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Friday, April 29, 2016

Fed Watch: Warning: Hawkishness Ahead

Tim Duy:

Warning: Hawkishness Ahead, by Tim Duy: The Fed has proven very dovish since their December rate hike. Tumultuous financial markets gave the Fed doves the upper hand, leading the Fed to pause in it’s “normalization” campaign and cut in half the expected pace of rate hikes this year.
But be prepared for the tenor of the song to change. I would not be surprised to see doves shedding their feathers to reveal the hawk underneath.
Boston Federal Reserve President Eric Rosengren exemplifies this shift. Twice in recent weeks, Rosengren, typically considered a notable dove, warned that financial markets were underestimating the odds of rates hikes this year. The Fed made clear in the dots they expect at least two hikes; financial markets anticipate only one.
What is going on here? First, as I said earlier this week, the Fed is not happy that markets wrote of a June rate hike. I am wary that the data arrives to support a rate hike, but don’t think the Fed is ready to give up on that hike just yet.
One thing to remember is that the Fed still prefers to hike early and slowly if possible. They are more aware of the asymmetric risks they face than in December, and hence recognize that they should error on the side of looser policy in an uncertain environment. Hence skip March and April. But once the risk subsides, they will return to old habits. And old habits in this case mean a return to quarterly rate hikes.
My assumption is that they want the option to both hike quarterly and hike three times should the economic environment shift. That means they are thinking June-September-December is a possibility still (the dots are just a forecast, they are not committed to just two rate hikes). So they really need to keep the June option open, otherwise they run a greater risk of bunching up the next few hikes. Which means they want to raise the odds of a June hike to something closer to 50-50. The recent FOMC statement, in which declined to mention the risks, was an early signal of the direction they want to move.
And note that not mentioning the risks at all is arguably a de facto assessment of balanced risks in the world of central banking. My suspicion is the Fed feared that actually saying “balanced” would be a stronger indicator than they wanted to send. But they still said a lot by saying nothing at all.
Now, why should the Fed have a change of heart? Didn’t Federal Reserve Chair Janet Yellen just go all dovish? How can they change their story so fast?
They can change their story within the scope of six weeks. Just like they did from the December to January meetings. And they have the one good reason to change the story: The dramatically change in financial market conditions.
The tightening in financial markets during the winter was the proximate cause of a more cautious Fed. The data didn’t help, to be sure, but more on that later. The combination of a surging dollar, collapsing oil, and a stock market headed only south signaled that the Fed’s policy stance has turned too hawkish, too fast. The Fed relented and heeded the market’s warnings.
But things are different now. US stock market rebounded. The dollar is languishing. And oil is holding its gains, despite disappointment with the lack of an output agreement.
This improvement will not go unnoticed on Constitution Ave. Even among the doves.
That brings us to the data story. To be sure, incoming data this quarter has been lackluster. But that might soon be changing. Gavyn Davies, writing for the FT, is spinning a more optimistic tale:
The Fulcrum nowcast suggest that US activity growth fell continuously from the beginning of 2015 to February 2016, by which time it was around 1.0 per cent. However, in a potentially important change, the nowcast moved sharply higher in March and April, and it is now fluctuating around 2.0-2.5 per cent. This change was rapidly reflected in the prices of US risk assets, which recovered slightly before, and then along with, the daily US nowcasts.
Financial markets do not wait for quarterly GDP to be published, and they often ignore it altogether when it does finally appear. We prefer to ignore the noise from quarterly GDP, while focusing attention on the underlying activity factor that is driving the business cycle.
He includes this picture:

Fulcrum

Be forewarned: The Fed is primed by financial markets to change their story. If the data shifts as well, they will be looking hard at June. I don’t think the data will line up in time, but the possibility should be on your radar. There is a lot of data between the April and June meetings – two releases of many critical indicators. Too much data to be complacent.
Bottom Line: Remember, the Fed can turn hawkish as quickly as it turned dovish.

Wednesday, April 06, 2016

Fed Watch: Dovish Minutes

Tim Duy:

Dovish Minutes, by Tim Duy: The FOMC minutes indicates the Fed is just a dovish as believed. This was somewhat surprising given the tendency of minutes to have a more balanced perspective which would appear to be hawkish relative to current market expectations. But not this time. This time the message was fairly clear: They can't ignore the asymmetry of policy risks any longer. Gradual went to glacial, with April now off the table, leaving June as the next possible data for a rate hike. Expect Fedspeak to sound somewhat hawkish given they will want to keep June on the table - but I am less than certain they will have the data in hand to justify another hike until the second half of the year.

Meeting participants were generally confident in the outlook:

With respect to the outlook for economic activity and the labor market, participants shared the assessment that, with gradual adjustments in the stance of monetary policy, real GDP would continue to increase at a moderate rate over the medium term and labor market indicators would continue to strengthen. Participants observed that strong job gains in recent months had reduced concerns about a possible slowing of progress in the labor market.

But outside of the consumer, all is not rosy:

Many participants, however, anticipated that relative strength in household spending would be partially offset by weakness in net exports associated with lackluster foreign growth and the appreciation of the dollar since mid-2014. In addition, business fixed investment seemed likely to remain sluggish. 

And global concerns loomed large:

Furthermore, participants generally saw global economic and financial developments as continuing to pose risks to the outlook for economic activity and the labor market in the United States. In particular, several participants expressed the view that the underlying factors abroad that led to a sharp, though temporary, deterioration in global financial conditions earlier this year had not been fully resolved and thus posed ongoing downside risks.

Caveats abound, however:

Several participants also noted the possibility that economic activity or labor market conditions could turn out to be stronger than anticipated. For example, strong expansion of household demand could result in rapid employment growth and overly tight resource utilization, particularly if productivity gains remained sluggish.

Is the economy at full employment? Maybe:

Some participants judged that current labor market conditions were at or near those consistent with maximum sustainable employment, noting that the unemployment rate was at or below their estimates of its longer-run normal level and citing anecdotal reports of labor shortages or increased wage pressures.

Maybe not:

In contrast, some other participants judged that the economy had not yet reached maximum employment. They noted several indicators other than the unemployment rate that pointed to remaining underutilization of labor resources; these indicators included the still-high rate of involuntary part-time employment and the low level of the employment-to-population ratio for prime-age workers. The surprisingly limited extent to which aggregate data indicated upward pressure on wage growth also suggested some remaining slack in labor markets.

The climb in the unemployment rate since the March meeting supports the latter over the former. There was mixed views regarding the inflation outlook:

Participants commented on the recent increase in inflation. Some participants saw the increase as consistent with a firming trend in inflation. Some others, however, expressed the view that the increase was unlikely to be sustained, in part because it appeared to reflect, to an appreciable degree, increases in prices that had been relatively volatile in the past. 

But concerns about too low inflation clear dominated:

Several participants indicated that the persistence of global disinflationary pressures or the possibility that inflation expectations were moving lower continued to pose downside risks to the inflation outlook. A few others expressed the view that there were also risks that could lead to inflation running higher than anticipated; for example, overly tight resource utilization could push inflation above the Committee's 2 percent goal, particularly if productivity gains remained sluggish. 

And there was concern that low inflation was bleeding into expectations:

Some participants concluded that longer-run inflation expectations remained reasonably stable, but some others expressed concern that longer-run inflation expectations may have already moved lower, or that they might do so if inflation was to persist for much longer at a rate below the Committee's objective.

Notably, no one was concerned that inflation expectations were trending up. The consensus was stable or deteriorating. One-sided risks.

The primary reason the Fed anticipates stable growth this year is because they marked down interest rate forecasts:

...most participants, while recognizing the likely positive effects of recent policy actions abroad, saw foreign economic growth as likely to run at a somewhat slower pace than previously expected, a development that probably would further restrain growth in U.S. exports and tend to damp overall aggregate demand. Several participants also cited wider credit spreads as a factor that was likely to restrain growth in demand. Accordingly, many participants expressed the view that a somewhat lower path for the federal funds rate than they had projected in December now seemed most likely to be appropriate for achieving the Committee's dual mandate. Many participants also noted that a somewhat lower projected interest rate path was one reason for the relatively small revisions in their medium-term projections for economic activity, unemployment, and inflation.

Altogether, the risks are simply too one-sided to ignore:

Several participants also argued for proceeding cautiously in reducing policy accommodation because they saw the risks to the U.S. economy stemming from developments abroad as tilted to the downside or because they were concerned that longer-term inflation expectations might be slipping lower, skewing the risks to the outlook for inflation to the downside. Many participants noted that, with the target range for the federal funds rate only slightly above zero, the FOMC continued to have little room to ease monetary policy through conventional means if economic activity or inflation turned out to be materially weaker than anticipated, but could raise rates quickly if the economy appeared to be overheating or if inflation was to increase significantly more rapidly than anticipated. In their view, this asymmetry made it prudent to wait for additional information regarding the underlying strength of economic activity and prospects for inflation before taking another step to reduce policy accommodation.

The winter turmoil made the asymmetric risks all-too-real. They need to allow the economy to run hot to justify sufficient rate hikes to drive a wedge between policy and the zero bound. They need to make a choice: Risk inflation, or risk returning to the zero bound? They are coming around to seeing the former as a less costly risk as the latter.

This begs the question of how quick they will be to react to inflation that overshoots 2%. I don't think they will react too quickly - they will need to tolerate some overshooting to avoid cutting the recovery off at the knees. It will still be about the balance of risks until interest rates are much higher.

Finally, the pretty much decided they wouldn't have enough data to hike rates in April:

A number of participants judged that the headwinds restraining growth and holding down the neutral rate of interest were likely to subside only slowly. In light of this expectation and their assessment of the risks to the economic outlook, several expressed the view that a cautious approach to raising rates would be prudent or noted their concern that raising the target range as soon as April would signal a sense of urgency they did not think appropriate. In contrast, some other participants indicated that an increase in the target range at the Committee's next meeting might well be warranted if the incoming economic data remained consistent with their expectations for moderate growth in output, further strengthening of the labor market, and inflation rising to 2 percent over the medium term.

Not clear that they will in June either. First quarter growth numbers are looking weak, so they may want a clear picture of the second quarter before acting. That speaks to July or September.

Bottom Line: The Fed is on hold until they are sufficiently confident they can make a liftoff stick. The bar is higher now given the focus on asymmetric risks. They won't want to take June off the table just yet, so expect them to say that it is still too early to rule it out. April, however, is set to be a yawner.

Tuesday, April 05, 2016

Fed Watch: Fed Has Little Reason to Hike Rates

Tim Duy:

Fed Has Little Reason to Hike Rates, by Tim Duy: Despite some occasionally hawkish rhetoric from a handful of disaffected Federal Reserve bank presidents, expect the Fed to remain on hold until inflationary threats clearly emerge. In practice, that means the Fed is not likely to raise rates until the unemployment rate resumes its downward trajectory. Soft though generally positive data coupled with market turbulence over the winter scared most policymakers straight with regards to their overly-optimistic plans to normalize policy. The risks to the outlook are simply too one-sided too believe this is anything like the tightening cycles of the past.
Generally positive incoming data continues to defy the predictions of the recessionistas. ISM data, both manufacturing:

EMPREPf041616

and nonmanufacturing:

EMPREPg041616

posted improved headline numbers with general solid internals. The worst of the manufacturing downturn may be behind us. The JOLTS numbers:

EMPREPh041616

have remained fairly stable in recent months, suggesting no significant changes in dynamics in labor flows in and out of firms. Not surprisingly, nonfarm payroll growth remains on its steady path:

EMPREPa041616

The unemployment rate ticked up in March as the labor force grew:

EMPREPb041616

The Fed would like unemployment to settle somewhat below their estimates of the natural rate to promote further reduction of underemployment. So a stagnant unemployment rate at these levels argues for stable policy.
One red flag I see is that temporary employment has stalled, suggesting some loss of momentum:

EMPREPe041616

Nothing to panic about, just something I am watching. Indeed, in many ways the current dynamic is not dissimilar to the mid-90s, when the economy sputtered in the wake of tighter monetary policy. Then, like now, the Fed need to back down in response. The economy subsequently gathered steam.
Moreover, declining estimates of first quarter growth also give the Fed reason to remain on hold. Soft consumption, weaker auto sales, still anemic manufacturing, and a rising trade deficit have all conspired to bring the latest Atlanta Fed estimate of first quarter growth to an anemic 0.4%. To be sure, this might just be the first quarter curse of recent years. As such, the Fed may be confident it does not represent the pace of underlying activity. And they expect that the worst impact of the rising dollar and falling oil prices on manufacturing will soon be behind us. But they don't know these things - and it will take another three months of data at least until they know these things. That pushes that date of another rate hike into the until June at the earliest, but don't be surprised if they want to see a more complete picture of the second quarter before acting.
A steady unemployment rate at or above the Fed's estimate of the natural rate also argues for a substantial policy pause. I am hard pressed to see a reason for the Fed to resume hiking rates until unemployment clearly resumes declining. This holds true even if a growing labor force drives a flattening unemployment rate. The Fed will see that as evidence that excess slack remains in the economy, hence inflationary pressures are less than feared when the unemployment rate was heading steadily lower. 
Note also tamer inflation in February after a spike the previous month:

EMPREPk041616

This supports Federal Reserve Chair Janet Yellen's caution over reading too much into any one inflation reading. 
Financial indicators have firmed in recent months:

EMPREPj041616

EMPREPi041616

That said, the improvement for most indicators largely just offsets the damage done during the winter. And credit conditions for less than perfect debt remain less than perfect. 
In short, while the data is not indicating a recession it upon us, and supportive of the case for improvement later this year, it also gives little reason to justify a rate hike anytime soon.
Furthermore, the Fed appears to have stopped - at least for the moment - pursuing rate hikes for the sake of hiking rates. The financial market turmoil made them realize that yes, the policy risks are asymmetric, and they need to take the asymmetries seriously. Chicago Federal Reserve President Charles Evans concisely summaries the challenges of being hit with a negative shock while near the zero bound:
Faced with such uncertainty, policymakers could make two potential policy mistakes. The first mistake is that the FOMC could raise rates too quickly, only to be hit by one or more of the downside surprises. In order to put the economy back on track, we would have to cut interest rates back to zero and possibly even resort to unconventional policy tools, such as more quantitative easing. I think unconventional policy tools have been effective, but they clearly are second-best alternatives to traditional policy and something we would all like to avoid. I should note, too, that with the economy facing a potentially lower growth rate and lower equilibrium interest rates, the likelihood of some shock forcing us back to the effective lower bound may be uncomfortably high. The difficulties experienced in Japan and Europe come to mind.
And compares it to the challenges of being hit with a positive shock:
The second (alternative) potential policy mistake the Committee could make is that sometime during the gradual normalization process the U.S. economy experiences upside surprises in growth and inflation. Well, policymakers have the experience and the appropriate tools to deal with such an outcome; we probably could keep inflation in check with only moderate increases in interest rates relative to current forecasts. Given how gradual the rate increases are in the baseline SEP, policy could be made a good deal more restrictive, for example, by simply increasing rates 25 basis points at every meeting — just as we did during the measured pace adjustments of 2004–06. A question for the audience: Who thinks those were fast? So, to me, concerns about the risks of rapid increases in rates in this scenario seem overblown.
Until now, the driving argument for raising rates was that they needed to do so to avoid a faster pace of rate hikes. But as Evans points out, why the rush? Would it really be so bad to raise rates at a "moderate" pace rather than a "gradual" or what has become now a "glacial" place? After all, they have better tools to reduce inflation than to raise it. Clearly, many Fed officials did not appreciate the asymmetry of risks until this past winter. 
Separately, Boston Federal Reserve President Eric Rosengren argued that financial market participants are getting it wrong:
So, while problems could still arise, I would expect that the very slow removal of accommodation reflected in futures market pricing could prove too pessimistic. While it has been appropriate to pause while waiting for information that clarified the response of the U.S. economy to foreign turmoil, it increasingly appears that the U.S. has weathered foreign shocks quite well. As a consequence, if the incoming data continue to show a moderate recovery – as I expect they will – I believe it will likely be appropriate to resume the path of gradual tightening sooner than is implied by financial-market futures.
He seems to have learned little from Federal Reserve Vice-Chair Stanley Fisher's experience in January:
Well, we watch what the market thinks, but we can't be led by what the market thinks. We've got to make our own analysis. We make our own analysis and our analysis says that the market is underestimating where we are going to be. You know, you can't rule out that there is some probability they are right because there's uncertainty. But we think that they are too low .
They would probably be better off just stating their expectations as the baseline rather than appearing to challenge the markets so directly. But they can't seem to help themselves; they seem to view it as their job to warn that rate hikes are coming, that markets are getting it wrong, an unnecessarily hawkish message for a central bank trying to raise inflation while facing an asymmetric balance of risks. Not sure what the point is anyway - if Rosengren is at two rate hikes this year while the market is at one, is that difference really all that significant? Is he just priming us for Fed minutes that will also be more hawkish than current market expectations?
And the implied hawkish message has proven consistently wrong, for that matter. The history of this recovery is that while the Fed always sounds hawkish relative to market expectations, the Fed has consistently moved in the direction of market expectations.
Bottom Line: The Fed is on hold for at least a few months until the data provides a more definite reason to justify another hike. With any luck, if the Fed continues to hold steady now, maybe they will get the chance to chase the long-end of the curve higher later - which is exactly what they need to be able to "normalize" policy. Expect officials to remind us that they expect a faster pace of a rate hikes than markets anticipate. But I think the bar for further hikes has risen since December. An appreciation of the asymmetric policy risks will prod them to seek more definitive signs inflationary pressures are growing to justify the next rate hike.

Friday, April 01, 2016

Fed Watch: Yellen Pivots Toward Saving Her Legacy

Tim Duy:

Yellen Pivots Toward Saving Her Legacy: As 2016 began to evolve, it quickly became apparent that Federal Reserve Chairman Janet Yellen faced the very real possibility that her legacy would amount to being just another central banker who failed miserably in their efforts to raise interest rates back into positive territory. The Federal Reserve was set to follow in the footsteps of the Bank of Japan and the Riksbank, seemingly oblivious to their errors. In September of last year, a confident Yellen declared the Fed would be different. From the transcript of her press conference:

ANN SAPHIR. Ann Saphir with Reuters. Just to piggyback on the global considerations—as you say, the U.S. economy has been growing. Are you worried that, given the global interconnectedness, the low inflation globally, all of the other concerns that you just spoke about, that you may never escape from this zero lower bound situation?

CHAIR YELLEN. So I would be very—I would be very surprised if that’s the case. That is not the way I see the outlook or the way the Committee sees the outlook. Can I completely rule it out? I can’t completely rule it out. But, really, that’s an extreme downside risk that in no way is near the center of my outlook.

Shuddering financial markets in the wake of the Fed’s first rate hike since 2006 certainty tested Yellen’s confidence that failure to exit the zero bound was nothing more than an “extreme” tail risk. Indeed, it looked all too possible, even as policymakers such as Federal Reserve Vice-Chair Stanley Fischer and San Francisco Federal Reserve President John Williams counseled dismissing financial market turbulence as something the economy could withstand as it has in the past (ignoring though the role the Fed play in such resilience).

Luckily for Yellen, she heeded the warnings of Federal Reserve Governor Lael Brainard, who has since last fall has cautioned that the Fed faced more danger than commonly believed within the confines of the Eccles Building. With her speech this week, Yellen clearly embraced Brainard’s warnings. She is choosing the risk of overheating the economy – and sending inflation above target – over the risk of failing at the one and perhaps only chance to leave the zero bound behind.

While the exit from the zero bound remains uncertain, Yellen’s new path is at least more likely to succeed than blindly ignoring financial market signals by following through with expected rate hikes. And that’s important for more than just Yellen’s legacy. Her legacy is intertwined with the health of the US economy.

There is much to be had in Yellen’s speech this week. Highlights include an awareness that the neutral rate of interest is not rising as quickly as expected, the global economy is a risk that cannot be ignored, the recent uptick in inflation might be less than meets the eye, and a recognition that falling long-rates represent an expectation of easier monetary policy, and the Fed needs to meet that expectation to ensure that financial market remain sufficiently accommodative.

But two points in particular caught me eye. The first was a deeper appreciation of the asymmetric risks facing policymakers. Yellen notes that although the Fed retains a litany of potential unconventional tools:

“…if the expansion was to falter or if inflation was to remain stubbornly low, the FOMC would be able to provide only a modest degree of additional stimulus by cutting the federal funds rate back to near zero.”

If you want to successful pull off the zero bound, you better make sure that you conditions give you some distance from that bound before you need to start cutting again. That distance is effectively almost none, and will likely remain limited for substantial time. Better to move glacially rather than gradually.

But more important was the role of deteriorating inflation expectations in her analysis. Recall that in her September speech, Yellen sought to emphasize her faith in the Phillips curve as a reason to begin rates hikes sooner than later. She noted the importance of anchored inflation expectations in her assessment, saying:

“…the presence of well-anchored inflation expectations greatly enhances a central bank's ability to pursue both of its objectives--namely, price stability and full employment...

… Although the evidence, on balance, suggests that inflation expectations are well anchored at present, policymakers would be unwise to take this situation for granted. Anchored inflation expectations were not won easily or quickly: Experience suggests that it takes many years of carefully conducted monetary policy to alter what households and firms perceive to be inflation's "normal" behavior, and, furthermore, that a persistent failure to keep inflation under control--by letting it drift either too high or too low for too long--could cause expectations to once again become unmoored.”

The stability of inflation expectations is now, however, less certain:

"The inflation outlook has also become somewhat more uncertain since the turn of the year, in part for reasons related to risks to the outlook for economic growth...

… Lately, however, there have been signs that inflation expectations may have drifted down. Market-based measures of longer-run inflation compensation have fallen markedly over the past year and half, although they have recently moved up modestly from their all-time lows. Similarly, the measure of longer-run inflation expectations reported in the University of Michigan Survey of Consumers has drifted down somewhat over the past few years and now stands at the lower end of the narrow range in which it has fluctuated since the late 1990s…

…Taken together, these results suggest that my baseline assumption of stable expectations is still justified. Nevertheless, the decline in some indicators has heightened the risk that this judgment could be wrong."

To be sure, Yellen recognizes that inflation may rebound more quickly than expected, but the overall thrust of her argument is that although labor markets have continues to improve and rising wages suggests the economy is reaching full employment, the risks to stable inflation expectations are now too on the downside. And if expectations become unanchored, the Fed will fail to meet it’s 2 percent inflation target anytime soon. Moreover, the Fed would be faced with trying to re-establish expectations in the absence of their conventional tools. That might be a tall order.

Bottom Line: Rising risks to the outlook placed Yellen’s legacy in danger. If the first rate hike wasn’t a mistake, certainly follow up hikes would be. And there is no room to run; if you want to “normalize” policy, Yellen needs to ensure that rates rise well above zero before the next recession hits. The incoming data suggests that means the economy needs to run hotter for longer if the Fed wants to leave the zero bound behind. Yellen is getting that message. But perhaps more than anything, the risk of deteriorating inflation expectations – the basis for the Fed’s credibility on its inflation target – signaled to Yellen that rates hike need to be put on hold. Continue to watch those survey-based measures; they could be key for the timing of the next rate hike.

Monday, March 28, 2016

Fed Watch: Oil, Inflation Expectations, and Credibility

Tim Duy:

Oil, Inflation Expectations, and Credibility, by Tim Duy: In an IMF blog post, Maurice Obstfeld, Gian Maria Milesi-Ferretti, and Rabah Arezki offer a solution to the "puzzle" of the weak positive macroeconomic response to low oil prices. Specifically, they posit a sharp rise in real interest rates due to falling inflation expectations is the culprit:
Even though oil is a less important production input than it was three decades ago, that reasoning should work in reverse when oil prices fall, leading to lower production costs, more hiring, and reduced inflation. But this channel causes a problem when central banks cannot lower interest rates. Because the policy interest rate cannot fall further, the decline in inflation (actual and expected) owing to lower production costs raises the real rate of interest, compressing demand and very possibly stifling any increase in output and employment. Indeed, those aggregates may both actually fall. Something like this may be going on at the present time in some economies. Chart 3 is suggestive of a depressing effect of low expected oil prices on expected inflation: it shows the strong recent direct relationship between U.S. oil futures prices and a market-based measure of long-term inflation expectations.
Initially, I was a bit enamored with this idea. As I thought on it more, however, I came to see it as a cautionary tale of chart crime. But digging underneath the surface a bit uncovered some interesting questions about monetary policy and credibility. Specifically, how worried should we be that inflation expectations will soon become unanchored?
Obstfeld et al. rely on a version of this widely publicized chart to support their contention:

OBSa032816

The first and most obvious problem is that this chart really proves nothing. For example, I could just as easily presented this chart:

OBSb032816

Now I can tell a story that the rising dollar (note the inverted scale) is driving down inflation expectations and thus driving up the real interest rate. Oil, on the other hand, is having exactly the effect we might expect - just look at sales of light trucks and SUVs, not to mention vehicle miles traveled:

OBSE032816

Hence, there is no paradox of oil. Lower oil prices are triggering the expected positive impacts. It's about the dollar weighing on inflation expectations that is creating the offsetting impact. Obstfeld et al. apparently do not try to distinguish their story from this one.
(Warning: wonkishness ahead.)
This problem, however, just scratches the surface. Look at either of the first two charts above and two red flags should leap off the screen. The first is the different scales, often used to overemphasize the strength of a correlation. The second is the short time span, often used to disguise the lack of any real long term relationship (I hope I remember these two points the next time I am inclined to post such a chart).
Consider a time span that encompassed the entirety of the 5-year, 5-year forward inflation expectations:

OBSc032816

The correlation is less obvious to say the least (note too that changing the scale also suggests less correlation). Why does the correlation appear and disappear? Could any supposed correlation across selected time periods be spurious?
That gets to another issue. When you show me this chart

OBSa032816

and claim there is a meaningful relationship, I see two nonstationary variables you are claiming to be cointegrated. The trouble with that is that while oil is a nonstationary process - it is not mean reverting, nor is there reason to believe it should be a mean reverting series. Inflation expectations, however, should be a mean reverting series.
Or more specifically, it should be mean reverting if the central bank is credibly committed to their inflation target. If the central bank is credible, then we anticipate that policymakers will respond with policy that offsets inflation shocks to maintain their inflation target. Hence, inflation expectations should revert to that target and we would expect the series to be stationary.
If inflation expectations are a nonstationary series, then shocks build in the series and inflation expectations would drift persistently away from the central bank's inflation target. Inflation expectations would be unanchored. In other words, if inflation expectations are nonstationary, then we have a problem. More on that in a bit.
It appears that oil prices are nonstationary:
Dickey-Fuller Unit Root Test, Series DCOILBRENTEU
Regression Run From 1987:05:22 to 2016:03:21
Observations 7523
With intercept
With 1 lags chosen from 9 by AIC
Sig Level Crit Value
1%(**) -3.43430
5%(*) -2.86246
10% -2.56729
T-Statistic -1.47895
while, luckily, inflation expectations are stationary:
Dickey-Fuller Unit Root Test, Series T5YIFR
Regression Run From 2003:01:14 to 2016:03:24
Observations 3444
With intercept
With 7 lags chosen from 7 by AIC
Sig Level Crit Value
1%(**) -3.43524
5%(*) -2.86290
10% -2.56752
T-Statistic -4.63374**
Which leads me to conclude that the recent correlation between oil prices and 5-year, 5-year forward inflation expectations is not indicative of an underlying relationship and hence policymakers should be wary of accepting the Obstfeld at al. hypothesis. Of course, this should not be a surprise as the theoretical underpinnings for such a relationship are weak. A level shock to the price of oil should not change inflation expectations five years from now.
(The same is true for the dollar as well. And while both the dollar index and oil prices are nonstationary, they don't appear cointegrated, suggesting that instances of high correlation are more spurious than anything else.)
Digging a little deeper, note the University of Michigan Survey of Consumers has a longer series of 5-year inflation expectations which shows less variability than 5-year, 5-year forward inflation expectations:

OBSd032816

The UMich inflation series also appears to be stationary:
Dickey-Fuller Unit Root Test, Series UMICH5YEAREX
Regression Run From 1990:08 to 2016:03
Observations 309
With intercept
With 3 lags chosen from 4 by AIC
Sig Level Crit Value
1%(**) -3.45322
5%(*) -2.87105
10% -2.57180
T-Statistic -2.92456*
Consequently, I think we have evidence to support the claim that the Federal Reserve is a credible policymaker in the most important arena, that of maintaining stable inflation expectations.
I suspect the high variability of the 5-year, 5-year forward measure is attributable to financial market structural issues (depth of the market for TIPS, for example) rather than rapidly shifting inflation expectations. Hence, we would expect that should those structural issues lessen in importance, the measure will revert to its mean (assuming the Fed remains a credible policymaker). Nor should we read too much about inflation expectations in this measure. Federal Reserve Chair Janet Yellen has reached the same conclusion, which is why she is wary of claims that shifts in the 5-year, 5-year forward measure reflect inflation expectations - and why she refers to these measures as inflation "compensation" not "expectations." From the March 2016 press conference:
In addition, the Phillips curve theory suggests that inflation expectations are also an important driver of actual wage- and price-setting decisions and inflation behavior, and I believe there’s also solid empirical evidence for that. And it’s one of the reasons that I highlighted in my statement, and we continue to highlight in the FOMC statement, that we are tracking indicators of the inflation expectations that matter to wage and price setting.
Now, unfortunately, we don’t have perfect measures of these things. We have survey measures. We know that household measures, even when households are asked about longer- term inflation—at longer-term inflation, they tend to move in response to salient changes in prices that they see every day. In particular, when gas prices go down, which is very noticeable to most households, you tend to see a view—you tend to see responses about long-term inflation marked down. So that’s kind of an overresponse to something that’s transitory. So it’s difficult to get a clear read from those survey measures.
Inflation compensation as measured in financial markets also embodies a variety of risk premia and liquidity premia. And so, it’s also—we monitor those closely and discuss them in the statement in paragraph one, but, again, there’s not a straight read on what’s happening to the expectations that influence wage and price setting. But this model continues to at least influence my own thinking, and it certainly is a factor that I and at least some of my colleagues are incorporating in these projections.
Note too that she also questions the importance of the recent slight downward drift in survey-based measures. I would place more weight on those measures (I think others on the FOMC, such as Governor Lael Brainard, are similarly inclined). In any event, I think the Fed is moving in a credible way to either measure by moving more cautiously than anticipated in December. Hence, we should expect inflation expectation measures to remain stationary.
Of course, if expectations devolve into nonstationary processes (it is a long-period property of the data, hence we cannot definitely declare the answer in any finite time period), we should be very worried that policymakers have lost control of inflationary expectations. And at the present time, they would be unanchored to the downside, not the upside as often feared.
Bottom Line: Be wary of claims that oil prices are influencing inflation expectations; the recent correlation is likely spurious. Inflation expectations look to be following a mean reverting process, indicating that the Federal Reserve's has credibly committed to their inflation target. We should expect policymakers will maintain such credibility if they continue to react to inflation shocks with offsetting policy.

Friday, March 25, 2016

Fed Watch: On Credibility

Tim Duy:

On Credibility: Narayana Kocherlakota and David Andolfatto have been discussing the issue of Fed credibility. This is my effort to weigh in on the topic.

I break the issue of credibility of monetary policy into two parts. The first I think of as “soft” credibility, or the perception that policy needs to follow a proscribed course due to some perceived promise. The second I think of as “hard” credibility, or the expectation that policymakers will pursue policies that maximize its odds of achieving its goals over the long run, price stability with maximum sustainable employment, regardless of perceived promises. We should encourage policymakers to pursue “hard” credibility and avoid communications or actions that lead to policy directed at achieving “soft” credibility.

Let’s step back to last summer. It was widely anticipated that the Fed would hike interest rates at the September 2015 FOMC meeting. Market turmoil in August, however, made the Fed think twice. It also encouraged no shortage of commentary urging the Fed to pursue what I consider “soft” credibility. Via Jon Hilsenrath at the Wall Street Journal:

After months of forewarning by Federal Reserve officials that they are preparing to raise short-term interest rates, some international officials attending the Fed’s annual retreat here this week have a message: Get on with it already.

Fed policy makers are wavering on whether to move rates up in September. Volatile stock prices, falling commodities, a strong dollar and signs of a deepening economic slowdown in China have created doubts at the U.S. central bank about the outlook for global growth.

International officials have been saying for months they will be prepared when the Fed moves rates higher, a message that is being echoed as central bankers, academics, journalists and others converge now in Jackson Hole for the Federal Reserve Bank of Kansas City’s annual symposium.

“If you delay something that you were planning to do, then you leave the impression that your compass is different than what you led markets to believe,” Jacob Frenkel, chairman of J.P. Morgan Chase International and former head of the Bank of Israel, said in an interview Thursday. Market drama is increased by delay, he added.

What I wrote:

Hey, it's been a hard couple of weeks. Things changed. That certain rate hike became a lot less certain. Maybe that changes back by September 17. Maybe not. All of us Fed watchers probably won't come to agreement until September 16. Getting emotional and moralizing about change isn't going to stop it…Stocks dropped sharply. It is a clear sign, on top of other signs, that financial conditions are tightening ahead of the Fed, and arguably too much ahead of the Fed. If the Fed heeds that warning you have to remember that's their job. Smoothly functioning financial markets. Lender of last resort. All that stuff. Maybe things work out just fine if they don't heed that warning. I am not interested in taking that risk. Not enough upside for me.

Ultimately, the Fed took a pass on the September meeting. That I consider favoring “hard” credibility over “soft” credibility. Rather than meet a perceived promise to hike, Yellen & Co. stood down in response to changing economic and financial conditions.

Unfortunately, I fear the Fed took a wrong turn in the October meeting, setting up an expectation that a December hike was a certainty. Fed officials took much grief over their decision to skip September. Market participants subsequently priced out rate hikes for 2015. But the Fed had promised a hike, and they were damn well going to deliver. And they drove the message home in October with this line:

In determining whether it will be appropriate to raise the target range at its next meeting, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation.

According to some excellent reporting by Jonathan Spicer, Ann Saphir and Howard Schneider at Reuters:

When the U.S. Federal Reserve tweaked its policy statement last week and put a December rate rise squarely back in play, it took a calculated gamble that reaching for an old and controversial policy tool would get financial markets' attention.

That gamble was to specifically reference the next policy meeting as a date of a possible lift-off, and it had the desired effect: investors quickly rolled back bets that rates would stay near zero until next year.

But interviews with current and former Fed officials, and with those close to policymakers, show the decision to use what is called calendar guidance in central bank parlance and what some described as a "hammer" did not come easy. Some officials felt that even mentioning a date in the context of a potential policy change would be taken not as a contingent expectation but as a promise that would be painful to break...

...Yet Fed Chair Janet Yellen and her deputies got so frustrated that investors virtually ignored their message that a rate rise before the year end was probable that they decided last month it was a risk worth taking, the interviews show.

As a result, futures markets are now giving slightly better-than-even odds that rates will rise from near zero next month, compared with mid-October when the odds were less than 30 percent. In contrast, economists polled by Reuters have been leaning towards a December rate hike even before the Fed's last meeting.

So the Fed wanted to raise rates just to teach markets a lesson? Maybe the message was ignored because it was the wrong thing to do and market participants expected the Fed to pursue "hard" over "soft" credibility? More telling was this line:

On Oct. 16, Dudley got an earful from Wall Street bankers and economists on a New York Fed advisory panel criticizing the Fed for its muddled message, according to three people who attended the meeting.

The interviews with Fed officials and those close to the central bank suggest that it was around this time that the plan to hint at December in the next policy statement started taking shape.

That sounds as if Dudley was falling prey to the fetish of “soft” credibility. We need to pick a message and stick with it. That's what the guys on Wall Street say. They say we are going to loose our credibility. We need to get ahead of that.

And perhaps this is why the Fed’s decision in December always felt forced. Me, in December:

Given that the Fed likely only gets one chance to lift-off from the zero bound on a sustained basis, it is reasonable to think they would wait until they were absolutely sure inflation was coming. Even more so given the poor performance of their inflation forecasts. But the Fed thinks there is now more danger in waiting than moving. And so into the darkness we go.

I don’t think the Fed would ever admit December was a mistake, but at a minimum the decision to hold pat in March and dramatically mark down their rate expectations for further rate hikes in 2016 tells me the Fed thought they were certainly on the verge of making a major policy error and pulled back quickly. In my framework, the Fed shifted back to seeking to preserve “hard” credibility.

That said, note the tendency to try to goad the Fed right back into seeking “soft” credibility. From the March press conference:

Steve Liesman, CNBC. Madam Chair, as you know, inflation has gone up the last two months. We had another strong jobs report, the tracking forecasts for GDP have returned to 2 percent, and yet the Fed stands pat while it’s in a process of what it said it launched in December was a “process of normalization.” So I have two questions about this: Does the Fed have a credibility problem, in the sense that it says it will do some—one thing under certain conditions but doesn’t end up doing it? And then, frankly, if the current conditions are not sufficient for the Fed to raise rates, well, what would those conditions ever look like?

I hope Fed policymakers remain resistant to such taunts.

The Fed is especially vulnerable to the problem of “soft” credibility when they lay down specific markers. The infamous dot-plot is one such marker. Policymakers have difficulty explaining the dot-plot is not a promise of future action; it is nothing more than a guideline. But the instant they establish that guideline, the mere fact that it induces some market participants to believe a promise has been made creates the belief that not meeting that promise will cost the Fed credibility. “Soft” credibility. The Fed needs to distinguish between this and “hard” credibility.

Another such marker is the 2 percent inflation target. Although Fed officials have repeatedly warned that they assume there will be symmetric errors around the target, we don’t know that until we actually have above-target inflation. The rule was created in an era of below-target inflation, so it is easy to say the Fed lacks credibility on the inflation target. I have said so. But I have come to perceive this as another instance of “soft” credibility. I worry that if the Fed becomes concerned about their supposed credibility from inflation at 50bp below target, they will overreact to inflation that is 50bp above target. What we really want is the Fed to maintain inflation within 50bp of target without triggering a recession. That would be the “hard” credibility of meeting the Fed’s mandate over the long run.

Bottom Line: The Fed should be playing the long game. In my opinion, that means pursuing the “hard” credibility of choosing the path most likely to meet their mandate over the long run. This may require sacrificing some “soft” credibility along the way. That means not hiking rates – or hiking rates – despite a perceived promise to do the opposite. The Fed should not fret over those costs. They are minor and quickly forgotten. And worse yet, being a slave to the fetish of “soft” credibility only raises the odds of a policy error. They will do less harm by breaking their “promise” than by keeping that promise via a poor decision.

Monday, March 07, 2016

Fed Watch: State of Play

Tim Duy:

State of Play: We are heading into the March FOMC meeting next week. The recessionistas are on the sidelines, waiting for data to turn in their favor. I suspect they have a long wait. In the meantime, FOMC participants will hone their arguments as they prepare for what is likely to be a contentious meeting. At stake is not a decision of rates; they will hold steady. At stake is a decision on the balance of risks. Do they want to send a dovish, neutral, or hawkish signal for the April and June meetings? I expect them to default to the neutral/dovish side. I don’t think there is sufficient weight on the hawkish side of the FOMC to drive an aggressive rate signal at this juncture. 
Labor markets shook off the January “slowdown” with nonfarm payrolls rising an above-consensus 242k. The twelve-month trend is slowing, but ever-so-gradually:

NFP030416

The unemployment rate held constant near the Fed’s estimate of the natural rate:

UN030416

This is actually good news, as it reflects a faster pace of labor force growth:

LF030416

The labor force participation rate is now 0.5 percentage points above its September low. Assuming this trend will continue, the US economy can sustain fairly strong job growth while unemployment rates drift lower very gradual, in line with the Fed’s expectations. It would also give the Fed a bit more breathing room with regards to raising rates. And it would help boost potential GDP growth as it helps offset weakness in productivity growth. 
Incoming data, including the inflation uptick, will solidify the positions of those FOMC participants opposed to an extended pause. A fairly clear split emerged in recent weeks. David Harrison at the Wall Street Journal:
The report likely will accentuate a growing split among Fed officials. On one side are regional Fed bank presidents such as San Francisco’s John Williams, Richmond’s Jeffrey Lacker and Kansas City’s Esther George who continue to press for rate increases this year. In the other camp are policy makers who prefer to take a more cautious approach and wait until the effects of the global financial turmoil and the fall in oil prices have played themselves out. Count the Dallas Fed’s Robert Steven Kaplan, Boston’s Eric Rosengren and Philadelphia’s Patrick Harker among them.
And to be sure, the Fed will have its external critics as well. Drew Matus, chief US economist at UBS, told Bloomberg Surveillance that the Fed will “take the cowards way out” by not raising interest rates in the first half of this year. 
I don’t find this a compelling interpretation. If you are a “coward” by definition you are not “brave.” And one should remember there is a fine line between “brave” and “foolhardy.” I suspect that Federal Reserve Chair Janet Yellen will wisely follow Falstaff’s advice and recognize that discretion is the better part of valor. True, one can argue that some financial indicators have stabilized since the January FOMC meeting:

FIN030416

To be sure stocks and oil are off their lows, while the dollar is off its highs. Even market-based inflation expectations are heading back up. Panic has subsided. On the surface, that may add weight to the argument that the Fed should “just follow the data.” But corporate bond spreads, although narrowing, still indicate fairly tight credit conditions:

BAML030416

This is on top of a very cold IPO market. So while incoming data points toward solid growth in Q1, the Fed still needs to stand down while the lagged impacts of this winter’s financial tightening pass through to the real economy. Discretion. Yes, this does put the Fed at risk of falling behind the curve. A dovish Fed now on the back of an improving economy suggests that the yield curve will steepen in the near term. If necessary, the Fed can chase that with a higher fed funds rate in the back half of the year. 
Also suggesting caution on the part of the Fed is a renewed awareness of the sensitivity of global financial flows to the Fed’s policy stance. Federal Reserve Governor Lael Brainard:
Financial tightening associated with cross-border spillovers may be limiting the extent to which U.S. policy diverges from major economies. As policy adjusts to the evolution of the data, the combination of heightened spillovers from weaker foreign economies, along with a lower neutral rate, could result in a lower policy path in the United States relative to what many had predicted…
And New York Federal Reserve President William Dudley:
Our monetary policy actions, however, often have global consequences that, in turn, influence the U.S. economy and financial markets. At the same time, external factors can impact the monetary policy transmission mechanism in the U.S. and influence the effectiveness of our monetary policy in achieving our objectives. We cannot appropriately calibrate policy without keeping these spillover and feedback effects in mind.
The degree to which the Federal Reserve can tighten short-term rates is limited by the extent of global feedback effects. In short, the Fed has limited capacity to defy the pattern of zero (or negative) rates abroad. 
Overall, I don’t believe a Federal Reserve pause is inconsistent with the data. All it takes is the realization that financial market outcomes are in fact data. Ultimately just prices and quantities of bonds and stocks and other assets – data just like any other data that measure prices and quantities of labor or goods. Data that provides insight into the direction of the economy. Or, as Dudley explained:
The federal funds rate is only one element of the broader set of financial conditions affecting the U.S. growth and inflation outlook. Tighter financial conditions abroad do spill back into the U.S. economy, and policymakers must take this into account in their assessment of appropriate monetary policy. Of course, this does not mean that we will let market volatility dictate our policy stance. There is no such a thing as a “Fed put.” What we care about is the country’s growth and inflation prospects, and we take financial market developments into consideration only to the extent that they affect the economic outlook.
Still, I am sympathetic to complaints of communication confusion. Harrison concludes his article:
Fed officials, chief among them Ms. Yellen, have repeated for months that their interest-rate decisions will depend on the economic data. It could be harder to make that case if it appears the central bank is acting contrary to increasingly strong data.
The Summary of Economic Projections is a woefully incomplete description of the Fed’s reaction function. It attempts to distill the Fed’s reaction function into a simple Taylor rule that abstracts away from financial sector. In other words, it does not capture the role of the financial sector in the Fed’s reaction function. And I think it fails to do so because of complex endogeneities involved (the Fed is in integral part of the financial sector) and, as a consequence, a lack of consensus about the implications for the Fed’s reaction function. 
Indeed, Cleveland Federal Reserve President Loretta Mester, Kansas City Federal Reserve President Esther George, San Francisco Federal Reserve President John Williams, and Board of Governors Vice Chair Stanley Fischer all appear to discount the importance of the Fed’s financial reaction function (see here and here for example). Brainard and Dudley clearly see a more complex relationship. 
Where does Yellen stand? My sense is that six month ago Yellen’s position would align close to Fischer. But I think she would now find Brainard’s position more persuasive, especially with Dudley’s support. That suggests that the Yellen will work to pull the Fed toward a neutral/dovish statement.
Bottom Line: Fed will hold steady next week. Key FOMC participants are shifting in a dovish direction. The financial market volatility, which induced clear tightening in financial conditions, bolstered the Brainard’s arguments. Despite solid incoming data, the Fed will find it necessary to tread cautiously in the months ahead.

Wednesday, March 02, 2016

Fed Watch: Dudley the Dove

Tim Duy:

Dudley the Dove, by Tim Duy: The beleaguered manufacturing sector saw an uptick in February, at least according to the ISM report: 

This information builds on the stronger consumer spending and inflation numbers we saw last week. Not to mention solid auto sales for February. The news is sufficiently good that Torsten Sløk of Deutsche Bank argues (via Business Insider) that the Fed should raise rates:
Today we got more confirmation that the negative effects of dollar appreciation on the US economy are starting to fade, see the first chart below. Specifically, we have in recent months seen a solid turnaround in the employment data for the manufacturing sector and in the manufacturing ISM. Combined with the acceleration we are seeing in consumer spending and inflation I would argue that if the Fed is truly data dependent then they should be raising rates at their next meeting...
I don't think the Fed will raise in March, nor do I think they should raise in March. I think the financial markets signaled fairly clear that further tightening now would be a mistake. The Fed would be wise to heed that call.
And, if New York Federal Reserve President William Dudley is any indication, they will heed that call. Indeed, he goes even further than me. Whereas yesterday I raised the possibility of a "hawkish pause" at the March meeting where the Fed revives the balance of risks with an upside bias, he opens the door to the opposite.
First, note that Dudley appears unmoved by the uptick in core inflation:
Turning to the outlook for inflation, headline inflation on a year-over-year basis has begun to rise as the sharp falls in energy prices in late 2014 and early 2015 are removed from the calculations. However, inflation still remains well below the Federal Reserve’s 2 percent objective. As the FOMC has noted in its statements, this continued low inflation is partly due to recent further declines in energy prices and ongoing impacts of a stronger dollar on non-energy import prices. Although energy prices will eventually stop falling and the dollar will stop appreciating, these factors appear to have had a more persistent depressing influence on inflation than previously anticipated.
This is actually quite dovish. If core inflation is a good signal for the direction of overall inflation, then the latter will leap sharply when the "transitory" impacts fades. This suggests to me that the forecast of a gradual return to target is almost certainly wrong. When (and if) inflation turns, it will turn quickly. Dudley is discounting that possibility.  
I suspect he is discounting inflation concerns because he is focussed on inflation expectations:
This continued period of low headline inflation is a concern, in part, because it could lead to significantly lower inflation expectations. If this drop in inflation expectations were to occur, it would, in turn, tend to depress future inflation. Evidence on the inflation expectations front suggests some cause for concern...
...With respect to the market-based measures, there are some reasons to discount the decline...Still, given the extent to which inflation compensation has fallen since mid-2014, I believe that it is prudent to consider the possibility that longer-term inflation expectations of market participants may have declined somewhat.
What I find more concerning is the decline in some household survey measures of longer-term inflation expectations....To date, these declines have not been sufficiently large for me to conclude that inflation expectations have become unanchored. However, these developments merit close scrutiny, as past experience shows that it is difficult to push inflation back up to the central bank’s objective if inflation expectations fall meaningfully below that objective. Japan’s experience is cautionary in this regard.
Asymmetric risk surrounds inflation expectations. Difficult to raise up, but easy to push down. Hence, it is important to guard against falling expectations. This is especially the case as he sees risks to the outlook as now tilted to the downside:
Now, putting these inputs and my judgment together, I see the uncertainties around my forecast to be greater than the typical levels of the past. This assessment reflects the divergent economic signals I highlighted earlier, and is consistent with the turbulence we have seen in global financial markets. At this moment, I judge that the balance of risks to my growth and inflation outlooks may be starting to tilt slightly to the downside. The recent tightening of financial market conditions could have a greater negative impact on the U.S. economy should this tightening prove persistent and the continuing decline in energy and commodity prices may signal greater and more persistent disinflationary pressures in the global economy than I currently anticipate. I am closely monitoring global economic and financial market developments to assess their implications for my outlook and the balance of risks.
Hence Dudley is likely to stand as a bulwark against FOMC participants who think the Fed should hike in March and those who would like a more optimistic balance of risks. Moreover, this is a pretty clear signal of his expectations for March:
The federal funds rate is only one element of the broader set of financial conditions affecting the U.S. growth and inflation outlook. Tighter financial conditions abroad do spill back into the U.S. economy, and policymakers must take this into account in their assessment of appropriate monetary policy. Of course, this does not mean that we will let market volatility dictate our policy stance. There is no such a thing as a “Fed put.” What we care about is the country’s growth and inflation prospects, and we take financial market developments into consideration only to the extent that they affect the economic outlook.
In other words, when we don't hike in March, it's not because of a Fed "put" on the stock market. It is more accurately a Fed "put" on the economy. Financial market weakness signals tighter financial conditions, and to prevent those conditions from spilling into the rest of the economy, the Fed needs to respond with a more accommodative policy stance. The Fed then is not saving Wall Street. It is saving Main Street from Wall Street.
The upshot is that if the economy remains on firm ground (the "no recession" camp), inflation is heating up, and the Fed goes solidly dovish, we should see the yield curve steepen in the near term, at least until the Fed turns hawkish again. If we are really lucky, the secular stagnation story is wrong and the entire yield curve lifts up as the Fed chases higher rates. Then we could really imagine the "short treasuries" bet to be a no-brainer.  If secular stagnation remains the order of the day, then the long end quits rising soon after the Fed sends out hawksh signals, setting the stage for a renewed flattening. 
An interesting possibility is that in the back half of 2016, inflation pops above trend and one of the Fed's fears is realized. That fear is that they fall behind the curve and need to raise rates quickly to counteract rising inflation. They seem to think that they have no choice at that point but to murder the expansion. I disagree with that conclusion. I think they tend to forget about the long and variable lags of policy at the end of the cycle and consequently rush raising rates needlessly. In any event, how they respond to (potentially) higher inflation later this year will shape the 2017 and 2018 economic environment. So, obviously it is something to keep an eye on.
Bottom Line: The Fed will take a pass on the March meeting. Whether the statement is dovish, neutral, hawkish is the key question. Dudley opens up the possibility of a not just a neutral statement, but a dovish one. My sense is that this is shaping up to be a very contentious meeting as participants struggle with the question of exactly which data are they dependent upon.

Monday, February 29, 2016

Fed Watch: Fed Doves Still Have The Upper Hand For March

Tim Duy:

Fed Doves Still Have The Upper Hand For March, by Tim Duy: The Personal Income and Outlays report for January delivered a surprise for the Fed doves. It does not, however, derail their push for a March pause. I believe policymakers will still take a pass on the March meeting as they assess the impact of recent market unpleasantness. But if markets calm further ahead of the March meeting and data remains solid, beware that they may choose to re-instate the balance of risks into the FOMC statement. Furthermore, sufficiently supportive data may induce them to shift the risks to the upside to signal the hope of a June hike.
Real personal consumption expenditures rose 0.4% in January and stands a respectable 2.9% higher than last year. The death of the consumer has been greatly exaggerated (although the death of the department store has not). Fairly firm consumer spending should be expected given the broad-based support from the labor market. Equally if not more important is that the report rewarded the defenders of the Phillips curve as core-PCE inflation spiked higher during the month:

PRICES22916

Core inflation was up 1.7 percent from a year ago, actually bringing the FOMC's target into view. Note that as of the December meeting, the Fed did not expect to see 1.6 percent until the end of the year. It is easy to see unemployment close to their year-end target of 4.7 percent by the next meeting. It is already at 4.9 percent. In other words, it is easy to see economic projections updated to reveal a faster than expected return to both mandates.

It seems then like the Fed should consider picking up the pace of rate hikes rather than pausing. Indeed, there is some commentary that the current level of interest rates is inconsistent with the expected path of growth and inflation. This is sometimes described as Treasury market participants "underestimating" the Fed. Fed Governor Lael Brainard, however, continues to reconcile this apparent disconnect between the bond market and the economy with her focus on the international side of the equation. In yet another compelling speech, Brainard argues that the decline in the neutral rate of interest is a common shock that prevents policy diversion:

To the extent that we are observing limited divergence in inflation outcomes and less divergence in realized policy paths than many anticipated, this could be attributable to common shocks or trends that cause economic conditions to be synchronized across economies. The sharp repeated declines in the price of oil have been a major common factor depressing headline inflation...Even so, most observers expect this source of convergence in inflationary outcomes to eventually fade and thereafter not affect monetary policy paths over the medium term...In contrast, a more persistent source of convergence may be found in an apparent decline in the neutral rate of interest.

The persistent of this shock has significant implications for policy:

The very low levels of the shorter run neutral rate reflect in part headwinds from the crisis that are likely to dissipate over time. However, if many of the common forces holding down neutral rates prove persistent, then neutral rates may remain low through the medium term, implying a shallower path for policy trajectories.

It seems reasonable to equate the "persistent" common shock weighing on the natural rate of interest with the concept of secular stagnation. She reiterates estimates of the degree of tightening already impacting the US economy:

...although the U.S. real economy has traditionally been seen as more insulated from foreign trade shocks than many smaller economies, the combination of the highly global role of the dollar and U.S. financial markets and the proximity to the zero lower bound may be amplifying spillovers from foreign financial conditions. By one rough estimate, accounting for the net effect of exchange rate appreciation and changes in equity valuations and long term yields, over the past year and a half, the United States has experienced a tightening of financial conditions that is the equivalent of an additional increase of over 75 basis points in the federal funds rate...

...Financial channels can powerfully propagate negative shocks in one market by catalyzing a broader reassessment of risks and increases in risk spreads across many financial markets...Recent events suggest the transmission of foreign shocks can take place extremely quickly such that financial markets anticipate and indeed may thereby front-run the expected monetary policy reactions to these developments.

In other word, market participants are correctly assessing the Fed's response to recent turmoil by anticipating a slower path of rate hikes. Or, as I have said, the Fed has to be easier because everything else is tighter. Brainard draws special attention to the exchange rate (emphasis added):

It also appears that the exchange rate channel may have played a particularly important role recently in transmitting economic and financial developments across national borders. Indeed, recent research suggests that financial transmission is likely to be amplified in economies with near-zero interest rates, such that anticipated monetary policy adjustments in one economy may contribute more to a shifting of demand across borders than a boost to overall demand. This finding could explain why the sensitivity of exchange rate movements to economic news and to changes in foreign monetary policy appear to have been relatively elevated recently.

Read that carefully. She is saying that at the zero bound, the domestic impact of monetary policy is limited, leaving external demand as the primary policy channel. Hence exchange rates shift rapidly to induce that shifting of demand.

Or, in other words, Brainard is saying that at the zero bound monetary policy degrades to currency wars. Chew on that admission for awhile.

The implication for US policy:

Financial tightening associated with cross-border spillovers may be limiting the extent to which U.S. policy diverges from major economies. As policy adjusts to the evolution of the data, the combination of heightened spillovers from weaker foreign economies, along with a lower neutral rate, could result in a lower policy path in the United States relative to what many had predicted.

Pulling away from the zero bound is easier said than done. The Fed cannot lift the rest of the world from the zero bound; the rest of the world drags the Fed to the zero bound.

How does this relate to the idea that market participants are underestimating the Fed? I see two paths. One is that Brainard's "common shock" lowering the neutral rate of output is very persistent. Hence small changes to short-term rates have substantial economic impacts and the Fed needs to be very cautious in their response to inflation. In this scenario, the yield curve continues to flatten just as in any other tightening cycle. There is little movement in the long-end because market participants anticipate that the Fed has little room to maneuver.

Alternatively, the common shock dissipates, the long-end of the yield curve rises, and the Fed chases it with a faster than expected pace of rate hikes. I do not view this as a best on the markets underestimating the Fed. I view this as a bet against secular stagnation (the common shock).

It is worth pointing out at this juncture that shorting the long end (once thought a no brainer) has been something of a widowmaker trade. Just like it has been for Japanese government bonds.

If you accept the secular stagnation hypothesis and that the Fed will need to tighten in response to higher inflation, then expect long rates to hold flat or more likely decline as short rates rise. In other words, the yield curve would flatten further. Note that the yield curve has flattened per usual after the Fed began tightening.

So how I do interpret the incoming information of recent weeks as it regards at least near term policy? As follows:

  1. The rise in wage growth and now inflation is consistent with an economy near full-employment. In this dimension, the world is not much different than it has always been. Push unemployment low enough and resource constraints start to bite.
  2. Fed hawks will argue vociferously that they will soon fall behind the curve, if they have not already. Even some moderates will push for higher rates sooner than later. Here I am thinking of Fed Vice Chair Stanley Fischer.
  3. Federal Reserve Chair Janet Yellen will be swayed by Brainard to a dovish position in the near term. Brainard correctly called the importance of the external transmission channels last year. Those channels are forcing the Fed to lower the path of rate hikes in response by skipping at least the March meeting. And incoming data is largely backward looking; the Fed needs time to assess the impact of recent tightening in financial markets.
  4. I don't expect Fed hawks to go quietly into the night on this. I think they will want something in return for pausing, and that solid incoming data with a whiff of inflation will prompt them to revive the balance of risks.
  5. Unless growth does slow down dramatically, delaying rate hikes now means, as the Fed sees it, falling behind the curve later this year (remember that the push for raising rates in 2015 was premised on the need to be able to raise slowly ahead of inflation). The Fed will then have a choice between accepting a greater risk of above target inflation or accelerating the pace of rate hikes. I don't know which way that debate will fall yet.

Bottom Line: Inflation concerns are not likely to prompt a the Fed to hike rates in March. Financial market issues will dominate; like it or not, the Fed cannot separate the financial system from the real economy. The former is signaling it requires a looser policy stance to compensate for the stronger dollar. It would be tempting fate to ignore that signal. Be wary, however, of a hawkish message sent through the statement.

Thursday, February 25, 2016

Fed Watch: Lacker, Kaplan, Fischer

Tim Duy:

Lacker, Kaplan, Fischer, by Tim Duy: Today Richmond Federal Reserve President Jeffrey Lacker argued that the case for rate hikes remains intact, arguing that monetary policy remains quite accommodative:
So at this point, estimates of the natural real rate of interest do not suggest that the zero lower bound is impeding the Fed’s ability to attain its 2 percent inflation objective. In fact, this perspective would bolster the case for raising the federal funds rate target.
And in he is quoted by Reuters adding:
Ongoing strength in the U.S. job market could give the Federal Reserve justification for multiple interest rate increases this year, Richmond Fed President Jeffrey Lacker said on Wednesday...
.."I still think prospects for rate increases this year is the logical" view, Lacker said in a presentation to a business school in Baltimore, adding that economic data did not indicate that a recession was imminent in the United States.
If Lacker were still voting this year, he would likely be a serial dissenter. On the opposite side of the table sits Dallas Federal Reserve President Robert Kaplan. In an interview with the Financial Times, Kaplan leans very dovish:
Now was a time for patience as the Federal Reserve seeks to understand the impact of financial market turbulence and slowing growth in other economies, said Mr Kaplan, who does not vote on Fed rates this year but takes part in the debate.
“In order to reach our inflation objective we may need to be more patient than we previously might have thought,” he said. “If that means we take an extended period of time where we stop and don’t move, that may also be necessary. I am not prejudging that.”
Pure wait-and-see, risk management mode, and the most likely direction the Fed will take in March and April. Federal Reserve Vice Chair Stanley Fischer remains less-moved by recent developments. Instead, low unemployment rates capture his attention (emphasis added):
..most estimates of the full employment rate of unemployment are close to 5 percent. The actual rate of unemployment is now slightly below 5 percent, and the median view of the members of the FOMC is that it will decline further, perhaps even to the vicinity of 4.7 percent. The question is, should we be concerned about that possibility? In my view, a modest overshoot of this sort would be appropriate in current circumstances for two reasons. The first reason is that other measures of labor market conditions--such as the fraction of workers with part-time employment who would prefer to work full time and the number of people not actively looking for work who would like to work--indicate that more slack may remain in the labor market than the unemployment rate alone would suggest. And the second reason is that with inflation currently well below 2 percent, a modest overshoot could actually be helpful in moving inflation back to 2 percent more rapidly. Nonetheless, a persistent large overshoot of our employment mandate would risk an undesirable rise in inflation that might require a relatively abrupt policy tightening, which could inadvertently push the economy into recession. Monetary policy should aim to avoid such risks and keep the expansion on a sustainable track.
Unemployment is currently at 4.9 percent. It doesn't take much imagination to see it falling to 4.7 percent in short order. Fischer sounds very uncomfortable with the prospect of the unemployment rate falling much below 4.7%. He is getting an itchy trigger finger.
I remain unmoved by this logic:
If the recent financial market developments lead to a sustained tightening of financial conditions, they could signal a slowing in the global economy that could affect growth and inflation in the United States. But we have seen similar periods of volatility in recent years--including in the second half of 2011--that have left little visible imprint on the economy, and it is still early to judge the ramifications of the increased market volatility of the first seven weeks of 2016. As Chair Yellen said in her testimony to the Congress two weeks ago, while "global financial developments could produce a slowing in the economy, I think we want to be careful not to jump to a premature conclusion about what is in store for the U.S. economy."
This echoes the comments of San Francisco Federal Reserve President John Williams, and again misses the Fed's response to financial turmoil. In 2011, it was Operation Twist. One would think they would keep a chart like this on hand:

SP22316

I really do not understand how Fed officials can continue to dismiss market turmoil using comparisons to past episodes when those episodes triggered a monetary policy response. They don't quite seem to understand the endogeneity in the system.
My sense is that there remains a nontrivial contingent within the Fed that really, truly believes they need to hike sooner than later for fear that overshooting the employment mandate will result in overshooting the inflation target. This contingent is attempting to look at the financial system as separate from the "real" economy. That will not work. No matter how good the underlying fundamentals, if you let the financial system implode, it will take the economy down with it. I don't know that the Fed needs to cut rates, or that they needed to cut rates as deeply as they did during the Asian Financial crisis, but I do know this: The monetary authority should not tighten into financial turmoil. Wait until you are out of the woods. That's Central Banking 101. And I suspect that is ultimately the direction the Fed will take.
Bottom Line: Despite some hawkish talk, the Fed will find themselves in risk management mode at the March meeting. Some will not like it. There will remain a contingent that fears standing still risks excessive overshooting of the inflation target.

Wednesday, February 24, 2016

Fed Watch: Not All Fed Presidents On Board With March Pause

Tim Duy:

Not All Fed Presidents On Board With March Pause: The Fed will almost certainly pause in March. But not all Fed presidents are leaning that way. And at least one seems to be shifting closer to March than further away. At the end of January, San Francisco Federal Reserve President John Williams had this to say, via Reuters:
San Francisco Federal Reserve Bank President John Williams told reporters he now sees slightly slower growth, slightly higher unemployment, and about a tenth of a percent lower inflation this year than he had expected in December, when the Fed raised rates for the first time in nearly a decade...
..."Standard monetary policy strategy says a little less inflation, maybe a little less growth ... argue for just a smidgen slower process of normalizing rates," Williams said. 
"We got a little stronger dollar, some mixed data on the economy, some weakness in (fourth-quarter U.S. GDP growth), all of those coming together kind of tell me that we probably need a little bit more monetary accommodation this year than I was thinking in the middle of December."
But yesterday, the LA Times reported:
And unlike some of his colleagues at the Fed, who have suggested that the central bank hold off on raising interest rates next month, Williams says no such thing. The Fed lifted its benchmark rate in December after keeping it at near zero for seven years, but officials made no change at their last meeting in late January, amid tumbling stock and oil prices, and rising fears about China’s slowdown.
Williams, in an interview with the Los Angeles Times, said the recent global developments certainly need to be closely monitored. But he said the “big picture for me hasn’t changed,” and his view on U.S. employment and inflation — the two key areas determining the Fed’s monetary policy — remains sanguine.
Sounds like Williams is backing down from his "smidgen" slower pace of rate hikes. Of course, really the only way to have just a "smidgen" slower pace is to skip the March meeting and acquiesce to at most three rate hike this year. So if Williams is backing down, he is saying that March remains an open question. 
What would have changed his position? Data would be my guess. Since Williams spoke with reporters in January, the data has been fairly supportive. As he notes in his most recent speech, unemployment has fallen below 5%, his estimate of the natural rate of unemployment, and wage growth is starting to accelerate. Moreover, he still expects inflation will accelerate. I would add that initial unemployment claims turned back down:

CLAIMS021816

Quits rates rose in December, indicating more, not less, confidence among workers:

QUITS21816

Industrial production ticked up and weakness remains fairly concentrated:

IP021816

Retail sales were stronger than expected, knocking a hole in the "consumer is dying" story:

RETAIL21816

In addition, housing remains solid - and housing generally does not strengthen into a recession. Indeed, Toll Brothers is not exactly worried about the economy in 2016. And, to top it off, last week we saw more evidence of rising inflation in the CPI report:

PRICES21816

Hence I am not surprised to hear more optimism among Fed presidents than at the end of January. To be sure, some never wavered in their confidence. Kansas City Federal Reserve President Esther George today, via Bloomberg:
Federal Reserve policy makers should be prepared to consider raising interest rates in March despite recent financial market volatility, said Kansas City Fed President Esther George, whose outlook for solid growth this year remains intact.
“It absolutely should be on the table” at the next meeting, George told Pimm Fox and Kathleen Hays in a Bloomberg Radio interview Tuesday from the bank. “At this point I would not say that the data have suggested there has been a fundamental shift in the outlook.”
She even suggests that the Fed could surprise markets:
“It is clear the markets have taken that off the table,” said George, a voting member of the FOMC in 2016. “Policy makers have to look at what are the fundamentals of the economy.” Investors currently view the probability of a single rate rise in 2016 at around 45 percent, according to trading in federal funds futures contracts. The FOMC next meets on March 15-16.
That's not going to happen; the Fed will pause in March because ultimately they have to. The events since December have only bolstered the position of Federal Reserve Governor Lael Brainard, the strongest voice on the Board arguing for a cautious approach. That said, not all will see it this way. Back to Williams:
Of course, I am aware of, and closely monitoring, potential risks. But I want to be clear what that means. It’s often said that the economy isn’t the stock market and the stock market isn’t the economy. That’s very true. Short-term fluctuations or even daily dives aren’t accurate reflections of the state of the vast, intricate, multilayered U.S. economy. And they shouldn’t be viewed as the four horsemen of the apocalypse. Remember, the expansion of the 1980s wasn’t derailed by the crash of ’87, and we sailed through the Asian financial crisis a decade later. I say “remember”—some of you here will actually remember and others will remember it from your high school history class.
This paragraph was almost painful to read. Revisionist history. It is as if Williams completely forgets the role of monetary policy in both instances. What did the Fed do in November of 1987? Did they continue hiking rates? What did the Fed do in 1998? Did they continue hiking rates? No, in both instances they actually cut rates. And it was that monetary response that helped the economy "sail through" these episodes. 
The Fed will reach the same conclusion this time as well: Even if the economic data is solid and the recovery remains intact, there is reason to believe that tightening financial conditions alone give sufficient reason for the Fed to pause. The Fed knows this. From the January minutes:
Almost all participants cited a number of recent events as indicative of tighter financial conditions in the United States; these events included declines in equity prices, a widening in credit spreads, a further rise in the exchange value of the dollar, and an increase in financial market volatility. Some participants also pointed to significantly tighter financing conditions for speculative-grade firms and small businesses, and to reports of tighter standards at banks for C&I and CRE loans. The effects of these financial developments, if they were to persist, may be roughly equivalent to those from further firming in monetary policy.
These issues are not going away by March. Hence, risk management mode remains the order of the day.
Moreover, consider the situation from the perspective of Federal Reserve Chair Janet Yellen. You have no doubt that your actions at this point define your legacy. On one side is the risk that your policy traps the US economy at the zero bound. You are just another in a long line of failed central bankers who tried to normalize too soon. This risk has been brought into sharp relief in the past two months (Brainard warned you, you think). On the other side is the risk that inflation drifts above your 2% target but you raise the odds of pulling off the zero bound. And you know that if push comes to shove, you can always argue that a period of above-2% inflation only makes up for a extended period of sub-2% inflation. And that you need somewhat higher inflation to firm up faltering inflation expectations. Which risk do you want to embrace? I am guessing the second. That's what Yellen will choose.
Bottom Line: The Fed is on hold. No clear end to the pause. But be wary that some Presidents might want something in return for that pause. What I am watching for are signs that Fed officials will lean toward re-instating the balance of risks assessment to the post-FOMC statement. And which way would that assessment lean? That, I think, is the question I would like to see financial journalists asking of Fed officials.

Thursday, February 18, 2016

Fed Watch: FOMC Minutes and More

Tim Duy:

FOMC Minutes and More, by Tim Duy: So much Fed, so little time. But the short story is this: The Fed is in risk management mode, which means they will leave rates on hold until they see clear evidence that markets are stabilizing, growth remains on track, and they are even leaning towards needing to see the white in the eyes of the inflation beast. This has the makings of a significant strategic shift. To date, the Fed has argued for early and modest action toward "normalizing" policy with the ultimately goal of staying ahead of the inflation curve. We are moving to a new strategy where Fed policy lags the cycle. The cost of a Fed pause now is the risk of more aggressive policy later.
The minutes of the January FOMC meeting revealed that policymakers struggled to reconcile market volatility with their economic outlook:
In discussing the appropriate path for the target range for the federal funds rate over the medium term, members agreed that it would be important to closely monitor global economic and financial developments and to continue to assess their implications for the labor market and inflation, and for the balance of risks to the outlook. Members expressed a range of views regarding the implications of recent economic and financial developments for the degree of uncertainty about the medium-term outlook, with many members judging that uncertainty had increased. Members generally agreed that the implications of the available information were not sufficiently clear to allow members to assess the balance of risks to the economic outlook in the Committee's postmeeting statement.
That said, they could agree on the following:
However, members observed that if the recent tightening of global financial conditions was sustained, it could be a factor amplifying downside risks.
And they had plenty of reasons to fear the downside risks:
Almost all participants cited a number of recent events as indicative of tighter financial conditions in the United States; these events included declines in equity prices, a widening in credit spreads, a further rise in the exchange value of the dollar, and an increase in financial market volatility. Some participants also pointed to significantly tighter financing conditions for speculative-grade firms and small businesses, and to reports of tighter standards at banks for C&I and CRE loans. The effects of these financial developments, if they were to persist, may be roughly equivalent to those from further firming in monetary policy.
It is very unlikely that these fears will be ameliorated by the March meeting, or even the April meeting, and Fed speakers are signaling as much. See, for example, remarks by Philadelphia Federal Reserve President Patrick Harker and Boston Federal Reserve President Eric Rosengren.
These concerns are growing:
Several participants noted that monetary policy was less well positioned to respond effectively to shocks that reduce inflation or real activity than to upside shocks, and that waiting for additional information regarding the underlying strength of economic activity and prospects for inflation before taking the next step to reduce policy accommodation would be prudent.
And echo a repeated warning from the Fed staff:
The staff viewed the uncertainty around its January projections for real GDP growth, the unemployment rate, and inflation as similar to the average of the past 20 years. The risks to the forecast for real GDP were seen as tilted to the downside, reflecting the staff's assessment that neither monetary nor fiscal policy was well positioned to help the economy withstand substantial adverse shocks; the downside risks to the forecast of economic activity were seen as more pronounced than in December, mainly reflecting the greater uncertainty about global economic prospects and the financial market turbulence in the United States and abroad. Consistent with the downside risk to aggregate demand, the staff viewed the risks to its outlook for the unemployment rate as skewed to the upside. The risks to the projection for inflation were seen as weighted to the downside, reflecting the possibility that longer-term inflation expectations may have edged down and that the foreign exchange value of the dollar could rise substantially further, which would put downward pressure on inflation.
The recent unpleasantness in financial markets has likely prompted the FOMC to take the downside risks more seriously than they did in December. The fact of the matter is that they have very little left in their toolkit should the economy take a turn for the worse. Yes, they could turn toward more quantitative easing, but I think on average they are loathe to go down that route. And yes, they could consider negative interest rates, but that now looks a lot riskier than it did just a few weeks ago. Indeed, from the minutes:
The effects of a relatively flat yield curve and low interest rates in reducing banks' net interest margins were also noted.
A financial system based on banking starts to run into challenges when banks can't make a profit. Significantly negative rates likely require some substantial re-plumbing of the financial pipes to be effective.
The Fed may be turning toward my long-favored policy position - the best chance they have of lifting off from the zero bound is letting the economy run hot enough that inflation becomes a genuine concern. That means following the cycle, not trying to lead it. And I would argue that if the recession scare is just that, a scare, they are almost certainly going to fall behind the curve. The unemployment rate is below 5 percent and wage pressures are rising. The economy is already closing in on full-employment. If we don't have a recession, then how much further along will the economy be by the time the Fed deems they are sufficiently confident in the economy that they can resume raising rates? And note the importance of clearly progress on inflation:
Several participants reiterated the importance of monitoring inflation developments closely to confirm that inflation was evolving along the path anticipated by the Committee.
and:
A couple of members emphasized that direct evidence that inflation was rising toward 2 percent would be an important element of their assessments of the appropriate timing of further policy firming.
By the time we actually see inflation we will be in my "scenario five":
Financial markets remain choppy in the first half of the year, pushing the Fed into “risk management” mode despite solid labor market activity. The Fed skips the March and April meetings. Officials’ delayed response calms markets and prevents a slowdown in activity, but they feel behind the curve and try to catch up with a steeper pace of hikes late in the year.
Separately, some members questioned the effectiveness of the Fed communication strategy:
A couple of participants questioned whether some financial market participants fully appreciated that monetary policy is data dependent, and a number of participants emphasized the importance of continuing to communicate this aspect of monetary policy.
St. Louis Federal Reserve President James Bullard was likely one such participant. From the press release of his speech tonight:
Bullard noted that the FOMC has repeatedly stated in official communication and public commentary that future monetary policy adjustments are data dependent. He then addressed the possibility that the financial markets may not believe this since the SEP may be unintentionally communicating a version of the 2004-2006 normalization cycle, which appeared to be mechanical.
“The policy rate component of the SEP was perhaps more useful when the policy rate was near zero, and the Committee wished to commit to the idea that the policy rate was likely to remain near zero for some period into the future,” Bullard explained. “But now, post liftoff, communicating a path for the policy rate via the median of the SEP could be viewed as an inadvertent calendar-based commitment to increase rates.”
You might forgive market participants for believing that the SEP infers some calendar-based guidance when Federal Reserve Vice Chair Stanley Fischer says things like:
Well, we watch what the market thinks, but we can't be led by what the market thinks. We've got to make our own analysis. We make our own analysis and our analysis says that the market is underestimating where we are going to be. You know, you can't rule out that there is some probability they are right because there's uncertainty. But we think that they are too low.
Saying the markets are wrong implies that the policy direction is fairly rigid. In any event, I am not confident there is yet much support for Bullard's position (you would think to switching to a press conference at every FOMC meeting would be easier, but he hasn't apparently made much progress there either). Instead, the Fed is debating enhancing the SEP with fan charts around the projections to illustrate the associated uncertainty. My preference is to reveal each participant's forecast and their associated dot, as well as the Greenbook forecast. This can be done anonymously. Then we could throw out the crazy forecasts and focus on the reaction functions of the remaining forecasts. I don't think, however, the Fed wants us identifying any forecasts as crazy because they would like us to believe all are equally valid. And they don't want to use the Greenbook forecast because that would imply a central FOMC forecast, which they maintain does not exist. So we are stuck with the dot plot for the foreseeable future.
Bullard has also gone full-dove. He remembered that he thought inflation expectations were supposed to be important, and the decline in 5-year, 5-year forward expectations has him spooked. And he thinks that the excess air has been released from financial markets, so his fears of asset bubbles has eased. Hence, the Fed can easily pause now. But note that Bullard is fickle - just one higher inflation number and he will quickly change his tune.
Bottom Line: The Fed is on hold, stuck in risk management mode until the skies clear. If you are in the "recession" camp, the path forward is obvious. The Fed cuts back to zero, drags its heals on more QE, and fumbles around as they try to figure out if negative rates are a good or bad thing. Not pretty. But if you are in the "no recession" camp, it's worth thinking about the implications of a Fed pause now on the pace of hikes later. Being on hold now raises the risk that by the time the Fed moves again, they will be behind the cycle.

Thursday, February 11, 2016

Fed Watch: Fed Yet To Fully Embrace A New Policy Path

Tim Duy:

Fed Watch: Fed Yet To Fully Embrace A New Policy Path, by Tim Duy: The Fed will take a pause on rate hikes. An indefinite pause. The sooner they admit this, the better off we will all be. Indeed, the sooner they admit this, the sooner financial markets will calm and the the sooner they would be able to resume hiking rates. Federal Reserve Chair Janet Yellen had two high profile opportunities this week to make such an admission. Yet she failed to do so. She gave some ground on March, to be sure. But overall, the Fed just isn’t ready to stop talking about rate hikes later this year.
The framework from which I consider the Fed’s current predicament begins with this chart:

FED021116

Beginning in 2013 and extending through most of 2015, the domestic side of the US economy surged as consumer spending accelerated, investment stabilized, and government spending gained. The trade deficit acted as a pressure valve, widening to offshore some of the domestic demand. On net, economic activity was sufficient to collapse the output gap. By the end of 2015, the economy was near full-employment.
At full-employment, a combination of factors would work in tandem to slow activity to that of potential growth. I think of it as a new constellation of prices consistent with sustained full-employment. I can’t tell you exactly what the new constellation would look like other than the most likely combination: A mix of higher dollar, higher inflation, higher wages, and higher short term interest rates (tighter monetary policy).
How much monetary policy tightening is consistent with the new equilibrium depends on the evolution of the other prices. A reasonable baseline at the end of last year was that 100bp of tightening would be consistent with achieving full-employment. That was the Fed’s starting point as well.
The international interconnectivity of financial markets, however, dealt a blow to the expectation of even a gradual rate increase. The actual and expected policy divergence between the Federal Reserve and the rest of the world’s major central banks drove a rally in the dollar. That unexpected strength of that rally means that some other price has to move accordingly to sustain full employment. The most likely price is short-term interest rates. That’s the signal from the collapse in long rates. That signals the Fed will be lower for longer, reducing the magnitude of the policy divergence, and allowing the dollar to retreat.
Ironically, I suspect the Bank of Japan’s foray into negative interest rates sealed the fate of the divergence trade. First by pushing market participants into US Treasuries, signaling that the Fed would need to respond to the BOJ by reducing the expected short-term policy path. Second by killing bank stocks. Market participants in the US were already primed by Fed Vice Chair Stanley Fisher that negative rates could be a policy tool. And this point was seconded by Yellen this week.
But the collapse in banking stocks suggests strongly that negative interest rates are not compatible with our current economic institutions. The system relies on the banks, and the banks need to make money, and they struggle to do so in a negative rate environment. Should it be any surprise that the threat of global negative rates is slamming the financial sector?
If then zero (or something just below zero) is indeed a practical lower bound, and all major central banks are pulled in that direction, then the scope for policy divergence is limited. Again, this suggests the policy divergence trade – a one-way bet on the dollar – is nearing the end if not already there. It had to end sooner or later. A one-way bet would eventually cripple the US economy.
In sum, a key factor in keeping the US economy on the rails is acknowledging that tightening financial conditions via the dollar obviates the need to tightening conditions via monetary policy. This will also sustain the expansion and allow wage growth and inflation accelerate. The Fed can stand down, and let my scenario five evolve. All of this is well and good, but the Fed has yet to fully embrace this story. And that leaves them sounding relatively hawkish. Yellen’s testimony continues to emphasize that the Fed expects to keep raising rates. To be sure, she includes the data dependent caveat, and this:
Financial conditions in the United States have recently become less supportive of growth, with declines in broad measures of equity prices, higher borrowing rates for riskier borrowers, and a further appreciation of the dollar.
should be sufficient to take March off the table despite solid labor data. But the underlying message is that they expect higher rates. It is only the pace that changes, not the direction. There is just no reason to promise higher rates. All the Fed needs to say is:
“Monetary policy will be appropriate to achieve the Fed’s mandate.”
Yellen & Co. don’t need to emphasize the direction of rates. They just can’t stop themselves. Worse yet, they feel compelled to describe the level of future rates via the Summary of Economic Projections. A level entirely inconsistent with signals from bond markets, no less. They don't really know what the terminal fed funds rate will be, so why keep pretending they do? The “dot plot” does nothing more than project an overly-hawkish policy stance that leaves market participants persistently fearful a policy error is in the making. It is time to end the “dot plot.”
It might be helpful to add:
“We will not pursue negative interest rates if such a policy is incompatible with stability in financial sector.”
They should stop with the random and partially considered talk of negative interest rates. Instead, adopt a basic talking point indicating the idea has yet to be thoroughly vetted and as such any speculation on the topic is premature.
Bottom Line: The Fed has yet to fully embrace the change in financial conditionals and the implications for the path of policy. To be sure Yellen gave enough this week to take March off the table. That said, policymakers will hesitate to dramatically change their general policy outlook focused on higher rates. Consequently, I anticipate Fedspeak with seemingly unrealistic hawkish undertones. Essentially, they will leave the fear of policy error simmering on the back-burner.

Friday, February 05, 2016

Fed Watch: Solid Jobs Report Keeps Fed In Play

Tim Duy:

Solid Jobs Report Keeps Fed In Play, by Tim Duy: Just when you think it's safe to jump in the water, reality strikes. While I still think that the Fed passes in March, the solid jobs report is just what is takes to keep the Fed in the game. Back it up with another such report in March and a stronger inflation signal in one of the upcoming price reports and you set the stage for a divisive battle at the next FOMC meeting.
Nonfarm payrolls grew by 151k, below consensus but within a reasonable range of estimates. The twelve-month moving average reveals a very modest slowing of job growth over the year:

JOBSd020516

The jobs numbers in the context of data Federal Reserve Chair Janet Yellen pervasively identified as what to watch:

JOBSe020516

JOBSf020516

Notably, wage growth has accelerated over the past year, suggesting that the Fed's estimate of NAIRU is within range of reality:

JOBSc020516

Prior to the 2001 recession, wage growth typically accelerated at unemployment approached 6%. Now it looks like 5% is the magic number:

JOBSb020516

I suspect the the employment cost index will soon follow the wage numbers higher:

JOBSa020516

There are no signals of recession in this data. For those who will complain that it is lagging data, I suggest watching the temporary employment component:

JOBSg020516

Temporary hiring should flatten out as the cycle matures, and you can arguably see the beginning of that process. If you squint, that is. Even so, the process evolved over a two year period before the last recession struck. Even if the seeds of recession were sown this January, we wouldn't expect recession until 2017 at the earliest. Still not by base case; using history as a guide I have a recession penciled in for 2018. (Short story: economy is in later stages of a business cycle, Fed resumes tightening later this year and pushes it too far by middle of 2017. In a perfect world the Fed could moderate the pace of activity to hold unemployment near NAIRU for an extended period of time. That, however, has proven to be a challenge for the Fed in the past.)
Bottom Line: This jobs report complicates the Fed's decision making process. They are stuck with instability in the financial markets as the economy reaches full employment. They are concerned that in the absence of temporary factors, inflation will quickly jump higher if the economy continues on this trajectory. While they would like unemployment to settle somewhat below NAIRU to eliminate lingering underemployment, they don't want it to settle far below NAIRU. They don't believe they can easily tap the breaks to lift unemployment higher. Recession is almost guaranteed to follow. Hence they would like to be able to rates rates gradually to feel their way around the darkness in which the true value of NAIRU lies. They fear that if they delay additional tightening, they will pass the point of no return in which they are forced to abandon their doctrine of gradualism. The Fed's policy challenge just became a little bit harder today.

Thursday, February 04, 2016

Fed Watch: Jobs Day

Tim Duy:

Jobs Day, by Tim Duy: The jobs report for January is upon us. I would like to say this one will receive special attention but they all receive special attention. Consensus forecast is for nonfarm payrolls to gain 188k, with a range of 170k-215k, while unemployment holds constant at 5%. Calculated Risk looks at five indicators and concludes:
Unfortunately none of the indicators above is very good at predicting the initial BLS employment report. However, based on these indicators, it appears job gains will be below consensus.
One of the indicators CR considers in consumer sentiment, which as CR says is influenced by factors other than the labor market, so I will discount it in what follows. A regression of the monthly change in nonfarm payrolls on the remaining indicators - monthly change in ADP payrolls (ADP), the ISM employment index for manufacturing (NAPMEI), the ISM employment index for nonmanfucturing (NMFEI), and the monthly change in initial jobless claims (CLAIMS2) - yields:

NFPFORa020416

This is a quick and dirty regression, to be sure, and I would caveat it by saying that it is more accurately described as a model of the revised nonfarm payrolls number than the initial release. Note also that the coefficient on the manufacturing employment index is not significant. As CR says:
Note: Recently the ADP has been a better predictor for BLS reported manufacturing employment than the ISM survey.
With these caveats in mind, the one-step ahead forecasts are:

NFPFOR020416

The point forecast for January is 202.64k, a tad higher than consensus, but the 95% confidence interval is wide at (48k to 357k). Which is a reminder that trying to predict monthly payrolls is something of a fool's errand. I would not be surprised by any outcome within the 68% confidence interval, or 123k to 280k. A significant miss relative to consensus should not be a surprise. It would still be within the range of recent outcomes.
The Fed will be watching for signs that the economy has slowed precipitously since the final quarter of 2015. They will also be watching the unemployment rate and underemployment indicators to assess remaining slack in the economy. Further declines in the unemployment rate will make them increasingly uneasy with holding steady even as financial markets suggest they should. Watch wages for confirmation that slack has or has not diminished. And, finally, for those on recession watch, ignore the headlines whether they be weak or strong and look at temporary help payrolls and signs that long-term unemployment is back on the rise. Both tend to be leading indicators, especially the former.
In other news, New York Fed President William Dudley was reported to have cooled on rate hikes:
"One thing I think we can say with more confidence is that financial conditions are considerably tighter than they were at the time of the December meeting," said Dudley, a permanent voter on the Federal Open Market Committee, the Fed's monetary policy arm.
"So if those financial conditions were to remain in place by the time we get to the March meeting, we would have to take that into consideration in terms of that monetary policy decision," he said.
While the Wall Street Journal reports that Fed Governor Lael Brainard reiterated her warnings from last year:
Her concern is that stresses in emerging markets including China and slow growth in developed economies could spill over to the U.S. “This translates into weaker exports, business investment and manufacturing in the United States, slower progress on hitting the inflation target, and financial tightening through the exchange rate and rising risk spreads on financial assets,” Ms. Brainard said Monday in response to questions from The Wall Street Journal.

“Recent developments reinforce the case for watchful waiting,” she said.

Both are clearly more cautious than Kansas City Fed Esther George. And more influential as well. I enjoyed this:
“I don’t think it served Janet Yellen well,” former Dallas Fed President Richard Fisher said in an interview of Ms. Brainard’s critique. “It’s the only time I’ve known her when she didn’t appear to be a team player,” he said of Ms. Brainard, with whom he worked in the Clinton administration.
Seriously? Fisher has the gall to criticize Brainard as not a team player? Google "fisher dallas dissent" and see what you get. A sample:

FISHER

Being a team player isn't always what the Fed needs. Fisher obviously thought so when he was on the FOMC. Yet he insists Brainard be the team player he wasn't. Sad.
Separately, Goldman Sachs has erased their expectations of a rate hike in March, but left three more penciled-in for the rest of the year. Clearly in the "no recession" camp. I think that March is unlikely, as is a chance to "catch-up" in April. But I can make a story on the back of calm in financial markets and two strong employment reports that March comes back on the table. Not my baseline though.
Bottom Line: Fed mostly coming around to delaying the next rate hike. Would need to see a lot of change over just a few weeks to get them back on their original track. More than seems likely. Rest of the year? If you are in the "no recession" camp like me, you anticipate the Fed will resume hiking later this year. If you are in the "recession" camp, it's all over.

Wednesday, February 03, 2016

Fed Watch: Resisting Change?

Tim Duy:

Resisting Change?, by Tim Duy: Monday Federal Reserve Vice Chair Stanley Fischer offered up a speech and lengthy discussion on recent monetary policy. It was both illuminating and frustrating at once. Although his confidence is fading, I also sense that he is resisting change. Fischer begins by reviewing the December decision:

Our decision in December was based on the substantial improvement in the labor market and the Committee's confidence that inflation would return to our 2 percent goal over the medium term. Employment growth last year averaged a solid 220,000 per month, and the unemployment rate declined from 5.6 percent to 5.0 percent over the course of 2015. Inflation ran well below our target last year, held down by the transitory effects of declines in crude oil prices and also in the prices of non-oil imports. Prices for these goods have fallen further and for longer than expected. Once these oil and import prices stop falling and level out, their effects on inflation will dissipate, which is why we expect that inflation will rise to 2 percent over the medium term, supported by a further strengthening in labor market conditions.

This covers familiar territory, as does his subsequent remarks the even after raising rates, policy remains accommodative:

I would note that our monetary policy remains accommodative after the small increase in the federal funds rate adopted in December. And my colleagues and I anticipate that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate, and that the federal funds rate is likely to remain, for some time, below the levels that we expect to prevail in the longer run.

This is the first source of my frustration, because his definition of "accommodative" depends upon a specific idea of the neutral Fed Funds rates. From the subsequent discussion:

Well, I think we have to wait to see precisely where this process will take us. We expect now that the numbers given in the survey, we can now make projections, the SEP of members of the FOMC, of somewhere around 3 ¼, 3, 3 ½ percent, which is on average a bit lower than in the past. But we’ll be data-dependent and we’ll see what happens. We don’t have to fix a rate that we’ll be at. We can indicate what members of the FOMC believe, which is what the number I’ve just given you is.

If you don't know the longer-run rate, how can you know how accommodative policy is? If the longer-run rate is close to 2 percent, then policy is less accommodative than you think it is. The endgame of policy is the dual employment/price stability mandate, not a specific level of interest rates.

The Fed's forecasts, however, have been foiled by oil and the dollar:

At our meeting last week, we left our target for the federal funds rate unchanged. Economic data over the intermeeting period suggested that improvement in labor market conditions continued even as economic growth slowed late last year. But further declines in oil prices and increases in the foreign exchange value of the dollar suggested that inflation would likely remain low for somewhat longer than had been previously expected before moving back to 2 percent.

This in and of itself would suggest a slower or delayed pace of rate hikes, but more on that later. As for market volatility and external events:

In addition, increased concern about the global outlook, particularly the ongoing structural adjustments in China and the effects of the declines in the prices of oil and other commodities on commodity exporting nations, appeared early this year to have triggered volatility in global asset markets. At this point, it is difficult to judge the likely implications of this volatility. If these developments lead to a persistent tightening of financial conditions, they could signal a slowing in the global economy that could affect growth and inflation in the United States. But we have seen similar periods of volatility in recent years that have left little permanent imprint on the economy.

This is unimpressive. Are we allowed to say that about Fischer? First, the likely implications of the volatility are straightforward. The decline in longer term yields signals the Fed is likely to be lower for longer. Second, it seems that Fischer does not acknowledge the Fed's role in minimizing the impact of similar bouts of volatility. They have responded by either easing via additional quantitative easing, or easing by delaying tightening (such as pushing back expectations of the taper or skipping their hoped-for September 2015 rate hike).

I find this distressing because when you fail to recognize your role, you set the stage for a policy error. They can't use the logic that they should hike in March because past volatility had no impact on growth when that same volatility actually changed their behavior and thus the economic outcomes. I guess they can use that logic, but they shouldn't.

So is March on the table still? I don't think they will have the inflation data to support such a move. But I can tell a story where they push ahead on the labor data alone. Back to Fischer:

As you know, in making our policy decisions, my FOMC colleagues and I spend considerable time assessing the incoming economic and financial information and its implications for the economic outlook. But we also must consider some other issues, two of which I would like to mention briefly today.

First, should we be concerned about the possibility of the unemployment rate falling somewhat below its longer-run normal level, as the most recent FOMC projections suggest? In my view, a modest overshoot of this sort would be appropriate in current circumstances for two reasons. First, other measures of labor market conditions--such as the fraction of workers with part-time employment who would prefer to work full time and the number of people out of the labor force who would like to work--indicate that more slack may remain in labor market than the unemployment rate alone would suggest. Second, with inflation currently well below 2 percent, a modest overshoot actually could be helpful in moving inflation back to 2 percent more rapidly.

The economy is currently operating near the Fed's estimate of the natural rate of unemployment. Upward pressure on wages is constant with that hypothesis. The Fed would like unemployment to drop further to dissipate lingering underemployment and put upward pressure on inflation. So their is room for additional declines in the unemployment rate. But:

Nonetheless, a persistent large overshoot of our employment mandate would risk an undesirable rise in inflation that might require a relatively abrupt policy tightening, which could inadvertently push the economy into recession. Monetary policy should aim to avoid such risks and keep the expansion on a sustainable track.

Here Fischer echoes the comments of New York Federal Reserve President William Dudley. Policymakers fear that they cannot allow unemployment to drift far below the natural rate because they do not believe they could just nudge it back higher without causing a recession. They can only glide into a sustainable path from above. Hence one can envision the Fed getting caught up in the employment data between now and March. That is two reports; if those reports suggest that labor markets remain strong, then the Fed will resist holding rates steady. At a minimum, it would certainly complicate the March meeting and sap my confidence that they stand pat. Indeed, one voting member is already working hard to downplay recent events. Today's speech by Kansas City Federal Reserve President Esther George:

While taking a signal from such volatility is warranted, monetary policy cannot respond to every blip in financial markets. Instead, a focus on economic fundamentals, such as labor markets and inflation, can help guard against monetary policy over- or under- reacting to swings in financial conditions. To a great extent, the recent bout of volatility is not all that unexpected, nor necessarily worrisome, given that the Fed’s low interest rate and bond- buying policies focused on boosting asset prices as a means of stimulating the real economy. As asset prices adjust to the shift in monetary policy, it is to be expected that the pricing of risk will realign to this different rate environment…

…The exact timing of each move, however, is subject to the economic environment. Because monetary policy affects the economy with lags, decisions must necessarily rely on forecasts and their associated risks — not waiting until desired objectives are realized.

If we wait for the data to provide complete confirmation before making a policy decision, we may well have waited too long. Likewise, policy may be faced with altering its trajectory if the economy’s progress points to a different outlook. But in the absence of any substantial shift in the outlook, my view is that the Committee should continue the gradual adjustment of moving rates higher to keep them aligned with economic activity and inflation. These actions are often difficult, but also necessary to keep growth in line with the economy’s long-run potential and to foster price stability.

An additional point: Watch for policymakers to downplay the inflation numbers as well. Back to George:

Finally, inflation has remained muted as a result of lower oil prices and the strong U.S. dollar. Recent movements in each of these have been quite large by historical standards. Yet, despite these headwinds, core measures of inflation have recently risen on a year-over-year basis. And although inflation rates over the past few years have hovered below the Fed’s goal of 2 percent, they have been positive and broadly consistent with price stability.

Note the "positive and broadly consistent" line. And Fischer:

And our view of progress is what the law calls maximum employment and what we call maximum sustainable employment, and a 2 percent inflation rate. And when we get there—we’re there—we’re very close to there on employment, and on inflation the core number that came out this morning was 1.4 percent. You know, that’s not 2 percent. It’s not in another universe. It’s not a negative number. But inflation’s been pretty stable, and we’d like it to go up.

Not in "another universe' from 2 percent. Not negative. Sure we'd like it to go up, but are we really worried about it? Doesn't sound like it to me.

Bottom Line: Fischer is clearly less confident than earlier this month when he claimed that market participants were underestimating the pace of rate hikes. The baseline of four hikes is clearly is doubt; see here for my five potential scenarios. Financial market participants have almost completely discounted any rate hikes this year. This is a recession scenario that I am not enamored with. That said, I suspect market volatility and lack of inflation data keep them on hold in March and maybe April even if the recession does not come to pass. However (although not my baseline), I can tell a story where they feel like the employment data forces their hand. Especially so if they continue to downplay the inflation numbers. A substantial part of their policy still appears directed by a pre-conceived notion of "normal" policy. This I think is the Fed's largest error; the fact that the yield curve stubbornly resists being pushed higher suggests that the Fed's estimates of the terminal fed funds rates is wildly optimistic. There appear to be limits to which the Fed can resist the global pull of zero (or lower) rates.

Wednesday, January 27, 2016

Fed Watch: On The Dispersion, Or Lack Thereof, of Economic Weakness

Tim Duy:

On The Dispersion, Or Lack Thereof, of Economic Weakness, by Tim Duy: Gavyn Davies writes:
It is true that much of the weakness in the nowcast is identified by economic variables that relate to the industrial sector. But these variables have, in the past, been very closely correlated with activity in the economy as a whole, and are therefore usually among the best indicators of overall activity. It is dangerous to ignore weakness in these industrial variables that persists for a long period, which is what is happening now....The full model, including the industrial sector data, estimates that the recession probability has been hovering around 15-20 per cent (above right graph), no longer an entirely negligible risk. If the weak industrial data are excluded, on the grounds that they are “transitory” – a word often used by Fed officials – then the recession probability drops to about 10 per cent.
He adds this picture:

FT

Recession odds of just 10% would hardly be worth getting out of bed for. So how much weight should we be placing on the manufacturing data? I often see claims that manufacturing is already in recession. And Andrew Levin, former advisor to Federal Reserve Chair Janet Yellen, places much weight on the industrial production slowdown:
Unfortunately, the latest economic data underscore the risk that the economy may now be heading into another recession. Last Friday, the Federal Reserve Board reported that its index of industrial production sank further in December and was down 1.8% from a year earlier. Indeed, as shown in the accompanying chart, this pace of contraction has only occurred during prior recessionary periods. In some instances, the fall in industrial output was a harbinger at the onset of a recession. In other episodes, the industrial sector had been booming previously and turned downward after a recession was already underway. But since 1970 there has never been a case where the industrial sector shrank nearly 2 percent on a 12-month basis and the broader economy was left unscathed.
I think it is important to be very cautious with this aggregate data. What makes a recession a recession is that the decline in activity is felt widely throughout the economy. From the National Bureau of Economic Research:
During a recession, a significant decline in economic activity spreads across the economy and can last from a few months to more than a year.
With this in mind, I direct you to my fellow Oregon economist Josh Lehner, who correctly notes that in comparison to past recessions, the decline in manufacturing activity is not well disbursed across the sector. My version of Josh's chart:

RECESSIONb012516

The point is that during a recession, the vast majority of manufacturing industries (or all!) are declining. We are nowhere near that point. In other words, even manufacturing - arguably the most distressed sector of the US economy - is not recession. And if manufacturing is not even in recession, it is difficult to see that the US economy is in recession. Or even nearing it.
Initial unemployment claims across states tells a similar story:

RECESSIONa012516

In this version, I count the sates experiencing a 5% or greater change in year-over-year unemployment claims (I used 5% to account for the fact that as the cycle matures, claims will flatten out for more states and thus you would expect a wider dispersion of marginally higher claims). As is evident, recessions are characterized by rising claims across a wide swath of sates. In other words, a recession in Texas does not a US recession make. Note also that the economy can experience a fairly widespread increase in claims but not a recession. See 1995. Which means that while I think initial claims is an excellent leading indicator, it by itself is not infallible.
Aside from the recession risk, there is another important aspect of Davies's chart - discounting manufacturing, it indicates growth of just 2% in the US. This is fairly close with the Federal Reserve's estimate of potential growth, and I suspect that is the direction we will be heading by the end of the year if not sooner. Key sources of growth, such as autos, multifamily housing, and technology, that helped propel the economy closer to fully employment are likely leveling off. If so, that means the economy is at an inflection point as it transitions back to trend. The Fed expects that process will require addition tightening. The financial markets aren't so confident.
Bottom Line: The lack of widespread economic weakness across the economy indicates that the US is not currently in recession. It is not even evident manufacturing is in recession. If the economy were heading into recession, expect the dispersion of weakness will spread further across the economy, both geographically and sectorally.

Thursday, January 14, 2016

Fed Watch: So You Think A Recession Is Imminent, Yield Curve Edition

Tim Duy:

So You Think A Recession Is Imminent, Yield Curve Edition, by Tim Duy: If I had to rely on only two leading indicators of recessions, they would be initial unemployment claims and the yield curve (next in line would be housing). I talked about initial claims in the context of employment data in my last post. This post is about the yield curve.
An inversion of the yield curve has typically given a 12 month or better signal ahead of recessions:

YIELDb011516

Note also that it is the inversion that is important. The yield curve was fairly flat in the late-90's, a period of supercharged growth in the US economy. So when the Financial Times fueled the recession fears last week with this:
The US government bond market is blowing raspberries at the Federal Reserve. This could indicate trouble ahead for the American economy.
Last month, the Fed lifted interest rates for the first time in nine years, and short-term bond yields have duly climbed higher. But longer-term Treasury bonds have shrugged, with yields actually falling since the US central bank tightened monetary policy.
I was less concerned. In fact, I don't think the flattening yield curve should be any surprise as that is almost always the case after the Fed tightens policy:

YIELDa011516

The yield curve typically flattens to a 50bp spread between 10 and 2 year rates within a year of the initial Fed rate hike. Only the 1986 episode is unusual. Not only that, but the flattening begins immediately:

YIELD011516

Even after the 1986 tightening the yield curve was flatter after the first 60 days.
Currently, the flattening of the yield curve - and the lack of any upward movement in 10 year yields at all - is consistent with my long-standing concern that the Federal Reserve's long-run projection of the federal funds rate - 3.5% as of December - is a pipe dream. Also why I was wary about the Fed's determination to raise rates. My preference was the Fed to wait until they were absolutely sure rates could be "normalized."
Optimally, my concerns will prove to be unwarranted. The economy may progress better than expected, productivity rises, the Fed pares down its stock of fixed income assets, the term premium rises, and the entire yield curve shifts up and the secular stagnation story dies. We are back in Kansas. No more flying monkeys. That is a perfectly acceptable, well-reasoned forecast and one I am sympathetic to, but I am not yet seeing it realized. What I am seeing at the moment is that the global pull of zero interest rates is sufficient to limit the ability of the Federal Reserve to "normalize" policy. We are stuck in Oz.
There is a school of thought that the yield curve is irrelevant now that we are near the zero bound. After all, you can't invert the yield curve very easily! And just look at Japan. Clearly the Japanese economy still experiences recession. If we are heading down the Japanese path, then I would expect longer term yield US yields to plunge below 1%. That is not my baseline, I don't think it is very likely, but I can't discount the possibility entirely.
Bottom Line: Don't discount the yield curve just yet. I think it is signaling something important about the limits of monetary policy "normalization." But it is also a signal that recession concerns are overblown. Even in a zero short rate world, the long end needs to plunge much deeper before the yield curve becomes a concern.

Fed Watch: So You Think A Recession Is Imminent, Employment Edition

Tim Duy:

So You Think A Recession Is Imminent, Employment Edition, by Tim Duy: The recession drumbeat grows louder. This is not unexpected. Most forecasters have an asymmetric loss function; the cost of being wrong by missing a recession exceeds the cost of being wrong on a recession call. Hence economists tend to over-predict recessions. Eight of the last four recessions or so the joke goes. And while I don't believe a recession is imminent, there are perfectly good reasons to be wary that a recession will bear down on the economy in the not-so-distant future. Historically, when the Fed begins a tightening cycle, the clock is ticking for the expansion. By that time, the economy is typically in a late-mid to late-stage expansion, and you are looking at two to three years before the cycle turns, four at the outside.
Of course there are some not so good reasons for worrying about a recession. Like listening to an investor talking their book. Or someone who needs to whip up a never ending stream of apocalyptic visions to hawk gold.
So what I am looking for when it comes to a recession? It's not a recession until you see it economy wide in the labor markets. When it's there, you will see it everywhere. Clearly, we weren't seeing it in the final quarter of last year. But, you say, employment is a lagging indicator, so last quarter tells you nothing. Not nothing, I would say, but a fair point nonetheless. One would need to look for the leading indicators within the employment data.
First, since the manufacturing sector is the proximate cause of these recession concerns, we would look to leading indicators in that sector. One I watch is hours worked:

RECESSIONa011416

Hours worked are off their peak, just as prior to the 1900 and 2001 recessions, but not the 2007 recession (lagging indicator that time). But hours also dropped in 1994, 1998, 2002, and 2005. And that would be an extra four recessions that didn't happen. To add a bit more confusion, hours works are coming off a peak not seen since, sit down for this, World War II:

RECESSIONb011416

That caught me by surprise; I am thinking the surge in hours worked was not sustainable in any event. Overtime hours worked holds a bit more promise:

RECESSIONc011416

OK, not much more promise. Best as a leading indicator ahead of 2001, not counting 1994 and and 1998. Not particularly useful for 1990 and somewhat useful ahead of 2007. On balance, I would say manufacturing hours worked data is necessary but not sufficient for a recession call.
Perhaps the JOLTS data offers something more:

RECESSIONd011416

Unfortunately we a working with only two cycles here, and then only barely so. But it seems reasonable that manufacturing hires might be a coincident indicator (maybe leading by the few data points ahead of the 2001 recession) and layoffs/discharges a lagging indicator. But if a manufacturing "recession" were underway, then we would expect hiring to drop off quickly here.
Quits, however looks like a leading indicator:

RECESSIONe011416

Looks like quits in manufacturing dropped sharply ahead of 2001, modestly during 2007, but were still rising at the end of 2015. If quit rates aren't dropping among those at the front lines, the pain can't be reaching recessionary levels just yet.
But manufacturing is just one sector of the economy - just 8.8% of employment. The real hypothesis the recessionists are proposing is that manufacturing is an indicator of an economy wide shock. Here I would say the JOLTS data is less supportive:

RECESSIONf011416

If we are entering a recession, firms are a minimum should be pulling back on the pace of hiring. We are not seeing that yet. And workers should be wary of quitting:

RECESSIONg011416

Again, the workers are on the front lines of the economy. If the economy is in trouble, they know it, and quit rates start declining. Not there yet.
I also have a soft spot for the temporary help series as it as rolled over twelve months or more ahead of the last two recessions:

RECESSIONh011416

So if we were to see temporary help roll over now, we would still not see recession until 2017.
And finally, there is initial jobless claims, which typically lead a recession by six to twelve months:

RECESSIONi011416

Not seeing it. If claims started rising now, and continued rising for six months, then the probability of recession would rise sharply, and if they rose continuously for twelve months, the probability of recession would approach 1. But now? Nothing to fear.
Bottom Line: From a labor market perspective, I am not seeing conclusive evidence of an impending recession in manufacturing, let alone the overall economy. Might be at the tip of one, but even that will take a year to evolve. I have more sympathy for the view that the economy has evolved into a mid-late to late stage of the cycle, and the transition and associated uncertainty results in some not-surprising volatility in financial markets.

Thursday, January 07, 2016

Fed Watch: Despite Inflation Unease, Fed Still Talks Big On Rates

Tim Duy:

Despite Inflation Unease, Fed Still Talks Big On Rates, by Time Duy: The minutes of the December FOMC meeting were released today. The minutes were considered to have a dovish tone, although I would be wary of thinking there is much new information to be found. Labor market conditions had improved sufficiently to justify a certain degree of confidence in the inflation outlook:
Regarding the medium-term outlook, inflation was projected to increase gradually as energy prices and prices of non-energy imports stabilized and the labor market strengthened. Overall, taking into account economic developments and the outlook for economic activity and the labor market, the Committee was now reasonably confident in its expectation that inflation would rise, over the medium term, to its 2 percent objective.
but many members retained concerns about the downside risks:
However, for some members, the risks attending their inflation forecasts remained considerable. Among those risks was the possibility that additional downward shocks to prices of oil and other commodities or a sustained rise in the exchange value of the dollar could delay or diminish the expected upturn in inflation. A couple also worried that a further strengthening of the labor market might not prove sufficient to offset the downward pressures from global disinflationary forces. And several expressed unease with indications that inflation expectations may have moved down slightly. In view of these risks and the shortfall of inflation from 2 percent, members expressed their intention to carefully monitor actual and expected progress toward the Committee's inflation goal.
Why hike rates? It is all about setting the stage for a gradual path of subsequent rates hikes:
If the Committee waited to begin removing accommodation until it was closer to achieving its dual-mandate objectives, it might need to tighten policy abruptly, which could risk disrupting economic activity.
And while they ultimately pulled the trigger on higher rates in an unanimous vote, the doves were left with a bitter taste in their mouths:
However, some members said that their decision to raise the target range was a close call, particularly given the uncertainty about inflation dynamics, and emphasized the need to monitor the progress of inflation closely.
They intend to hold true to their "gradualist" scripture:
Based on their current forecasts for economic activity, the labor market, and inflation, as well as their expectation that the neutral short-term real interest rate will rise slowly over the next few years, members expected economic conditions would evolve in a manner that would warrant only gradual increases in the federal funds rate.
Actual outcomes are of course data dependent, but the Fed called out one piece of data as especially important:
In the current situation, because of their significant concern about still-low readings on actual inflation and the uncertainty and risks present in the inflation outlook, they agreed to indicate that the Committee would carefully monitor actual and expected progress toward its inflation goal. In determining the size and timing of further adjustments to monetary policy, some members emphasized the importance of confirming that inflation would rise as projected and of maintaining the credibility of the Committee's inflation objective. Based on their current economic outlook, they continued to anticipate that the federal funds rate was likely to remain, for some time, below levels that the Committee expected to prevail in the longer run.
Yes, this line from the December statement was not to be ignored:
In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal.
So we now know pretty much what we did going into the minutes: The inflation situation is making FOMC members nervous and thus holding them back from a more aggressive path of rate hikes. Hence progress on the inflation mandate is necessary to accelerate the pace of rate increases. Note too the emphasis on not just actual, but expected progress. That is where the labor report comes in. If jobs keep growing at 200k a month in the first part of the year, the unemployment rate pushes toward 4.5%, and wage growth accelerates, they will will compelled to raise rates further. Actual progress on inflation would accelerate that timeline.
And that is how you get to Vice Chair Stanley Fischer's CNBC comments today:
"We watch what the market thinks, but we can't be led by what the market thinks," Fischer told CNBC's "Squawk Box." He added that market expectations of the number of future rate hikes are "too low."
Fischer expects four rate hikes this year. But that is a data dependent forecast. Financial markets have a different forecast. It is worth recognizing that when it comes to forecasting the path of short rates, financial markets have had something of an upper hand of late.
Separately, ISM services came in below consensus but remains within a solid range. Internals pointed to rising orders and employment as well. It remains a story of two economies:

ISM010616

The trade deficit narrowed slightly in November, modestly boosting tracking indicators for fourth quarter GDP. And the ADP numbers game in at a solid 257k December increase in private payrolls, raising expectations for the actual employment release Friday. Consensus is 200k for nonfarm payrolls. I am taking the over.
Bottom Line: Financial markets are stumbling into the new year. The Fed is sticking to its story. Given that January is off the table for a rate hike, we have two and a half months of data - including three employment reports! - to see if the Fed has it right this time.

Monday, January 04, 2016

Fed Watch: A Look Ahead Into 2016

Tim Duy:

A Look Ahead Into 2016, by Tim Duy: What do I expect to see in 2016? Briefly, here are my baseline expectations for the year:
1.) No recession. I think that fears of recession in 2016 are overblown. Softness in the manufacturing sector is the primary motivation for such fears, but this ignores the declining economic importance of manufacturing in the US economy. Manufacturing now accounts for just 8.6% of jobs. I think people are falling into a trap of overemphasizing the importance of manufacturing as a cyclical indicator. A broader perspective indicates little reason to be worried of recession in 2016:

2016f

Also note that initial unemployment claims, one of our better leading indicators, shows no indication of a recession brewing:

2016l

I expect manufacturing indicators will look better by the end of the year as the energy sector and external economy stabilize.
2.) Economic growth will soften. Overall growth will slow toward trend growth, around 2%, this year. Growth accelerated in 2013 as the economy normalized:

2016d

Overall GDP growth hit a high point for this cycle in 2014 and began to taper off in 2015. Still, looking through the data further, we see that recent softness in top-line numbers are primarily related to the external sector and inventory correction. The external sector has been particularly important in moderating the pace of US growth. Note that the underlying domestic economy remains solid:

2016e

Recent growth has relied on upward trends in technology, automobile production, and multifamily housing. With at least the last two reaching their peak (I suspect), expect some moderation in overall growth in 2016. The Fed will see such moderation as necessary to contain inflationary pressures.
3.) The pace of job growth will decelerate. The underlying trend in job growth appears to have peaked in 2014, and is slowing trending down.

2016b

Moreover, the Federal Reserve will become increasingly uncomfortable as the unemployment rate pushes toward 4.5 percent. We are already near their expectations of full employment:

2016c

Monetary policymakers would like unemployment to stabilize somewhat below the natural rate for some time in order to support further reduction in underemployment. Such stabilization will require that job growth moderates to the pace of labor force growth. The Fed tends to thinks this is the 100-150k range. This expectation assumes that labor force participation rates remain fairly stagnate. Faster employment growth would be supported if a tighter labor market and higher wages succeed in drawing more workers into the labor market.
4.) Wage growth will accelerate. As the unemployment rate falls below 5%, age growth will accelerate further. I think the Atlanta Federal Reserve wage tracker indicates that the forces of supply and demand still apply in the labor market:

2016a

5.) Inflation will accelerate. I think 2016 will be the year that economic resources become sufficiently scarce to push inflation back to the Fed's target. I know this may seem like a wildly optimistic call given the persistence of low inflation during this cycle:

2016g

I simply don't think that economic slack had yet to diminish sufficiently to force greater price pressures. But I think we will be at that point this year.
6.) Oil will end the year higher than it began. Oil prices have been all over the place during the past ten years, hence any forecast is subject to great uncertainty. Given that producers are already giving the stuff away, I suspect we are close to the point that production will moderate sufficiently to stabilize prices and lead them higher this year.
7.) Stocks up, yield curve flattens, and the dollar is flat to declining. These baseline expectations are based entirely on past behavior of financial markets in the first year following a Federal Reserve rate hike:

2016j

2016i

2016h

I am most confident that the yield curve expectation, and least confident in the dollar expectation. I would expect any equity gains to be fairly modest.
8.) Single family housing will take center stage. Multifamily housing accelerated to a fairly high pace of activity between 2009 and 2015 while gains in single family housing have been less impressive:

2016k

I anticipate that the next stage in the normalization of housing activity will take the form of single family growth, supported by a solid job market and higher wages.
9.) The Federal Reserve will continue to hike rates, slowly. I expect that economic conditions will be sufficient for the Federal Reserve to justify 100bp of rate hikes in 2016. Although the Fed will not want to appear mechanical in its normalization process, they will likely find themselves hiking every other meeting beginning in January. They will be slow to begin the process of "normalizing" the balance sheet, although I expect that they will be fully engaged in that conversation by the middle of the year. That conversation will take on more urgency if they have difficulty controlling short rates with their new tools.
10.) Productivity is a wildcard. Declining productivity growth, combined with slow labor force growth, drives down estimates of potential growth. Might this story change this year? Perhaps, if tighter labor markets and higher wages forces firms to identify additional labor saving technology. Such an outcome would support stronger than expected growth, higher real wages, and still low inflation.
Bottom Line: By recent standards, a fairly optimistic baseline expectation for 2016. That said, nothing spectacular either, just a continued normalization of economy around trend growth. Expectations of recession remain premature. The most likely cause of the next recession will be a monetary mistake. The still-patient Fed hence argues against a recession in the foreseeable future.

Monday, December 21, 2015

Fed Watch: What Is The Fed's Expectation For Financial Markets?

Tim Duy:

What Is The Fed's Expectation For Financial Markets?, by Tim Duy: David Keohnae at FT Alphaville points us toward a JPM research note raising the prospect of a reappearance of Former Federal Reserve Chair Alan Greenspan’s “conundrum.” From the note:
If long-term interest rates matter more than short-term interest rates, will Fed’s current and prospective rate hikes matter much? The answer is yes if long-term interest rates respond to these short-term rate hikes. But this transmission is far from given, especially given the Fed’s decision that reinvestments would not be halted until the normalization of the funds rate is “well under way”
The previous hiking cycle of 2004-2006 is a reminder of how problematic the transmission from short rates to long-term interest rates can be. At the time, the 10y real UST yield rose by only 25bp between June 2004 and June 2006 despite the Fed lifting its target rate by 425bp (Figure 1). We depict the real rather than nominal UST yield in the chart to capture the potential impact of monetary policy actions on inflation expectations. This lack of transmission or “bond conundrum” at the time was attributed to global saving forces emanating from DM corporates and EM economies. Could these saving forces prevent once again rate hikes from transmitting to longer-term interest rates?
Keohane links to fellow Alphaville write Matthew Klein, who describes the “conundrum” as bogus. Klein draws attention to the shape of the yield curve:
In addition to forgetting his own experience at the Fed, Greenspan’s confusion can also be blamed on an unusual belief in the “normal” behaviour of forward short rates.
Short rates tend to go up and down with the business cycle, which typically lasts a lot less than ten years…
When the economy is weak and the Fed is stepping on the gas, short rates should be lower than your reasonable expectation of the average for the next ten years. (Like now.) Other times, of course, short rates are higher than your reasonable expectation of the average for the next ten years because the economy is running hot and the Fed is stepping on the brakes. Longer-term yields therefore shouldn’t always move with short-term rates.
This is why people think the slope of the yield curve is a decent signal of where the economy is going.
When the economy is peaking and poised to go into recession, short rates end up higher than long rates because traders are betting that short rates will fall significantly. To use the jargon, the curve is inverted. After the economy has hit bottom and is ready to grow, the yield curve gets nice and steep, reflecting the expectation of future increases in the short rate to match the expected acceleration in nominal spending.
What happens to the yield curve, and how the Federal Reserve responds, is one of my big questions for 2016. Almost always, the yield curve flattens after the Fed begins a tightening cycle. Within a year, the spread between the 10- and 2-year treasuries is a mere 50bp or so:

Spreadfed

An analogous situation today would be if the Fed raises the fed funds target range over the next year but longer-term yields don’t budge. How might the Fed respond? New York Federal Reserve President William Dudley often comments on this prospect. From November 2015:
Several examples will help me make these points. During 2004 to 2007, the FOMC raised the federal funds rate target 17 meetings in a row, lifting the federal funds to 5.25 percent from 1.0 percent. Yet, during this period, financial conditions eased, as evidenced by the fact that the stock market rose, bond yields fell and credit availability—especially to housing—eased substantially. In hindsight, perhaps monetary policy should have been tightened more aggressively…
…In contrast, if financial conditions did not respond at all, or eased, then I suspect we would go more quickly, all else equal.
This raises some red flags for me. While much attention is placed on the Fed’s failure to respond more aggressively to slowing activity and deteriorating financial conditions in 2008, I lean toward thinking the more grievous policy error was in the first half of 2006 when the Federal Reserve kept raising short rates after the yield curve first inverted in February of that year:

Spread

and despite clear evidence of slowing economic activity and increasing financial stress.
So how will the Fed respond if long rates do not respond in concert with short rates? How will the Fed interpret a flattening yield curve? Do they accelerate the pace of rate increases? Do they initiate asset sales? The truth is I don’t know (or the answer is “it depends”), but I find this exchange between Federal Reserve Chair Janet Yellen and New York Times reporter Binyamin Appelbaum a bit disconcerting:
BINYAMIN APPELBAUM. Binyamin Appelbaum, the New York Times. Bill Dudley has talked about the need for the Fed to adjust policy based on the responsiveness of financial markets as you begin to increase rates. You didn't talk about that today. Is it a point that you agree with? And if so, what is it that you're looking for? How will you judge whether financial markets are accepting and transmitting these changes?
CHAIR YELLEN. Well, there are number of different channels through which monetary policy is transmitted to spending decisions, the behavior of longer term, longer term interest rates, short term interest rates matter. The value of asset prices and the exchange rate, also, these are transmission channels. We wouldn't be focused on short-term financial volatility, but were there unanticipated changes in financial conditions that were persistent and we judged to affect the outlook. We would of course have to take those into account. So, we will watch financial developments, but what we're looking at here is the longer term economic outlook, are we seeing persistent changes in financial market conditions that would have a bearing, a significant bearing, on the outlook that we would need to take account in formulating appropriate policy. Yes we would, but it's not short-term volatility in markets.
BINYAMIN APPELBAUM. The part [inaudible], you didn't see changes, you would be concerned and have to move more quickly. Are you concerned that if markets don't tighten sufficiently you may need to do more?
CHAIR YELLEN. Well, look. You know, we-- this is not an unanticipated policy move. And we have been trying to explain what our policy strategy is. So it's not as though I'm expecting to see marked immediate reaction in financial markets, expectations about Fed policy have been built into the structure of financial market prices. But we obviously will track carefully the behavior of both short and longer term interest rates, the dollar, and asset prices, and if they move in persistent and significant ways that are out of line with the expectations that we have, then of course we will take those in to account.
I don’t know that Yellen understood the question. But she should have. Dudley has been telling this story for a long, long time. Does she and/or the Committee share his expectations? Why or why not? In my opinion, this is an important question, and it looks to me like Yellen fumbled it.
Bottom Line: We have a fairly good idea of the Fed’s reaction function with respect inflation and unemployment. Not so much with respect to financial market conditions. Who shares Dudley’s views? That is a space I am watching this year.

Wednesday, December 16, 2015

Fed Watch: As Expected

Tim Duy:

As Expected, by Tim Duy: Today, the FOMC voted to raise the target range on the federal funds rate by 25bp. The accompanying statement and the Summary of Economic Projections offered no surprises. That very lack of surprise should be counted as a "win" for the Fed's communication strategy. A little bit of extra direction since September went a long way.

The statement again described the economic growth as "moderate." Although there is some external weakness, the domestic economy is solid, hence "the Committee sees the risks to the outlook for both economic activity and the labor market as balanced." The Fed continues to expect that inflation will return to target. On the basis of that forecast and lags in the policy policy process:

Given the economic outlook, and recognizing the time it takes for policy actions to affect future economic outcomes, the Committee decided to raise the target range for the federal funds rate to 1/4 to 1/2 percent.

Importantly, the Fed does not believe policy is tight:

The stance of monetary policy remains accommodative after this increase, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.

The Fed currently expect future hikes to occur only gradually:

The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.

But, this is a forecast not a promise:

However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.

Note that the Fed highlights the importance of actual inflation outcomes with respect to future hikes:

In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal.

The Fed will proceed cautiously if evidence suggests inflation is not behaving as expected. This doesn't mean they need to see more inflation to hike rates further. But it would be nice.

No dissents; none of the possible dissenters thought their objections were sufficient to deny Federal Reserve Chair Janet Yellen a unanimous decision on this first hike.

The median forecasts for growth, employment, and inflation were virtually unchanged. Note that the central tendency range for longer run unemployment shifted down; participants continue to shave down their estimates of the natural rate of unemployment. The median rate projection for 2017 and 2018 edged down. This understates somewhat the decline in the range of the central tendency.

As I am running short of time today, I will leave any analysis of the press conference for a later time. Gradual, data dependent, not mechanical (not equally spaced or sized hikes), etc.

Bottom Line: Almost as exactly as should have been expected.

Tuesday, December 15, 2015

FOMC Preview - Watch the Dollar and Oil

Tim Duy:

The Federal Reserve is set to raise interest rates this week for the first time since 2006.

The final days of the zero interest-rate policy known as ZIRP are upon us; the end is here.

But the end of ZIRP is the beginning of a new chapter of monetary policy. This chapter will tell the story of the Federal Reserve’s efforts to normalize policy, and that particular tale has yet to be written. You can, however, expect Fed Chair Janet Yellen to emphasize “gradually” and “data dependent” as she pens the first few lines of the narrative at this week’s press conference....

Continue reading on Bloomberg...

Monday, December 14, 2015

Fed Watch: Makes You Wonder What The Fed Is Thinking

Tim Duy:

Makes You Wonder What The Fed Is Thinking, by Tim Duy: The Fed is poised to raise the target range on the federal funds rate this week. More on that decision tomorrow. My interest tonight is a pair of Wall Street Journal articles that together call into question the wisdom of the Fed's expected decision. The first is on inflation, or lack thereof, by Josh Zumbrun:
Central bank officials predict inflation will approach their target in 2016. The trouble is they have made the same prediction for the past four years. If the Fed is again fooled, it may find it raised rates too soon, risking recession.
A key reason for the Federal Reserve to raise interest rates is to be ahead of the curve on inflation. But given their poor inflation forecasting record, not to mention that of other central banks

Inffore

why are they so sure that they must act now to head off inflationary pressures? One would expect waning confidence in their inflation forecasts to pull the center more toward the views of Chicago Federal Reserve President Charles Evans and Board Governors Lael Brainard and Daniel Tarullo and thus defer tighter policy until next year.
Now combine the inflation forecast uncertainty with the growing consensus among economists that the Fed faces the zero bound again in less than five years. This one's from Jon Hilsenrath:
Among 65 economists surveyed by The Wall Street Journal this month, not all of whom responded, more than half said it was somewhat or very likely the Fed’s benchmark federal-funds rate would be back near zero within the next five years. Ten said the Fed might even push rates into negative territory, as the European Central Bank and others in Europe have done—meaning financial institutions have to pay to park their money with the central banks...
Not a surprising conclusion given that Fed officials expect the terminal fed funds rate in the 3.3-3.8 percent range (central tendency) while the 2001-03 easing was 5.5 percentage points and the 1990-92 easing was 5.0 percentage points. You see of course how the math works. Supposedly this is of great concern at the Fed. Hilsenrath cites the October minutes:
Fed officials worry a great deal about the risk. The small gap between zero and where officials see rates going “might increase the frequency of episodes in which policy makers would not be able to reduce the federal-funds rate enough to promote a strong economic recovery…in the aftermath of negative shocks,” they concluded at their October policy meeting, according to minutes of the meeting.
The policy risks are asymmetric. They can always raise rates, but the room to lower is limited by the zero bound. But that understates the asymmetry. You should also include the asymmetry of risks around the inflation forecast. The Fed has repeated under-forecasted inflation. It seems like they should also see an asymmetry in the inflation forecast that compounds the policy response asymmetry. Asymmetries squared.
Given all of these asymmetries, I would think the Fed should continue to stand pat until they understood better the inflation dynamics. The Fed thinks otherwise. Why would Federal Reserve Chair Janet Yellen allows the Fed to be pulled in such a direction? Partly to appease the Fed hawks. And then there is this from her December speech:
Were the FOMC to delay the start of policy normalization for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession.
Yellen is wedded to the theory that the sooner the Fed begins normalizing policy, the more likely the Fed can avoid a recession-inducing sharp rise in rates. She follows up this concern with:
Moreover, holding the federal funds rate at its current level for too long could also encourage excessive risk-taking and thus undermine financial stability.
This is what Mark Dow calls "avalanche patrol":
What the Fed has begun to worry about is financial stability—even if not as an imminent threat. Its concerns are one part risk management, one part the ghost of crises past. FOMC members understand that financial excesses are a positive function of time. Stability sooner or later breeds instability. And the longer rates stay very low, the greater the risk they become built into the current financial architecture and baked into our extrapolations. Once you get to such a point, an eventual normalization becomes a lot riskier, in terms of both financial dislocations and economic activity.
This then becomes a story of a Fed caught between a world in which the policy necessary to meet their inflation target is inconsistent with financial stability. That is what they call caught between a rock and a hard place. And my sense is that Yellen feels the best way to slip through those cracks is early and gentle tightening.
Bottom Line: Given that the Fed likely only gets one chance to lift-off from the zero bound on a sustained basis, it is reasonable to think they would wait until they were absolutely sure inflation was coming. Even more so given the poor performance of their inflation forecasts. But the Fed thinks there is now more danger in waiting than moving. And so into the darkness we go.

Monday, December 07, 2015

Fed Watch: And That's A Wrap

Tim Duy:

And That's A Wrap, by Tim Duy: If you had any doubt about the outcome of next week's FOMC meeting, Friday's employment report set you straight. When I try to think about what could stay the Fed's hand at this point, I am down to zombie apocalypse or act of God. I am not betting on either. By next week, we will be wrapping up our coverage of ZIRP, quietly filing away everything we learned for the next recession. That we return to ZIRP in the future remains my long-run view. But that is a concern for a future date.
The employment report was solid, with the economy adding 211k jobs in November while October was revised up to 298k. Some momentum has been lost since the 2014 as the cycle transitioned from late-spring to summer:

NFPa120615

This pace of job growth remains sufficient to eat away at remaining underemployment; the Fed believes that even 150k a month would still do the job. The unemployment rate held steady and labor force participation ticked up. Even if unchanged, unemployment at 5% hovers near the Fed's estimates of the natural rate:

NFPb120615

It is reasonable to assume that at these job growth rates, unemployment will fall toward 4.5% in the months ahead, pushing wage growth higher. I suspect the Fed would accept unemployment stabilizing near 4.5% in the second half of next year. Optimally, it would stabilize because labor force participation picked up. Alternatively, the job growth could slow to 100k/month naturally or at the hand of the Fed. In practice, I expect some combination.
In other news, the ISM indicators came in soft: ISM120615
The service sector number continues to bounce around a respectable range. A bit less so for the manufacturing indicator. You need to go back to the mid-80's to find another time the Fed hiked with a sub-50 manufacturing ISM. But this isn't the mid-80's anymore. The Fed is betting that a.) this data is noisy and b.) that the service sector is much, much more important to the economy than manufacturing and c.) some of the weakness in manufacturing will be alleviated as the oil/gas drilling and export drag soften over the next year in relative terms. Speaking of exports, the trade report came with a larger-than-expected deficit, a factor that added another hit to GDP nowcasting models. The Atlanta Federal Reserve Bank's GDPnow indicator is currently tracking at 1.5%, a rate generally believed to be below potential growth. No fear, though, according to Fed Chair Janet Yellen, who in her speech last week highlighted total real private domestic final purchases as the number to watch:
...Growth this year has been held down by weak net exports, which have subtracted more than 1/2 percentage point, on average, from the annual rate of real GDP growth over the past three quarters. Foreign economic growth has slowed, damping increases in U.S. exports, and the U.S. dollar has appreciated substantially since the middle of last year, making our exports more expensive and imported goods cheaper.
By contrast, total real private domestic final purchases (PDFP)--which includes household spending, business fixed investment, and residential investment, and currently represents about 85 percent of aggregate spending--has increased at an annual rate of 3 percent this year, significantly faster than real GDP...
That sent everyone to FRED (the code is LB0000031Q020SBEA) to make charts like this:

PFPD120615

When they search through the data for the happy numbers, you know they are looking to hike. Indeed, the clear takeaway from Yellen's speech was that a rate hike was coming (emphasis added):
...In particular, recent monetary policy decisions have reflected our recognition that, with the federal funds rate near zero, we can respond more readily to upside surprises to inflation, economic growth, and employment than to downside shocks. This asymmetry suggests that it is appropriate to be more cautious in raising our target for the federal funds rate than would be the case if short-term nominal interest rates were appreciably above zero. Reflecting these concerns, we have maintained our current policy stance even as the labor market has improved appreciably.
However, we must also take into account the well-documented lags in the effects of monetary policy. Were the FOMC to delay the start of policy normalization for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession. Moreover, holding the federal funds rate at its current level for too long could also encourage excessive risk-taking and thus undermine financial stability.
On balance, economic and financial information received since our October meeting has been consistent with our expectations of continued improvement in the labor market...
And this was before the employment report. In any event, we are now well beyond the issue of the first rate hike. The new questions are how gradual will "gradual" be and when will the Fed begin widening down the balance sheet by ending the reinvestment policy. On the first point, the Fed is trying to send the message that subsequent rate hikes will be data dependent and not on any fixed schedule. On the second point, Federal Reserve Governor Lyle Brainard argued to hold the balance sheet at current levels until interest rates are sufficient to provide a cushion for the next recession:
Moreover, because the Federal Reserve's asset holdings help maintain accommodative financial conditions, it would be prudent to maintain reinvestments until the normalization of the federal funds rate is sufficiently far along to allow room to cut nominal rates if economic conditions deteriorate.
Brainard knows she has lost the battle to forestall the first rate hike further and has now chosen to stake out a position on one of the next big issues. My expectation is that the Fed will begin ending reinvestment in the middle of next year. But that is just a baseline; this is an evolving topic.
Bottom Line: Rate hike coming. This round of ZIRP is nearly wrapped up. But that end is really just a new beginning. Arguably, the end of ZIRP raises more questions than it answers. The pace of subsequent tightening, the normalization - or not - of the balance sheet, and the countdown to the next easing are all issues now on the table.

Tuesday, December 01, 2015

Fed Watch: The Final Countdown

Tim Duy:

The Final Countdown, by Tim Duy: The latest read on the Fed’s preferred inflation metric was not particularly kind to policymakers:

PRICESa112915

Indeed, as Craig Torres at Bloomberg notes, this is only one of a number of indicators that should give a reality check to FOMC participants as December’s meeting approaches. A stronger dollar, weaker commodity prices, and falling inflation expectations suggest that the “transitory” negative weights on inflation might persist longer than the Fed anticipates.  
In addition, since I last wrote, real time estimates of fourth quarter GDP weakened in the face of incoming data. And manufacturing is data is off to a weak start this month with a fall in the Chicago PMI. Indeed, manufacturing indicators are weaker than we would normally see at the onset of a tightening cycle, but the Fed is betting that these indicators are passé in a world dominated by services. And that side of the economy seems to be holding up nicely:

ISM112915

We get fresh national readings from the Institute of Supply Management this week. Still, even if the numbers are on the soft side, there is little I think that will dissuade officials from hiking rates in December. With unemployment at 5% and wage growth picking up to confirm receding slack in the labor market, the general consensus on Constitution Avenue is that the time is ripe to nudge rates higher. Wait any longer, the thinking goes, you risk being unable to raise rates “gradually.” It will be interesting to see how the Fed would react to a weak November labor report, due Friday. It seems as long as the employment report is not a complete disaster, even numbers on the soft side would be enough to justify Fed action on the basis that the underlying trends remain in place.
As Torres also notes, even if December is pretty much in the bag despite questions about inflation, the path of subsequent rate hikes will depend on confidence in the path of inflation. Boston Federal Reserve President Eric Rosengren via an extensive interview with the FT:
My own personal view is we should have a flexible approach to thinking about the path with gradual being the important consideration, but we are still not near 2 per cent inflation. By the core PCE at 1.3 per cent we are still pretty far away. What gives me reasonable confidence about the path of inflation is the fact that the labour market slack seems to be diminishing relatively quickly. But I would want to continue to see progress on wages and prices moving up. If we weren’t seeing wages and prices moving up over time our willingness to keep raising rates would go down . . . 
So it is partly conditional on whether that reasonable confidence, as your rates get higher you should probably want a standard that is a little higher than reasonable confidence. I would not expect to continue to see 1.3s for the core PCE. If we continue to see 1.3 [per cent] for the core PCE we would have to think about why is inflation not picking up towards our 2 per cent goal.
Will wages and prices move higher? I would be surprised if this wasn’t the case, assuming of course the economy maintains sufficient cyclical momentum to sustain further improvements in the labor force. An often-overlooked point is that wage growth is arguably not as puzzling as it seems. Consider the Atlanta Fed Wage Growth Tracker, which estimates median wage growth of matched individuals, those with earnings now and twelve months ago. By tracking persons with continuous employment over a year, this metric avoids the problem of compositional effects due, for example, to persons entering and leaving the labor force due, for example, to demographic shifts or cyclical factors. The Atlanta Fed measure compared to other measures of wages:

WAGESe112915

The Atlanta Fed measure accelerated in 2015 as unemployment moved below 6%:

WAGESa112915

Note the deceleration in wages in recent months; this is attributable to lower wage growth for women. Looking at men only, the relationship between unemployment and wage growth is somewhat tighter:

  WAGESc112915

The Atlanta Wage Growth Tracker suggests that the underlying relationship between unemployment and wages remains intact. Weaker than expected wage growth seen in traditional metrics is thus attributable to compositional effects. These effects should lessen as unusually high levels of underemployment continue to recede (although demographic change will continue as high wage workers retire), and thus traditional wage metrics should accelerate. That is the Fed’s expectation as well.
But what about inflation? Will inflation necessarily move higher as labor markets improve further? That is still an open question. Rising wages would be evidence of decreasing economic slack, and Federal Reserve Chair Janet Yellen has said that she anticipates inflation to rise back to target as slack diminishes and the transitory impacts on inflation wane. Indeed, if the economy reverts to an equilibrium similar to that of the late 2000’s, we would expect both wage growth and inflation to both move roughly 100bp higher as unemployment declines toward 4.5%. In such a scenario, real wage growth would be unchanged. Indeed, adjusting the Atlanta Fed numbers for inflation indicates that real wage growth has already returned the late 2000’s range of 1.5-2% year-over-year: 

WAGESb112915

It appears that the economy transitioned to lower real wage growth relative to the late 1990’s in response to the productivity slowdown. 
Hence I think the base case of rising wages and prices remains reasonable – assuming sufficient cyclical momentum to carry unemployment lower still. But how much tightening can the economy weather before that cyclical momentum wanes? Therein lies the Fed’s challenge. Employment indicators tend to be lagging, and the economy may already be already easing into a soft patch. Conor Sen sees that the drivers of growth this cycle are abating, and hence activity will need to be a transition to new drivers. Note also signs that the US credit cycle is already tightening and the rising levels of distressed debt (only a third of which is oil and gas related). In other words, if the economy is indeed at an inflection point with credit conditions already tighter, the room for tightening is likely limited – and the room for error higher. This is likely more so the case in a world of low interest rates; in such a world, policy might turn tighter more quickly than in previous cycles.  
Bottom Line: Just how data-dependent is the Fed when it comes to December? Not much, I think. They are likely just looking for evidence that basic labor market trends remain intact to justify pulling the pin on higher rates. Absent any sharp financial disruptions or disastrous data, it looks like we are on the final countdown to the first rate hike of this cycle. Beyond that, they will proceed very cautiously; this is especially the case if they don’t see evidence of still-declining slack in the form of rising wages and inflation. And if the economy turns choppy as the drivers of recent growth loose their momentum, policy will turn choppy as well. Indeed, in such an environment, future rate hikes would likely comes in fits and starts. Thus while 100bp of tightening is a reasonable baseline for next year, the path is not likely to be a smooth 25bp every other meeting. That will likely pose some interesting communications challenges for the Fed.

Monday, November 23, 2015

Fed Watch: Mission Accomplished

Tim Duy:

Mission Accomplished, by Tim Duy: Federal Reserve policymakers have pretty much taken all of the mystery out of this next meeting. Federal Reserve Vice Chair Stanley Fischer, via Reuters:

"In the relatively near future probably some major central banks will begin gradually moving away from near-zero interest rates," Fed Vice Chairman Stanley Fischer told the San Francisco Fed's biannual Asia Economic Policy conference.

"While we at the Fed continue to scrutinize incoming data, and no final decisions have been made, we have done everything we can to avoid surprising the markets and governments when we move, to the extent that several emerging market (and other) central bankers have, for some time, been telling the Fed to 'just do it'."

New York Federal Reserve President William Dudley, via Reuters:

The Federal Reserve should "soon" be ready to raise interest rates as U.S. central bankers grow confident that low inflation will rebound and that employment remains stable, William Dudley, the influential head of the New York Fed, said on Friday.

"We hope that relatively soon we will become reasonably confident that inflation will return to our 2 percent objective," he said at Hofstra University. Dudley said it was "very logical" to expect that the Fed's inflation and employment conditions would be met "soon," allowing policymakers to "start thinking about raising the short-term interest rates."

Atlanta Federal Reserve President Dennis Lockhart, via CNBC:

A top Federal Reserve official said Thursday he is "comfortable" with raising the federal funds rate "soon," as concerns about low inflation and global risks are not persuasive enough to keep interest rates near zero.

"I'm comfortable with moving off zero soon," said Atlanta Fed President Dennis Lockhart in prepared remarks.

San Francisco Federal Reserve President John Williams, via Reuters:

"The data I think have been overall encouraging, especially on the labor market," San Francisco Fed President John Williams told reporters after a conference at University of California Berkeley's Clausen Center.

"Assuming that we continue to get good data on the economy, continue to get signs that we are moving closer to achieving our goals and gaining confidence getting back to 2-percent inflation... If that continues to happen there's a strong case to be made in December to raise rates."

Obviously serial dissenter Richmond Federal Reserve President Jeffrey Lacker is also looking for a rate hike. And so too is Cleveland Federal Reserve President Loretta Mester. To be sure, they all give a nod to “data dependence,” implying that a rate hike is not a sure thing. But, barring an outright collapse in financial markets, it is very difficult to see the data evolve between now and December 15-16 in such a way that the Fed suddenly has a change of heart. And note there is little reason for them to think at this point that growth has slowed well below trend. It is widely expected that Q3 GDP is this week revised up to 2.1% while current quarter GDP is tracking at 2.3%. While in 1990s terms these are not staggering numbers, in 2010 terms they exceed the Fed’s estimate of potential GDP growth. And with more and more Fed officials convinced the economy is operating near full employment, anything over 2% raises worries on Constitution Avenue that the economy might overheat.

Now, we still have one employment report ahead of us. Aside from the now-reversed equity declines in August, recall from the last minutes that uncertainty regarding the labor market helped stay the Fed’s hand:

In assessing whether economic conditions and the medium-term economic outlook warranted beginning the process of policy normalization at this meeting, members noted a variety of indicators, including some weaker-than-expected readings on measures of labor market conditions, and almost all members agreed it was appropriate to wait for additional information to clarify whether the recent deceleration in the pace of progress in the labor market was transitory or reflected more persistent factors that might jeopardize further progress.

It would seem that the October labor report put an end to those concerns. Consequently, the following comes into play:

Members emphasized that this change was intended to convey the sense that, while no decision had been made, it may well become appropriate to initiate the normalization process at the next meeting, provided that unanticipated shocks do not adversely affect the economic outlook and that incoming data support the expectation that labor market conditions will continue to improve and that inflation will return to the Committee's 2 percent objective over the medium term.

I suspect that only an outright disaster in the November labor report would prompt the Fed to take a pass at the December meeting. It is just simply the case that given their Phillips curve framework, they are running out of reasons not to raise rates. They would need enough weak data to fundamentally alter their outlook to the downside, and it is hard to see that happening in the short time remaining.

Consequently, it is hard to come to any other conclusion than that they are going to raise the target range on the federal funds rate in December. In Fedspeak, they might as well be screaming it into your ears.

While they may be taking the mystery out of the first rate hike, however, they are trying to put the mystery into subsequent rate hikes. Lockhart, via Reuters:

"The pace of increases may be somewhat slow and possibly more halting than historic episodes of rising rates," Lockhart said in a speech to the DeKalb Chamber of Commerce in Atlanta.

Williams, via Reuters:

"We definitely do not want to, either through our actions or our words, indicate a preference for a very mechanical path of interest rates, whether it’s every other meeting or however you think about it," Williams said. "Since economic data can surprise on the upside and the downside, maybe there will be opportunities to show we are data dependent."

And St. Louis Federal Reserve President James Bullard, via Bloomberg:

“When we had a normalization in 2004 to 2006 we moved at the same 25 basis points per meeting for 17 meetings in a row,” Bullard said. “I am virtually certain that was not optimal monetary policy. That was a very mechanical approach to increasing rates. This time I am hopeful we can be more flexible and reactive to data.”

How will they communicate uncertainty in the path of rate hikes? I wonder if they can simply retain this sentence in the next statement:

In determining whether it will be appropriate to raise the target range at its next meeting, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation.

It seems like this could be used to convey uncertainty in subsequent meetings, especially if they choose not to hike in January.

Bottom Line: The Fed is set to declare “Mission Accomplished” at the next FOMC meeting. Indeed, many policymakers have already said as much. Absent a very significant change in the outlook, failure to hike rates in December would renew the barrage of criticism regarding their communications strategy that prompted them to highlight the December meeting in their last statement. Once they have communicated their intentions for subsequent rate hikes, they will turn their attention to the issue of normalizing the balance sheet. Even though officials have not committed to a specific path, I am working with a baseline of 100bp of tightening between now and next December, or roughly 25bp every other meeting. I expect that by the second quarter of next year they will begin communicating the fate of the balance sheet. Whether they should hike or not remains a separate issue. Over the next twelve months we will learn the extent of which the Federal Reserve can resist the global downward pull of interest rates. Other central banks have been less-than-successful in their efforts to pull off of the zero bound – not exactly a hopeful precedent.

Monday, November 09, 2015

Fed Watch: Onto The Next Question

Tim Duy:

Onto The Next Question, by Tim Duy: It would seem that a December rate hike is all but certain barring some dramatic deterioration in financial conditions. The October employment report should remove any residual concerns among FOMC members over the underlying pace of activity, clearing the way for the Fed to make good on the strongly worded October FOMC statement. Given the resilience of recent trends, it is tough to see that even a weak-ish November employment report would dissuade the Fed from hiking rates. Quite frankly, regardless of whether you think they should hike rates, if they don't hike rates, the divergence between what they say and what they do would become truly untenable from a communications perspective.
Nonfarm payrolls jumped 271k in October, a relief after two weaker reports. Note though that the three-month moving average still indicates that job growth has lost some momentum:

NFPb110815

That said, momentum remains sufficient to sustain ongoing improvement in a wide array of labor market indicators. Those pervasively identified by Federal Reserve Chair Janet Yellen:

NFP110815

NFPa110815

Notably, wage growth accelerated, giving fresh hope that it has broken out of its multiyear doldrums. The Fed will see this as evidence that their estimates of the natural rate of unemployment are more right than wrong:

NFPc110815

Another way to see that wage growth may be set to break higher:

NFPd110815

If nominal wage growth were to break higher, would that reflect the impact of productivity gains, margin compression, or higher inflation? Your view on that question will influence your rate outlook.
With unemployment edging below the Fed's current estimate of the natural rate (note that we get updated forecasts in December) and wages showing signs of life, it seems that the Fed is positioned to move forward with a rate hike in December. This is especially if they want to make good on their promise to hike rates at a gradual pace. San Francisco Federal Reserve President John Williams reiterated that point last week. Via the Wall Street Journal:
“An earlier start to raising rates would also allow a smoother, more gradual process of policy normalization, giving us space to fine-tune our responses to any surprise changes in economic conditions,” Mr. Williams said. “If we were to wait too long to raise rates, the need to play catch-up wouldn’t leave much room for maneuver,” he said.
Note that the first hike and pace of tightening were never really separate as the Fed would like you to believe. Williams makes clear the the pace was in fact dependent on the timing of the first hike. The earlier they start, the more gradual the subsequent pace.
The question now arises, however, of what is "gradual"? The general consensus is the "gradual" means 25bp every other meeting. St. Louis Federal Reserve President James Bullard says there is not fixed definition as of yet. Via Reuters:
"Once 'liftoff' occurs the debate will immediately shift to when is the next move going to come? How fast is the pace of increases going to be? ... What does 'gradually' actually mean?" Bullard said. "That is going to be a hot debate and we won't really have credibility as a committee for the notion of gradualness until we make that second move."
Has the Fed already waited too long to sustain a path of 25bp every other meeting? That is what we should be asking. Indeed, I believe the next labor report will have more implications for the January meeting than the December meeting. Anxiety among Fed officials regarding whether or not they are falling behind the curve is inversely proportional to the unemployment rate. If it ticks down to 4.8% in the November report, they will start to get very nervous that 25bp every other meeting is not tenable. It of course goes without saying that if core-inflation starts to firm in the next two months and tend toward trend more quickly than anticipated, policymakers will break into a cold sweat.
Still unknown is how rate hikes will interact in the global environment. Fed Governor Lael Brainard has yet to give up her concerns. Via MarketWatch:
Brainard said the "feedback loop" between market expectations of divergence between the U.S. and its major trading partners and financial tightening in the U.S. means that "material restraint to U.S. conditions is already in place."
How much tightening Fed tightening can the US sustain in a world driven the zero lower bound globally? Such concerns are generally downplayed by Fed officials; that lack of concern is something I view as a key risk. The tipping point between loose and tight financial conditions is likely lower than in the past. The Fed may blow past that tipping regardless of how fast they hike rates. In some sense, one can argue that the end point for rate hikes is more important than whether the Fed moves on average at 12.5bp or 25bp every meeting.
Bottom Line: The debate is shifting. It is soon to be no longer about the first rate hike. Fed officials, the question is shifting from whether they should go at all to whether they waited too long.

Wednesday, November 04, 2015

Fed Watch: What 2016 Might Bring

Tim Duy:

What 2016 Might Bring, by Time Duy: I recently predicted the following:
One of two things is going to happen. Either the US economy is or will soon be slowing on the back of already tighter financial conditions. Or the US economy will soon be slowing on the back of future tighter financial conditions as directed by the Federal Reserve.
My baseline expectations for next year need more explanation, particularly in light of the weak third quarter GDP report and the early signals on fourth quarter growth via the Atlanta Fed’s GDPNow tracker (currently at the low-end of consensus). Three caveats, however, to keep in mind. First, I avoid over-analyzing the quarterly fluctuations in GDP preferring instead to track trends over a longer period. Second, similarly, the initial release will be subject to substantial revision. Third, the Atlanta Fed number may or may not evolve over the course of the quarter; where it is now is not necessarily where it will be when fourth quarter data is released.
That said, GDP growth slowed noticeably in the third quarter, dragging down recent trends:

GPDCONT110315

Negative inventory adjustment, however, was a significant factor. When we look at recent trends in final sales to domestic purchases, domestic momentum remains solid:

DOMPUR110315

Generally, housing, autos, services, and the government sectors remain solid. The soft spots are the external sector and manufacturing. These two are obviously related; weakness in manufacturing is closely tied to a stronger dollar and reduced activity in the oil and gas exploration. ISM surveys reveal a striking divergence between the manufacturing and services sides of the economy:

ISM110315

It is thus quite arguable that, after accounting for inventories, little momentum has been lost. The softening of the job growth, however, suggests that the underlying pace of growth has pulled back from full throttle (at least our current definition of full throttle):

NFP110315

Perhaps then growth has in fact softened, possibly a consequence of already tighter monetary policy. Minneapolis Federal Reserve President Narayana Kocherlakota:
In mid-2013, the FOMC announced its intention to taper its ongoing asset purchase program. We can see that this announcement represented a dramatic change in policy from the sharp upward movements in long-term bond yields that it engendered. Personally, I interpret this policy change back in 2013 as the onset of what the Committee currently intends to be a long, gradual tightening cycle. As I noted earlier, we would typically expect that such a change in monetary policy should affect the economy with a lag of about 18 to 24 months. Viewed through this lens, the slow rate of labor market improvement in 2015 is not all that surprising.
We will get a reading on the labor market Friday to help confirm or deny recent trends. Suppose the numbers both this month and next are better than expected, thus belying the recent softness. What will be the Fed’s reaction? I think it is fairly safe to say the “raise rates” contingent will have the upper hand in December, thus formally beginning the “normalization” process with a first rate hike of the cycle.
In other words, if growth is not in fact slowing, then the Federal Reserve will likely soon take action to slow growth. How many rate hikes follow? And how rapidly do they follow? The Fed appears to believe that they have roughly 375bp ahead of them and can raise rates every other meeting to get there. What actually happens will depend on how hard they think they will be running up against any constraints in the economy. As a summary indicator, note that the unemployment rate already sits at something near policymaker’s estimate of the natural rate of unemployment:

UNEMP110315

My interpretation of the Fed’s intentions is that they would like to see the unemployment rate temporarily stabilize at something below the natural rate to allow for further reduction in underemployment. To accomplish this job growth will need to slow over the next year to that necessary to absorb growth in the labor force. What does that mean for the numbers? San Francisco Federal Reserve President John Williams offers what is probably a reasonable middle ground among officials:
As we make our way back to an economy that’s at full health, it’s important to consider what constitutes a realistic view of the way things will look. The pace of employment growth, as well as the decline in the unemployment rate, has slowed a bit recently…but that’s to be expected. When unemployment was at its 10 percent peak during the height of the Great Recession, and as it struggled to come down during the recovery, we needed rapid declines to get the economy back on track. Now that we’re getting closer, the pace must start slowing to more normal levels. Looking to the future, we’re going to need at most 100,000 new jobs each month. In the mindset of the recovery, that sounds like nothing; but in the context of a healthy economy, it’s what’s needed for stable growth.
As the next year unfolds, what we want to see is an economy that’s growing at a steady pace of around 2 percent. If jobs and growth kept the same pace as last year, we would seriously overshoot our mark. I want to see continued improvement, but it’s not surprising, and it’s actually desirable, that the pace is slowing.
All else equal, if they are not seeing evidence of that slowing by the middle of next year I would expect them to accelerate the pace of rate increases. That is probably when we need to worry about overshooting. Not so much from the faster rate increases, but from the failure to account for policy lags. It may be a challenge to see the impacts of policy tightening early on if rate hikes are at a glacial pace. Hence the Fed may erroneously believe they need to play “catch-up” more than is truly necessary.
Overshooting, however, is a consideration for a later day. At this point it is sufficient to recognize that, at least under the current monetary policy framework, either the economy will slow by itself or the Fed will eventually work to force it to slow. That would seem to suggest that growth is at or past its peak for this cycle. That is the situation I am most wary of at the moment, leading me to the conclusion that growth is headed down in 2016.
I am not wedded to that scenario. I can envision sustained higher growth on the back of either faster than anticipated labor force growth or faster productivity growth. Recent trends tend not to be terribly supportive, but nonetheless I remain watchful that those trends shift. Indeed, perhaps we will see productivity rise as firms react to tighter labor markets. Such a scenario could deliver a sustained growth with accelerating wages. That would obviously be something of a win-win situation.
To be sure, the inflation outlook has an impact on the Fed's timing, but it remains something of a wildcard. The Fed expects to normalize only after they are reasonably confident that inflation will return to target. Two more solid job reports are enough to get there. The pace of subsequent rate hikes depends on the evolution of inflation relative to that target. As Federal Reserve Chair Janet Yellen said today, via the Wall Street Journal:
Referring to recent remarks by Fed governor Lael Brainard on the subdued state of U.S. inflation, Ms. Yellen told lawmakers that “if we were to move, say in December, it would be based on an expectation -- which I believe is justified -- that with an improving labor market and transitory factors fading, that inflation will move up to 2%. But of course if we were to move, we would need to verify over time that expectation was being realized, and if not, adjust policy appropriately.”
Near term inflation perked up a bit in September, but still remains below target:

PCE110315

One might think that persistently low inflation eventually wears on inflation expectations. Yellen raised this concern in September:
Although the evidence, on balance, suggests that inflation expectations are well anchored at present, policymakers would be unwise to take this situation for granted. Anchored inflation expectations were not won easily or quickly: Experience suggests that it takes many years of carefully conducted monetary policy to alter what households and firms perceive to be inflation's "normal" behavior, and, furthermore, that a persistent failure to keep inflation under control--by letting it drift either too high or too low for too long--could cause expectations to once again become unmoored. Given that inflation has been running below the FOMC's objective for several years now, such concerns reinforce the appropriateness of the Federal Reserve's current monetary policy, which remains highly accommodative by historical standards and is directed toward helping return inflation to 2 percent over the medium term.
Interestingly, the University of Michigan’s survey of inflation longer-term inflation expectations continues to drift lower just as the Fed is considering rate hikes:

INFEXP1110315

Contrast with the cycle of tightening in the middle of the last decade:

INFEXP2110315

The accuracy of survey-based measures is in doubt, however. For example, via the St. Louis Federal Reserve, economist Kevin Kliesen concludes:
Going forward, most Federal Reserve officials expect inflation to eventually return to 2 percent. But when using measures of inflation expectations to forecast future inflation, policymakers and forecasters should focus on market-based measures of inflation expectations. They are much more accurate than survey-based measures.
Yellen, however, hesitates to embrace market-based measures of inflation expectations (although I suspect she would quickly embrace them if they headed higher). Discarding both measures thus leaves us with little guidance, unfortunately. My take is that there is probably some information from the direction of both measures, and that information is generally not supportive of the Fed’s confidence that inflation will return to target in a timely fashion. The Fed would have a hard time justifying ongoing hikes, even if the economy outperforms their expectations, if inflation remains tame. My suspicion is that under such a scenario the Fed would pivot away from their current inflation framework to financial stability concerns to justify tighter policy.
Bottom Line: I tend to believe that growth has peaked for this cycle, or, more accurately, that sustaining these growth rates will likely require faster productivity or labor force growth. Indeed, it appears the Fed will force such an outcome if they remain committed to their basic policy framework. This seems like a reasonable baseline from which to think about the next 4 or 5 quarters. Productivity growth could pick up such that a stabilizing unemployment rate remains consistent with steady growth. Assuming growth is not yet softening, a 25bp rate hike every other meeting beginning in December is also a reasonable baseline for monetary policy; if the Fed doesn't see that having an impact, they will likely step up the pace. It should go without saying that a slowing economy is not to be equated with a recession.

Thursday, October 29, 2015

Fed Watch: December Still Very Much A Live Meeting

Tim Duy:

December Still Very Much A Live Meeting, by Tim Duy: One of two things is going to happen. Either the US economy is or will soon be slowing on the back of already tighter financial conditions. Or the US economy will soon be slowing on the back of future tighter financial conditions as directed by the Federal Reserve.

In a worst case scenario, both of these things will happen.

And the odds of both of these things happening seems higher after this week's FOMC meeting. Rather than being a nonevent as expected, it was actually quite exciting. We learned that the majority of the FOMC remains wedded to the idea of a December rate hike. That was made very clear with this sentence:

In determining whether it will be appropriate to raise the target range at its next meeting, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation.

That was a fairly clear warning that December is really, really in play. No, really this time. They mean it. After all, a number of them are on record repeatedly saying that they expect to hike interest rates this year. I tend to wonder if they feel compelled to act on these statements? The opportunities to show their mettle are fairly limited at this point.

It also seems as if Federal Reserve Governors Lael Brainard and Daniel Tarullo were schooled hard this week. They argued publicly that they did not see reason to raise rates this year. I doubt they changed their opinions - at least not privately. But they very clearly did not change any opinions on the FOMC. Indeed, one wonders if they only hardened their colleagues positions on a rate hike this year. Consider Paul Krugman's response to me:

Maybe, but it’s also worth noting the difference in perspective that comes from having your original intellectual home in international versus domestic macroeconomics. I would say that Brainard’s experience is dominated not so much by the Great Moderation as by the Asian financial crisis and Japan’s stagnation; internationally oriented macro types were aware earlier than most that Depression-type issues never went away. And if you read Brainard’s argument carefully, she devotes a lot of it to the drag America may be facing from weakness abroad and the stronger dollar, which acts as de facto monetary tightening

Krugman is right; I should have mentioned this. Regardless, note what key line was removed from the September statement:

Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.

Downplaying these concerns appears to be an effort to cut the knees out from under Brainard. To be sure, US markets rebounded, but have we seen much in the last six weeks to so quickly remove global concerns? I am wary to believe so with data like these:

CRB spot raw industrial price index set new 6 year low this week. https://t.co/gN9Pcbhbua
— Caroline Baum (@cabaum1) October 28, 2015

In any event, it seems reasonable to believe that the bar for a rate hike at the next FOMC meeting is fairly low. Prior to the meeting I said this:

The middle range of closer to 150,000 jobs a month—a more lackluster reading similar to the past two months—is the gray area. This is the range in which the proper application of risk management principles becomes critical. In that range—a range I find likely—the degree to which Brainard & Co. shape the debate at this week’s meeting will determine the policy outcome in December, and likely beyond.

I am thinking we now we know how little Brainard shaped the debate. Lackluster numbers seem likely to suffice at this juncture. Hence why market expectations moved as they did:

The "hawkish" shift in hike expectations (yest => today)... Dec: 34% => 46% Jan: 41% => 54% Mar: 57% => 68% pic.twitter.com/1NLZwHgivE
— Charlie Bilello, CMT (@MktOutperform) October 28, 2015

The willingness of the Fed to hike in the face of lackluster numbers is a bit disconcerting, to say the least. Lackluster numbers, by definition, indicate slower activity, and one would think that the Fed would like to see how that played out before piling on. But assuming this from Jon Hilsenrath at the the Wall Street Journal:

Mr. Fischer is among those more eager to raise rates.

It is easy to see how the Fed gets behind tighter policy. I don't know that Brainard could easily counter the gravitas of Fischer.

Bottom Line: December stays on the table. Very much so, in fact. Indeed, in all reality the only reason market participants have not gone all in on December is because they recognize that the Fed has repeatedly cried "wolf" this year. Makes one distrustful of the Fed's proclamations. At this juncture, my expectation is that only disappointing data prevents the Fed from moving in December. It will be interesting to see how well the Fed statement holds up to the light of this week's GDP report and the next two employment reports.

Tuesday, October 13, 2015

Fed Watch: Brainard Drops A Policy Bomb

Tim Duy:

Brainard Drops A Policy Bomb, by Tim Duy: What if a Federal Reserve Governor drops a policy bomb in the woods and no one is there to hear it? Did it really make a noise?

That's what happened today. While the bond market was closed and whatever financial journalists were left focusing their efforts on newly-minted Nobel Prize recipient Angus Deaton, Federal Reserve Governor Lael Brainard dropped a policy bomb with her speech to the National Association of Business Economists. It was nothing short of a direct challenge to Chair Janet Yellen and Vice Chair Stanley Fischer. Is was, as they say, a BFD.

That, at least, is my opinion. Consider, for example, Brainard's opening salvo:

The will-they-or-won't-they drumbeat has grown louder of late. To remove the suspense, I do not intend to make any calendar-based statements here today. Rather, I would like to give you a sense of the considerations that weigh on both sides of that debate and lay out the case for watching and waiting.

Wait, who is making calendar-based statements? Yellen:

...these two judgments imply that the real interest rate consistent with achieving and then maintaining full employment in the medium run should rise gradually over time. This expectation, coupled with inherent lags in the response of real activity and inflation to changes in monetary policy, are the key reasons that most of my colleagues and I anticipate that it will likely be appropriate to raise the target range for the federal funds rate sometime later this year and to continue boosting short-term rates at a gradual pace thereafter as the labor market improves further and inflation moves back to our 2 percent objective.

and Fischer:

In the SEP, the Summary of Economic Projections prepared by FOMC participants in advance of the September meeting, most participants, myself included, anticipated that achieving these conditions would entail an initial increase in the federal funds rate later this year.

After essentially saying that such calendar-based guidance is beneath her, she says what she is going to do: Explain why policymakers should delay further. Note however this stands in sharp contrast with Yellen and Fischer. Their efforts have been spent on explaining why rates need to rise soon. Hers will be spent on why they do not.

After assessing the quality of the recovery, Brainard asserts:

In contrast to the considerable progress in the labor market, progress on the second leg of our dual mandate has been elusive. To be clear, I do not view the improvement in the labor market as a sufficient statistic for judging the outlook for inflation. A variety of econometric estimates would suggest that the classic Phillips curve influence of resource utilization on inflation is, at best, very weak at the moment. The fact that wages have not accelerated is significant, but more so as an indicator that labor market slack is still present and that workers' bargaining power likely remains weak.

Recall that Yellen, in her most recent speech, made the Phillips Curve the primary basis for her case that rates will soon need to rise:

What, then, determines core inflation? Recalling figure 1, core inflation tends to fluctuate around a longer-term trend that now is essentially stable. Let me first focus on these fluctuations before turning to the trend. Economic theory suggests, and empirical analysis confirms, that such deviations of inflation from trend depend partly on the intensity of resource utilization in the economy--as approximated, for example, by the gap between the actual unemployment rate and its so-called natural rate, or by the shortfall of actual gross domestic product (GDP) from potential output. This relationship--which likely reflects, among other things, a tendency for firms' costs to rise as utilization rates increase--represents an important channel through which monetary policy influences inflation over the medium term, although in practice the influence is modest and gradual. Movements in certain types of input costs, particularly changes in the price of imported goods, also can cause core inflation to deviate noticeably from its trend, sometimes by a marked amount from year to year. Finally, a nontrivial fraction of the quarter-to-quarter, and even the year-to-year, variability of inflation is attributable to idiosyncratic and often unpredictable shocks.

Yellen concludes, after breaking down the inflation shortfall into its constituent parts, that the resource utilization component is now fairly small and will soon dissipate, having only the temporary components to worry about:

Although an accounting exercise like this one is always imprecise and will depend on the specific model that is used, I think its basic message--that the current near-zero rate of inflation can mostly be attributed to the temporary effects of falling prices for energy and non-energy imports--is quite plausible. If so, the 12-month change in total PCE prices is likely to rebound to 1-1/2 percent or higher in 2016, barring a further substantial drop in crude oil prices and provided that the dollar does not appreciate noticeably further.

Brainard, however, is not buying this story. Brainard's focus:

Although the balance of evidence thus suggests that long-term inflation expectations are likely to have remained fairly steady, the risks to the near-term outlook for inflation appear to be tilted to the downside, given the persistently low level of core inflation and the recent decline in longer-run inflation compensation, as well as the deflationary cross currents emanating from abroad--a subject to which I now turn.

While Yellen sees the risks weighted toward rebounding inflation, Brainard sees the opposite. Moreover, policymakers have been twiddling their thumbs as the world economy turns against them:

Over the past 15 months, U.S. monetary policy deliberations have been taking place against a backdrop of progressively gloomier projections of global demand. The International Monetary Fund (IMF) has marked down 2015 emerging market and world growth repeatedly since April 2014.

While all of you have been arguing about when to raise rates, the case for raising rates has been falling apart! As a consequence:

Over the past year, a feedback loop has transmitted market expectations of policy divergence between the United States and our major trade partners into financial tightening in the U.S. through exchange rate and financial market channels. Thus, even as liftoff is coming into clearer view ahead, by some estimates, the substantial financial tightening that has already taken place has been comparable in its effect to the equivalent of a couple of rate increases.

Brainard buys into the view that recent activity in financial markets has already tightened monetary conditions. Later:

There is a risk that the intensification of international cross currents could weigh more heavily on U.S. demand directly, or that the anticipation of a sharper divergence in U.S. policy could impose restraint through additional tightening of financial conditions. For these reasons, I view the risks to the economic outlook as tilted to the downside. The downside risks make a strong case for continuing to carefully nurture the U.S. recovery--and argue against prematurely taking away the support that has been so critical to its vitality.

Not balanced, but to the downside. That calls for different risk management:

These risks matter more than usual because the ability to provide additional accommodation if downside risks materialize is, in practice, more constrained than the ability to remove accommodation more rapidly if upside risks materialize.

In effect, the Fed can't cut rates quickly, but they can raise rates quickly:

...many observers have suggested that the economy will soon begin to strain available resources without some monetary tightening. Because monetary policy acts with a lag, in this scenario, high rates of resource utilization may lead to a large buildup of inflationary pressures, a rise in inflation expectations and persistent inflation in excess of our 2 percent target. However, we have well-tested tools to address such a situation and plenty of policy room in which to use them.

Brainard is willing to risk a rapid rise in rates. Yellen is not. Indeed, quite the opposite. Yellen desperately wants a very slow pace of rate increases:

If the FOMC were to delay the start of the policy normalization process for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession.

The more I think about it, the less I am worried about this issue. Suppose that the Fed needs raise rates at twice the pace they currently anticipate. What does that mean? 25bp at every meeting instead of every other meeting? Is that really an "abrupt tightening?" Not sure that Yellen has a very strong argument here. Or one that would withstand repeated attacks from her peers.

I feel like I haven't scratched the surface on this speech, but I will cut to the chase: This is an outright challenge to the Yellen/Fischer view.

I think these three players are all products of their experience. Yellen received her Ph.D in 1971. Fischer in 1969. Both experienced the Great Inflation first hand. Brainard earned her Ph.D in 1989. Her professional experience is dominated by the Great Moderation.

I think Yellen wants to raise interest rates. I think Fischer wants to raise rates. I think both believe the downward pressure on inflation due to labor market slack is minimal, and the Phillips Curve will soon assert itself. I think both do not find the risks as asymmetric as does Brainard. I think they believe the risk of inflation is actually quite high. Or, probably more accurately, that the risk of destabilizing inflation expectations is quite high.

I think that Brainard knows this. I think that this speech is a very deliberate action by Brainard to let Yellen and Fischer know that she will not got quietly into the night if they push forward with their plans. I think that she is sending the message that they will not have just one dissent from a soon-to-be-replace regional president (Chicago Federal Reserve President Charles Evans), but a more-difficult-to-ignore Fed governor still voting when January 1 rolls around.

And now that Brainard has laid down the gauntlet, it will look very, very bad for Yellen and Fischer if their plans go sideways. This is very likely the last big decision of their careers. They know what happened to Greenspan’s legacy. I doubt they want the same treatment. Why risk their reputations when the cost of waiting is a 25bp move every meeting instead of every other meeting? Is it worth it?

Brad DeLong suggested the Fed commit to one of two policy messages:

I must say that they are not doing too well at the clear-communication part. I want to see one of following things in Fed statements:

  1. We will begin raising interest rates in December at a pace of basis points per quarter, unless economic growth and inflation fall substantially short of our current forecast expectations.
  2. We will delay raising interest rates until we are confident that it will not be appropriate to return them to the zero lower bound after liftoff.

If we had one of these, we would know where we stand.

But Stan Fischer's speech provides us with neither.

I think that Fischer wants the first option, but knows Brainard’s views, and hence knows that December is not a sure thing if Brainard can build momentum for her position. Hence the muddled message. Brainard could be the force that drives the Fed toward option number two. An option closer to that of Evans and Minneapolis Federal Reserve President Narayana Kocherlakota. That would be a game changer.

Bottom Line: This is the most exciting speech I have read in forever. Not necessarily for the content. But for the politics. Evans and Kocherlakota are no longer the lunatic fringe. This could be a real game changer that shifts the Fed toward the Evans view of the world, with no rate hike until mid-2016. Brainard muddied further the already murky December waters.

Monday, October 12, 2015

Fed Watch: Fed Struggles With The High Water Mark

Tim Duy:

Fed Struggles With The High Water Mark, by Tim Duy: Gavyn Davies reviews the evidence on the apparent slowing of US economic activity and concludes:

So is the US slowdown for real? Yes, but it is not yet very severe — and some of it is the result of the temporary inventory correction, and some to the rising dollar. Unless it grows worse in the next few weeks, it is unlikely to dislodge the Fed from the path it has now firmly chosen.

This I think is broadly consistent with views on the FOMC and explains why many policymakers insist that a rate hike this year remains likely. Vice Chair Stanley Fischer was the latest to reiterate the point. Via his prepared remarks for the IMF:

In the SEP, the Summary of Economic Projections prepared by FOMC participants in advance of the September meeting, most participants, myself included, anticipated that achieving these conditions would entail an initial increase in the federal funds rate later this year.

They will want look through any near term GDP volatility, and discount volatility related to inventories. Look then to real final sales rather than GDP. Avoid getting caught up in the headline numbers; watch the underlying trends instead.

Still, there is a range of views on the FOMC, from Richmond Fed Jeffrey Lacker, who believes the Fed should already have raised rates, to Minneapolis Federal Reserve President Narayana Kocherlakota, who would like the Fed to consider a negative rate. And arguably even the center is not particularly committed to a particular policy path. To be sure, they like to talk tough, but every time they get ready to jump, they walk back from the edge.

Why the lack of conviction? Essentially, the economy is resting on what is likely its high water mark for growth in this cycle, leaving the Fed perplexed regarding their next move. They want the economy to slow from its current pace and glide into a soft landing. But acting too early will leave their job half finished and sow the seeds of the next recession. Acting too late, however, will yield the inflationary outcome they so fear. And they don't know the exact definitions of "too early" and "too late."

This chart (modified from Davies' version) illustrates the evolution of US growth since 2012:

CONTRIB101115

In broad terms, consumption, investment, and government spending jointly accelerated during 2013. The external side of the economy offset some of this acceleration by first moving from a slightly positive contribution to none and then, beginning in 2014, a substantial negative contribution. The net effect is that overall economy largely normalize around a 2.5% growth rate in 2014 and remained there since.

That 2.5% growth is what the economy delivers given the combination of long-term factors (labor and productivity growth) and the current set of fiscal, monetary, and external conditions. The actual composition of output will evolve around that 2.5% rate. It is likely the high-water mark, in terms of growth, for this recovery. Faster growth likely requires a net easier combination of monetary and fiscal policy. Slower growth may already be locked in by past policy, or maybe the economy just moves generally sideways from here.

Most important is to remember that monetary policymakers expect and want the economy to slow as it gently glides down to that mythical soft-landing. They aren't looking for faster growth. The current pace of growth will, in their view, force unemployment further below the natural rate next year than they are willing to tolerate. Hence the most recent employment reports are not necessarily unmitigated bad news from their perspective. New York Federal Reserve President William Dudley, via Bloomberg:

Dudley said the key to liftoff will be whether the labor market continues to improve, thereby putting more upward pressure on wages and inflation. Last month’s jobs report was “definitely weaker,” but even monthly gains of 120,000 or 150,000 are enough to continue to push the U.S. unemployment rate lower, he said.

Or, more explicitly, from San Fransisco Federal Reserve President John Williams:

The pace of employment growth, as well as the decline in the unemployment rate, has slowed a bit recently…but that’s to be expected. When unemployment was at its 10 percent peak during the height of the Great Recession, and as it struggled to come down during the recovery, we needed rapid declines to get the economy back on track. Now that we’re getting closer, the pace must start slowing to more normal levels. Looking to the future, we’re going to need at most 100,000 new jobs each month. In the mindset of the recovery, that sounds like nothing; but in the context of a healthy economy, it’s what’s needed for stable growth. (emphasis added)

Williams is looking for 2% growth in the second half of this year and next year. He expects the economy to slow, and believes it needs to slow to sustain healthy, long-run growth. But I don't think he knows exactly when and how much the Fed needs to tap the breaks to achieve that healthy growth. And he would not be alone - lack of consensus around the question is exactly why communication appears so muddled. They can't tell you what they don't know.

Further confusing the issue is the cat that Kocherlakota let out of the bag last week:

In mid-2013, the FOMC announced its intention to taper its ongoing asset purchase program. We can see that this announcement represented a dramatic change in policy from the sharp upward movements in long-term bond yields that it engendered. Personally, I interpret this policy change back in 2013 as the onset of what the Committee currently intends to be a long, gradual tightening cycle. As I noted earlier, we would typically expect that such a change in monetary policy should affect the economy with a lag of about 18 to 24 months. Viewed through this lens, the slow rate of labor market improvement in 2015 is not all that surprising.

I believe the FOMC should take actions to facilitate a resumption of the 2014 improvement in the labor market by adopting a more accommodative policy stance...

As group, monetary policymakers have stuck by the line that "tapering is not tightening." Kocherlakota is not following the party line. He explicitly connects the dots and concludes that the current inflection point in the economy is the result of the tapering debate begun over two years ago. He essentially argues that had it not been for the taper and end of QE3, then financial conditions would be more accommodative today and the economy would not yet be at an inflection point.

Kocherlakota is an outlier; he is not interested seeing the labor market throttle back just yet, fearing that such an outcome will end improvement in underemployment indicators. This would lock the economy into a suboptimal state of persistent excess slack and impede the return of inflation to the Fed's target. The general consensus on the FOMC is that such a goal can be achieved with more a more moderate pace of improvement in labor markets that holds unemployment modestly below the natural rate for a time. Hence he is alone in his view that more easing is needed at this time. Chicago Federal Reserve President Charles Evans probably comes closest with his explicit calls to hold rates at current levels until the middle of 2016.

But even if the party line is that "tapering is not tightening," Kocherlakota must have planted the seeds of doubt in the minds of his colleagues. After all, it is a risk management exercise. If they are wrong, and Kocherlakota is right, then they will look like the dropped the ball if they pull the trigger too early. Something of a big risk to take when inflation remains persistently below trend and you lack traditional tools to respond to a renewed slowdown in activity.

Bottom Line: So where does all of this leave Fed policy? Confused, I think, like September when economists saw the outcome of that meeting as a coin toss. Don't expect communications to become much clearer. October is off the table (despite what Lacker might believe). They first need to decide if the last two months of jobs data were aberrations or signals of slowing job growth. They can't do that before October. And I am not confident they can do so by December. If we get two more reports hovering around 200k a month between now and December, matched with generally consistent data across other indicators, then December is on the table. That would indicate the economy is not coming off its high water mark without some help from the Fed. If jobs growth slows to 100k a month, again with a broad swath of generally consistent data, then we are looking at deep into 2016 before any hike. Around 150k is the gray area. They won't know if the economy is poised to head lower on its own, or if that is sufficient to contain inflationary pressures. They don't know if they should be tapping on the breaks or not. Risk management under the assumption of constrained inflation suggests they push off action until January or March. But they would not send such a clear message. Indeed, I suspect that more numbers like the last two will make the December meeting much like September's. That I fear is my current baseline - another close call in which the Fed concludes to take a pass.

Thursday, September 17, 2015

Fed Watch: Final Thoughts On September

Tim Duy:

Final Thoughts On September, by Tim Duy: Everyone's bets are placed for the outcome of tomorrow's FOMC statement and subsequent press conference. Final thoughts heading into the meeting:
I expect the Fed will pass on raising rates this meeting. This is a highly contentious issue, and reasonable arguments can be made for either case. Economists appear to be roughly split, while financial market participants taking the under with a roughly 25% probability of a rate hike. Whatever the outcome, roughly half of the economists on Wall Street will be wrong. Good thing, as misery loves company.
I believe FOMC participants will arrive at a consensus for the timing and direction of policy for subsequent meetings. The FOMC has had something of a luxury in that economic conditions have not forced them to choose a defined policy path. I believe they no longer have that luxury. They will need to commit policy to one side of the mandate or the other. At this meeting they will decide if their Phillips curve view of the world in concert with their estimate of the natural rate of unemployment dominates the fact that inflation continues to drift away from their target.
I expect the Fed will ultimately pledge allegiance to the Phillips curve. I think they believe that stable inflation is incompatible with sub-5% unemployment if short term interest rates remain at zero. Hence, they will signal that the first rate hike is imminent.
Fed Chair Janet Yellen has the opportunity to prove her mettle. Assuming that I am correct that the Fed needs to forge a consensus, Yellen will be the guiding influence on that consensus. The best outcome for her is a consensus with no dissenting votes. That said, it may be that only an immediate rate hike would be acceptable to Richmond Federal Reserve President Jeffrey Lacker.
I expect Yellen will make a strong attempt to open the door for October. The Fed has established expectations that, outside of obvious exigent circumstances, they can only make major decisions when there is a scheduled press conference. Yellen will push back hard. Indeed, I think there is a possibility that this becomes the "rate hike" press conference in spirit, with the actual hike in October. Something to think about.
The Fed will try to take the sting out of any hawkish signals with a dovish message. I expect the terminal rate forecasts in the dot plot to drift lower. In addition, I expect Yellen will emphasize that low inflation provides room for a slow and halting pace of rate increases. (My expectation, however, is that assuming the first hike goes smoothly, subsequent hikes will come at regular intervals.) Finally, the estimate of the natural rate of unemployment may drift down further. 
If I am wrong...two potential alternatives. First is that everything above remains the same, but they pull the trigger today. They tend not to surprise, but maybe this time is different. Maybe they don't need to built a consensus, although I think that unlikely.  Second is that Yellen pushes the FOMC into a dramatically more dovish direction that re-emphasizes the issue of underemployment and shifts expectations to 2016. I don't think that is likely as I think she is fairly entrenched in the 5% NAIRU camp, but we will see tomorrow.
Enjoy the day's excitement!

Tuesday, September 15, 2015

'Why the Fed Is Likely to Stand Pat This Week'

Tim Duy at Bloomberg:

Why the Fed Is Likely to Stand Pat This Week: What a week it might have been?

Speeches and interviews have made it fairly clear that Federal Reserve officials were building a case to begin normalizing interest rate policy as soon as this month, but they are increasingly wary that a misstep could derail the economy at a time when they perceive a lack of tools to address renewed weakness.

From the policy discussion of the June Federal Open Market Committee meeting:

Another concern related to the risk of premature policy tightening was the limited ability of monetary policy to offset downside shocks to inflation and economic activity when the federal funds rate was near its effective lower bound.

This concern will weigh heavily on the policy discussion as the Fed begins what promises to be a tumultuous two-day meeting this week. While the central bank was likely prepared to raise interest rates this month at the conclusion of the last FOMC meeting, deteriorating global economic conditions and market volatility will likely derail those plans.

Nor is the inflation picture particularly supportive at this juncture. ...[continue]...

Tuesday, September 08, 2015

Fed Watch: Flying Mostly Blind Heading Into the September FOMC Meeting

Tim Duy:

Flying Mostly Blind Heading Into the September FOMC Meeting, by Tim Duy: Last year, I would have said you were crazy if you told me that short-term rates would still be hugging zero even as unemployment fell to 5.1 percent. Yet here we are, gearing up for a FOMC meeting that promises to be the most contentious in years. The era of data dependence yielded substantially less clarity on the direction of policy than one would hope for, leaving expectations for the meeting’s outcome all over the place. That means this meeting is not just about 25 basis points – it’s about defining the parameters of the Fed’s reaction function. We will learn what data dependence means not just in theory, but in practice.
The argument for a move next week is straightforward. Actual and underlying economic activity remains sufficient to sustain further improvement in the labor market. Indeed, dramatic progress has been made when viewed through the eyes of Federal Reserve Chair Janet Yellen as she scoped out the economic landscape in 2013:

YELLEN1090815

With unemployment at the Fed’s estimate of the natural rate, inflationary pressures will soon emerge. To be sure, wage growth remains flat, but even Yellen leans toward writing that off as an expected outcome of low productivity growth:
The growth rate of output per hour worked in the business sector has averaged about 1-1/4 percent per year since the recession began in late 2007 and has been essentially flat over the past year. In contrast, annual productivity gains averaged 2-3/4 percent over the decade preceding the Great Recession. I mentioned earlier the sluggish pace of wage gains in recent years, and while I do think that this is evidence of some persisting labor market slack, it also may reflect, at least in part, fairly weak productivity growth.
When combined with stable inflation expectations, policymakers have good reason to be confident that actual inflation will soon reverse course and trend toward the Fed’s target. In such an environment, financial accommodation needs to be withdrawn pre-emptively to avoid overshooting the targets. As policymakers prefer to raise rates gradually, they are impelled to raise them early to avoid the risk of more rapid increases in the future.
The counterargument, however, is also straightforward. Labor markets remain far from healed if viewed through the eyes of Yellen in 2014: 

YELLEN2090815

Low wage growth is thus consistent with the hypothesis that underemployment indicators are important measures of labor market health. The persistence of weak wage growth should leads to revised estimates of the natural rate of unemployment. After all, targeting 5 percent unemployment when the natural rate is 4 percent means denying jobs to roughly 1.5 million people. That’s no small responsibility.
Moreover, inflation continues to trend away from target. If you are uncertain of your estimate of the natural rate and inflation is moving away from target, why rush to hike rates? Even though Fed officials believe that inflation has been unduly influenced by the temporary factors of falling oil prices and a rising dollar, those factors reasserted themselves since the last FOMC meeting. And market-based measures of inflation expectations do not signal a revival of inflation anytime soon.
Recent financial turbulence also calls into doubt the wisdom of raising rates next week. To be sure, the Federal Reserve is not responsible for maintaining the value of everyone’s portfolio. But they are responsible for maintaining the financial stability necessary to sustain economic growth. Recent market activity, including a stronger dollar, wider credit spreads, and falling stocks, points toward already tighter financial conditions in the absence of a rate hike. A forward-looking central bank should be cautious of further tightening. Indeed, a forward-looking central bank would be expected to react to current signals with a delayed and shallower path of rate hikes.
Ultimately, the Fed will need to choose between one of these two arguments, and by doing so they will define a direction for policy. This will be important new information. Ultimately, we will learn who rules the roost at the FOMC – the Janet Yellen of 2013, or the Janet Yellen of 2014. Will it be the hawkish or dovish Janet Yellen that appears in the subsequent press conference? I tend to think the later will appear, but the case for the former is strong as well. In any event, the signaling information we receive next week is far more important than any 25 basis points could be.

Saturday, September 05, 2015

Fed Watch: If You Ever Wondered Whose Side The Federal Reserve Is On...

Tim Duy:

If You Ever Wondered Whose Side The Federal Reserve Is On..., by Tim Duy: Catching up with Richmond Federal Reserve Jeffrey Lacker's speech. His dismissal of low wage growth numbers:
Some argue there must be excessive slack in labor markets if wage rates are not accelerating. But real wages are tied to productivity growth, and productivity growth has been slow for several years now. Wage growth in real terms has at least kept pace with productivity increases over that time period, which is perfectly consistent with an economy from which labor market slack has largely dissipated. 
Real wage growth is consistent with productivity, thus there is no excess slack in the labor market. If you think this is some crazy hawk-talk, think again. Fed Chair Janet Yellen in July:
The growth rate of output per hour worked in the business sector has averaged about 1‑1/4 percent per year since the recession began in late 2007 and has been essentially flat over the past year. In contrast, annual productivity gains averaged 2-3/4 percent over the decade preceding the Great Recession. I mentioned earlier the sluggish pace of wage gains in recent years, and while I do think that this is evidence of some persisting labor market slack, it also may reflect, at least in part, fairly weak productivity growth.
For more than three decades, the pace of productivity growth has exceed that of real compensation:

PROD090415

Another view from real median weekly earnings:

FRED090415

Real median weekly earnings have grown 8.6% since 1985. Nonfarm output per hour is up 79% over that time. Yet the instant that there is even a glimmer of hope that labor might get an upper hand, the Federal Reserve looks to hold the line on wage growth. It still appears that the Fed's top priority is making sure the cards remain stacked against wage and salary earners.

Monday, August 31, 2015

Fed Watch: Does 25bp Make A Difference?

Tim Duy:

Does 25bp Make A Difference?, by Tim Duy: I am often asked if 25bp really makes any difference? If not, why does it matter when the Fed makes its first move? The Fed would like you to believe that 25bp really isn't all that important. Indeed, they don't want us focused on the timing of the first move at all, reiterating that the path of rates is most important. Yet I have come to believe that the timing of the first rate hike is important for two reasons. First, it will help clarify the Fed's reaction function. Second, if the experience of Japan and others who have tried to hike rates in the current global macroeconomic environment is any example, the Fed will only get one shot at pulling the economy off the zero bound. They better get it right.
On the first point, consider that there is no widespread agreement on the timing of the Fed's first move. Odds for September have been bouncing around 50%, lower after a couple of weeks of market turmoil, but bolstered by the Fed's "stay the course" message from Jackson Hole. I think you can contribute the lack of consensus to the conflicting signals send by the Fed's dual mandate. On one hand, labor markets are improving unequivocally. The economy is adding jobs and measures of both unemployment and underemployment continue to improve. The Fed has said that only "some" further progress is necessary to meet the employment portion of the dual mandate. I would argue the Fed Vice-Chair Stanley Fischer even was kind enough to define "some" while in Jackson Hole:
In addition, the July announcement set a condition of requiring "some further improvement in the labor market." From May through July, non-farm payroll employment gains have averaged 235,000 per month. We now await the results of the August employment survey, which are due to be published on September 4.
Nonfarm payroll growth was the only labor market indicator he put a number to. He clearly intended to tie that number to the Fed statement. Basically, he said "some" further improvement is simply another month of the same pattern.
While the Fed is moving closer to the employment mandate, however, the price stability mandate is moving further from view:

PCE082815

On a year-over-year basis, core-CPI is at four year lows, and the collapse in the monthly change suggests that year-over-year trends will not soon turn in the Fed's favor. One can argue that the net effect on policy should be zero. After all, the Fed has long argued that inflation will revert to target, yet inflation has only drifted away from target. What kind of central bank tightens policy when they are moving farther from their inflation target?
Fischer, however is undeterred:
Can the Committee be "reasonably confident that inflation will move back to its 2 percent objective over the medium term"? As I have discussed, given the apparent stability of inflation expectations, there is good reason to believe that inflation will move higher as the forces holding down inflation dissipate further. While some effects of the rise in the dollar may be spread over time, some of the effects on inflation are likely already starting to fade. The same is true for last year's sharp fall in oil prices, though the further declines we have seen this summer have yet to fully show through to the consumer level. And slack in the labor market has continued to diminish, so the downward pressure on inflation from that channel should be diminishing as well.
So back to the question: What kind of central bank tightens policy when they are moving further from their inflation target? Answer: The Federal Reserve. Why? Faith in their estimate of the natural rate of unemployment. Inflation expectations hold the baseline steady, shocks cause deviations from that baseline. The shocks will all dissipate over time, including labor market shocks. The economy is approaching full employment, therefore the downward pressure from labor market slack will soon diminish and turn into upward pressure in the absence of tighter monetary policy.
Now note that, aside from the equilibrium real rate, of the four variables in a Taylor-type reaction function, only one of those variables is unobserved. The target inflation rate is defined, and unemployment and inflation are measured. The natural rate of unemployment is unobserved and needs to be estimated. How confident are policymaker's in their estimate (5.0-5.2 percent) of the natural rate of unemployment?
I would argue that the Fed will reveal a high degree of confidence in that estimate if they hike rates in the face of inflation drifting away from trend. That would be new information in defining their reaction function. I think it would be a signal that Federal Reserve Chair Janet Yellen has largely abandoned here concerns about underemployment, which remains unacceptably high.
The clarification of the Fed's reaction function by narrowing the confidence interval around the Fed's estimate of the natural rate of unemployment would, I think, be an important new piece of information. Moreover, I think it would be a fairly hawkish signal - remember that financial market participants, as well as the Federal Reserve staff, tend to have a more dovish outlook that FOMC participants. The sooner the Fed hikes rate, the more hawkish the signal relative to expectations.
That signal, I suspect, is more important than the actual 25bp. The latter might not mean much, but at the zero bound, the former probably means a lot.
The timing of the first hike is also important because the Fed will only get one bite at the apple. That at least is what we saw with the rush to tighten in Japan, Europe, and Sweden. The downside risks of tightening too early are thus enormous, amounting to essentially locking your economy into a subpar equilibrium. This was the Fed's staff's warning in the last set of minutes:
The risks to the forecast for real GDP and inflation were seen as tilted to the downside, reflecting the staff's assessment that neither monetary nor fiscal policy was well positioned to help the economy withstand substantial adverse shocks.
Again, Fischer seems to fear the opposite risk more. Via the New York Times:
And Mr. Fischer emphasized that Fed officials could not afford to wait until all of their questions were answered and all of their doubts resolved. “When the case is overwhelming,” he said, “if you wait that long, then you’ve waited too long.”
I am not looking for an overwhelming case, just inflation that is trending toward target instead of away. Yet even that is apparently too much for Fischer as unemployment bears down on their estimate of the full employment.
You can take the central banker out of the 1970's, but you can't take the 1970's out of the central banker.
Bottom Line: I am coming around to the belief that the timing of the first rate hike is more important than Fed officials would like us to believe. The lack of consensus regarding the timing of the first hike tells me that we don't fully understand the Fed's reaction function and, importantly, their confidence in their estimates of the natural rate of unemployment. The timing of the first hike will thus define that reaction function and thus send an important signal about the Fed's overall policy intentions.

Friday, August 28, 2015

Fed Watch: Hawkish Rumblings

Tim Duy:

Hawkish Rumblings, by Tim Duy: Fedspeak from the Jackson Hole conference suggests that the more hawkish FOMC participants are sticking to their guns. Cleveland Federal Reserve Bank President Loretta Mester, via the Wall Street Journal:
“I want to take the time I have between now and the September meeting to evaluate all the economic information that’s come in, including recent volatility in markets and the reasons behind that,” Ms. Mester said. “But it hasn’t so far changed my basic outlook that the U.S. economy is solid and it could support an increase in interest rates.”
Then there is St. Louis Federal Reserve President James Bullard, via Bloomberg:
“The key question for the committee is -- how much would you want to change the outlook based on the volatility that we’ve seen over the last 10 days, and I think the answer to that is going to be: not very much,” Bullard told Bloomberg Television in an interview Friday at the Kansas City Fed’s annual conference in Jackson Hole, Wyoming.
“You’ve really got the same trajectory that the committee will be looking at that we were looking at before, so why would we change strategy, which was basically to lift off at some point,” said Bullard, who votes on the FOMC next year...
...“The committee does not like to move when there’s volatility,” he said. “If we had the meeting this week, people would probably say let’s wait.”...
...He added, “but the meeting is not this week, it’s Sept. 16 and 17.”
Bullard does not want financial market turmoil to derail his long-supported rate hike. He is hoping all this noise just fades away over the next few weeks. And he wants to open up the October option:
Bullard also said he would support scheduling a press conference following the Oct. 27-28 FOMC meeting if the committee doesn’t raise rates next month. That would make it easier for the Fed to explain a liftoff in October.
Bullard has repeatedly sought a press conference for every meeting, to no avail. I agree with him. The Fed has reinforced the view that major policy shifts are limited to only four of the eight meetings a year. Ridiculous and unnecessary. There should be a press conference at every meeting. That said, they can't now announce a press conference for October because it will be taken as a clear signal of a rate hike on that date. After they get the first hike out of the way, then they should switch to a press conference with every meeting.
Here Bullard disappoints:
“I actually think we’re OK on the inflation front,” Bullard said. “I’ve been arguing that we should get going, because interest rates -- it’s not that we’re a little bit below normal, we’re all the way down at zero, so you’ve got to think about: How is this going to play out over the next two to three years.”
I can remember when Bullard had a reliable view on inflation. When inflation deviates from trend, you act. But the inflation picture is not friendly for hawks and even less so after this morning:

PCE082815

Core-PCE inflation decelerated to a meager 0.87 percent annualized rate in July. The uptick in near-term inflation had provided strong support for a September rate hike as it was consistent with the view that last year's disinflation was temporary. That no longer looks to be the case, pulling apart the argument that the Fed can be confident that inflation will trend back to target. If anything, all the monthly data looks like noise as inflation slowly drifts further and further away from target.
Moreover, I would have thought that Bullard would give more weight to market-based measures:
BreakI believe Bullard is increasingly held by the siren-song of the Neo-Fisherians, thinking the only way to raise inflation is to hike rates. Good luck with that.
I like this from Greg Robb at MarketWatch:
Fischer just trying to show the Fed is as cool as the underside of your pillow http://t.co/6HjoYsLYsA
— Greg Robb (@grobb2000) August 28, 2015
Fischer went into this interview with the goal of leaving September open. Via CNBC:
"I think it's early to tell: The change in the circumstances which began with the Chinese devaluation is relatively new and we're still watching how it unfolds, so I wouldn't want to go ahead and decide right now what the case is—more compelling, less compelling, etc.," he said.
Fischer was trying not to tip his hat as much as New York Federal Reserve President William Dudley did on Tuesday. Or even arguably trying to pull back Dudley's comments as they had seemed to close off September. Perhaps more telling, when asked about the PCE numbers, Fischer reiterated his confidence that inflation will trend to target, citing the transitory nature of the oil shock. This is somewhat disappointing given the data and his dovish comments on inflation just two weeks ago. But then again, he couldn't take a dovish stance if his intent was to keep September on that table.
Where does Fischer get his confidence on inflation? A basic Phillips curve story. It is the story that makes a September liftoff compelling. He believes the labor market is near full employment and that you need to move ahead of the inflation curve:
Still, he added that he has not seen "much evidence" of increasing risks to staying at near-zero rates for longer, but he also said he didn't want to wait too long.
"When the case is overwhelming, if you wait that long, you'll be waiting too long," he said. "There's always uncertainty."
The Fed very much wants to ignore the inflation data and follow the labor markets. And even as inflation drifts further away from their target, they keep doubling down on their bets. It's what the Phillips curve is telling them they should do.
Bottom Line: The Fed doesn't want to take September off the table. Many officials had what they believed was a solid case for hiking rates at the next meeting, and they don't want market turmoil to undermine that case. And that case is not complicated. It's the Phillip curve combined with an estimate of full employment (an estimate of full employment that remains sticky despite the persistent downtrend in inflation). If they move in September, that's the story they will run with. They don't have another paradigm.

Wednesday, August 26, 2015

Fed Watch: Dudley Puts The Kibosh On September

Tim Duy:

Dudley Puts The Kibosh On September, by Tim Duy: Monday's action on Wall Street was too much for the Fed. That day, Atlanta Federal Reserve President Dennis Lockhart pulled back his previous dedication to a September rate hike earlier, reverting to only an expectation that rates rise sometimes this year. But today New York Federal Reserve President William Dudley explicitly called September into question. Via the Wall Street Journal:

In light of market volatility and foreign developments, “at this moment, the decision to begin the normalization process at the September [Federal Open Market Committee] meeting seems less compelling to me than it did several weeks ago. But normalization could become more compelling by the time of the meeting as we get additional information” about the state of the economy, he told reporters.

While this comment was sufficiently nuanced to leave open the possibility of September, in reality Dudley pretty much ended the debate. He only reinforced expectations that September was off the table, and time is running out to pull back expectations. Incoming data, what little there is at this point, would need to come in well above expectations to bring September back into play. And that is just mostly like not going to happen.

What about October or December? I tend to think that October is off the table due to a lack of a press conference. Yes, I know the Fed claims every meeting is live, but the reality is that they have reinforced the perception that major policy shifts occur only on meetings with scheduled press conferences. If the Fed  wants eight live meetings a year, they need eight press conferences. December remains open with sufficiently strong data, but does the Fed really want to attempt the first rate hike when financial markets are already tight seasonally?

Fundamentally, the problem for the Federal Reserve is that US financial conditions have tightened since the end of the quantitative easing, and will most likely continue to tighten as the rest of the world, notably now China, eases further. In effect, easier policy in the rest of the world requires, all else equal, easier policy in the US as well. Hence this from the FT:

Interest rate futures indicate that investors now see just a 24 per cent chance of a rate increase in September, down from more than 50 per cent earlier this month. The probable path of rate rises in 2016 has also moderated markedly, according to Bloomberg futures data.

The path of rates necessary to maintain stable growth in the US will be lower in response to easing conditions elsewhere. This is something known to bond market participants who as a group have long been more dovish than FOMC participants. But it was the equity market participants that shocked the Fed into the same realization.

To be sure, critics will loudly proclaim that the Fed must hike in September if only to prove they are not governed by the equity markets. That call will be heard in the next FOMC meeting as well, but it will be a minority view. A thousand point drop in the Dow will not be ignored by the majority of the FOMC. Dismissing what are obviously fragile financial market conditions would be a hawkish signal the FOMC does not want to send. Hiking rates is not going to send a calming message of confidence. That never works. If the history of financial crises has taught us anything, it is that failure to respond with easier policy only adds to the turmoil.

Bottom Line: The Fed has long argued that the timing of the first rate hike does not matter. I had thought so as well, but that is clearly no longer the case. A rate hike during a period of substantial financial market turmoil would matter a great deal. It looks like the Fed's plans to raise rate will once again be overtaken by events.

Thursday, August 20, 2015

Fed Watch: FOMC Minutes Give No Clear Signal

Tim Duy:

FOMC Minutes Give No Clear Signal, by Tim Duy: The FOMC minutes from the July 28-29 FOMC meeting were released today. Arguably they are stale. Arguably they have been overtaken by events. And because the Fed has been very good about not signaling their exact intentions, arguably you can read anything into them you want. If you want to take a hawkish view, I think you focus on this and similar portions of the minutes:

During their discussion of economic conditions and monetary policy, participants mentioned a number of considerations associated with the timing and pace of policy normalization. Most judged that the conditions for policy firming had not yet been achieved, but they noted that conditions were approaching that point. Participants observed that the labor market had improved notably since early this year, but many saw scope for some further improvement. Many participants indicated that their outlook for sustained economic growth and further improvement in labor markets was key in supporting their expectation that inflation would move up to the Committee's 2 percent objective, and that they would be looking for evidence that the economic outlook was evolving as they anticipated.

When considering a rate hike, "many" participants were willing to dismiss current low inflation if they believe evidence of stronger growth supports their conviction that inflation would trend toward target over time. The data since the July meeting tends to support that view. July retail sales were healthy, and revisions to previous months points toward upward revisions to second quarter GDP growth to 3.0 percent or higher. Industrial production was higher, perhaps starting to move past the declines related to the sharp drop in oil prices. Single family housing starts continued their slow but steady rise, reaching a level last seen in 2007. Homebuilder confidence is up. While manufacturing has been soft, the service sector as measured by the ISM non-manufacturing measure is picking up the slack. And the employment report was yet another in a long line of employment reports suggesting slow yet steady gains. Overall, a picture generally supportive of sustained growth and further improvement in labor markets.

A dovish view, however, could be easily derived from the following sentences and similar portions:

However, some participants expressed the view that the incoming information had not yet provided grounds for reasonable confidence that inflation would move back to 2 percent over the medium term and that the inflation outlook thus might not soon meet one of the conditions established by the Committee for initiating a firming of policy. Several of these participants cited evidence that the response of inflation to the elimination of resource slack might be attenuated and expressed concern about risks of further downward pressure on inflation from international developments. Another concern related to the risk of premature policy tightening was the limited ability of monetary policy to offset downside shocks to inflation and economic activity when the federal funds rate was near its effective lower bound.

Many market participants took this and related comments specifically referring to China and currency prices to argue that September was all but off the table. I would not be so quick; the former view is held by "many," whereas the latter was held by "some." Moreover, I find it hard to believe that any would think it a surprise that some officials explicitly discussed China and currencies. How could they not? How could you not think that in a wide-ranging discussion they had not discussed all that is both good and bad in the economy? That said, as I noted earlier, the minutes are stale. The depreciation of the yuan and further declines in commodity prices since the last FOMC meeting give reason to believe that the ranks of "some" has grown.

The latter points also appealed to those inclined against a rate hike. For instance, prior to the release of the minutes, the prescient Cullen Roche argued:

There is still a lot of chatter about the potential for a September rate hike by the Fed. I have to be honest – I think this is nuts at this point.

After the minutes he added:

My guess is that the odds of a Sept rate hike are fast approaching 0%.

— Cullen Roche (@cullenroche) August 19, 2015

I am clearly sympathetic to the view that the Fed looks to be rushing with the rate hike talk. That said, it is what many officials are talking about since the last FOMC meeting while looking at the same data we are. Via John Hilsenrath at the Wall Street Journal:

Officials speaking since the July meeting have sent conflicting signals about where the group as a whole is most likely to go. In an interview with The Wall Street Journal earlier this month, Atlanta Fed President Dennis Lockhart said he was inclined to move in September. St. Louis Fed President James Bullard said in an interview with Market News International on Wednesday he would push for it. But in an opinion piece written in The Wall Street Journal on Wednesday, Minneapolis Fed President Narayana Kocherlakota said it would be a mistake and Fed governor Jerome Powell said earlier this month a decision hadn’t been made.

Lockhart is seen as swaying with the general consensus, which argues for September. Bullard arguably shouldn't be pushing for a rate hike given his path tendency to follow the direction of market-based inflation expectations, but the neo-Fisherians seem to be making some traction with him. Powell is wisely keeping his cards close to his chest. They should not, after all, have made any decisions yet. And I would say that if Kocherlakota feels so strongly a need to argue against a rate hike in the Wall Street Journal, he must think the momentum is shifting the other direction.

Former Federal Reserve Governor Lawrence Meyer is also interesting here:

“What are you worrying about, September or December? It doesn’t matter. Just pull the trigger,” said Laurence Meyer, co-founder of Macroeconomic Advisers, a research firm, in an interview before the release of the minutes.

Just sick of the debate and wanting to move on? Or a real conviction that the Fed is set to move?

Bottom Line: I have believed that there was a better than 50% chance that the Fed would move in September and am hesitant to move much below 50%. I didn't expect the minutes would give a clear signal regarding September, and am not surprised by the dimensions of the general discussion. And I am wary the Fed may be less responsive to financial market disruption than during most of the post-crisis era given than the economy is close to their estimate of full employment. This is shaping up to be one of the most contentious meetings since the tapering debates. We will soon learn more exactly what data the Fed is data dependent on.

Tuesday, August 04, 2015

Fed Watch: Gearing Up For Employment Day

Tim Duy:

Gearing Up For Employment Day, by Tim Duy: The big event this week is the employment report. Fed watchers will eagerly dive into the data, looking for signs that the labor market made "some" further improvement. "Some" improvement appears to be an important hurdle to clear before the Fed will raise interest rates. How much "some" is necessary? I suspect it's like pornography - you will know it when you see it.
Incoming data continues a pattern general mediocrity. Today we received the June income and spending report, which one could have largely backed out of the second quarter GDP numbers. Real incomes edged up 0.2% while real spending was flat. Spending softened compared to last year, not unlike the pattern of 2004:

PCEa080315

Recall that it was in July of 2004 that the Fed initiated the previous tightening cycle. Note also that one aspect of consumer spending, auto sales, showed no signs of softening in July.
Inflation remains below target, but arguably not far below target: 

PCE080315

While on a year-over-year basis, core-PCE remains well below target, recent reading are more solid. On an annualized basis, core-PCE rose 1.79% in June, within the range that I suspect most policymakers believe is consistent with their mandate (you can't hit exactly 2% all the time). The Fed will see these numbers as supporting their view that the 2014 inflation drop was driven by largely temporary factors.  
Manufacturing numbers remain on the soft side:

ISM080315

Stronger dollar, lower commodity prices, and softer global demand took the wind out of that sector, to be sure. Note that a sharp decline in ISM numbers from mid-2004 through mid-2005 did not deter the Fed from continuing its rate hike campaign.
Coming on the heels of last week's disastrous employment cost report, Friday's measure of wages will be closely watched. The tentative signs of wage growth acceleration we had been seeing in the ECI were quickly wiped out in the second quarter:

ECI080315

How will the Fed view this data? Tough call at this point. Digging into the data may lead them to conclude that this report was more smoke than fire.  Millan Mulraine via across the curve:

...I wanted to make a few observations on the ECI report following our conversation with the BLS. The key findings reinforce our earlier view that this anomalous performance in both wages and benefits has been driven by one-off factors that should unwind. As such, we believe that this report does not reflect a germane deterioration in underlying inflation dynamics, and will have little bearing on the Fed’s deliberation on policy.

1. The sharp deceleration in the growth rate of the wages and salaries component (which accounts for about 70% of total compensation) was driven by a sharp falloff in incentive pay this quarter versus Q1. This accounted in the sharp drop in the growth rate of private industry wages (on an NSA basis) from 0.8% q/q in Q1 to 0.2% q/q in Q2. Excluding commission sale incentives, wages and salaries were unchanged at a solid 0.6% q/q pace in both quarters.

2. Benefits were also affected by special factors, and the key driver was the redefinition to retirement benefits in Q2, perhaps caused by the underfunding of some retirement pension plans. The 0.8% q/q drop in unionized workers benefits was a big part of this. Here is a link of various stories highlighting this fact earlier this year...

 The Fed may also find solace in the Atlanta Fed Wage Growth Tracker:

Atlanta-fed_individual-wage-growth-3

Of course, maybe they don't need faster wage growth at all, as Jon Hilsenrath at the Wall Street Journal reminds us:

Given her [Fed Chair Janet Yellen] stance, Friday’s employment cost report doesn’t look like a deal breaker for the Fed in its long-running debate about when to raise short-term interest rates. Wages appear to be stagnant but not clearly weakening, which is what she set out as her threshold for not acting. Still, it creates new doubts for officials and doesn’t help them build the confidence they’re hoping to build that the job market is nearing full employment and inflation rising toward 2%.

At least one Fed official is on record saying he couldn't care less about the ECI report. That is St. Louis Federal Reserve President James Bullard, via the Wall Street Journal:

“We are in good shape” for increasing the Fed’s currently near-zero short-term rate target at the Sept. 16-17 central bank gathering, Mr. Bullard said in an interview with The Wall Street Journal. He said officials needed to see how growth data released Thursday shaped up before clearing the way to act. 
Mr. Bullard shrugged off a report Friday showing surprising tepid wage gains, saying he isn’t that worried about that situation right now.

That said, I think that most Fed officials would be more comfortable ignoring the ECI report if they see some hard evidence in the next two labor reports that wage growth really is strengthening.

Bottom Line: My general sense is that the data is falling in line in such a way that the Fed can justify a rate hike in September. Not sure I would describe the situation as being in "good shape" as Bullard does, but I see where they can find room in the data, especially if their logic is to go early so they can go slower. A 200k+ nonfarm payroll gain, a tick down in unemployment, and some wage growth would support that case. September is a hard call, however, because I doubt that the next six weeks of data will give them a clear, consistent story free of any warts or boils. If they ultimately need perfect data to move forward, then they will again take a pass on September. Perfect data will simply be hard to come by, I suspect, in a world where 2% growth is the new 4%.

Thursday, July 30, 2015

Fed Watch: GDP Report

Tim Duy:

GDP Report, by Tim Duy: The second quarter GDP report, while not a blockbuster by any measure, will nudge the Fed further in the direction of a September rate hike. At first blush this might seem preposterous - 2.3% growth is nothing to write home about in comparison to history. But history is deceiving in this case. It remains important to keep in mind that 2% is the new 4%.
Year-over-year growth rates continue to hover around 2.5%:

GDP073015

While the 2.3% quarterly rate of the second quarter was below consensus forecasts, the first quarter figure was revised up from -0.2% to 0.6%. That said, the annual revisions from 2012-2014 disappointed. Average annual growth from 2011 to 2014 dropped from a previsouly reported 2.3% to 2.0%. Sad, very sad.
That was still enough growth, however, to sustain fairly solid job growth and sharp declines in the unemployment rate, suggesting that potential output growth is indeed fairly anemic. The Fed staff appear to agree; see their very low potential growth numbers in the accidentally released forecasts (and for more on the implications of those forecasts, see Gavin Davies). Note also the low end of the range of potential growth estimates from FOMC meeting participants is 1.8%. Furthermore, San Francisco Federal Reserve President John Williams wants the Fed to guide the economy to a 2.0% growth rate in 2016. Hence 2.3% growth when the economy is operating near full-employment is sufficient for many policymakers to pull the trigger on the first rate hike.
A second implication of the revisions is that they provide no relief for those pondering low productivity growth. Indeed, it is quite the opposite, and they suggest downward revisions to productivity. Low productivity plus low labor force growth equals low potential output growth. 2% is the new 4%. And don't expect that all the data will fall into the same nice, consistent patterns we typically see in a business cycle. Some indicators will point up, others down, leading to many erroneous calls that a recession is soon upon us.  
As an aside, solid research and development spending gives hope that productivity growth will accelerate:

GDPa073015

We can only wait and see.
The inflation numbers also point to a September hike. Recall that the Fed is waiting until they are reasonably confident that inflation is heading back to target. Headline and core PCE rebounded to 2.15% and 1.81% annual growth rates in the first quarter, respectively, adding weight to the Fed's conviction that the inflation weakness of the first half was indeed transitory. To be sure, these gains have yet to translate into higher year-over-year numbers. But a forward looking Fed will expect they will head higher.
Separately, the forward-looking indicator of initial unemployment claims continues to hover at very low levels:

CLAIMS073015

A reminder that layoffs are few and far between as we head into next week's employment report for July.
Bottom Line: An unspectacular recovery, but sufficient to keep the Fed on track for raising rates this year. The case for September further strengthens.

Wednesday, July 29, 2015

Fed Watch: FOMC Recap

Tim Duy:

FOMC Recap, by Tim Duy: The July FOMC meeting yielded the widely expected outcome of no policy change. Very little change in the statement either - pulling out any useful information is about as easy as reading tea leaves or chicken bones. But that won't stop me from trying! On net, I would count it was somewhat more hawkish as the Fed gears up to hike rates later this year. By no means, however, did the statement make any definitive signal about September. The Fed continues to hold true to its promise to make the next move about the data. The era of handholding fades further into memory.
The first paragraph contained nearly all of the changes in the statement. Using the Wall Street Journal's handy-dandy Fed tracker:

FOMCa072915

In my opinion, this represents a not trivial upgrade of their thoughts on the labor market. Job growth is "solid," unemployment continues to decline, and a much more forceful conclusion on underemployment. No longer has underutilization diminished by a wishy-washy "somewhat." It now conclusively "has" diminished. Hence, it seems like the Fed is closer to declaring victory over one impediment to hiking rates - Fed Chair Janet Yellen's concerns about the high degree of underemployment.
I tend to regard the exclusion of the "energy prices appear to have stabilized" as the elimination of an artifact from the June statement. Energy prices are not in free-fall as the were at the end of last year, and have instead been tracking within a range since the beginning of the year. Hence the Fed can later repeat the inflation forecast as:
"...the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of earlier declines in energy and import prices dissipate."
Some may interpret it as a more dovish signal in light of the recent declines in oil prices. I am wary of that interpretation.
The only other change to the statement was in the third paragraph:

FOMCb072915

The addition of the determiner "some" fits nicely with the changes to the first paragraph. The labor market has now shown sufficient improvement such that the bar to a rate hike is actually quite low. Essentially, meeting participants believe the economy is closing in on full employment. And that in and of itself will raise their confidence on the inflation outlook.
There was some early chatter regarding the continued description of the risks to the outlook as "nearly" balanced. This was taken as dovish. Had they said the balance is weighted toward inflation, however, the Fed would have essentially been promising a rate hike in September, and they have been very clear they do not want to make such a promise. So the failure to change the balance of risks should not be that surprising. In that vein, I suspect that when they do hike, they will say something like "with today's action, the risks to the outlook remain balanced" such that they leave no signal regarding the timing or the magnitude of the next move.
Bottom Line:  All else equal, the next two labor reports will factor strongly into the Fed's decision in September. A continuation of recent labor trends is likely sufficient to induce them to pull the trigger. Further signs of stronger wage growth would make a September move a certainty.

Friday, July 17, 2015

Fed Watch: The Case For September

Tim Duy:

The Case For September, by Tim Duy: The Wall Street Journal reports that most economists still expect the Fed to raise rates in September:

BN-JK371_FEDSUR_G_20150715183208

Financial market participants tend to be less confident, with odds of a September hike running around 35%. Still, the consideration of any rate hike may seem odd given the lackluster nature of the US economy. Notably, inflation wallows below trend and anemic wage growth suggests significant remaining labor market slack. The Fed, however, looks at the progress towards its goals, which on the unemployment side has been substantial, as well as the perceived need to act ahead of actual inflation.
In short, the Fed believes the risks to the economy are shifting toward overheating, even if the economy is not yet overheating. And, as Greg Ip at the Wall Street Journal identifies, this has important consequences for monetary policy:
Risk management suggests they ought to start in September, because then they retain the option of tightening once or twice before the end of the year. But if they wait until December, they forgo that option. (This assumes they do not move at their meeting in October, which is not followed by a press conference.)
This is probably the best argument for a September rate hike. Federal Reserve Chair Janet Yellen made it fairly clear in her Congressional appearances this week that she would prefer to move earlier but more gradually than later and more rapidly. And even if you think she only anticipates a single rate hike this year, that outcome is not precluded by a hike in September. Yellen has also said we should not expect a clearly identified path similar to the last tightening cycle. They can hike in September and pass on December.
Paul Krugman thinks the Fed's logic is completely backwards. From his Bloomberg interview this week:
If the Fed waits too long to raise rates, then we get a little bit of inflation. If the Fed raises rates too soon, we risk getting caught in another lost decade. So the risks are hugely asymmetric. I really find it quite mysterious that the Fed is eager to raise rates given that, they're going to be wrong one way or the other, we just don't know which way. But the costs of being wrong in one direction are so much higher than the costs of being the other.
The Fed, I think, believes the risks are asymmetric in the other direction - that inflation expectations are very fragile to the upside, and hence waiting too long risks a costly rise in actual inflation.
If I had to bet who would be proven right, I would put my money with Krugman. Inflation and inflation expectations have proven substantially less fragile in the past twenty years than the Fed likes to admit. Consider first that inflation has tended to hover mostly below two percent since 1995:

PCE071515

Core inflation averaged 1.70% since 1995, headline inflation 1.86%, both comfortably below target. Note the particular rarity of periods where core inflation rises more than 25bp above target. What used to be one of the Fed's favorite indicators, the 5-year, 5-year forward breakeven rate, isn't pointing toward high inflation in the medium term:

BREAK071515

Although the Fed frets about unemployment, even at low levels of unemployment, inflation is more often than not below target:

PHILLIP071515

And neither faster wage growth nor low unemployment triggers higher inflation expectations. Inflation expectations are remarkably stable, with relatively few deviations from 3% which tend to be traced back to gasoline prices:

WAGEEXP071515

UNEMPEXP071515

The Fed would argue that their credibility explains stable inflation expectations. By acting ahead of inflation, the Fed ensures there is no above-target inflation, and that connection between policy and outcomes gives rise to that credibility. I would argue that two decades of generally below target inflation suggests an overly excessive pursuit of credibility at the cost of economic underperformance. We don't reach the target inflation consistently, but we do get recessions and slow job market recoveries.
Also, it seems that Yellen abandoned her enchantment with optimal control models. A recent version from the IMF indicates it would be still preferable to delay rate hikes in favor of a more aggressive normalization path later:

IMF

Under the optimal control approach, the Fed would accept the cost of temporarily higher inflation (still within a 25b range of target) in return for a faster return to potential output. Yellen now appears will to tolerate a return to the inflation target from below, rather than above, in order to avoid the possibility of a sharper rise in rates later.
Why the change of heart? Why the gradualist approach? It is reasonable to believe its about financial market instability. Back to Greg Ip:
... the effects of six years of zero rates on leverage and risk-taking are increasingly evident. As Ms. Yellen’s Monetary Policy Report noted, “Credit markets have been reflecting some signs of reach-for-yield behavior, as issuance of speculative grade bonds continues to be strong, yields are low, and credit spreads are somewhat narrow by historical standards.”
Fair enough, maybe it isn't about inflation, but financial markets. But that is kind of disconcerting as well - the gradualist approach didn't work so well last time around. Seems like if you were really worried about financial markets, you would want to follow the optimal control approach and move quickly when inflation warranted a policy shift. The error of the last cycle may not have been in waiting too long to hike, but hiking too slowly when the time came.
Bottom Line: Ultimately, as the crisis fades further into the rearview mirror, the Fed see the policy risks shifting. Many, including Yellen, will shift back toward the central banker's natural inclination to fight inflation, despite the lack of inflation for the past two decades. And that natural inclination keeps the September option alive. Given the Fed's penchant for tight policy on average, the risk is that while they don't trip the economy into recession in the near term, they instead lock the economy into a sub-par equilibrium.

Tuesday, July 14, 2015

Fed Watch: More Mediocrity

Tim Duy:

More Mediocrity, by Tim Duy: Federal Reserve Chair Janet Yellen will be playing a game of mixed messages with Congress tomorrow as she explains why she believes a rate hike approaches in spite of lackluster data. Today's data didn't help. The June retail sales report was a disappointment, slipping from May levels with generally soft internals in addition to downward revisions to previous months. Consequently, core spending growth is decelerating on a year-over-year basis to 2013 rates:

RETAIL071415

Maintaining the 2014 growth bump has been something of a challenge, to be sure.The report triggered downgrades to the second quarter growth forecast as it offset upward revisions attributable to last week's new estimates of federal spending and inventories:

Gdpnow-forecast-evolution-3

More mediocre growth - stuck in that 2.5 percent range which is a touch higher than the Fed's longer-run central tendency of 2.0-2.3 percent. And therein lies the key to understanding the Fed's repeated calls that 2015 is the year for the first rate hike. I think they are concluding 2014 was sufficient to largely close the output gap, as evidenced by falling unemployment and other measures of labor underutilization. San Francisco Federal Reserve President John Williams even believes that optimally, US growth needs to DECELERATE in 2016:
Looking towards next year, what we really want to see is an economy that’s growing at a steady pace of around 2 percent. If jobs and growth kept the same pace as last year, we would seriously overshoot our mark. I want to see continued improvement, but it’s not surprising, and it’s actually desirable, that the pace is slowing.

With the output gap closing, Fed policymakers believe they need to begin reducing financial accommodation. They are not sufficiently sure of that hypothesis to begin hiking at anything more than a modest pace, but are sufficiently sure to comfortably declare that the first rate hike is upon us. Hence, Boston Federal Reserve President Eric Rosengren can say things to Reuters like:

"If we do continue to get improvement in labor markets, if we do become reasonably confident that we're moving back to 2-percent inflation, it may be appropriate as early as September," he said of raising rates from near zero. "I don't think we have seen that evidence yet but we still have a couple months of data to see whether it's more strongly confirmed."
Rosengren has long advocated for more monetary accommodation than most of his colleagues at the central bank, which has kept interest rates at rock bottom to boost the recovery. With wages showing early signs of a pick-up and U.S. unemployment down to 5.3 percent, he set a high bar for delaying a hike.
Only if labor markets unexpectedly weaken, if core inflation starts to drop off, or if the wage gains dissipated, "those would be the things that would make me want to pause and wait and see whether there is further evidence," he said.
And Federal Reserve Chair Janet Yellen says:
My own outlook for the economy and inflation is broadly consistent with the central tendency of the projections submitted by FOMC participants at the time of our June meeting. Based on my outlook, I expect that it will be appropriate at some point later this year to take the first step to raise the federal funds rate and thus begin normalizing monetary policy.
Whereas Cleveland Federal Reserve President is somewhat more aggressive in an interview with the Financial Times:
Loretta Mester, president of the Federal Reserve Bank of Cleveland, said the case for “emergency” levels of interest rates was now gone given that the economy was “fundamentally sound”, as she signalled that she would support two increases in short-term rates this year.
To be sure, it is all data dependent. More solid wage growth would do the trick, I think, to draw the Fed to September. Without that wage growth acceleration, I suspect the more dovish side of the FOMC will pull the Fed toward December. No reason to rush given the lackluster numbers we are seeing. But one senses greater impatience on the more hawkish side of the FOMC. They will argue like Mester that the general consistency of underlying growth, steady improvement in labor utilization, and proximity to mandates signals it is time to leave behind the policies of the financial crisis.
Bottom Line: The basic theme is that the economy is that, in the Fed's eyes, the economy is sufficiently stable to justify a rate hike, but lacks any reason to rush that hike or the pace of subsequent hikes. That message I expect to hear tomorrow. In her appearance before the House Financial Services Committee, Yellen will reiterate the basic points of Friday's speech, maintaining faith that 2015 will be the year for the first rate hike since 2006. Heavy caveats, however, about data dependence. She may get asked directly about September. If so, she will not rule out September. She will instead say maybe September, maybe later. But more interesting might be the questioning surrounding the Fed's perceived intransigence; Congress is looking for more of that transparency the Fed is always bragging about.

Wednesday, July 01, 2015

Fed Watch: Ahead of the Employment Report

Tim Duy:

Ahead of the Employment Report, by Tim Duy: A rare Thursday release of the employment report is on tap for tomorrow, and all eyes will be watching to see if it falls in line with the other, more optimistic US data of late. Indeed, it increasingly looks like this year's growth scare was driven by temporary factors, not a fundamental downturn in the US economy. Consequently, anything reasonably close to expectations would bolster the case of those FOMC members looking for a first rate hike later this year, as early as September.
The ISM report for June was in-line with expectations, with fairly good internal components. Note in particular the bounce-back in the employment component:

NAPM070115

Other employment data also indicates the underlying trends in the labor market are holding. Initial unemployment claims - a leading indicator - give no cause for worry:

CLAIMS070115

And the ADP employment report came in slightly ahead of expectations at a private sector job gain of 237k for June. All of this suggests that the consensus for tomorrow's headline number of 230k is reasonable, although I am inclined to bet that the actual number will beat consensus.
The usual headline numbers, however, may not be the stars of the show. Attention will rightly be on the wage numbers. Further evidence that wage growth is accelerating would indicate that the labor market is finally closing in a full employment. Such data would point to a rate hike sooner than later as it would raise the Fed's confidence that inflation will be trending toward target. See Federal Reserve Governor Stanley Fischer today:
Regarding inflation, an important factor working to increase confidence in the inflation outlook will be continued improvement in the labor market. Theoretical and empirical evidence suggests that inflation will eventually begin to rise as resource utilization tightens. And while the link between wages and inflation can be tenuous, it is encouraging that we are seeing tentative indications of an acceleration in labor compensation.
Tantalizing evidence on wage growth comes from the Atlanta Federal Reserve Bank:

Atlanta-fed_individual-wage-growth

With fairly low inflation, this suggests that real wages growth is indeed accelerating, which helps account for the relatively solid consumer confidence numbers we are seeing. Demand for new cars and trucks also remains strong, although I sense that we are not likely to see higher numbers going forward.
Also from the Atlanta Fed is their GDP tracker, which continues to head back to consensus range:

Gdpnow-forecast-evolution

This is in-line with Fischer's assessment of the economy:
The U.S. economy slowed sharply in the first quarter of this year, with the most recent estimate being that real GDP declined 0.2 percent at an annual rate. Household spending slowed, while both business investment and net exports declined. Much of this slowdown seemed to reflect transitory factors, including harsh winter weather, labor disputes at West Coast ports, and probably statistical noise. Confirming that view, the latest monthly data on real consumption provide welcome evidence that consumer demand is rebounding, and that economic activity likely expanded at an annual rate of about 2.5 percent in the second quarter.
What about Greece? St. Louis Federal Reserve President James Bullard dismissed Greece as a reason for concern. Michael Derby at the Wall Street Journal reports:
What’s happening in Europe “would not change the timing of any rate hike. I would say September is still very much in play” for raising rates, Mr. Bullard told reporters after a speech in St. Louis. More broadly, he said “every meeting is in play depending on the data,” which he said had been “stronger” recently. He also described recent inflation data as being “more lively” and set to rise further over time.
I doubt other Federal Reserve officials are quite as confident, but they have plenty of time between now and September to assess the situation. As I said Monday, they will be looking for evidence of credit market spillovers. If they don't see it, the economic data will rule the day. Bullard also argued the case of a faster pace of rate hikes:
“The Fed should hedge against the possibility of a third major macroeconomic bubble in coming years by shading interest rates somewhat higher than otherwise” would be the case based on historical norms, Mr. Bullard said. “The benefit would be a longer, more stable economic expansion.”
Mr. Bullard warned “my view is that low interest rates tend to feed the bubble process.” He did not point to any major imbalances right now even as he flagged high stock market levels as something to watch, acknowledging the role of technology could be changing how the economy interacts with financial markets.
Derby correctly notes, however, that this places Bullard out of the Fed consensus:
Mr. Bullard’s suggesting that rates may need to be lifted more aggressively in the future puts him at odds with some of his central bank colleagues. Many key Fed officials are now gravitating to the view that changes in labor market demographics and other forces may mean the Fed could keep rates at a lower level relative to historic benchmarks. Most officials now expect that the long-term fed funds rate target, now at near zero levels, will likely stand at around 3.75%.
Fischer, for example, still argues for a gradual pace of normalization and is much more sanguine on the financial market excess:
Once we begin to remove policy accommodation, the Committee's assessment is that economic conditions will likely warrant raising the federal funds rate only gradually. Thus, we expect that the target federal funds rate will remain for some time below levels viewed as normal in the longer run. But that is only a forecast, and monetary policy will, in practice, be determined by the data--primarily data on inflation and unemployment.
What about financial stability? We are aware of the possibility that low interest rates maintained for a prolonged period could prompt an excessive buildup in leverage or cause underwriting standards to erode as investors take on risks they cannot measure or manage appropriately in a reach for yield. At this point, the evidence does not indicate that such vulnerabilities pose a significant threat, but we are carefully monitoring developments in this area.
Fischer is closer to the FOMC consensus than Bullard on these points.
Bottom Line: Incoming data continues to support the case that the underlying pace of activity is holding, alleviating concerns that kept the Fed on the sidelines in the first half of this year. I anticipate the employment report, or, more accurately, the sum of the next three reports, to say the same. Accelerating wage growth could very well be the trigger for a September rate hike, while Greece could push any rate hike beyond 2015. I myself, however, tend to be optimistic the Greece situation will not spiral out of control.

Monday, June 29, 2015

Fed Watch: Events Continue to Conspire Against the Fed

Tim Duy:

Events Continue to Conspire Against the Fed, by Tim Duy: Federal Reserve policymakers just can't catch a break lately. Riding on the back of strong data in the second half of last year, they were positioning themselves to declare victory and begin the process of policy normalization, AKA "raising interest rates." Then the bottom fell out. Data in the first half of the year turned sloppy. Although policymakers on average - and Federal Reserve Chair Janet Yellen in particular - could reasonably believe the underlying momentum of the economy had not changed, that the data reflected largely temporary factors, the case for a rate hike by mid-year evaporated all the same. The risk of being wrong was simply more than they were willing to bear in the absence of clear inflation pressures.

The story was clearly shifting by the end of June. Key data on jobs and the consumer firmed as expected, raising the possibility that September was in play. Salvation from ZIRP, finally. Federal Reserve Governor Jerome Powell called it a coin toss. Via Bloomberg:

Speaking at a Wall Street Journal event in Washington Tuesday, Powell said he forecast stronger growth than in the first half of 2015, growth in the labor market and a “greater basis for confidence” in inflation returning to 2 percent.

“If those things are realized, I feel that it is time, it will be time, potentially as soon as September,” he said. “I don’t think the odds are 100 percent. I think they’re probably in the 50-50 range that we will realize those conditions, but that’s my forecast.”

Earlier, San Francisco Federal Reserve President John Williams said he expected two rate hikes this year. Via Reuters:

"Definitely my own forecast would be having us raise rates two times this year, but that would depend on the data," San Francisco Fed President John Williams told reporters at the bank's headquarters.

Rate increases of a quarter percentage point each would be reasonable, he said, with little point in making rate increases any smaller.

Given that we have basically written off the possibility of a rate hike in October (Fed not positioning for a rate hike every meeting and no one expects October for a first hike in the absence of the press conference), that leaves September and December for hikes.

Over the weekend, New York Federal Reserve President William Dudley also raised the possibility of September in an interview with the Financial Times:

A Federal Reserve interest-rate hike will be “very much in play” at the central bank’s September meeting if the recent strengthening of the US economy continues, according to one of America’s top central bankers.

William Dudley, the president of the Federal Reserve Bank of New York, said recent evidence of accelerating wage gains, improving incomes, and growing household spending had alleviated some of his concerns about the sustainability of momentum in America’s jobs market.

Former Federal Reserve Governor Laurence Meyer expects Yellen to also be comfortable with two rate hikes in 2015 by the time September rolls around. Via Bloomberg:

"We expect the incoming data between now and the September meeting to help ease concerns about the growth outlook, prompting Chair Yellen and a majority of the FOMC to see two hikes this year as appropriate," Meyer said in a note to clients.

No, September was not a sure bet, but you could see how the data evolved to get you there. But then came Greece. Greece - will it never end? Financial markets were roiled as Greek Prime Minister Alexis Tsipras abandoned the latest round of bailout negotiations with the EU, IMF, and ECB and instead pursued a national referendum on the last version of the bailout proposal. Most of you know the story from that point on - run on Greek banks, the ECB ends further ELA extensions, a bank holiday is declared, likely missing a payment to the IMF etc., etc.

At this juncture, everything in Greece is now in flux. Greece will be holding a referendum on a deal that apparently no longer exists, so it is not clear what negotiations would happen even if it passes. Moreover, it seems likely that the economic damage that will occur in the next week or longer will almost certainly require an even bigger give on the part of Greece's creditors. Is that going to happen? There is no exit plan to force Greece out of the Euro. What if Greece refuses to leave? How does Europe respond to a growing humanitarian crisis Greece as the economy collapsed? This could drag on and on and on.

As would be reasonably expected, the jump in risk sank equities across the globe, in the process stripping away US stock gains for 2015. Not that there was much to give - it only took a little over 2% on the SP500. Yields on Treasuries sank in a safe-haven bid, and market participants pushed Federal Reserve rate hike expectations out beyond 2015.

At this moment, there is obviously little to confirm that 2015 is off the table. To be sure, we know the Fed is watching the situation closely. Back to the FT and Dudley:

That said, Mr Dudley warned that the financial market implications of a Greek exit from the euro could be graver than many investors seemed to believe, because it would set a “huge precedent” indicating that euro membership was reversible.

People “underestimate all the different channels in terms of how contagion works”, the central banker said. “We saw that in the financial crisis. People did not anticipate that the Lehman failure was going to affect the economy and financial markets to the degree that it did.”

At the risk of being guilty of underestimating contagion, I am optimistic that the ring fencing around Greece will hold. This will be a political disaster for Europe, and a humanitarian disaster for Greece, but I expect will ultimately prove to have limited impact beyond those borders.

Famous last words.

Of course, even if that is correct, we don't know it to be correct, and thus the Fed will again proceed cautiously, just like they did in the face of the weak first quarter. Hence, all else equal, pushing out the timing of the first hike is reasonable. September, though, is a long ways off, and plenty can happen between now and then. So what will the Fed be watching?

First is the data, as they have emphasized again and again. We have three labor reports between now and September, beginning this week. Strong monthly gains coupled with falling unemployment rates and further evidence of wage growth would go a long way to supporting a rate hike. All would give the Fed the faith that inflation will soon be heading toward target. This is especially the case if recent consumer spending and housing numbers hold and if business investment picks up. And it would be further helpful if the global economy did not sink under the weight of Greece. Essentially, the Fed wants to be confident that the first quarter was a fluke and thus the economy is in fact fairly resilient.

Second is the financial fallout from Greece. Mostly, they will be carefully watching to see if the Greece crisis impacts domestic credit markets and banking. Do interest rate spreads widen? Do lenders tighten underwriting conditions? Does interbank lending proceed without impediments? If they see conditions emerge like this, I would expect them to match market expectations and just stay out of the rate hike business until the fallout from Greece is clear. This likely holds even in the face of solid US data. There will (or at least should) recognize that periods of substantial unrest in credit markets are not the time to be raising rates.

Bottom Line: The Fed was already approaching the first rate hike cautiously, wary of even dipping their toes in the water. The crisis in Greece will make them even more cautious. Like their response to the first quarter data, until they see a clear path, they will be on the sidelines. That said, given the plethora of warnings not to underestimate the global impact of the crisis in Greece, one should be watching the opposite side of the story. Solid data and limited Greece impact would leave December at a minimum, and even September, in play.

Tuesday, June 23, 2015

Fed Watch: Dovish Fed

Tim Duy:

Dovish Fed, by Tim Duy: Coming on the heels of a dovish FOMC meeting and press conference, it might be surprising that San Francisco Federal Reserve President John Williams is still looking for two rate hikes this year. Via Bloomberg:

“We are getting closer and closer,” to raising rates, he told reporters on Friday after delivering a speech in San Francisco. Williams, a voter this year on the policy-setting Federal Open Market Committee, was head of research at the regional bank when it was led by now-Chair Janet Yellen.
“My own forecast would be having us raise rates two times this year,” he said. “But that would depend on the data.”
Why raise rates this year despite anemic inflation and moderate economic growth? He still expects the Fed will be moving closer to its stated goals in the second half of the year and moving sooner means moving slower:
Williams also said that raising rates earlier rather than later would allow the Fed to tighten gradually, which he favors because the U.S. economy still faces significant headwinds.
“If we raise rates sooner rather than later, then we can do it more gradually,” he said.
It is worth reiterating just how gradual the Fed is planning to raise rates. This I think remains more important than the timing of the first hike. Note that the midpoint forecasts from the Summary of Economic Projections imply a 0 percent equilibrium interest rate at the end of 2016, and just slightly higher than that in 2017:

RSTAR062215

And note that this is a somewhat more dovish projection than that made in March:

RSTAR0a62215

which was also more dovish than the prior SEP. Essentially, this Fed is jointly both hawkish and dovish - even as they warn they are moving ever closer to that first rate hike, they continue to push down the expected path of subsequent hikes. Persistently slow growth, low productivity, and low inflation are wearing on their outlook. Consequently, they continue to extend their expectations of a low interest rate environment. Policymakers are clearly moving toward market expectations in this regard.
Whether reality matches expectations remains an open question. Treasury rates have pulled up off their February lows, taking mortgages rates along for the ride. The Fed will be carefully monitoring this situation; they do not want mortgage rates in particular to climb ahead of the economy. The memories of the taper tantrum - and the subsequent stumble in the housing market - still sting. This time around, however, higher rates are being driven not by a shift in the expected Federal Reserve reaction function, but instead by an improved economic outlook. If housing markets can handle the higher rates (note the return of the first-time buyer), and there is reason to believe they will if wage growth continues to accelerate, then the Fed will feel more confident that they are getting across a message consistent with the evolution of activity. And they will thus be more willing to begin the normalization process in 2015 as they currently anticipate. 
Policymakers would like to orchestrate a smoother transition to more normal policy than that of the botched tapering signal. This time around they are more clearly signaling a transition in which interest rates are moving in line with an improvement in the broader equilibrium that includes stronger wage growth and inflation closer to target. They learned a lesson from the taper tantrum of 2013: Make sure the signals you send are consistent with the path of activity. Learning that lesson speaks well for the sustainability of the recovery. 
Bottom Line: Don't be surprised if you hear more Fed officials say they are still looking to rate hikes this year. Between being close to meeting their goals and the desire to move early to move slowly, the bar to hiking rates is probably not all that high. Watch instead for data that will either confirm or deny the Fed's near- and medium-term outlook. Seemingly paradoxically, that outlook has been increasingly dovish even as the countdown to the first rate hike ticks toward zero.

Wednesday, June 17, 2015

Fed Watch: June FOMC Recap

Tim Duy:

June FOMC Recap, by Tim Duy: The FOMC meeting ended largely as expected with a nod toward recent data improvement but no change in policy. It is still reasonable to believe that lift-off will occur in September, but only if incoming data removes any residual concern about the sloppy data from earlier this year. Still, as Federal Reserve Chair Janet Yellen emphasized today, the lift-off itself is less important than the subsequent path of rates. That path remains subdued.
The FOMC statement itself was little changed - see the Wall Street Journal statement tracker here. Key is the opening line that validates the belief that the first quarter weakness was largely transitory:
Information received since the Federal Open Market Committee met in April suggests that economic activity has been expanding moderately after having changed little during the first quarter.
Otherwise, growth is expected to continue at a moderate pace that justifies an extended period of low interest rates. The updated forecasts saw reduced growth expectations this year as expected, while the near-term unemployment forecast was raised modestly (I had felt the Fed would be wary of doing this given their tendency to be overly pessimistic on this point). Longer term forecasts were essentially unchanged. The forecasts:

FEDFORE

The highest interest rate forecasts for 2015 were eliminated as was virtually required given the lack of any rate hike today. The median rate forecast suggests a rate hike this year, as did Yellen in her press conference. Still, she also said they are looking for decisive evidence to justify a rate hike, and I suspect that evidence will not arrive prior to the July meeting. Maybe September. Maybe not. It's all meeting by meeting now, you know.
Interestingly, although the inflation and unemployment forecasts for 2016 and 2017 were largely unchanged, the median interest rate projection fell along with the most hawkish forecasts. See this handy chart from Fulcrum Asset Management:

FULCRUM

No change in the inflation and unemployment forecasts combined with a slower and longer path to normal rates suggests a modest change in the reaction function. In effect, the Fed has turned more dovish as the timing of lift-off is delayed. Even with unemployment falling to current estimates of full employment next year, they do not believe the economy needs (or maybe could withstand) a rapid pace of hikes. Persistently low inflation and wage growth is taking its toll on policy expectations. And even the most hawkish participants are falling in line with this story.
Bottom Line: Fed policy unchanged as expected, door still open for a rate hike in September, but the lower rate path indicates a modestly more dovish Fed resigned to a persistent low interest rate environment. It's the rate path we need to be watching, not the timing of the first hike.