank has very little value. If you can't spend it, is it really a euro? And even when banks reopen, it is assumed that capital controls will be imposed to prevent euros from leaving the island. So a French euro will be able to purchase goods and services in Germany, but a Cypriot euro will not. It seems then that a Cypriot euro is unambiguously worth less than a French euro.

Thus, there will be two Euros in circulation (if not already). This is the thesis of blogger Guntrum B. Wolff (ht Ed Harrison):

The most important characteristic of a monetary union is the ability to move money without any restrictions from any bank to any other bank in the entire currency area. If this is restricted, the value of a euro in a Cypriot bank becomes significantly inferior to the value of a euro in any other bank in the euro area. Effectively, it means that a Cypriot euro is not a euro anymore. By agreeing to this measure, the ECB has de-facto introduced a new currency in Cyprus.

I think this might be right. If I can spend my dollar in Oregon but not in California, it is really the same dollar? I think not.

Is this how the Eurozone experiment will end? Not with a formal "exit," but with a return to banking dominated by national boundaries and enforced by capital controls? No longer a true common currency, but a dozen currencies sharing the same name, each with a different value?

There will be another banking crisis in Europe (just as a bank will fail in some US state) and depositors are now aware that they are fair game in any crisis response, so capital flight will intensify at an earlier stage in the crisis. As may have been noted, European policymakers find rapid crisis resolution to be something of a challenge, thus accelerated capital flight will necessitate a more rapid imposition of capital controls in the future - and with each round of capital controls, a new sub-euro will be born.

Bottom Line: Europe's response to the Cyprus situation will have long-lasting impacts on the Eurozone experiment itself, none of the good. Indeed, the imposition of capital controls should lead one to wonder if the "solution" to Cyprus is effectively an exit from the Eurozone is everything but name. And don't forget that the crisis also threatens to destabilize the region geopolitcally. I don't think that "disaster" is too strong a word in this case.

Fed Watch: The Recovery is Real

Tim Duy:

The Recovery is Real, by Tim Duy: A lot of ink has been spilled over the past three years fretting about the fragility of the economy. But the reality is largely the opposite. The economy has proved to be very resilient. We have weathered external demand shocks, external financial crises, and even fiscal contraction, and all the while economic activity continued to grind higher. Looking back, it seems that the biggest risk the economy faced was the Fed's start/stop approach to quantitative easing. That problem appears solved with open-ended QE linked to economic guideposts.

At the risk of sounding overly optimistic, I am going to go out on a limb: The recovery is here to stay. Not "stay" as in "permanent." I am not predicting the end of the business cycle. But "stay" until some point after the Federal Reserve begins to raise interest rates, which I don't expect until 2015. This doesn't mean you need to be happy about the pace of growth. But it does mean that a US recession in the next three years should be pretty far down on your list of concerns.

Consider a handful of recent data. Last year's slowdown in manufacturing activity has proved temporary:

Remember, this was the data that ECRI claimed was a smoking gun in their hypothesis that the US economy slipped into recession in the middle of last year. Retail sales continued to gain in February despite the end of the payroll tax break:

Sure, you might complain about weak consumer confidence, but I think it best to pay more attention to what household do. The housing market is unambiguously improving, which by itself should ease any recession concerns:

Note recent reports that the housing market is catching even producers off-guard, constraining supply. Expect them to gear up over the year, setting the stage for a stronger activity in 2014. With the issues of jobs in mind, note that jobless claims continue to grind lower:

Still too high, but moving in the right direction; I expect claims will fall to 300k by then end of this year or early next year.

I anticipate monetary policy will remain on hold for much of this year before the Federal Reserve turns to the issue of tapering off the pace of asset purchases. Even then, rates will not increase until 2015; inflation is simply too low and unemployment too high to justify a policy shift before that time. Interestingly, I am believe the biggest risk to my expectations is that the economy accelerates faster than expected, prompting the Federal Reserve to raise rates in late 2014.

To be sure, I think that fiscal policy will weigh on growth in the first part of 2013. And I think that the European crisis is far from solved (note today's PMI release, not to mention Cyprus). And maybe China will slow further, undermining exports. But as far as the implications for the US economy, I tend to see these events as bumps in the road. They might cause air pockets for equity markets, but are of second or third order importance in the evolution of US activity.

Indeed, it seems to me that betting on a recession when the Fed is not tightening is clearly betting against history. Moreover, historically the Fed has inverted the yield curve prior to a recession:

And yes, I realize this seems to imply that the US economy cannot have a recession because the yield curve is upward sloping - which of course it has to be when short rates are constrained by the lower bound. But that still doesn't resolve the issue that recessions tend to occur only after a period of tighter policy. As long as the Fed is able and willing to ease in the face of negative shocks - and they have seemed to be willing to do so and have found a solution to the zero bound problem in quantitative easing - I would expect that monetary policy would largely offset most problems that comes down the pipeline.

Case is point is the Asian Financial Crisis. I remember predictions of US recession due to the trade shock, but that never occurred. The Fed eased into the crisis, mitigating its impact. The recession only occurred after the Fed revered course and tightened sufficiently to invert the yield curve. Arguably last summer's European shock was the same. The Fed met fire with fire, and recession fears faded.

Could I imagine a shock the Federal Reserve could not offset sufficiently? Something that just came on too strong, too fast? Sure - I suspect a US debt default would be such a shock. But I also put very low probability on such an occurrence. As a general rule, the US economy is a like a large ship. It may run into headwinds that slows its progress and I can argue it needs more coals in its furnace, but it doesn't turn on a dime. Pretty much best just to stay out of its way until the Federal Reserve decides it turn the rudder.

Mostly now I concern myself with the pace of growth (still disappointing) and the eventual policy reversal. Similar to Ryan Avent here, I am not convinced that the Fed will be successful in pulling the economy off the zero bound:

If recovery proceeds as the Fed anticipates, its interest-rate target will remain at near zero until at least 2015. Perhaps more worrying, the FOMC's best guess at the appropriate, long-run value of the fed funds rate is about 4%. That is strikingly low. In each of the past three recessions the Fed has responded by cutting the fed funds rate more than 4 percentage points. A fed funds rate at that level virtually guarantees that the next downturn will result in a relapse into ZLB territory. Unless the Fed suddenly becomes much more comfortable with unconventional policy, the unemployment rate will rise more than it otherwise would and recovery will be weaker as a result. And that's assuming that growth over the next few years actually is robust enough to allow the Fed to get rates back to 4%, which is not at all guaranteed.

My second concern is to what extent this expansion, like the last two, will be dependent on asset valuations. What will this chart look like in two years?

Caution: Pure speculation follows. If this recovery is built on an asset bubble (and I am starting to entertain a possibility that I had previously discounted, that it could be a joint equity/housing bubble), then I suspect we will learn after the Fed tightens policy that we are not off the zero bound. If so, I further suspect the next recovery will require the Fed to deliver a pure-helicopter drop of money.

Bottom Line: The US economy is less fragile than commonly believed; it has endured a series of shocks over the last three years without major incident. I am claiming neither that equity prices won't stumble, nor that we should be happy with the pace of activity. But I do think that a recession is unlikely before the Federal Reserve begins raising interest rates - something not likely to happen for two years. While long-run predctions are dangerous, for the sake of arguement add up to another two years for tighter policy to reverberate through the economy and you are looking at sometime around 2016/2017 when the next recession hits. That's the timeframe I am currently thinking about.

Fed Watch: Fed Holds

Tim Duy:

Fed Holds, by Tim Duy: The two-day FOMC meeting concluded with policy unchanged, as expected. The statement itself was little changed as well. The Fed acknowledged the improved flow of data since the last meeting, noted tighter fiscal policy, and reaffirmed its view that inflation is likely to remain at or below the 2 percent target. The Fed removed a statement referring to easing global strains, presumably a reflection of the challenges in Cyprus at the moment. Asset purchases continue at their current rate.

A more interesting change can be seen in the Fed's statement regarding the future of the asset purchase program. The relative paragraph from the January statement:

The Committee will closely monitor incoming information on economic and financial developments in coming months. If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until such improvement is achieved in a context of price stability. In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases.

was changed to this (emphasis added):

The Committee will closely monitor incoming information on economic and financial developments in coming months. The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives.

The addition of the final clause appears to be a bow to policymakers who are concerned that the pace of easing might need to be curtailed in the nearer future. I assume this issue will once again be highlighted in the minutes. It appears to give the Fed room to alter the pace of purchases as the unemployment rate tends toward the 6.5 percent threshold even if, for example, jobs continue to grow in the 150k-200k range.

That said, I expect asset purchases to continue at this pace for most of this year (if not into next year). Moreover, most policymakers expect this as well. Note the relatively minimal changes to the projections:

While the expected unemployment rate was revised downward, the Fed expects it to remain unacceptably high. Moreover, the top end of the expected inflation rate was revised downward for this year. The combination of high unemployment and low inflation argue for sustained easing. Indeed, the combination could argue that policy needs to be even more accommodative. Note also that the unemployment rate is expected to exceed 6.5% through 2015, putting that year as timing of the first rate hike, And, unsurprisingly, that is the expectation of vast majority of meeting participants.

In short, with unemployment this high and inflation this low, the benefits of continued easing exceed any potential costs. And with this in mind, note that Federal Reserve Chairman Ben Bernanke, in the press conference, stated that he did not see anything unusual in current equity valuations, another indication that he believes that concerns about financial market distortions are overblown.

Bottom Line: Policy is on hold. On hold for a long time. Unless activity accelerates substantially, asset purchases will continue at the current rate through most of this year (if not until well into next year), while short-term interest rates will remain locked down near zero until 2015. Beware of reading too much into the comments of the more hawkish monetary policymakers; they still represent a minority view.

Fed Watch: The War on Common Sense Continues

Tim Duy:

The War on Common Sense Continues, by Time Duy: This weekend, European policymakers opened up a new front in their ongoing war on common sense. The details of the Cyprus bailout included a bail-in of bank depositors, small and large alike. As should have been expected, chaos ensued as Cypriots rushed to ATMs in a desperate attempt to withdraw their savings, the initial stages of what is likely to become a run on the nation's banks. Shocking, I know. Who could have predicted that the populous would react poorly to an assault on depositors?

Everyone. Everyone would have predicted this. Everyone except, apparently, European policymakers.

The situation remains fluid, with even the final hit to depositors still unknown. The Financial Times is reporting that authorities are considering altering the plan to shift the burden on the tax away from smaller depositors. Moreover, at this point it is not clear is the parliment will concede to the measures despite a last minute push by ECB officials to affirm the deal before markets open Monday. And the impact on other nations in the European periphery remains unknown.

At this point, I would imagine the damage is done, regardless of any modification of the plan. Cypriots know that their savings are now on the bargaining table. To be sure, there will be repeated reassurances that this is a one-off event, but how trustworthy are such assurances? Indeed, if Greece is any example, this will not be the last bailout, and thus plenty of time for the European policymakers to insist on another bite at the apple. Perhaps if authorities completely backtrack on the plan could they stave off a bank run, but even on that I am not confident. Trust is easy to lose and hard to earn.

The bigger question is what does this mean for the European financial system as a whole? Will depositors across the Eurozone view Cyprus as a unique situation? Or will Greek citizens come to believe that the next tranche of bailout funds might come with a new conditions to shore up government finances? Will taxes on deposits be an element of any future bailouts? If so, Italian and Spanish depositors might come to view their mattresses as safer than the bank.

Perhaps expectations of a broader bank run are premature. Early reports from Spain claim that no such run is in the making (of course, what else would they say?). But I suspect this is still a game-changing event, sure to make the financial system more unstable by aggravating the negative feedback loop that surrounds financial crises. What else could be the case when you remove a basic safeguard against panic in the banking system?

I can only sample the amazing amount of excellent commentary in response to this new development. Frances Coppola, in a must read piece, explains the economic consequences:

The effect of large and small depositors removing funds on that scale will be a brutal economic downturn as the money supply collapses. In particular, the dominant financial sector will suffer a severe contraction, putting thousands of jobs at risk and paralysing lending to Cypriot households and businesses. And that is IN ADDITION to the estimated 4.5% economic contraction that is already happening due to austerity measures imposed on Cyprus in 2012 to reduce its fiscal deficit, and the further measures required in this bailout.

Yes, exactly how will this help Cyprus emerge from their recesssion? If you guessed "it won't," you are correct. But expect European policymakerst to drone on about how their plan will restore confidence in the economy of Cyprus. Coppola also bemoans the culpability in the ECB:

The FT confirms the ECB's role in forcing through the deal. It says the ECB threatened to stop providing liquidity to Laiki, Cyprus's second-biggest bank, which would have caused an immediate disorderly collapse. I have written previously about the ECB's disgraceful behaviour. This is the worst example yet.

Just two weeks ago I implored the ECB not to do anything stupid. They didn't listen.

Like me, Karl Whelan is challenged to see that this was a good choice:

Even if we get through the next week without panic, my gut feeling is that this decision is a bad one and the Europeans should have chosen from the other two options on the table. Over the longer-term, I doubt if financial stability in the euro area (and the continued existence of the euro) is compatible with a policy framework that doesn’t protect the savings of ordinary depositors.

Nick Rowe points out that savers in Cyprus are suffering disproportionately because they lack the ability to print their own currency:

The difference is that inflation from printing too much money is a tax on currency too. Cyprus cannot tax currency; it can only tax bank deposits.

Joseph Cotterill (another must read piece), identifies the reason to spread the pain to small depositors:

The spin that this is about spanking money-launderers is rubbish. The 9.9 per cent levy will be the cost of doing business for the average CIS corporate shell, as Pawelmorski notes. More to the point, someone clearly balked at increasing the rate above 10 per cent for big-ticket depositors — because why else distribute pain to small holders to make up for it. Someone has an eye on Cyprus somehow maintaining a future as an offshore banking centre.

Too big a hit to large depositors would end any hope that Cyprus could hold onto its biggest industry. The anonymously penned Some of it Was True blog wonders if there are any rules in European finance:

Probably of more lasting importance is the latest bout of rule-changing by the authorities. Debt unwindings are generally well-defined in law. First equity, then sub debt, then deposits and senior bonds together, and all treated equally. Most of these principles have been tweaked over the last few years, but the tweaks are getting steadily more aggressive. The ECB, holders of Athens-law and foreign law Greek debt all got different treatment; the Dutch didn’t restructure SNS Reeal paper, they confiscated it; the Irish banned lawsuits against the ultimate wind-down of Anglo Irish. This is scratching the surface compared with the rule-changes of the past but it’s getting steadily more creative.The referee has gone from being quasi-neutral arbiter, to pulling off his black shirt to reveal a Manchester United one underneath and awarding himself a series of penalties. While there’s clearly no point in market participants playing the shocked blushing virgin in the face of a situation where the consequences of following the legally-logical steps are socially unacceptable, the uncertainty generated creates costs too.

Edward Harrison (yet another must read) takes a fatalistic view of the news:

It was inevitable that we would be in crisis again. The austerity world view of crisis resolution is completely at odds with the capacity of the euro zone’s institutional architecture to handle a crisis. And so, we keep doubling down on the same policy of austerity in exchange for reforms which has created the downward spiral to begin with. I wish I could be optimistic here. But I think it is going to get worse. I hope I’m wrong. And I certainly hope that periphery depositors still have enough faith in the euro to ride this one out. If the Cyprus panic metastasizes, it will get ugly.

Peter Siegel at the FT places the blame on the Germans:

Unbeknown to the Cypriot delegation members as they entered the hulking Justus Lipsius summit building in Brussels on Friday night, their fate was already sealed: their German counterparts wanted about €7bn for the estimated €17bn bailout of their country to come from deposits in the country’s banks.

“They were hand in hand with Finns, who were much more dogmatic,” said one senior eurozone official involved in the 10-hour marathon talks that stretched until 3am on Saturday morning. “Had that not happened, full bail-in,” the official added, using the terminology for wiping out nearly all Cypriot bank accounts.

Felix Salmon see the German influence as bad for Euope and Germany itself:

The Cypriot parliament is probably not going to revolt this weekend, but any politician who votes for this bill is going to have a very, very hard time getting re-elected. This decision is important not only because of the precedent it sets with regard to bank depositors, but also because of the way in which it points up just how powerless all the Mediterranean countries (plus Ireland) have become. More than ever before, it’s Germany’s Europe. That’s bad for Cyprus — and it’s not even particularly good for Germany.

For their part, the Germans deny responsibilty for actions against small depositors:

"It was the position of the German government and the International Monetary Fund that we must get a considerable part of the funds that are necessary for restructuring the banks from the banks owners and creditors - that means the investors," German Finance Minister Wolfgang Schaeuble told public broadcaster ARD in an interview.

"But we would obviously have respected the deposit guarantee for accounts up to 100,000," he said. "But those who did not want a bail-in were the Cypriot government, also the European Commission and the ECB, they decided on this solution and they now must explain this to the Cypriot people."

Bottom Line: In the short-run, the implications for the European periphery might be limited. But, in the long-run, it is hard to see the assault on Cypriot depositors as anything but a step backwards for financial stability in Europe. This crisis remains far from over.

Fed Watch: The Importance of Printing Your Own Currency

Tim Duy:

The Importance of Printing Your Own Currency, by Tim Duy: Quick post - running to the final classes of the term....

Jim Hamilton is defending his recent work calling into question the sustainability of the US debt load. Brad DeLong takes a first shot at Hamilton's post here. I take issue with this paragraph:

Whether a country is able to borrow in its own currency is completely irrelevant for the above calculation. Yes, it means the country likely won't technically default on the debt, and could always create new money to pay off the creditors. But as Reis (2013) and Leeper (2013) have recently explained, printing money does not generate any magical resources with which to resolve a real fiscal shortfall. The central bank could create some more inflation, but anticipated inflation does nothing to alter the above determination of the limits on government debt. Anticipated inflation would just cause the nominal interest rate R and the nominal growth rate g to both increase by the same amount, and therefore would do nothing to change the net growth rate r = R - g which is the key parameter in our equation for sustainability (see for example equation (2) in Econbrowser March 6 or equation (8) in our paper).

This ignores the possibility of financial repression - meaning that the government can force yields on its own debt lower, thereby ensuring that inflation, even anticipated inflation, decreases real interest rates. Back to another post by DeLong:

...and (e) even if we start to tip over into an unsustainable debt-path scenario, we can handle it, because that is why God made financial repression.

Let me spell (e) out a little bit. If investors start to fear that the U.S. debt trajectory is truly unstable, the immediate consequence is a fall in the dollar and an export boom, with somewhat higher domestic inflation. Because the U.S. government regulates the financial system, it can set reserve requirements where it likes--it can thus use its reserve requirements to force banks to hold Treasuries, and if it doesn't like the interest rate at which banks are holding Treasuries, it can up reserve requirements some more.

No, financial repression is not ideal. But it is not a disaster like a collapse of confidence in the debt and the currency....

Arguably, we are currently witnessing a real-time example in Japan's Abenomics policy mix. The Yen has depreciated significantly, consistent with expectations of inflation. And there is even growing evidence that wages are responding as well. From FT Alphaville:

One of the big determinants of whether ‘Abenomics’ manages to pull Japan from its deflationary spiral is through wage growth. Inflation can’t really kick off or arguably even begin without rising wages. One can argue about how important wage growth is, or where it fits in causality-wise — and we’ll come to that later. But it is — or will be — an important signal as to whether this three-pronged approach of the new-ish Japanese government is working.

And actually, it might be catching on. The FT’s Ben McLannahan wrote in early February that the decision by convenience store chain Lawson Inc to raise wages of two-thirds of its staff by 3 per cent could be quite significant..

According to Hamilton, if we have higher anticipated inflation, we should see higher nominal interest rates on government debt, thereby debt sustainability is deteriorating. But alas:

Time and time again, Japan sticks out like a sore thumb that those preaching the unsustainability of government debt want to sweep under the rug with the "Japan is a special case" story (a country fixed effect). But it seems more likely that Japan's economy is behaving exactly as you might expect given that it issues debt in its own currency. In other words, Japan is just a normal case pushed to the extreme.

Fed Watch: A Solid Employment Report

Tim Duy:

A Solid Employment Report, by Tim Duy: The February employment report was solid - not a blockbuster report, but definitely solid. And three of the last four employment reports have been solid as well, with payroll growth about 200k per month. This will undoubtedly raise some chatter that the Federal Reserve's large scale asset purchase program will be tapered back soon than later. I suspect such talk would be premature. While the labor market currently has some momentum, we have seen such momentum fade in the past. Moreover, we are still deep in the labor market hole, so to speak. The Fed has time to see this play out, and, even if labor markets continue to improve at this pace, will most likely take that time, delaying any reduction of the pace of asset purchases until late this year.

Headline job gains totaled 236k for February:

December was revised up, but January was revised down. The three-month average is 191k, while the twelve-month average is a more modest 164k, declining slowly over the year. Note that during the last two years we have seen momentum on either side of the start of the year fade by spring or summer. The Fed knows this as well, and thus will tend to question the resiliency of these numbers. This is especially the case as the fiscal contraction is just beginning to work its way through the economy. Note that government employment continues to be an overall drag on the numbers:

The sequester may aggravate this trend in the near term. Calculated Risk is optimistic that layoffs at the state and local levels are mostly over; my conversations with municipalities in Oregon tend to be somewhat more pessimistic. Even though revenues are stabilizing in some cases, costs continue to rise, squeezing budgets. Anecdotal and regional evidence, so use with caution.

The unemployment rate edged down to 7.7%; at this rate of decline, we will be into next year before we see 6.5%. And that's not a trigger for Fed action on interest rates - as long as inflation remains contained, 6.5% early next year suggests a rate hike in late 2014 or early 2015, consistent with current expectations. Why the delay after hitting 6.5%? Again, I think it reflects the depth of the hole. Progress on some indicators remains woefully slow:

See also Robin Harding's cheat-sheet on Federal Reserve Vice Chair Janet Yellen's last speech.

Hawkish monetary policymakers might try to gain some traction on wage gains:

Here again, the depth of the hole matters. Wage growth has considerable room to climb before it becomes a worrisome inflation indicator. And note that the all employees figure is not showing the same gains:

I would expect that the intensity of public comments by Federal Reserve policymakers increases as the year progresses. The hawks will almost certainly get increasingly nervous, and like to be heard. This will probably continue to show up in the minutes. But the doves, and currently dovish-leaning center, recognize the importance of clear communications, and thus will feel compelled to respond even more vociferously than in the past. In my opinion, this is not a great overall strategy, but unless Federal Reserve Chairman Ben Bernanke wants to exert more direct control over communications to get everyone on the same talking points, it is what we have.

Bottom Line: A solid report, but we need a longer stream of solid reports before Fed chatter turns decisively toward tighter policy.

Fed Watch: If Not For That Pesky Sequester

Tim Duy:

If Not For That Pesky Sequester, by Tim Duy: This morning's Wall Street Journal headline on the sequester included this quote:

"If they could get this fixed, the economy is poised to take off," Bank of America Corp. Chief Executive Brian Moynihan said in an interview.

I believe this is largely correct, albeit "take off" is perhaps a bit strong. The US economy looks to have shaken off some of last year's doldrums, particularly in manufacturing and the housing recovery is set to accelerate further this year. While clearly some external headwinds remain, notably the ongoing economic disaster that is Europe, I tend to think these will have only a second-order impact on the US economy. The immediate concern is obviously the impact of the sequester and earlier tax hikes, especially considering the evolving views of the impact of fiscal policy. That said, while I find the timing of these policy changes unfortunate and believe they place an unnecessary speedbump in the recovery process, their impact should fade as the year progresses.

Also bolstering the outlook is that the Federal Reserve is most likely to continue the large scale asset purchase program throughout much of this year. That was the message of Federal Reserve Chairman Ben Bernanke this week as he minimized concerns that the risks of additional easing outweighed the benefits. I expect a similar message tonight. The initial impact of the sequestration will likely place enough downward pressure on the economy which, when coupled with still low inflation (low enough that additional easing would not be unreasonable), should be enough to keep the hawks at bay.

Earlier this week we learned that home sales continue to rise:

Yes, to be sure sales remain at very low levels. But it is the direction that matters now, and the direction is positive. In and of itself, the positive direction of housing is consistent with ongoing economic expansion (those ECRI guys are not likely to catch a break). And while there has been some commentary calling into question the quality of the January numbers, I would counter with signals from the latest ISM manufacturing report indicate that at least the underlying trend of improvement held in February:

"Business seems to be on an uptick. The normal seasonal downturn for us has been much shorter and not as severe as in the past four years." (Furniture & Related Products)

"Demand indicators are robust. Supply is constrained. Pricing is escalating." (Wood Products)

Speaking of manufacturing, that too is looking more robust. Core-manufacturing orders have staged a remarkable rebound in recent months:

Likewise, the ISM numbers were generally positive. Headline, and new orders, and production:

Moreover, even the external indicators were looking better. Most important in my mind is the improvement in new import orders, a signal of solid underlying domestic demand:

Finally, while the employment index slipped slightly, it still holds in expansion territory:

Were it not for the sequester, and the already evident impact on defense spending, manufacturing would be experiencing even stronger performance.

Changing tax laws created havoc in the personal income data, first boosting the December figure as taxpayers drew income and capital gains into the waning days of 2012 to avoid higher taxes and then dropping the January number on tax hikes, including the end of the payroll tax credit:

Still, courtesy of a drop in the saving rate as households adjusted to the tax hike, consumer spending continues to grind upward:

I anticipate the spending numbers to remain on the soft side in the near term as the impact of tighter fiscal policy continues to work its way through household budgets.

None of this is meant to imply that economics conditions are rosy, just that the economy continues to move in the right direction and was likely poised for stronger growth in 2013 if not for tighter fiscal policy. The anticipated impacts of tighter policy are expected to further widen the output gap:

And note that, still contrary to the expectations of those who believed Fed policy would send prices surging ever higher, inflation remains well under control, as would be consistent with an economy running below potential:

The challenge is not too much inflation; the challenge is too little inflation. Despite the generally positive direction of the economy, there remains room for additional monetary and fiscal stimulus. I doubt we get more of the former, and we are already seeing the opposite of the latter. Not exactly the optimal policy mix.

And I would admit to uncertainty about the sustainability the recovery over the longer term; I am still not confident we can exit smoothly from the zero bound. That, however, might not be a concern until 2016 or 2017 (assuming the Fed starts increasing rates in 2015). As far as the hear and now is concerned, I anticipate that 2013 is setting the stage for a stronger 2014.

Bottom Line: Near term trends are positive, and would be more so if not for the sequester. That said, I don't expect the near term to be sufficiently positive to derail the path of monetary policy. Fed hawks will still defer to Bernanke for the foreseeable future.

Fed Watch: Know Your Fed Chairs

Tim Duy:

Know Your Fed Chairs, by Tim Duy: Tennessee Senator Bob Corker (R) went on the offensive during the Q&A period of Federal Reserve Chairman Ben Bernanke's Senate testimony this week. A portion of the transcript, via Business Insider:

Sen. Corker: I don't think there's any question that you would be the biggest dove, if you will, since World War II. I think that's something you're rather proud of...Do you all ever talk about the longer term degrading effect of these policies as we try to live for today?

Chairman Bernanke: I think one concern we have is the effect of long term unemployment and the people who haven't had jobs for years. That means they're never going to acquire skills for years and be a productive part of our workforce

You called me a dove. Well maybe in some respects I am but on the other hand my inflation record is the best of any Federal Reserve chairman in the post-war period, or at least one of the best — about 2 percent average inflation...

It is not clear that Corker knows much about the history of inflation since WWII, so I thought a little chart would be handy:

[Click on image for larger chart]

As is clear to anyone who looks at the data, Bernanke does in fact have one of the better records on inflation in the post-WWII period. Is it the best? On the basis of average headline CPI during time as chair, Bernanke looks to come in second behind William McChesney Martin, Jr. Note, however, that it would be reasonable to point out that inflation accelerated during Martin's watch, setting the stage for the high-inflation 1970's. Taking the path of inflation into account, I would tend to argue the Bernanke's record is superior to Martin's.

If we change the focus to headline PCE inflation (quarterly), then Bernanke comes slightly ahead of Martin on averages alone:

[Click on image for larger chart]

Of course, using only inflation averages might not be the best measure on Fed performance. Volcker, for example, had high average inflation rates during his tenure, but inflation declined dramatically. And inflation declined further under Greenspan. Overall, I consider the Chairmen who presided over the 1965 to 1980 period as having the worst records on inflation, while all the Chairman since 1980 have solid inflation records. McCabe is a mixed bag. Clearly inflation was volatile during his tenure, but the Fed was working in the context of the transition out of WWII.

Finally, this whole discussion presupposes that low inflation is always desirable and ignores the fact that the Fed has a dual mandate. Monetary policy is about more than low inflation - it is about stable inflation in the context of the overall economic and financial landscape. Bernanke's battle hasn't even been to contain inflation; his focus has been preventing deflation. But putting these issues aside for the moment, it seems pretty clear that if the only metric that Corker cares about is low inflation, Bernanke has clearly delivered.

Fed Watch: ECB Should Pledge to Not Do Anything Stupid

Tim Duy:

ECB Should Pledge to Not Do Anything Stupid, by Tim Duy: Market participants were rattled today by the election news out of Italy, as it looks like the economically-challenged nation is now politically adrift. But what exactly might worry investors? I pulled this quote from Bloomberg:

“We don’t want to see more chaos out of Europe,” Bruce McCain, chief investment strategist at the private-banking unit of KeyCorp in Cleveland, said in a phone interview. His firm oversees more than $20 billion. “Any question about whether or not Italy would be committed to austerity measures after the elections gets investors concerned.”

Why should we be concerned that Italy backslides on its commitment to austerity? After all, evidence of the economic damage wrought by such policies continues to mount. If anything, a reversal of recent austerity should be welcome.

I suspect, however, that it is not the austerity that worries market participants. It is the fear that European Central Bank head Mario Draghi will threaten to pull his pledge to do whatever is takes to save the Euro in the face of Italian intransigence. The fear that European policymakers are about to partake in another grand game of chicken that once again will bring the sustainability of the single currency back into question. In short, I think that market participants fear tight monetary policy much more than loose fiscal policy.

I am very much hoping that the ECB will keep calm and not do anything that encourages market participants to once again doubt the central bank's commitment to the Euro. Otherwise, this spring and summer will look much like last year's. And the year before that. And the year before that.