Category Archive for: Fed Watch [Return to Main]

Tuesday, June 06, 2017

Fed Watch: Fed Just Sort Of Confident About Full Employment

Tim Duy:

Fed Just Sort Of Confident About Full Employment, by Tim Duy: Over at Project Syndicate, Brad DeLong takes issue with Fed policy decisions. Importantly, he identifies, correctly, that the Fed's forecasting record in recent years has been less than optimal. Much less. The repeated optimism that inflation will soon revert to target is a most significant problem for a central bank with a formal inflation target. On this point the Fed has faced disappointment time and time again.
Brad is correct in his summary that the Fed needs to reassess its forecasting methodology to ensure that it is not biased toward high inflation forecasts. That said, I believe the issue is not quite as severe as Brad believes. In particular, I think this may be a bit unfair:
The FOMC’s blind spot stems from the fact that it is relying more on its assessment of the labor market, which it considers to be at or above “full employment,” than on noisy month-to-month inflation data. But “full employment” is a rather tenuous and unreliable construct. It has now been 20 years since economists Douglas Staiger, James Stock, and Mark Watson showed that Fed policymakers should not be so confident in estimates of “full employment.” And yet, for some reason, the Fed community has not let this essential message sink in.
I think there is actually quite a bit of uncertainty among Fed officials about the exact level of full employment. To be sure, policymakers repeatedly argue that they believe they are near full employment. But first, take that into context of changing estimates of full employment:


Clearly policymakers are willing to change their minds as new information becomes available.
Second, if they were fairly inflexible regarding their estimates of full employment and the implications for inflation, they would have raised rates after unemployment fell to 6.5% - the threshold for maintaining zero rates under the Evans Rule.
Third, and probably most importantly, if they clung to a strict confidence in their estimates of full employment, they would have long ago abandoned their gradual approach to raising interest rates. As of now, the unemployment rate at 4.3% is a full 0.4 percentage points below the median estimate of the longer run unemployment rate and below the 4.5-5.0% range of estimates of that measure. Moreover, job growth remains strong enough to drive the unemployment rate further down. So if they were very confident of their estimates of full employment, Fed officials would be much more concerned that they had already fallen behind the inflation curve. They would be raising rates at every meeting, not just an expected three times this year. They wouldn't be dragging their heels on raising interest rates back to their estimate of neutral. They would be racing to do so.
The unemployment rate in May stood 0.5 percentage points below the January level. At this pace, the rate will fall below 4% by the end of this year. That is not unreasonable at this point. Yet policymakers largely continue to expect just two more rate hike this year - which I find incredibly patient given that I doubt there is any FOMC participant who believes that inflation can remain contained if the unemployment rate holds consistently below 4%.
Fourth, recall the conclusion of Federal Reserve Governors Lael Brainard's recent speech:
While that remains my baseline expectation, I will be watching carefully for any signs that progress toward our inflation objective is slowing. With a low neutral real rate, achieving our symmetric inflation target is more important than ever in order to preserve some room for conventional policy to buffer adverse developments in the economy. If the soft inflation data persist, that would be concerning and, ultimately, could lead me to reassess the appropriate path of policy.
I take this at face value - the Fed will likely reduce the path of expected rate hikes if inflation does not firm in the next few months.
Finally, I understand the hesitancy to raise rates in the face of low inflation. I too have an innate desire to hold back policy until we see the "whites in the eyes" of the inflation beast. But I also understand the position of policymakers - the uncertainty cuts both ways. There is a chance that the Phillips curve is nonlinear and the economy is close to an inflection point. And if that inflection point hits, they don't have confidence they can easily slow the economy without triggering a recession. So, from their perspective, restraining the economy a notch now may maximize the net present value of output if it prevents a recession later.
Bottom Line: The Fed's gradual, data-dependent path is almost perfectly designed to make no one happy. Too slow for some, too fast for others. Perhaps that means it is more right than wrong after all.

Thursday, June 01, 2017

Fed Watch: Brainard, Powell, Employment Report Ahead

Tim Duy:

Brainard, Powell, Employment Report Ahead, by Tim Duy: Federal Reserve policymakers are turning a cautious eye to the inflation numbers, but for now believe special factors account for much of the weakness. Consequently, they remain more focused on the labor market in their policy deliberations. For now, that implies they will resist changing their expectations of further tightening this year as the US jobs market continues to hold strong. Tomorrow we should see more evidence of that strength.
Inflation continues to come in below expectations. The latest PCE inflation report, for example, was better than March but still anemic:


This weakness has not gone unnoticed on Constitution Ave, but Fed officials are not ready to call it quits on the expected path of monetary policy. Federal Reserve Governor Lael Brainard said earlier this week:
Even so, I see some tension between signs that the economy is in the neighborhood of full employment and indications that the tentative progress we had seen on inflation may be slowing. If the tension between the progress on employment and the lack of progress on inflation persists, it may lead me to reassess the expected path of the federal funds rate in the future, although it is premature to make that call today.
Her colleague Governor Jerome Powell appears less concerned:
Core inflation was 1.5 percent for the 12 months through April. This measure has also risen since 2015, although its gradual increase appears to have paused because of weak inflation readings for March and April. Some of the recent weakness can be explained by transitory factors. And there are good reasons to expect that inflation will resume its gradual rise.
On the other side of the country, San Francisco Federal Reserve President John Williams repeats the same:
Meanwhile, although inflation has been running somewhat below the Fed’s goal of 2 percent, with the economy doing well and some of the factors that have held inflation down waning, I expect we’ll reach that goal by next year.
The tendency to dismiss weak inflation numbers will continue as long as unemployment plumbs fresh lows for this cycle. Central bankers believe they are in the range of full employment, and don't want to risk being too far below their estimates of the neutral interest rate when inflation finally does take hold a bit more aggressively.
But will unemployment continue to push lower? The labor market appears to maintain considerable momentum. Initial claims remain low, ADP anticipates private sector job growth for May at 253k, and the ISM employment index picked up. See Calculated Risk for the rundown. Wall Street anticipates job growth of 185k for May within a range of 140k to 231k. My expectation is just on the north side of the consensus number: Nfp617
This should be enough job growth to maintain downward pressure on unemployment; as the economy matures, the Fed anticipates a requirement of only roughly 100k jobs per months to hold unemployment steady. A number closer to 200k will leave them concerned that sooner or later inflation will eventually emerge and they need to be ahead of that emergence not behind.
Two more interesting points on this from Powell. First, he thinks that labor force participation is near trend levels:
The labor force participation rate, which had declined sharply after the crisis, has now been roughly stable for 3-1/2 years, which represents an improvement against its estimated downward trend. Participation is now close to estimates of its trend level.
This implies that he anticipates need to slow job growth sooner than later to avoid excessive undershooting of the unemployment rate. Second, he see wages growth as just about right after accounting for productivity:
Wage data have gradually moved up, consistent with a tightening labor market. Although average hourly earnings are rising only about 2.5 percent per year, slower than before the crisis, much of that downshift may reflect the slowdown in productivity growth we have experienced. For example, over the past three years, unit labor costs--that is, nominal wages adjusted for increases in productivity--have been generally rising a bit faster than prices.
If productivity growth is 50bp lower than just prior to the recession, then real wages are close to target:


So, assuming the Fed maintains its assumptions regarding productivity growth, we don't need to see much faster wage growth for policymakers to become more convinced the economy is near full employment. Another point to remember when analyzing the labor report.
Bottom Line: The Fed's focus remains on the labor market. Hence, they remain focused on two rate hikes and balance sheet action still to come this year. One of those rate hikes will come this month. If sustained, weak inflation will eventually push them to rethink the path of policy. But the impact of those changes might fall more on 2018 than on 2017.

Thursday, May 25, 2017

Fed Watch: Fed Not Ready To Change Course

Tim Duy:

Fed Not Ready To Change Course, by Tim Duy: The minutes of the May Federal Reserve meeting reveal central bankers remained poised to raise interest rates again in June:
With respect to the economic outlook and its implications for monetary policy, members agreed that the slowing in growth during the first quarter was likely to be transitory and continued to expect that, with gradual adjustments in the stance of monetary policy, economic activity would expand at a moderate pace, labor market conditions would strengthen somewhat further, and inflation would stabilize around 2 percent over the medium term…
…Members generally judged that it would be prudent to await additional evidence indicating that the recent slowing in the pace of economic activity had been transitory before taking another step in removing accommodation.
With incoming data brighter and suggesting that the first quarter slowdown was indeed temporary, a June rate hike looks more certain than not. But why are they even contemplating raising rates at all given recent inflation numbers? And how long can the Fed stick with its current rate hike trajectory with inflation persistently below their 2 percent target?
The Fed finds itself stuck in a conundrum of low inflation despite low unemployment. One interpretation of this situation is that it is not a conundrum at all. The Fed’s estimates of the natural rate of unemployment are too high, and hence unemployment isn’t really all that low.
The other interpretation is with unemployment low and projected to be lower, it is only a matter of time before the inflation shoe drops. As noted in the Fed minutes:
Labor market conditions strengthened further in recent months. At 4.5 percent, the unemployment rate had reached or fallen below levels that participants judged likely to be normal over the longer run. Increases in nonfarm payroll employment averaged almost 180,000 per month during the first quarter, a pace that, if maintained, would be expected to result in further increases in labor utilization over time.
This is the potential outcome that keeps Fed Chair Janet Yellen and her colleagues gently resting their feet on the brakes.
To compare inflation-unemployment dynamics during the last three tightening cycles, I use here the estimate of the non-accelerating inflation rate of unemployment (NAIRU) produced by the Congressional Budget Office and core Personal Consumption Expenditures inflation. I assume for consistency that the Fed has a 2 percent inflation target throughout this period, but that is technically true only since 2012. 
Consider the late 1990s. The high productivity growth and rising dollar environment kept downward pressure on inflation even as unemployment fell as low as 3.8 percent:


Will history repeat itself? Should the Fed take the chance that history will repeat itself? There are risks to such a strategy. Inflation eventually did take hold, accelerating in 2001:


The return of inflation spooked the Fed enough that they hiked rates 50 basis points in May 2000, the last hike of the cycle. In retrospective that final hike was too much, too late and helped set the stage (or at least worsen) for the 2001 recession. One lesson learned: Even in a favorable macroeconomic environment, there are limits to how low the Fed can let unemployment fall.
Contrast this with the next hiking cycle, initiated by former Fed Chair Alan Greenspan and concluded by his successor Ben Bernanke. The post-2001 economy saw stagnant to falling productivity and a weaker dollar. It also experienced higher inflation with a smaller unemployment gap:


Greenspan had the best of both worlds, whereas Bernanke arguably had the worst. But the lesson learned was again that unemployment cannot be reduced indefinitely without triggering higher inflation, and once the Fed allowed unemployment to fall too low, reversing course was very difficult and likely to conclude in recession. It is no wonder then that current Federal Reserve Chair Janet Yellen repeats the concern that:
…waiting too long to remove accommodation would be unwise, potentially requiring the FOMC to eventually raise rates rapidly, which could risk disrupting financial markets and pushing the economy into recession.
This time around, the Fed faces low productivity but a generally stronger dollar. And the unemployment-inflation dynamic is splitting the difference between the past two tightening cycles:


Stuck in the middle, so to speak. Will the economy face a positive productivity shock that further reduces inflationary pressures? Or will the dollar continue its recent slide with the opposite impact on inflation? Will low unemployment finally start to kindle an inflationary fire? Or is the estimate of the natural rate of unemployment still too high? Interestingly, the minutes suggest that the majority of central bankers expect it more likely than not that these dynamics play out in such a way that the Fed needs to steepen the path of tightening:
Several participants, however, pointed to conditions under which the Committee might need to consider a somewhat more rapid removal of monetary accommodation--for instance, if the unemployment rate fell appreciably further than currently projected, if wages increased more rapidly than expected, or if highly stimulative fiscal policy changes were to be enacted. In contrast, a couple of others judged that the Committee could withdraw monetary accommodation even more gradually than reflected in the medians of forecasts in the March Summary of Economic Projections, noting that slack might remain in the labor market or that inflation was not very sensitive to declines in the unemployment rate below its estimated longer-run normal level.
The Fed, it seems, is biased toward more tightening not less - a situation that doesn't seem tenable if inflation remains persistently low as the year drags on.
Bottom Line: The bar to scaling back the Fed’s plans appears fairly high and requires either a more evident slowdown in growth that is likely to stabilize the unemployment rate or a substantial downward revision of NAIRU estimates. Until then, policymakers look committed to the middle ground of gradual removal of accommodation.

Tuesday, May 16, 2017

Fed Watch: Can't Keep A Good Economy Down

Tim Duy:

Can't Keep A Good Economy Down, by Time Duy: Call it the revenge of the hard data. Industrial production popped in April while the number of sectors contracting fell sharply:


Manufacturing itself enjoyed a healthy monthly gain:


One point to watch is the improvement in automobile assemblies:


Given tepid auto sales, this may add to inventories and ultimately place downward pressure on car prices.
Housing starts remained solid in April:


To be sure, the volatile multi-family component slid, but I think that should not be unexpected. Apartment construction bounced backed more quickly after the recession and I suspect has peaked. More of the action should now be in the single family component, which continues to gain traction. Given under-building in many markets, there seems to be plenty of room for continued growth in that sector.
From last week, retail sales growth continues, albeit as a lackluster pace:


Nothing to write home about, either good or bad.
Altogether incoming data adds up to some healthy growth expectations for the first quarter. The Atlanta Fed GDPNow tracker is looking for 4.1 percent growth in the second quarter. Still, I don't think the US economy is really posting such numbers any more than I believe first quarter growth was 0.7 percent. Take the average of the two and you get 2.4 percent, which is probably closer to reality.
This all clears the way for the Fed to hike rates again in June. But going forward, inflation remains a sticking point:


Either inflation is headed higher or the economy has more slack than the Fed believes. We will be seeing how that story plays out in the second half of this year.

Thursday, May 04, 2017

Fed Watch: Employment Day Ahead

Tim Duy:

Employment Day Ahead, by Tim Duy: Tomorrow the Bureau of Labor Statistics releases the employment report for April. The Fed has their eyes set on a June rate hike on the expectation that first quarter weakness was largely temporary. The April and May employment reports will be crucial to evaluating the call. But note they do not have to be blowout reports to justify a rate hike. They just need to show solid job growth reasonably north of 100k a month. At that pace, the Fed would anticipate, in the absence of additional rate hikes, further declines in the unemployment rate and excessive inflationary pressure. I expect the April report will deliver something like that, with a bump from last month but not so much strength that it would prompt the Fed to pursue a faster pace of hikes than currently anticipated.
If you were concerned about the first quarter GDP number (you shouldn't), you should take comfort in the still low levels of initial unemployment claims:


The lack of any upturn is a strong indication that underlying growth remains solid (albeit "solid" is less solid that we came to expect 10 or 20 years ago). ADP estimates private sector job growth of 177k in April, which is solid but not spectacular. But the ISM non-manufacturing employment index continues to hover just above in a lackluster range. The latter pulls down my estimate of April job growth to 148k:


This is weaker than the consensus forecast of 185k and just below the forecast range of 150k to 225k. So I am expecting something less than consensus tomorrow morning. That said, I think that an average of 150k over the next two months would likely be easily sufficient for the Fed to justify hiking rates in June. They will say that such a number remains above longer run expectations for labor force growth and thus slower job growth is eventually needed to settle the economy into a stable, noninflationary path.
Stronger numbers, particularly in the context of further declines in unemployment and/or accelerating wage growth, would certainly lock down the June hike and raise the odds of at least another in the second half of the year. But if job growth falls to a 100k or below average for the next couple of months and unemployment holds steady, the Fed will have trouble justifying further hikes, particularly if such a situation were to continue past June.
Bottom Line: As always, actual policy outcomes are data dependent. That said, expectations for this job report are generally consistent with the Fed's forecast and thus supportive of additional rate hikes.

Tuesday, April 18, 2017

Fed Watch: Autos Drag Down Industrial Production, Housing Solid

Tim Duy:

Autos Drag Down Industrial Production, Housing Solid, by Tim Duy: The Federal Reserve released March industrial production data today. Overall production was up 0.5% supported by a big jump in utilities. Despite the headline gains, it was something of a mixed message. First, the dispersion of weakness was the lowest since 2014:


It looks like with the rebound in energy prices and related production activity, the industrial side of the economy has turned a corner. On a softer note, manufacturing activity tumbled:


This was fairly disappointing considering the long run of solid growth beginning in the second half of last year. Slowing motor vehicle production took a bite out of the numbers. Specifically, autos, not trucks:


That chart makes it fairly clear that Americans prefer big vehicles to small ones. Overall motor vehicle sales are probably past their peak, and we can expect this source of weakness in industrial production to persist until sales settle into a new level. Note that motor vehicle output contributed 0.14 and 0.06 percentage points to overall growth in 2015 and 2016 respectively. That gives some sense of the magnitude of the opposite effect on growth this year - noticeable, but small.
Housing starts were below expectations, but February was revised upwards. Overall, a solid start to the year:


I don't see any reason to believe the uptrend in single family has broken, but multifamily is likely near cycle highs. For more on housing see Calculated Risk here and here.
Yesterday Federal Reserve Governor Stanley Fisher gave remarks on central bank communication. Of more immediate relevancy were his comments on balance sheet adjustment. Specifically, he doesn't see it as having a disruptive impact:
My tentative conclusion from market responses to the limited amount of discussion of the process of reducing the size of our balance sheet that has taken place so far is that we appear less likely to face major market disturbances now than we did in the case of the taper tantrum. But, of course, as we continue to discuss and eventually implement policies to reduce our balance sheet, we will have to continue to monitor market developments and expectations carefully.
Separately, Kansas City Federal Reserve President Esther George argued for continued rate hikes despite choppy data:
Overall, I am encouraged by the start of the normalization process and want to see it continue. Resisting the temptation to react to near-term fluctuations in the data will be necessary. Looking ahead, we should expect inflation to move up and down around 2 percent. A modest decline in inflation or an overshoot may not necessarily warrant the monetary policy normalization process to slow or accelerate. Such attempts at monetary fine-tuning can easily backfire, so a more forward looking view of inflation is needed.
And as part of that process she would like to see balance sheet reduction placed on auto pilot mode:
Balance sheet adjustments will need to be gradual and smooth, which is an approach that carries the least risk in terms of a strategy to normalize its size. Importantly, once the process begins, it should continue without reconsideration at each subsequent FOMC meeting. In other words, the process should be on autopilot and not necessarily vary with moderate movements in the economic data. To do otherwise would amount to using the balance sheet as an active tool of policy outside of periods of severe financial or economic stress, and would increase uncertainty rather than reduce it.
She also argues against deliberately overshooting the inflation rate. Her key reason is an often forgotten point. Not all goods and services have the same inflation rate, and a higher overall inflation rate may exacerbate inflation differences across the economy. Those differences would be expected to force a restructuring of the economy that could be costly. Her example is that housing costs may accelerate even faster if the Fed were to push for above target inflation:
Such concentration and persistently rising prices in one area suggests the economy is struggling to reallocate resources. For housing, it could reflect several factors such as tight lending standards faced by home builders and scarcity of skilled craftsmen needed to construct homes. I expect the market to eventually solve for, or at least adapt to, such factors. Using monetary policy however to compensate for them could easily end up hurting the population the policy is intended to help.
So count George as a "no" when it comes to any discussion of raising the Fed's inflation target.
Meanwhile, the Trump trade in bonds is reversing course; ten year yields are below 2.2 percent as I write. Also, odds of a Fed rate hike in June have fallen below 50 percent. Market participants are reasonably starting to think that the normalization process may take a bit longer than the Fed anticipates. It will be interesting to see if the Fed agrees. I expect that on average Fedspeak will stick with a fairly hawkish story as policymakers largely dismiss the choppy data of late. We will see if any of George's colleagues share her conviction that policy should not react to recent noise. I tend to think it is a small group, but I argued that Federal Reserve Chair Yellen sounded fairly complacent about the economy last week. Given that the Fed doesn't like to surprise, expect policymakers to speak out forcefully if they feel market participants just don't get it.

Monday, April 17, 2017

Fed Watch: Fed Looking Forward to the Second Quarter

Tim Duy:

Fed Looking Forward to the Second Quarter, by Tim Duy: First quarter growth is likely to fall flat - at least that is the signal from numerous forecasters and the Atlanta Fed. But what does it mean for Fed policy? Probably not much for now. It will leave policymakers a little cautious as we head toward the June FOMC meeting (May seems most likely a off the table for policy action). But mostly the Fed will be watching incoming data from the end of the first quarter and the beginning of the second. If the data flow picks up over the next couple of months, they will likely move forward with a June hike. They seem to be in a "what, me worry?" frame of mind.
Retail sales stumbled in March, following up on a revised decline in February as well. Motor vehicle sales are partly to blame; we have likely seen the peak in car sales for this cycle and are settling into a lower pace of activity going forward. Lower gas prices and sluggish sales at building supply stores contributed to the fall as well. Stripping out the more volatile components, however, suggests a bit more stability in sales than suggested by the headline numbers:


March inflation came in lower than expected, with a surprise hit to core:


Ocular econometrics suggests the March print is something of an outlier - the first monthly decrease since 2010. A big 7 percent decline in cellular service prices played a roll, as did falling used car and apparel prices. While I anticipate a rebound in April, this kind of print will help keep the Fed's inflation forecast intact thus preventing them from stepping up the pace of tightening. Watch how this plays through to core-PCE inflation. As a reminder, that was running hot in the first two months of the year:


In another sign that the Fed's inflation metrics will remain contained, the PPI for health services remained subdued in March:


The New York Federal Reserve issued its survey of inflation expectations for February. Interesting split between the high and low numeracy groups:


The low numeracy group tends to be more volatile, so I anticipate it will revert back in the next month.
How will any of this matter for the Fed? First, remember that the Fed started dismissing first quarter data at the March FOMC meeting. From the minutes:
Participants generally saw the incoming economic information as consistent, overall, with their expectations and indicated that their views about the economic outlook had changed little since the January-February FOMC meeting. Al­though GDP appeared to be expanding relatively slowly in the current quarter, that development seemed primarily to reflect temporary factors, possibly including residual seasonality.
Hence I don't think they will be surprised by a weak GDP number; they will be surprised if that weakness looks to be carrying forward into the second quarter.
Second, I think the same goes for inflation. For the moment, I think that the decline in unemployment to 4.5% will weigh more heavily on their decisions than a weak inflation number. Still, I believe that if inflation looks to be tracking below their forecasts, they will eventually reduce their estimate of the natural rate. Just not right away.
Third, I think this take on Federal Reserve Chair Janet Yellen's talk last week from Marc Chandler is accurate:
We had detected a shift in the Fed’s stance that we characterized as looking for data to confirm the recovery to now looking for opportunities to normalize conditions. Yellen sees similarly. She said the Fed has shifted from “a post-crisis exercise of healing” to now trying to sustain the economic progress.
The Fed is not living in the crisis anymore. Policymakers no longer worry about trying to boost the pace of activity. The economy is, by their estimates, near full employment with growth is near potential growth. In this framework, a normal economy demands a more normal monetary policy. Policymakers are thinking that the expansion will be eight years old this summer with a good chance that this could turn into the longest running US economic expansion on record. They generally believe that preemptive but gradual rate hikes offer the best chance of expanding the expansion to ten years and beyond. Hence I tend to think their bias is to continue along the current policy path, which suggests they will continue to sound hawkish relative to what recent data would suggest.
Bottom Line: Fed likely to dismiss recent data as unrepresentative of underlying economic trends.

Tuesday, April 11, 2017

Fed Watch: Solid Employment Report

Tim Duy:

Solid Employment Report, by Tim Duy: Labor markets were generally solid in March, with nothing by itself to dissuade the Fed from its current path. We should be watching for the Fed reaction to the decline in the unemployment rate, assuming it persists in the coming months. Could be dovish if the Fed lowers its estimate of the natural rate. Could be hawkish if they see a higher risk of undershooting the natural rate.
Nonfarm payroll growth slowed to 98k:


While this was below expectations, it wasn't a surprise. My interpretation is that most analysts expected downside risk to the estimates based on cold weather in March. No reason to think the basic underlying trend of solid but slowing declining job growth.
The unemployment rate dipped to a cycle low of 4.5% and stands below the Federal Reserve's longer run unemployment projection:


This will raise some eyebrows at the Federal Reserve. The median FOMC participant forecast 4.5% for December. So we are a little ahead of schedule on that. Does this mean the economy is poised to overheat? The wage numbers do not support that hypothesis:


Wage growth flattened out in recent months, suggesting the economy is not yet in danger of overheating. Policymakers will be closely watching this dynamic and, more importantly, the path of inflation, between now and the next meeting. If inflation looks to be overshooting the forecast, the Fed may conclude that weak wage growth reflects low productivity rather than slack in the economy. That would be hawkish. Keep an eye on this space.
While the headline jobs growth numbers disappointed, note that the forward looking indicator temporary help payrolls remains on an uptrend:


In some ways this feels like 1995-96, with a temporary slowdown followed by a sustained period of solid growth.
The back-to-back declines in retail trade reflected the ongoing stress in that sector:


Note too slowing wage growth in retail trade:


As of the last JOLTS report, the dynamics in retail trade employment are not driven by layoffs, but by a hiring slowdown:


Looks like both quits and hirings rolled over in recent months. What is interesting is that the due to the labor churn in the sector, a slowdown in hiring alone can have significant impact on the net job growth without relying on mass layoffs - at least not yet. Notice that discharges and layoffs in the sector are down from 2015. Still, the decline in the level of quits reflects employee worries about the state of the industry - they don't see it quite as easy to find a new job as they did in 2015.
One data point that doesn't seem to fit with the story of an industry in decline is the level of job openings:


If the sector is experiencing a truly apocalyptic event, we would expect job openings to roll over. How will the Fed view this story? Most likely as industry specific and not indicative of the broader economy but they will attempting to gauge the resulting slack, if any, in labor markets.
Bottom Line: Employment report was in line with (diminished) expectations. Most important for monetary policy was the decline in the unemployment rate. But absent more data, the exact implication could be either dovish or hawkish. Until the fog on that issues clears, expect the Fed to stick to its story: More tightening is coming, but at a gradual pace.

Friday, April 07, 2017

Fed Watch: Fed Likely To Discount Weakness in March Employment Report

Tim Duy:

Fed Likely To Discount Weakness in March Employment Report, Tim Duy: It seems that we are conditioned for a disappointing jobs report tomorrow. Although the ADP report came in strong, we have mixed signals from the employment components of the ISM reports, with the employment index up in manufacturing but down in the much bigger service sector. In addition, weather may be a factor - did warm weather goose the January and February numbers and now we will see payback due to a cold March? I expect that the Fed will be expecting the latter. The minutes suggest they are already primed for weaker first quarter numbers to begin with:
Participants generally saw the incoming economic information as consistent, overall, with their expectations and indicated that their views about the economic outlook had changed little since the January-February FOMC meeting. Al­though GDP appeared to be expanding relatively slowly in the current quarter, that development seemed primarily to reflect temporary factors, possibly including residual seasonality.
They would probably write off a weak headline payrolls numbers as a reflection of just another temporary factor. Of course, that also means they will embrace a solid number. It's kind of a heads they win, tails you lose situation for the Fed.
Consensus is looking for 175k on the payrolls in a range of 125k to 202k. This sounds reasonable; my estimate is 190k within a wider range of 106k to 275k:


Variance on these estimates, however, is notoriously high. My inclination is to expect the actual print to be more likely below and above 190k.
Assuming a weak read of payrolls that is written off to weather, the rest of the report is more important. The Fed maintains a laser sharp focus on signs unemployment is significantly undershooting the natural rate. Consensus expects the rate to hold at 4.7%. A drop would raise eyebrows at the Fed. An increase in the participation rate, however, would be welcome news that they can maintain a gradual pace of tightening. And wages of course will help guide them as they assess their distance from the natural rate.
Bottom Line: Unless the report is a complete disaster, I would expect the Fed is poised to look though any weakness. But that means a strong report will grab their attention.

Thursday, April 06, 2017

Fed Watch: Lots To Chew On In The FOMC Minutes

Tim Duy:

Lots To Chew On In The FOMC Minutes, by Tim Duy: The minutes of the March FOMC meeting confirmed that the Fed remains poised to tighten policy further, first via raising the federal funds rate followed by action to reduce the balance sheet later in the year. It appears most likely that the Fed will see the latter as a substitute for the former. That means rate hikes would perhaps be on hold during the start of 2018 as the Fed assesses the efficacy of its actions. To be sure, however, the pace and mix of tightening remain data dependent. With the Fed in general agreement that the economy is near full employment, an uptick in either the pace of growth or inflation concerns will prompt the Fed begin murmuring about an accelerated the pace of tightening.
The Fed tackled balance sheet strategy early in the meeting. On timing, the policymakers thought thought it soon be upon us:
Provided that the economy continued to perform about as expected, most participants anticipated that gradual increases in the federal funds rate would continue and judged that a change to the Committee's reinvestment policy would likely be appropriate later this year.
Now place that prediction in the context of this discussion from the committee action portion of the minutes:
Members generally noted that the increase in the target range did not reflect changes in their assessments of the economic outlook or the appropriate path of the federal funds rate, adding that the increase was consistent with the gradual pace of removal of accommodation that was anticipated in December, when the Committee last raised the target range.
The median rate projection in March held at a total of three hikes for 2017. The Fed believes that the March rate hike was consistent with the gradual pace of policy removal as anticipated in December. Assume then that the economy continues to stay the course, holding generally in line with the Fed's forecasts. Suppose that means the current pace of tightening holds as well.
A continuation of the current pace of tightening - one action per quarter - would put rate hikes in June and September. At that point, the target range in 1.25-1.5%. That is roughly halfway to the currently anticipated neutral rate. Then the normalization of rate policy would be well underway, and then, in December, the Fed switches gears to balance sheet reduction. Later this year, as stated in the minutes.
That suggests that "gradual" means policy action once a quarter. (Remember the Fed began 2016 thinking four hikes? I think once a quarter seems about right to them.) If so, and they still intend a total of three rates hikes and balance sheet action for 2018, it implies they think, reasonably, that action on balance sheet reduction is a substitute for rate hikes. And, furthermore, that the balance sheet forecast is implicitly built into the median rate forecast. If not for having to deal with the balance sheet, I suspect the median forecast for 2017 would be 4 rate hikes.
That gets you through 2017. What about 2018? They probably have in mind that the phasing out of reinvestments could take six months, though this has not yet been decided. Back to the minutes:
An approach that phased out reinvestments was seen as reducing the risks of triggering financial market volatility or of potentially sending misleading signals about the Committee's policy intentions while only modestly slowing reductions in the Committee's securities holdings. An approach that ended reinvestments all at once, however, was generally viewed as easier to communicate while allowing for somewhat swifter normalization of the size of the balance sheet.
The Fed could go cold turkey on reinvestments, option 2, but I suspect will choose to ease into balance sheet reduction, option 1. Less chance of disrupting financial markets. That would mean policy action at the second meeting of 2018 to get reinvestment strategy on its final path, followed up quarterly rate hikes after that.
Assuming this is the schedule they have in mind, policymakers expect to tighten policy once per quarter for the next two years, trading off between rate hikes and balance sheet policy. The risk, however is that balance sheet reduction takes longer than expected, or it more disruptive than expected, thus reducing the scope for rate hikes in 2018. Time will tell on that one.
The Fed, however, could step up the pace of action. On the mandates:
Nearly all participants judged that the U.S. economy was operating at or near maximum employment. In contrast, participants held different views regarding prospects for the attainment of the Committee's inflation goal.
Inflation continues to be the sticking point. If inflationary pressures were more visible, the Fed would be acting more aggressively. Watch this space, and core-PCE inflation in particular. It picked up in January and February. If that continues into March and April, the Fed will worry that they have pushed "gradual" as far as it will go. Watching employment, however, is a bit more tricky. For now, I expect the Fed to get nervous of a significant undershoot if the unemployment rate dips much further. Persistent low inflation, however, could yield a decrease in the Fed's estimate of the natural rate of unemployment.
Finally, note this:
In their discussion of recent developments in financial markets, participants noted that financial conditions remained accommodative despite the rise in longer-term interest rates in recent months and continued to support the expansion of economic activity. Many participants discussed the implications of the rise in equity prices over the past few months, with several of them citing it as contributing to an easing of financial conditions. A few participants attributed the recent equity price appreciation to expectations for corporate tax cuts or to increased risk tolerance among investors rather than to expectations of stronger economic growth. Some participants viewed equity prices as quite high relative to standard valuation measures. It was observed that prices of other risk assets, such as emerging market stocks, high-yield corporate bonds, and commercial real estate, had also risen significantly in recent months. In contrast, prices of farmland reportedly had edged lower, in part because low commodity prices continued to weigh on farm income. Still, farmland valuations were said to remain quite high as gauged by standard benchmarks such as rent-to-price ratios.
Fed officials aren't growing nervous about just equities. They are seeing high prices across a wide range of risky assets. If it was just one asset class, they might conclude that it doesn't pose systemic risk for the US economy. Or they might conclude that macro prudential policies were sufficient to maintain financial stability. But a wide range of assets might require a more blunt tool - like higher rates. Another space to watch. Where this space gets messy is the tendency of equity prices to remain high even as the Fed tightens - a pattern which may induce the Fed to tighten much more aggressively than they should.
Bottom Line: The Fed clearly anticipates more tightening, likely at a pace of one action per quarter between interest rates and balance sheet. My interpretation of the minutes is that with the economy near full employment and assuming asset prices stay high, it wouldn't take much movement on the labor market or inflation expectations to make Fed officials sufficiently nervous that you begin to hear more about stepping up the pace of tightening.

Wednesday, March 22, 2017

Fed Watch: Is Bank Lending A Concern?

Tim Duy:

Is Bank Lending A Concern?, by Tim Duy: I have seen some angst recently over declining growth in commercial bank lending. See, for example, the Wall Street Journal:
Bank loans across all categories are increasing 4.6% annually, the slowest pace since 2014, according to weekly Fed lending data from March 1. The trend is particularly marked in business loans, which are increasing 3.9% annually, a rate that is a nearly six-year low.
A number of factors are at play, including rising interest rates; bankers also said some business clients put borrowing on hold before the U.S. election and aren't confident enough to jump back in.
The slowdown is noteworthy because it is occurring when many metrics show the U.S. economy strengthening.
Looking at the weekly data, there does on the surface look to be some reason for concern:


These low rates of growth are rarely seen outside of recessions. Still, optical econometrics suggests this is more of a lagging than leading indicator. Moreover, we have another indicator that also exhibited behavior only seen in recessions. Spot the odd man out:


Recall a year ago when weak industrial production numbers raised recession concerns that proved unfounded. We could be seeing something similar in bank lending. Consider that industrial production might be a leading indicator for bank loans:


Here I focus on the post-1984 period (the Great Moderation). Optical econometrics again suggests to me that lending lags industrial production. To quantify that a bit more, I converted the data to log differences (multiplied by 100), and ran it through a 13 lag vector autoregression. Granger causality tests (the f-tests here) indicate that loans (DLOANS) do not cause (or are predictive of) industrial production (DIND):


Impulse response functions (in this case, the responses are converted to impacts on the levels of the variables) illustrate the dynamics of the system:


The impact of a shock to industrial production on commercial lending (lower left chart) is delayed six months and then builds gradually over the next 18 months. The impact of a shock to lending on industrial production (upper right chart) is negligible. Ordering of the variables does not affect these results. If I use the full sample (data begin 1947:1), both variables Granger cause each other, but the impact of loans on industrial production in the short-run is minimal and dies out in the long-run:


Bottom Line: The fall in commercial lending growth looks more consistent with a lagged impact from the industrial slowdown that weighed on the US economy last year than with a warning about future activity. Something to keep an eye on, to be sure, but if past history is a guide, it is more likely than not that lending will pick up over the next year.

Tuesday, March 14, 2017

Fed Watch: Shifting Dots

Tim Duy:

Shifting Dots, bt Tim Duy: The Federal Reserve begins its two-day meeting today. The outcome of the meeting is no longer in debate. A 25bp rate hike is widely expected after a round of Fedspeak in the week prior to the blackout period and the February employment report. More important now is what signal the Fed sends with the statement, the press conference, and the dots. I anticipate the overall message to signal general confidence in the economic outlook while reinforcing the idea that the Fed is neither behind the curve nor intends to fall behind the curve. The combination will give the Fed room to tighten policy at a gradual pace. I think that four hikes this year would still be considered gradual from the Fed's perspective. After all, the expectation of four hikes a year was considered gradual at the beginning of 2016. Not sure why it shouldn't be considered gradual now. 
At the end of last year, the Fed's median interest rate projection anticipated 75bp of rate hikes in each of 2017 and 2018. That translated into my 2017 baseline of two rate hikes with an option on a third, basically including a bias to account for the fact that the Fed's forecast has fallen short in recent years. If economic conditions were such, however, that the Fed pulled forward the first hike to March, I said that my expectation would shift to a baseline of three with an option on four. What that means, in effect, that I expect the dots to shift upward to reflect an anticipation of four rate hikes in 2017.
With March likely, will the dots move as I expect? Not everyone thinks so. Morgan Stanley, for instance, expects the dots will show higher rates in 2018 and 2019 instead. Via Business Insider:


 So why do I think it is more likely than not that the Fed raise the dots for 2017? Consider first the projections for output growth, unemployment, and inflation. Those should play directly into the rate hike forecast in a systematic fashion. So it you think the odds favor some combination of a higher expect growth gap (the difference between actual and longer run output growth), a lower than anticipated unemployment gap (the difference between actual and longer run unemployment), and a higher inflation forecast, then you should anticipate the dots will shift upward. 
In practice, of course, these estimates depend in part on the Fed's estimate of potential growth and the natural rate of unemployment. I don't think either has likely change, so the relevant factors should be the forecasts of the actual variables. Overall, I think it reasonable to believe that at least one, and likely two factors will point to higher rates.
Second, the Fed clearly believes that the balance of risks has tilted at least to completely balanced if not toward the upside. External risks have waned, incoming data both soft and now, with the employment report, hard have been solid, and Fed officials are captured by the allure of fiscal stimulus. FOMC participants whose rate forecasts incorporated a heavy downside risk (reasonable given what happened in 2016) will likely pull their rate forecasts up in a sigh of relief. In essence, these members will believe that without pulling forward rate hikes, they will be in danger of overshooting their targets.
Third, the financial markets were particularly buoyant in recent months even as expectations of tighter policy intensified. I think some FOMC members - yes, New York Federal Reserve President William Dudley, I am looking at you - will want to push back on those easier conditions in the name of financial stability. So that argues for pulling rate hikes forward.
Fourth,  estimates of the longer-run natural rate could rise. I don't anticipate this, as I don't see they have evidence to suggest this is the case, but I did not anticipate the small bump upward in the neutral rate estimates in the December Summary of Economic Projections. 
Altogether then I see more reasons likely to raise the 2017 rate projections than to hold them steady. Hence my expectations for the dots to nudge upward. Basically, it just puts the Fed back to where they started in 2016, expect with more cause to believe it will actually work out this time.
Of course, the rate projection is not a promise, and given recent history I tend to shade down my expectation from what the Fed projects. Hence my three with an option on four. I also am not entirely sure how they will integrate balance sheet reduction with rate hikes? Do they announce a balance sheet reduction at the same meeting they raise rates? Or do they pass on a rate hike to announce a balance sheet reduction? It seems like they would what to avoid the latter because it would equate the balance sheet tool with a rate hike a little too directly. Instead, I expect they would want everyone to think the balance sheet reduction is no big deal. So that argues for both at say the September meeting and that then places an option on the December meeting. If would be nice to have better guidance on this issue.
I tend to think the balance sheet issue is another reason to front load hikes in 2017 if possible. Then they have room to pause in 2018 if balance sheet reduction is a bit sloppier than anticipated.
Bottom Line: I see more reasons that not that the Fed will push up its 2017 rate hike projections. Lots of different factors - external, data flow, fiscal stimulus, and financial conditions - to say that with the economy hovering near potential output, the time is right to make a slightly faster move toward the neutral rate. Indeed, I have a hard time seeing why they would pull forward a rate hike if they weren't trying to create room for an additional hike this year. Note that this would really be just moving the ball down the field a bit quicker, not changing the goal posts - the estimate of the neutral rate. A higher estimate of the neutral rate would be much more hawkish than just quickening the pace slightly to that rate. 

Monday, March 13, 2017

Fed Watch: Green Light


Green Light, by Tim Duy: If there was truly any potential impediment to a rate hike from the Fed this week, it would have come from a weak employment report. The employment report was decidedly not weak. Instead, it finished paving the way to a Fed rate hike. Not enough yet, however, to justify a dramatic acceleration in the pace of future rate hikes, implying only a 25bp upward nudge in the Fed's rate projections for 2017.
Nonfarm payroll growth came in above expected at 235k:


The number may have been boosted by mild weather in February. Still, the underlying pace of growth in recent months is around 200k/month. This is faster than the Fed expects necessary to hold unemployment steady after the cyclical boost to labor force participation plays out. So far, however, labor supply continues to respond. Labor force participation edged up during the month, leaving the decline in the unemployment rate a modest 0.1 percentage points to 4.7 percent. This is just a touch below the Fed's estimate of NAIRU.
Underemployment numbers to continue to improve, as the Fed expects:


The economy is at something of a sweet spot, with job growth strong enough to prod along continued healing of the labor market but slow enough that the Fed can continue to remove accommodation at a gradual pace.
Wage growth rebounded in February, continuing to hover in the 2.5-3 percent range:


Should we be expecting much faster wage growth? Probably not. It strikes me that we are closing in on pre-recession rates:


If inflation rises to two percent (and here I am thinking core inflation), and wages rise with it, that adds about 30bp which pushes wage growth a bit above three percent. Note also, real wage growth was likely a touch higher prior to the recession, but not much:


And this needs to be taken in context of falling productivity growth over the past two decades:


So in order to expect substantially faster wage growth, we need to expect substantially higher productivity growth or substantially higher inflation. The Fed is betting against the former and actively tries to contain the latter. Indeed, on the latter they are only looking to get another 30bp or so. Which suggests to me that a meaningful acceleration of wages at this point would be interpreted by the Fed as evidence they had overshot the full employment mandate and needed to tighten policy more aggressively to contain inflationary pressures. But we are not there yet.
Bottom Line: Looks like the Fed knew what it was doing by signaling a rate hike in recent weeks. The earlier than expected rate hike should correspond to a bump up in this week's "dots." Some participants with two dots will switch to three, some with three to four. I expect the median rate hike projection of Fed participants will be four, which I translate into a baseline case this year of three with an option on four. The Fed will want to front load these hikes to stay ahead of the curve, which means March, June, and September if the data allows. Then December if needed. Data as of yet does not suggest a need by itself to step up the pace of hikes even more quickly. Watch the longer-run rate forecast. A rise in the end game dots would have much more hawkish implications than just a small acceleration in the near-term pace of hikes.

Wednesday, March 08, 2017

Fed Watch: Employment Report Ahead

Tim Duy:

Employment Report Ahead, by Tim Duy: Arguably, the Fed took the mystery out of this next FOMC meeting by fairly clearly signaling a rate hike is coming. What could hold them back at this point? Only a complete disaster of an employment report. And today's ADP number suggests that's very, very unlikely. Indeed, if the ADP number translates into a blowout employment report, the Fed probably didn't need to signal as aggressively as they did about this next meeting. The data would have brought market expectations to the same place. 

Calculated Risk provides a preview of the February employment report, concluding that he will take the "over" on the current forecast of a 195k gain in nonfarm payrolls within a range of 162k to 220k. I concur. Feeding recent data into my quick and dirty forecasting model suggests a gain of 273k for the month:


That said, I would not put too much emphasis on the point forecast itself. The change in payrolls is notoriously difficult to forecast. Almost a fool's game. That said, I do read this as a signal that there is substantial upside risk to the consensus forecast.

As important, if not more, is the unemployment rate and wage growth. A large gain in payrolls suggests a drop in the unemployment rate unless labor force responds positively. The Fed expects that as the recovery progresses, growth in the labor force will slow as demographic effects dominate cyclical effects. If this happens before job growth slows, the unemployment rate will decrease sharply and the Fed will undershoot the natural rate of unemployment. Faster wage growth would help confirm such an undershoot.

Bottom Line: A surge in hiring coupled with a decline in unemployment would be a red flag for the Fed. If that happens, expect the Fed to be more aggressive this year. It will give them more reason to front load rate hikes, and, if repeated in the next employment report, would open up the possibility of a May hike. Monetary policy is not on a preset course, and gradualism is not a promise, only an expectation.

Wednesday, March 01, 2017

Fed Watch: More on Dudley

Tim Duy:

More on Dudley, by Tim Duy: Following up on my piece this morning at Bloomberg, it is worth going into a little deeper detail on New York Federal Reserve President William Dudley’s comments. I think in this interview Dudley is doing a good job explaining policy in terms of the forecast. That is something the Fed needs to keep pushing. It doesn’t sound like the forecast or the risks have moved sufficiently to change the number of rate hikes expected this year. But he sure seems to be leaning toward pulling forward those hikes.

The CNN interview starts hawkish. What does “fairly soon” mean? According to Dudley:

President Dudley: I think it means what it says. It doesn't say it's a week, a month, a couple months. Fairly soon means in the relatively near future…

Quest: And that's obviously fairly soon, which implies sooner rather than later?

Dudley: I think that's fair.

March is sooner than June. May is sooner than June. March is sooner than May. June is sooner than December. Compared to last year, the next rate hike will certainly come sooner in the year. But given the context Dudley must be aware of how his comments would be received.

On the forecast Dudley says:

We've basically been saying that if the economy continues on the trajectory that it's on, slightly above-trend growth, gradually rising inflation, we're going to continue to remove monetary policy accommodation. So let's look at what we've actually gotten. It seems to me that most of the data we've seen over the last couple months is very much consistent with the economy continuing to grow at an above-trend pace, job gains remain pretty sturdy, inflation has actually drifted up a little bit as energy prices have increased. So we're very much on the trajectory that we said -- that we thought we'd be on and we said if we were on that trajectory we're going to gradually remove accommodation.

This is how I how been viewing the situation. The forecast seems pretty much intact, so there seems to be little reason to pull policy hikes forward. But then he adds:

What else have we seen? We've also seen things that should make us even more confident that this is going to continue in the future. After the election we've seen very large increases in household and business confidence, we've seen very buoyant financial markets -- the stock market is up, credit spreads are narrow. And we have the expectation that fiscal policy will probably move in a more stimulative direction. So, put it all together, I think the case for monetary policy tightening has become a lot more compelling.

Three issues are on the top of his mind – confidence measures, easier financial conditions, and fiscal policy. Arguable, these all distill down to expectations of stimultive fiscal policy. While none of these have yet translated into hard data, they have raised the probability of upside risk to the forecast. Indeed, he says this explicitly:

But we do know that fiscal policy is going to move in a more stimulative direction. So what that says to me is that the risks to the outlook are now starting to tilt to the upside. So while I haven't really built it into my GDP forecast, when I think about the balance of risks -- up or down in terms of economic activity -- I think the fiscal side tends to push things -- the risks to the upside.

And raising that upside risk thus makes the case for a preemptive rate hike more compelling.

All of this sounds like a strong push for March. As the interview continues on, however, he seems to walk back his own outlook:

Quest: But you can't wait for it to happen, can you? I mean the whole question of monetary lag. I know you've got to think about many of these policies not coming into force until 2018, but you have to plan now.

Dudley: Well, look, I think monetary policy is pursued on the basis on the economic outlook. Fiscal policy outlook obviously affects that -- the trajectory of GDP, unemployment and inflation. So that's a factor weighing on us but the fact that we have so little specifics yet about what's going to happen -- it's got to wind its way through Congress -- means I don't put a lot of weight on it in terms of my modal forecast. I just think it makes the risks to the outlook a little bit tilted to the upside at this point.

But Dudley said earlier that the case for policy tightening was “a lot more compelling.” So how does a “little bit tilted to the upside” translate to “a lot more compelling?”

What about financial conditions? Surely that demands an immediate response.

Quest: Into this difficult area we have the financial markets. They're on a tear. I mean today could be the 13th record high, we could be in record territory, you know the numbers better than myself. You can't wait for the fiscal plans completely until next year, but you have to take into account what's happening in the markets at the moment, don't you?

Dudley: Well, financial conditions are very important in terms of how they influence economic activity. So if the stock market is up, credit spreads are narrow, financial conditions are more buoyant, that's going to tend to make the economy stronger. The important thing for us, though, is not to overreact to every little movement in the stock market. It's got to be something that lasts for a period of time for it to actually affect household and business behavior. So if the stock market goes up, and then goes right back down, it's not going to have much consequence for the economic outlook. But if it goes up and stays up, then that's going to support, presumably, consumption through higher household wealth.

It important not to “overreact” because there is a lag between the stock market and the real economy. Stocks could head back down. Maybe the Trump rally will fade (but maybe it is less about Trump and more about cyclical improvement). In that case, it would not affect the outlook and thus shouldn’t influence the Fed’s policy decision.

But those confidence surveys, that’s the ticket, right? Well, maybe not:

Quest: What do you believe you're seeing at the moment?

Dudley: Well, there's no question that animal spirits have been unleashed a bit post the election. Stock market is up a lot. Household and business confidence have increased significantly. There's a survey of small businesses that showed a very large increase in December and sustained that increase in January. So, there's no question that sentiment has improved quite markedly post the election.

Quest: That -- animal spirits or whatever you want to call it -- that market influence. It transmits itself around to the entire economy, doesn't it?

Dudley: Well, we would expect to have some consequence for economic activity. But we'll have to see if that actually -- one if the confidence is sustained, and whether it actually materializes in terms of increases in spending. I would say so far we haven't seen much effect of the improvement in confidence actually leading into greater spending. I think the economy is still on about a 2% GDP track, which about what it's been over the last year or so.

So sentiment is a lot better, but it might not hold and even if it does it needs to be felt in the real economy to change the forecast.

Notice that in all three case he emphasizes that those factors have yet to change his forecast. And he downplays the likelihood of those points even translating into something that might change his forecast. So why then does he lead with the case for rate hikes is “a lot more compelling?” It doesn’t sound like it about the number of hikes for him, at least not yet. It is about the timing of the hikes. It seems to have less to do with the forecast itself and more to do with his desire to take preemptive action.

Bottom Line: When I read the interview, it is hard for me to see that he has a strong conviction for drawing forward the rate hike to March. It seems odd to do so if he sees no change in the forecast and downplays the impact of the upside risks. If he does want to move in March, it tells me then it has little to do with either factor and is entirely about staying ahead of the curve. It is about the need for a preemptive rate hike. If his forecast is for three hikes and he wants to hike in March, then his patience has ended and he wants those hikes frontloaded. If for FOMC participants as a whole the forecast has yet to change much, then it is possible that the even if they raise in March, the median projection of three rate hikes this year remains steady.

Monday, February 13, 2017

Fed Watch: Takeaways From Fischer Speech

Tim Duy:

Takeaways From Fischer Speech, by Tim Duy: Federal Reserve Governor Stanley Fischer gave a very nice speech this weekend that shed light on the current monetary policymaking process. I found three points particularly notable. First:
One important but underappreciated aspect of the SEP is that its projections are based on each individual's assessment of appropriate monetary policy. Each FOMC participant writes down what he or she regards as the appropriate path for policy. They do not write down what they expect the Committee to do. Yet the public often misinterprets the interest rate paths we write down as a projection of the Committee's policy path or a commitment to a particular path.
The interest rate projections in the SEP do not represent the Committee’s forecast because there is no such forecast. And they certainly do not represent a policy commitment. It is often easy, however, to use the shorthand of referring to the median of the SEP projections as the Fed’s forecast, which is why we fall in the habit of doing so. It is important to realize, however, that this is not an official forecast, and even if it were, it can change over the year so it is not a promise.
My preference is to view the median SEP projection as a baseline to assess policy shifts throughout the year. For instance, I do not believe that incoming data suggests that the Fed will raise its projection relative to the baseline at the upcoming March FOMC meeting. In other words, the median projection is not likely to shift from three to four hikes. This further suggests that given the Fed’s predilection to delay rate hikes in favor of further labor market gains, there is no pressing reason for the Fed to hike in March. They still have plenty of time to raise rates three times this year if necessary and the data do not suggest they need to move early to act on the possibility of needing four rate hikes this year. So no rate hike is likely in March.
A second point from Fischer:
Figure 2 reproduces panels from the April 2011 Tealbook that show the staff's baseline forecast--the solid black line--as well as prescriptions from three simple policy rules that were generated using the FRB/US model. The panel on the left shows the paths for the federal funds rate, while the panels on the right show the implications of those policy prescriptions for the unemployment rate and core PCE (personal consumption expenditures) price inflation, respectively…
… How does the FOMC choose its interest rate decision? Fundamentally, it uses charts like those shown in figure 2 as an important input into the discussion. And in their discussion, members of the FOMC explain their policy choices, and try to persuade other members of the FOMC of their viewpoints.
The chart:


An important takeaway here is that the Fed makes monetary policy decisions on the basis of a medium term forecast. In other words, they tailor policy to meet their objectives over the medium term. This stands in contrast with criticism that the Fed either only sees the short-term outcomes of their actions or that they base policy only on the last piece of data. In reality, they are incorporating that most recent data into the medium term forecast and adjusting policy appropriately.
This process, however, is challenging for the public to understand. Moreover, I do not think the Fed has spent sufficient time explaining their actions in terms of the forecast. I suspect that the Fed may not be doing itself any favors with the opening paragraph of the FOMC statement, which is backwards-looking in nature and portrays the impression that the most recent data is the basis of policymaking. I thus appreciate that Fischer is using charts like these to explain policy choices and hope to see more of it in the future.
A final point from Fischer:
As the August 2011 meeting illustrates, the eureka moment I thought I had 50-plus years ago was a chimera. Why is that? First, the economy is very complex, and models that attempt to approximate that complexity can sometimes let us down. A particular difficulty is that expectations of the future play a critical role in determining how the economy reacts to a policy change. Moreover, the economy changes over time--this means that policymakers need to be able to adapt their models promptly and accurately in real time. And, finally, no one model or policy rule can capture the varied experiences and views brought to policymaking by a committee. All of these factors and more recommend against accepting the prescriptions of any one model or policy rule at face value.
The Fed relies on models, but not only models. Moreover, those models, or the underlying components of those models, such as the natural rate of interest, change over time. This is not a weakness of policymaking, it is a strength. The Fed responds to a ;changing economy. It is not possible to place the Fed in the straightjacket of a simplistic Taylor Rule and expect good outcomes for the economy. Clearly this is intended to push back at ongoing efforts to limit the Fed’s independence.
Bottom Line: Read Fischer’s speech for a greater understanding of the interplay between models, forecasts, data and judgment that governs the Fed’s policy choices.

Thursday, February 02, 2017

Fed Watch: FOMC, Employment Report, Warsh

Tim Duy:

FOMC, Employment Report, Warsh, by Tim Duy: The FOMC meeting came and went with little fanfare this week. As expected, there was no policy change, with only small modifications to post-meeting statement. With only small changes, it is a struggle to read much into the statement. Some thoughts:
1. Business investment. The Fed drew attention to weak business investment. The recent gains in core capital goods orders and improving ISM manufacturing numbers could be pointing to an upturn in the months ahead, possibly enough to boost growth estimates. Keep an eye on this space.
2. Business/Consumer Confidence. The Fed cited the post-Trump improvement in confidence. These gains, however, could easily prove to be ephemeral. The Fed will see them as a risk to their outlook, but will need actual data before changing their outlook.
3. Inflation expectations. The Fed noted that market-based inflation compensation estimates remain low. I think this means that they are not panicking about the recent rise in such expectations; they remains well below pre-recession levels:


If they aren't panicking, neither should you. For what it's worth, I suspect that they will only address market-based inflation numbers when convenient and ignore them when inconvenient.
4. Inflation confidence. The Fed deleted the factors (energy, import prices) restraining inflation. This could be viewed as confidence in their inflation outlook (my initial response). Alternatively, it could be interpreted as saying they don't have any more excuses if inflation remains below target. Or, it could mean the former to some at the table, the latter to others at the table.  
All that said, the changes were relatively minor and provide no concrete clues about the Fed's next move. My thoughts on March remains unchanged - without more supportive data, the odds of a March rate hike remains low.
Could the January employment report start building the case for a March hike? It sure can - if, in particular, the ADP report is a reliable predictor. But regardless of ADP, the case was building for a solid number - see Calculated Risk. The consensus expectation is 175k within a range of 155k to 190k. Taking the ADP number at face value suggests the report will prove to be better than expected: 


I think there is upside risk to the consensus forecast this month. (Note the error bands. Forecasting the monthly NFP change is risky business). If that is indeed the reality, the Fed will take notice. They will certainly take notice if unemployment dips lower or wages spike higher.
This week I wrote a detailed response to former Federal Reserve Governor Kevin Warsh's recent WSJ op-ed. One interpretation of this puzzling op-ed is that auditions for the Fed Chair require you to find fault with the Fed regardless of whether or not you actually find fault. Hence he lists supposed reforms that more than anything already reflect current policy, knowing that if chosen to be Chair he would be able to maintain much of that policy. This, however, is something of a dangerous game because it undermines the credibility of the Fed - how much can we trust the Fed if one of their own is so critical of their policies? That credibility is especially vulnerable now given the extent of the current threats to Fed independence. In effect, he is giving the Fed's critics ammunition to weaken the institution he reportedly is in the race to lead. One would think this is then a counterproductive approach. Moreover, he is doing the public and market participants no favors  by misrepresenting the Fed and its policies.
Bottom Line: And now we await the employment report...

Wednesday, February 01, 2017

Fed Watch: Was Kevin Warsh Really A Fed Governor?

Tim Duy:

Was Kevin Warsh Really A Fed Governor?, by Tim Duy: Former Federal Reserve Governor Kevin Warsh’s column in Tuesday’s Wall Street Journal was so riddled with errors and misperceptions that it is hard to believe he was actually a governor.
Warsh wants the Fed to announce a “practicable long-term strategy and stick to it,” claiming they have offered many such plans but never stuck to them. I don’t agree. The Fed has a plan, but Warsh just refuses to see it.
The former governor’s first critique:
A year ago around this time, the U.S. stock market fell about 10%. The Fed reacted precipitously, reversing its announced plan for 2016 of four quarter-point rate increases. But when prices rallied near the end of the year, the Fed decided it wouldn’t look good to let the moment pass without raising rates. It raised its key interest rate by a quarter point in December.
The Fed did not reverse its announced plan. The rate forecast contained within the Fed’s Summary of Economic Projections is just that, a forecast, not a plan. Incoming data triggered a revision of that forecast. And, contrary to the narcissistic belief of many market participants, it wasn’t all about them. Falling equity prices were just one of many data points that changed the course of policy. The Fed faced a very real slowdown in activity. Andrew Levin, former Fed economist, for instance, described the economy as operating at stall speed. Note that output growth slowed markedly during 2015 and into 2016:


The unemployment rate stalled out:


And inflation remained tepid:


If the Fed updated their forecast, it was for good reason.
Warsh follows with another instance of the Fed supposedly reversing course:
In late October, Fed Chair Janet Yellen expressed willingness to run a “high-pressure economy” to push the unemployment rate lower and inflation higher. Yet in a speech two weeks ago, she said that allowing the economy to run “persistently ‘hot’ would be risky and unwise.”
Yellen never expressed a willingness to run a high-pressure economy. That was always a complete misrepresentation of her comments. In that speech, she was simply proposing a research agenda for macroeconomists, including the topic of the influence of aggregate demand on supply. Had anyone actually read the speech (and I have to assume Warsh did not), they would see that she did not provide any policy proposals. Her subsequent comments were nothing more than an effort to set the record straight, not a shift in position.
Warsh uses the above episodes to claim that the Fed lacks a strategy:
Changes in judgment should be encouraged, but they ought to indicate something other than day trading or academic fashion. They must be rooted in strategy. Otherwise, the real economy winds up worse off…
…The Fed’s technocratic expertise is no substitute for a durable strategy. This make-it-up-as-you-go-along approach causes many Fed members to race to their ideological corners, covering themselves as hawks and doves…
The problem here is that the Fed does have a strategy, but Warsh refuses to see it. Specifically, incoming information alters the Fed’s economic forecast and, in accordance with a basic Taylor Rule, the Fed’s rate forecast with the goal of meeting the dual mandates over the medium term. Indeed, San Francisco Federal Reserve economists Fernanda Nechio and Glenn Rudebusch show that the Fed altered its rate forecast systematically in response to incoming data in this manner. That data brought the Fed’s original forecast for four rate hikes down to the actual one rate hike.
There is indeed a strategy. It is not the Fed that is too focused on the near-term. It is Warsh that is too focused on the near-term.
Warsh proposes five reforms for the Federal Reserve, beginning with:
First, the Fed should establish an inflation objective of around 1% to 2%, with a band of acceptable outcomes. The current 2.0% inflation target offers false precision. According to the Fed’s preferred measure, inflation is running at 1.7%, only a few tenths below target. The difference to the right of the decimal point is too thin a reed alone to justify the current policy stance. It also undermines credibility to claim more knowledge than the data support.
This one reveals Warsh’s true intentions – the current inflation target does not support his desire for higher rates, so he wants to move the target! Moreover, the current target does not offer false precision. No one at the Fed believes they can consistently hit two percent. And being below two percent has not stopped them from raising rates. In practice, the Fed will tolerate misses within a reasonable (25bp) range around two percent as long as forecasted inflation is trending toward target. That’s the medium-term strategy Warsh claims to be so concerned about.
Second, the Fed should adjust monetary policy only when deviations from its employment and inflation objectives are readily observable and significant. The Fed should stop indulging in a policy of trying to fine-tune the economy. When the central bank acts in response to a monthly payroll report, it confuses the immediate with the important. Seeking in the short run to exploit a Phillips curve trade-off between inflation and employment is bound to end badly.
It is a misperception that the Fed acts impetuously on the most recent data. They use that data to update their forecast in a systematic fashion (see above). I generally excuse most people from not understanding this distinction. It is a difficult concept and, quite frankly, one that the Fed does a poor job communicating. Warsh, however, has no such excuse.
For his third reform:
…the Fed should elevate the importance of nonwage prices, including commodity prices, as a forward-looking measure of inflation. It should stop treating labor-market data as the ultimate arbiter of price stability…A material catch-up in wages after a long period of stagnation need not trigger a panicky response.
I don’t think Warsh understands the foundations of Fed’s approach to inflation forecasting. From Yellen’s lengthy discussion of the topic in September 2015:
To summarize, this analysis suggests that economic slack, changes in imported goods prices, and idiosyncratic shocks all cause core inflation to deviate from a longer-term trend that is ultimately determined by long-run inflation expectations. As some will recognize, this model of core inflation is a variant of a theoretical model that is commonly referred to as an expectations-augmented Phillips curve. Total inflation in turn reflects movements in core inflation, combined with changes in the prices of food and energy.
Wages aren’t in that description. Wages are primarily a guide to estimating full employment (economic slack). Rising wage growth indicates the economy is approaching full employment. Wage growth in excess of the inflation target plus productivity growth raises warning signs that the economy is operating beyond full employment. Also, commodity prices are included as idiosyncratic shocks. Finally, the labor market data is very clearly not the ultimate arbiter of price stability. In the long-run, inflation expectations are the ultimate arbiter of price stability.
Warsh’s next reform:
Fourth, the Fed should assess monetary policy by examining the business cycle and the financial cycle. Continued quantitative easing—which Fed leaders praise unabashedly—increases the value of financial assets like stocks, while doing little to bolster the real economy. Finance, money and credit curiously are at the fringe of the Fed’s dominant models and deliberations. That must change, because booms and busts take the central bank farthest afield from its objectives.
Note that earlier Warsh complained that the Fed reacted to the financial cycles – easing policy when equity prices were falling and vice-versa. Now he wants the Fed to react to those cycles? In actuality, the Fed does take financial considerations seriously. See, for example Governor Jerome Powell here. Vice Chair Stanley Fischer here. Governor Daniel Tarullo here. Go back to the work of former Governor Jeremy Stein. And with regards to quantitative easing, the Fed would argue that their actions have indeed bolstered the real economy. And while busts in particular do take the Fed far away from its mandate, so too would strangling the economy to address a theoretical financial risk. Incorporating a financial stability term in the Taylor Rule is easier said than done.
Fifth, the Fed should institutionalize its new strategy and boldly pursue it with a keen eye toward the medium-term.
As I noted earlier, the Fed does have a strategy, the focus of that strategy is the medium run forecast, and the Fed changes their behavior in a systematic way to pursue that strategy. In short, the Fed’s already acts in accord with this supposed “reform.” Move along, folks, nothing to see here.
Bottom Line: If you want to understand the Federal Reserve and monetary policy, I don’t think reading Warsh’s op-ed gives you much to work with.

Sunday, January 29, 2017

Fed Watch: FOMC Preview

Tim Duy:

FOMC Preview, by Tim Duy: The Fed will take a pass at this week’s FOMC meeting. The median policy participant forecasts just three 25bp rate hikes this year and incoming data offers no surprises to force one of those this month. March, however, remains in play.
The three forecasted rate hikes is not a promise. It could be one hike or could be four or more. The actual outcome will depend on the path of actual economic outcomes and what those outcomes imply for the forecast.
The Fed is aware that crosscurrents in the economy – such as potentially significant changes to fiscal and economic policy – create substantial uncertainties about the course of monetary policy this year. From the most recent minutes:
…many participants emphasized that the greater uncertainty about these policies made it more challenging to communicate to the public about the likely path of the federal funds rate.
Translation: The Fed’s crystal ball is as cloudy as everyone else’s, but that’s hard to explain. For example, the potential positive demand shock from expected deficit spending could be overwhelmed by a potential negative supply shock from an increasingly xenophobic Trump Administration.
What does this mean for March? Currently, market participants place low odds of a March rate hike. The underlying bet is that if the Fed moves three times this year, the most likely timing will be June, September, and December. I think this is reasonable; bringing March into that mix requires a change in the tone of the data.
Specifically, to pull a rate hike forward, the Fed needs evidence that either inflation is firming more than anticipated or that unemployment is more significantly undershooting its natural rate. Both would be cause for concern for policymakers. But, in practice, given the inflation inertia evident in recent years, the labor market would most likely be the driving force of behind a March rate hike. From the minutes:
Several members noted that if the labor market appeared to be tightening significantly more than expected, it might become necessary to adjust the Committee's communications about the expected path of the federal funds rate, consistent with the possibility that a less gradual pace of increases could become appropriate.
The December labor report was largely consistent with the Fed’s forecasts, and thus will have little impact on the March meeting. The same is true for the GDP report for the final quarter of 2016. Notable is that domestic demand has held up well the last three quarters:


They will also be heartened that equipment investment, broke a string of four consecutive negative quarters with a 3.1 percent gain. Also, note that core durable goods orders are finally back to making year over year gains:


This too is consistent with the small uptick in growth anticipated by the Fed for 2017.

But we still have plenty of data between now and March. In particular, watch incoming data and how they impact the forecast of key variables such as unemployment and inflation. The Fed will pay close attention to:
  • Nonfarm payrolls. They expect payroll growth to continue slowing to something close to 100k a month. A re-acceleration would raise eyebrows on Constitution Ave.
  • The unemployment rate. The Fed’s estimate of the natural rate of unemployment firmed over the past year. Hesitation to drop it lower means that surprise falls in unemployment would prompt more aggressive Fed action.
  • Faster wage growth. Some policy makers argued in December that subdued wage growth gave them more time to respond to an unemployment overshoot. But wage growth accelerated in December to 2.9% annually, the highest pace since 2009. Watch this space (and see this from Bloomberg on competition for workers in the fast food industry).
  • Inflation numbers. Although, as noted earlier, inflation has been fairly inertial, that could change at the economy settles further into full employment/potential output.
  • Acceleration? The Fed is not anticipating a large acceleration in activity this year, so any indication that activity is picking up more than expected will be watched with wary eyes.
At this point I still do not anticipate a March hike. And note that a March move doesn’t guarantee a faster pace of rate hikes; it could be largely pre-emptive, just displacing a subsequent rate hike. But if they could justify a March move and you were anticipating two to three rate hikes this year, you should probably be thinking of three to four. Not to mention some action on the balance sheet added to the mix.

Tuesday, January 24, 2017

Fed Watch: Quantifying The Changing Rate Forecast

Tim Duy:

Quantifying The Changing Rate Forecast, by Tim Duy: In my last post, I asserted:
The actual amount of tightening will ultimately depend on the evolution of the forecasts for unemployment and inflation. If the expectation for unemployment drifts lower for this year, for instance, the median dots are likely to shift higher to ensure that the Fed continues to meet its mandate.
Can we quantify the impact of a changing economic forecast on the projected amount of tightening this year? Yes, using the methodology of Federal Reserve Bank of San Francisco economists Fernanda Nechio and Glenn Rudebusch. In a recent article, they argue the change in the Federal Reserve’s 2016 projected rate increase from 100bp to 25bp was consistent with a simple extension of a Taylor-type policy rule, specifically:
Funds rate revision = neutral rate revision + (1.5 × inflation revision) – (2 × unemployment gap revision).
Recall that the interest rate projections contained in the Fed’s Summary of Economic Projections (SEP) are not policy commitments. They are forecasts that we should expect to change with evolving forecasts of key variables, notably inflation and unemployment. The Fed’s credibility should not be judged on the accuracy of its rate forecast. It should be judged on its ability to meet its mandate. Actual policy should shift relative to the rate forecast as economic conditions change.
We can look to the December 2016 SEP as an example of the Nechio-Rudebusch approach. The Fed’s median rate forecast for 2017 rose 0.3 percentage points relative to the September SEP (Note: There is a rounding issue here. Effectively, the forecast changed from two to three 25bp hikes). The median neutral rate estimate (the longer run forecast of the funds rate) rose 0.1 percentage points. The inflation forecast (Nechio-Rudebusch use core inflation) was unchanged. The unemployment forecast fell 0.1 percentage points while the estimate of the natural rate of unemployment (the longer run forecast of the unemployment rate) remained unchanged. Thus the Fed revised down the unemployment gap estimate by 0.1 percentage points.
Applying the Nechio-Rudebusch policy rule:
0.3 percentage points = 0.1 percentage points + (1.5 x 0.0 percentage points) – (2 x (-0.1 percentage points)
In other words, the changing economic forecast for 2017 explains the magnitude of the change in the 2017 rate projection. Thus, we should watch incoming data for its impact on the forecasts for key variables to estimate its impact on policy.
In practice, we might expect minimal revisions of the longer run rates of interest and unemployment over the course of 2017. The estimate of the neutral interest rate declined substantially in 2015 and early 2016, but I suspect that pattern will not repeat in 2017. The estimate has already held fairly steady since the June 2016 SEP. Also note that the Laubach-Williams estimates of the natural rate of interest are now edging upward:


The era of declining estimates of the natural rate of interest may be over. Likewise, the estimate of the natural rate of unemployment remains at the March 2016 SEP. Assuming these parameters remain constant in 2017, the variation in the fed funds rate projection will depend on the unemployment and inflation and inflation forecasts.
As a practical example, I view the December employment report as consistent with the December SEP economic forecasts. The pace of underlying job growth continues to slow toward a range that is likely consistent with a steady unemployment rate after the demographic impacts on labor participation reassert themselves. This suggests the Fed’s forecast for a fairly small (0.2 percentage points) fall in the unemployment rate is largely unchanged. Hence, the employment report should not impact the median rate forecast for 2017.
Bottom Line: The Fed’s policy stance shifts in consistent manner. Important to understanding these shifts is estimating the impacts of incoming data on the Fed’s medium term forecast. In my opinion, the policymakers spend too little time discussing the impact of incoming data on their forecasts, leading to the perception that policy is more backward than forward looking. The above example illustrates, however, the importance of the latter for monetary policy.

Friday, January 06, 2017

Fed Watch: Solid Employment Report Keeps Fed On Track

Tim Duy:

Solid Employment Report Keeps Fed On Track, by Tim Duy: The labor market finished out the year on a solid note. Solid, not spectacular, and largely consistent with the Fed's expectations. Consequently, the final employment report for 2016 should not impact the Fed's median forecast for 75bp of rate hikes in 2017.
Payrolls rose 156k in December and jobs gains the previous two months were revised upwards by 19k. While good numbers, job growth continues to slow:


Since January 2015, the 12-month moving average of monthly job growth slowed from 262k to 180k. Still, that remains greater than the pace necessary to hold the unemployment rate constant once the demographic impacts again dominate the cyclical factors (Federal Reserve Vice Chair Stanley Fischer estimates that number to be 65k-115k). But the economy continues to trend toward that pace.
Supported by an increase labor force participation, the unemployment rate ticked up to 4.7%, holding just below the Fed's estimate of the natural rate of unemployment:


Measures of underemployment are now again showing signs of improvement, albeit the pace of improvement has slowed along with the pace of job growth:


The pace of wage growth accelerated to 2.9%, the highest rates since 2009:


Overall, the report should win hearts and minds on Constitution Ave. The economy looks to be tracking exactly where the Fed expects it to go, with job growth slowing sufficiently such that the unemployment rate holds steady just below full employment. Such a situation would allow for continued improvement in measures of underemployment while maintaining healthy but not excessive pressure on wage growth. In contrast, recall the concerns about about undershooting the natural rate of unemployment that surfaced during the December FOMC meeting. From the minutes:
...In discussing the possible implications of a more significant undershooting of the longer-run normal rate, many participants emphasized that, as the economic outlook evolved, timely adjustments to monetary policy could be required to achieve and maintain both the Committee's maximum-employment and inflation objectives.
...Several members noted that if the labor market appeared to be tightening significantly more than expected, it might become necessary to adjust the Committee's communications about the expected path of the federal funds rate, consistent with the possibility that a less gradual pace of increases could become appropriate...
The economy is now at a point where a sudden boost in activity would prompt the Fed to accelerate the pace of rate increases. This employment report, however, suggests this isn't happening just yet.
One note of caution, though. Manufacturing employment rose in this latest report by 17k, the largest gain since January 2016. This comes on top of improved data from the manufacturing sector:


This serves as further evidence that the inventory correction process over the past year has run its course. Note also the improvement in the service sector in recent months:


This suggests to me that risks for growth and hence rates are currently weighted to the upside.
Bottom Line: A solid report largely consistent with expectations among monetary policymakers. Hence it should have little impact on interest rate forecasts for the coming year. But watch out for upside risks to the outlook; the economy gained some traction in the final months of 2016. It is reasonable to believe that traction will hold in 2017.

Tuesday, December 27, 2016

Fed Watch: Is The Fed About To Experience A Repeat of 2016?

Tim Duy:

Is The Fed About To Experience A Repeat of 2016?, by Tim Duy: In the most recent Summary of Economic Projections, Fed officials penciled in three 25bp rate hikes for 2017. The reality, however, could be very different. We all remember how “four” became “one” in 2016. The median dots are neither a promise nor an official forecast. As 2016 progressed, forecasts associated with a lower path of SEP “dots” evolved as the consensus view of policymakers. Will the same happen this year? I don’t think so; it is hard to see the Fed on pause for another twelve months.
As a starting point, I think it best to assume the US economy is near full-employment. But the US economy was near full-employment at this time last year as well. I think the key difference between then and now is that then the after-effect of the oil price slide and dollar surge placed a drag on the US economy sufficient to ease hiring pressure. At the same time, labor force participation perked up, setting the stage for a flat unemployment rate for most of the year. Inflationary pressures eased as well; the January inflation pop proved to be short-lived:


In effect, the US economy settled into a nice little equilibrium in 2016 that obviated the need for additional rate hikes. To expect a repeat scenario in 2017, one would need to assume that the US economy does not pick up speed and threaten that equilibrium by pushing past full employment.
Evidence, however, piles up suggesting that the slowdown of the past year is drawing to a close. ISM manufacturing and nonmanufacturing surveys are stronger, temporary help employment is heading up again, new manufacturing orders for nondefence, nonair capital goods have flattened out, and the broader inventory overhang is easing:


All of this occurs in the context of an unemployment rate that suddenly dipped toward the lower end of the Fed’s estimates of the natural rate of unemployment. And if the demographic forces reassert themselves, there is likely to be further downward pressure on the unemployment rate – job growth is well above estimates necessary to hold unemployment constant.
But would a total of 75bp of hikes be necessary to hold inflation in check? That depends in part the sensitivity of inflation to greater resource utilization. Greg Ip of the Wall Street Journal noted last week:
Unlike in 2009, this fiscal stimulus will be hitting when the economy is close to full employment with far less spare capacity. Yet it’s premature to assume inflation will therefore jump. In the last decade inflation, excluding swings due to energy, has proven surprisingly inertial, barely moving in response to high unemployment. The same is likely true if unemployment drops further below its “natural” level.
It is true that inflation is fairly inertial, although some policymakers will dismiss the lack of response to high unemployment as a consequence of downward nominal wage rigidity. Moreover, others will claim the reason for inertial inflation is that the Fed has properly responds to weak or strong economic conditions to hold inflation and, importantly, inflation expectations, in check. In other words, you won’t see inflation if the Fed acts preemptively.
Still, the broader point remains true that while further declines in unemployment will pressure the Fed to hiking rates more aggressively, low inflation like seen in November will temper that response.
In addition, policy going forward depends on the relative tightness of financial markets in general, and the dollar in particular. And the dollar has been on a tear in recent weeks:


The dollar serves as a break on the US economy. If activity expands as I anticipate, and the economy is near full employment as I believe, then some demand will be offshored as the rising dollar prompts the trade deficit to widen. Consequently, the Fed needs to be wary of feedback effects from the dollar as they tighten policy.
Bottom Line: The economic situation on the ground is very different from December of last year. Whereas the decision to raise rates at that time looked ill-advised, this latest action appears more appropriate given the likely medium-term path of the US economy. Assuming the US economy is near full employment, that path likely contains enough upward pressure on activity to justify more than one more rate increase in 2017. Three I think is more likely than one. That said, the change in administrations and the path of fiscal policy creates uncertainties in both directions.

Thursday, December 15, 2016

Fed Watch: Fed Turns Hawkish

Tim Duy:

Fed Turns Hawkish, by Tim Duy: The FOMC raised the target range for the federal funds rate by 25bp today, as expected. But the tone of the press conference and the summary of economic projections were more hawkish than I anticipated. The Fed is shifting gears, a shift I did not expect until more data piled up in the first quarter of 2017. 
My error in analyzing this meeting was thinking that the Fed would nudge down the longer term estimate of unemployment - essentially, the natural rate of unemployment - on the basis the 4.6% unemployment rate in November. Such a downward drift happened in 2015:


I expected something similar given that the pace of inflation and wage gains remains moderate. But the Fed stuck to their prior estimates, 4.8% with a central tendency of 4.7-5.0% and an overall range of 4.5-5.0%. They didn't budge.

What did budge was the rate forecast, the dots. The median dot shifted up 25bp; the September median forecast of 50bp of rate hikes for 2017 is now 75bp. My interpretation is that rather than showing up in a declining estimate of the natural rate, the unemployment drop showed up as a rise in the rate forecast. This is important. It is almost as if the Fed is drawing a line in the sand with an increased confidence that they have the correct natural rate estimate. Their tolerance for further declines below that line is wearing thin.

Assuming that the natural rate forecast does not change - which essentially depends on the path of wages and inflation - this means that you should anticipate that further declines in unemployment will be met with a more aggressive Fed in 2017. I don't think this will be the last increase in the median rate forecast for 2017. 

It is reasonable to argue that the median dot doesn't really represent the Fed's forecast for rates. But I think the shifts in the dots at a minimum reflect general changes in sentiment. Down for more dovish. Up for more hawkish. This is more hawkish.

Federal Reserve Chair Janet Yellen exuded confidence in the economic outlook during the press conference. Three points were particularly notable:

  1. The Fed is obviously watching the path of fiscal policy, but it is too early to say what it meant for monetary policy. She did note, however, that fiscal stimulus was not needed to help the economy reach full employment. The implication was that fiscal policy designed to boost demand rather than productivity would be met by a faster pace of rate increases. This sets the stage for a potential conflict with the Trump Administration. 
  2. She repeatedly argued that her run a "high-pressure" economy comments from October were misinterpreted. She was recommending a research program, not a policy path. If you were expecting otherwise, time to get over it.
  3. She did not dismiss the possibility of staying on as a board member after her term as Chair ends. Another potential conflict with the Trump Administration.

Bottom Line: Sentiment on Constitution Ave. is shifting toward a modestly more hawkish stance a few months ahead of my schedule.  Policymakers finally see the light at the end of the tunnel.

Monday, December 12, 2016

Fed Watch: December FOMC Preview

Tim Duy:

December FOMC Preview, by Tim Duy: The Federal Reserve will nudge rates 25bp higher this week. This will not end the policy tension among FOMC members. How will that unfold in 2017? My expectation is that whereas 2016 began with excessively high expectations for rate hikes, 2017 will be the opposite. My tendency is think that the risks to the Fed’s median forecast of 50bp of rate hikes in 2017 are more weighted to the upside than the downside. Beware then of a more aggressive than expected Fed.
The FOMC statement represents a compromise position. Broadly speaking, some policymakers rely on earlier paradigms calling for preemptive policy action as the economy heads toward estimates of full employment. Another group questioned those estimates given the apparent decreased sensitivity of inflation to unemployment in addition to risk management concerns at the zero lower bound.
Slower growth, an uptick in the labor force participation rate, and low inflation in 2016 lent support to the latter group, keeping the Fed on the sidelines since last December. Support from the data, however, has waned.
To be sure, incoming data does not entirely resolve the debate. On one hand, the unemployment rate plunged 0.3 percentage points in November to 4.6 percent:


This is below the range of the longer-run central tendency (4.7 – 5.0 percent), sufficient to prompt a preemptive rate hike in December without dissent.
Still, unemployment continues to decline in the absence of widespread wage or inflationary pressures. Wage growth declined in November:


and the October read on inflation was tepid:


Consequently, we shouldn’t be surprised by a modest downward revision to the Fed’s longer-run estimate of unemployment. Moreover, measures of underemployment remain elevated, suggesting that labor slack remains even near estimates of full employment, allowing for unemployment to dip below those estimates without much concern. These factors provide breathing room to maintain a slow pace of rate hikes of 50bp in 2017 implied by the Fed’s Summary of Economic Projections.
But job growth continues to exceed estimates of that necessary to exert downward pressure on the unemployment rate. Plus, temporary help employment is picking up, suggesting that broad employment growth will accelerate as well:


Incoming data indicates the Fed should place higher weight on upside risks to the medium run growth forecast. The Institute of Supply Management’s positive manufacturing report for November adds to the evidence in the third quarter GDP report that the sector’s inventory correction process is drawing to a close. The non-manufacturing counterpart also gained traction, including a sharp rebound in the employment component. Finally, the third quarter GDP number – a respectable 3.2 percent – might be underestimating economic strength. Gross domestic income (GDI) jumped a whopping 5.2 percent during the quarter.
And then there is the fiscal picture. Fed policymakers will maintain a careful approach to that topic – see New York Federal Reserve President William Dudley and Chicago Federal Reserve President Charles Evans here. But the prospect of wider fiscal deficits should tilt the balance of risks toward a faster pace of rate hikes as 2017 progresses.
Altogether, whereas in late 2015 the economy passed through an inflection point that derailed expectations for 100bp of rate hike, the economy looks to be hitting in the opposite infection point as 2016 draws to a close. That suggests that the central tendency of the Fed’s rate projections will prove to be too low this year.
In other words maybe, just maybe, this is the year the economy starts to feel “normal.” Rather than the Fed moving closer to the markets, the markets will move to the Fed.
Bottom Line: The Fed will hike rates this week; the unemployment drop will give added weight to case for a preemptive rate hike. They will play it close to the vest regarding future policy; although the stars are beginning to align for stronger growth next year, this represents more of a risk than a reality. Expect Federal Reserve Chair Yellen to emphasize that policy is data dependent.

Monday, November 14, 2016

Fed Watch: December Still A Go

Tim Duy:

December Still A Go, by Tim Duy: Some back of the envelope calculations: The Fed's long-run real GDP growth estimate - the rate of potential GDP growth - is 1.8%. According to Federal Reserve Vice Chair Stan Fischer last week:
If labor force participation was to remain flat, job gains in the range of 125,000 to 175,000 would likely be needed to prevent unemployment from creeping up. However, if labor force participation was to decline, as might be expected given demographic trends, the neutral rate of payroll gains would be lower. If we assumed a downward trend in participation of about 0.3 percentage point per year, in line with estimates of the likely drag from demographics, job gains in the range of 65,000 to 115,000 would likely be sufficient to maintain full employment.
Labor force growth of 0.3%. Together, these two points imply a productivity estimate of 1.5%. The Fed's inflation target is 2%. The 2% inflation target plus 1.5% productivity growth suggests that the Fed anticipates wage growth of 3.5% when the economy settles into full employment.
Roughly; these are just back-of-the envelope calculations. Notice though that the 3-month moving average for average wage growth ticked up to 3.3% last month:


To be sure, 12-month wage growth still lags at 2.8%, but you can see where that trend is headed. Just like inflation, headed higher.
Under these conditions, it is reasonable to believe the economy is very close to full employment. Of course, some slack may still lurk in the background. Perhaps it exists in the underemployment estimates:


Or perhaps labor force participation will feel more cyclical pull before demographics begin to dominate again. But that would be a short-term impact. Longer run, the aging population will take its toll on the labor force. Anyway you slice it, the Fed's comfort level with their estimate of full employment must be on the rise:


Indeed, given the current pace of job growth, the Fed anticipates the economy is positioned to soon reach their mandates. Perhaps even more so. Fischer from last week:
...the more interesting and important questions relate to the next few years rather than the next few months. They relate in large part to the secular stagnation arguments that were laid out yesterday in Larry Summers' Mundell-Fleming lecture--in particular the behavior of the rate of productivity growth. The statement that the problem we face is largely one of demand--and we do face that problem--seems to imply either that productivity growth is called forth by aggregate demand, or a Say's Law of productivity growth, namely that productivity growth produces its own demand.
That is not an issue that can be answered purely by theorizing. Rather, it will be answered by the behavior of output and inflation as we approach and perhaps to some extent exceed our employment and inflation targets.
The Fed faces a familiar dilemma in December. Act preemptively, or hold still waiting for labor force and productivity growth to comes along? Most likely the Fed will take the opportunity in December to act preemptively and reiterate that doing so allows for them to retain their "move gradually" plan.
Does the election throw a wrench in their plans? Financial markets were buoyed by the prospect of a Republican dominated government, sending stocks higher and bonds lower. Would the bond sell off induce the Fed to take a pass in December, on the theory that higher interest rates imply tighter financial conditions? In this case, I think not. The steepening of the yield curve:


likely reflects the prospect of a reflationary policy mix. Note also that market-based inflation expectations tell the same story:


The Fed finally has the chance to chase the yield curve higher; I think they take it.
The situation differs from the steepening of the infamous "taper tantrum." Then the sell-off on the long end reflected a perceived change in the path of monetary policy, a perception the Fed did not share. Hence they needed to act in such a way to communicate their true intentions. In this case, the market is digesting new developments and raising estimates of the medium-run economic outlook and the likely monetary policy path.
Note that the Fed sees the prospect of fiscal stimulus as well. Fischer again, via Reuters:
"On more expansionary fiscal policy, I think many members of the open market committee and of the Federal Reserve Board have commented it would be useful to have a more expansionary fiscal policy," Fischer said.
It is not exactly a secret that the Fed would like a more expansionary fiscal policy to take on more of the macroeconomic policy burden. The Fed believes that a more expansionary fiscal policy would provide them greater room to "normalize" interest rates. Hence they will be closely watching the evolving fiscal agenda. It is too early for them to update their economic projections dramatically, but with regards to the December rate decision, the prospect of substantial fiscal stimulus must count as an upside risk for growth and inflation.
Given that the economy is already near the Fed's estimates of full employment, the risk of fiscal stimulus should imply a risk of a higher rate path in 2017 and beyond. Assuming no change in productivity or labor force growth, it is reasonable to anticipate that the Fed would consider a full monetary offset to any fiscal stimulus; the alternative from their perspective would be substantially higher inflation. President-elect Donald Trump might not take too kindly to such an agenda, thinking that it would undermine his efforts to
"make America great" again. The risk is that he would attempt to further politicize the Fed, nominating friendly governors willing to minimize the monetary offset. Beware of higher inflation in such an environment.
Bottom Line: With the economy hovering near full employment, the Fed will want to press forward with a December rate hike. Market odds of 85% are reasonable. Watch for signs the Fed will feel they have little choice but to offset fiscal stimulus if they want to preserve their inflation target. This is particularly the case for any large stimulus; Republican administrations have historically been pro-deficit spending. The stage is set for a contentious relationship with the next Administration. Watch for increasing politicization of the Federal Reserve.

Wednesday, November 02, 2016

Fed Watch: Fed Remains On The Sidelines

Tim Duy:

Fed Remains On The Sidelines, by Time Duy: As expected, the Federal Reserve left policy unchanged this month. The statement itself was largely unchanged as well. The near term inflation outlook improved, going from this is in September:

Inflation is expected to remain low in the near term, in part because of earlier declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further.

To this in November:

Inflation is expected to rise to 2 percent over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further.

With the year-over-year impacts of oil prices falling out of the data, headline inflation will track back upwards. Not a big surprise. With regards to the timing of the next move, the Fed went from this in September:

The Committee judges that the case for an increase in the federal funds rate has strengthened but decided, for the time being, to wait for further evidence of continued progress toward its objectives.

To this now:

The Committee judges that the case for an increase in the federal funds rate has continued to strengthen but decided, for the time being, to wait for some further evidence of continued progress toward its objectives.

See what they did there? Conditions are moving in the right direction, but the Fed still waits for some "further" evidence. Continuation of recent trends is likely sufficient to be that "further" evidence needed to justify a rate hike in December.

What would derail a December rate hike? Greg Ip at the Wall Street Journal speculates that a Trump win in next week's election would do the trick:

...a Trump victory would probably cast enough of a pall over the outlook to give the Fed reason to delay its next rate increase into next year. Ironically, Mr. Trump may discover that he, not Mr. Obama, is the reason the Fed hasn’t tightened.

Agreed, although this doesn't seem likely at this juncture. More likely to stay the Fed's hands would be a slowdown in hiring to something closer to 100k a month. That would probably end the downward pressure on the unemployment rate and raise questions about the Fed's basic forecast that the unemployment rate will continue to decline in the absence of additional rate hikes. We get two employment reports before the December meeting; for the Fed to stay on the sidelines yet again, we probably need to see both reports come in weak. The first one - for October - comes Friday morning. ADP estimates that private payrolls will be up 147k - not surging, but still easily sufficient for the Fed to justify a rate hike. If this comes to pass, we would probably need a deluge of soft numbers to keep the Fed on hold again.

Bottom Line: Fed is looking past the election to the December meeting for its second move in this rate hike cycle. Probably need some unlikely softer numbers to hold them back again.

Tuesday, October 18, 2016

Fed Watch: Are Yellen and Fischer Really Worlds Apart?

Tim Duy:

Are Yellen and Fischer Really Worlds Apart?, by Tim Duy: This from Bloomberg surprised me:

Michael Gapen, chief U.S. economist at Barclays Plc in New York, said Fischer’s comments “reflect an ongoing divergence of opinion” at the central bank. Fischer “doesn’t see much room for running the economy hot” while Yellen’s views “seem to provide a wide-open door to do that. You have a chair and a vice chair who see policy differently right now,” he said.

I don't think there exists a yawning gap between Federal Reserve Vice-Chair Fischer and Federal Reserve Vice Chair Yellen. The perception of this gap stems in part from what I think was an aggressive reading of Yellen's speech last week. The line in question:

If we assume that hysteresis is in fact present to some degree after deep recessions, the natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a "high-pressure economy," with robust aggregate demand and a tight labor market.

Is this a call for a "high-pressure economy"? My interpretation is somewhat more muted. Note that this was posed as a potential research question, along with three others, that macroeconomists should pursue in the wake of the Great Recession:

The Influence of Demand on Aggregate Supply
The first question I would like to pose concerns the distinction between aggregate supply and aggregate demand: Are there circumstances in which changes in aggregate demand can have an appreciable, persistent effect on aggregate supply?

My second question asks whether individual differences within broad groups of actors in the economy can influence aggregate economic outcomes--in particular, what effect does such heterogeneity have on aggregate demand?

Financial Linkages to the Real Economy
My third question concerns a key issue for monetary policy and macroeconomics that is less directly addressed by this conference: How does the financial sector interact with the broader economy?

Inflation Dynamics
My fourth question goes to the heart of monetary policy: What determines inflation?

She does not actually say that the Fed should run a high pressure economy. Nor should this be seen as a defense of current policy because this is decidedly not a high pressure economy. Instead, Yellen argues we need more research on the topic to understand the costs and benefits of such a policy approach:

More research is needed, however, to better understand the influence of movements in aggregate demand on aggregate supply. From a policy perspective, we of course need to bear in mind that an accommodative monetary stance, if maintained too long, could have costs that exceed the benefits by increasing the risk of financial instability or undermining price stability. More generally, the benefits and potential costs of pursuing such a strategy remain hard to quantify, and other policies might be better suited to address damage to the supply side of the economy.

Now, to be sure, she is willing to delay rate hikes to explore the possibility of drawing more supply from the labor market. From the press conference:

But with labor market slack being taken up at a somewhat slower pace than in previous years, scope for some further improvement in the labor market remaining, and inflation continuing to run below our 2 percent target, we chose to wait for further evidence of continued progress toward our objectives.

Does this mean the economy is a running at a high pressure? Later in the conference:

And that is some news that we’ve received in recent months, that the labor market does have that potential to have people come back in without the unemployment rate coming down. So we’re not seeing strong pressures on utilization suggesting overheating, and my assessment would be, based on this evidence, that the economy has a little more room to run than might have been previously thought.

One reason Yellen is willing to delay rate hikes is because the economy is not overheating. Again, this is not a high pressure economy - and if it was, she would not be so willing to delay rate hikes. Indeed, willingness to accept a high pressure economy suggests that Yellen has abandoned preemptive policy. But:

So I think the notion that monetary policy operates with long and variable lags—that statement is due to Milton Friedman, and it is one of the essential things to understand about monetary policy, and it has not fundamentally changed at all. And that is why I believe we have to be forward looking, and I’m not in favor of a “whites of their eyes” sort of approach. We need to operate based on forecasts.

Compare this with Fischer, via the same Bloomberg story:

“If you go below the full employment rate, or peoples’ estimates of full employment, by a couple of tenths of percentage points, I don’t think there’s any danger in that,” Fischer said Monday in response to questions at an Economic Club of New York lunch. “But saying we should keep going until the inflation rate shows us we’re wrong, then you’re going to change too late.”

Then, back to Yellen:

One is the risk that the economy runs too hot, that unemploy—the labor market tightens too much, that unemployment falls to a very low level, that we need to tighten policy in a less gradual way than would be ideal, and in the course of doing that, because that is a very difficult thing to accomplish, to gently create a bit more slack in the labor market, we could cause a recession in the process.

So you get the idea. There is nothing here to suggest that Yellen looks to generate a high pressure economy. She holds the commonly held view within the Fed that policy makers need to prevent the unemployment rate from sinking too low because they cannot just nudge the rate higher. If anything, with the unemployment rate dancing on the edge of Fed estimates of the natural rate, she would almost certainly react to an acceleration in activity with an acceleration in the pace of rate hikes. So too would Fischer. But with growth around 2 percent per tracking estimates, labor force participation rising to meet job growth, and inflation below target, we do not have a high pressure economy and hence the need for immediate rate hikes dissipates. Yellen will let it play out a bit longer. But if the labor force participation rate stalls out and unemployment starts heading back down, Yellen would become nervous that the Fed is poised to fall behind the curve.

Bottom Line: The key debate within the Fed at the moment centers around the need for preemptive rate hikes. The hawks prefer more preemption, the doves favor less. Federal Reserve Lael Brainard pulled the FOMC to the dovish camp, primarily through her influence at Constitution Ave. Yellen is probably somewhat more sympathetic to Brainard than Fischer, but as I said last week, Fischer has moved substantially in Brainard's direction. It is really the presidents that are on the hawkish side of the aisle. There just isn't that much space between Yellen and Fischer at the moment.

Monday, October 10, 2016

Fed Watch: Jobs Data Keeps Hawks Sidelined

Tim Duy:

Jobs Data Keeps Hawks Sidelined: Federal Reserve hawks face an array of labor market data that threatens a key pillar holding up their policy view. That pillar is the assertion that monthly nonfarm payroll growth over roughly 100k will soon force unemployment far below the natural rate, thus placing the US economy in grave danger from inflationary forces. By this view, the decline of unemployment long ago justified further rate hikes. Hawks failed to anticipate that the unemployment rate would flatten out at 5 percent despite steady payrolls growth. This outcome does not fit in their worldview. Fundamentally, they were supply-side pessimists. The recent strength in labor force growth suggests their pessimism was sorely misplaced and undermines their argument for immediate rate hikes. The key elements of the FOMC - the permanent voters - now stand as supply-side optimists and are prepared to hold rates at current levels through the next meeting, and perhaps even longer. A December rate hike is still not a foregone conclusion. 
In recent speeches, Federal Reserve Chair Stanley Fischer appears to be now fully under the sway of Fed doves. Fischer's take on the employment report, from his speech this weekend:
Despite the strong job growth, the unemployment rate, at 5 percent in September, has essentially moved sideways this year as individuals have come back into the labor market in response to better employment opportunities and higher wages. As a consequence, the labor force participation rate has edged up against a backdrop of a declining longer-run trend owing to aging of the population. This increase is a very welcome development.
Four charts deserve attention here. First, "strong job growth:


Second, the unemployment rate has "moved sideways":


Third: "higher wages":


Fourth "labor force participation has edged up":


Overall, the October employment report justified the FOMC's decision to hold rates steady in September. The reasoning, according to Fischer:
But with labor market slack being taken up at a somewhat slower pace than in previous years, scope for some further improvement in the labor market remaining, and inflation continuing to run below our 2 percent target, we chose to wait for further evidence of continued progress toward our objectives.
The Fed sees that demand-side policy triggers a supply side response, and consequently does not want to risk leaving millions in the ranks of the unemployed (and remaining workers with sub-optimal wage growth) with a premature tightening of policy. Moreover, the lack of substantial inflationary pressures continues to the bedevil the hawks. As Fischer notes, inflation expectations remain in check, or, if they have moved, have drifted down. And while inflation has indeed edged up in recent months, it remains below target:


And I would argue that much of the rise in inflation was attributable to January's gain:


Fischer also undercuts the hawks' argument that preemptive hikes are necessary because without them the Fed will fall behind the curve:
But since monetary policy is only modestly accommodative, there appears little risk of falling behind the curve in the near future, and gradual increases in the federal funds rate will likely be sufficient to get monetary policy to a neutral stance over the next few years.
The key is that he sees policy as only modestly accommodative - a view that follows the Fed's epiphany on the persistence of a low natural rate of interest. Hence no massive catch-up would be needed even if future conditions require a faster pace of rate hikes.
I suspect that the hawks, now derailed by the employment data, will further pivot toward financial stability as they argue for a more rapid reduction of financial accommodation. Here too, however, Fischer is prepared to meet them head on. From last week:
Let me briefly mention a second reason for worrying about ultralow interest rates: The transition to a world with a very low natural rate of interest may hurt financial stability by causing investors to reach for yield, and some financial institutions will find it harder to be profitable. On the whole, however, the evidence to date does not point to notable risks to financial stability stemming from ultralow interest rates. For instance, the financial sector has appeared resilient to recent episodes of market stress, supported by strong capital and liquidity positions.
Overall, sounds to me that Fischer now embraces the intellectual framework pushed for over a year by his colleague, Federal Reserve Governor Lael Brainard. This likely is true also of all the permanent voting members. Within the context to the Board's current framework, the hawkish Fed president can do little more than squawk.  
Bottom Line: A November rate hike remains dead. We have two labor reports until the December meeting. A continuation of recent trends would leave a rate hike at that meeting in doubt. Odds favor that meeting currently, but it is not a foregone conclusion. The doves are supply-side optimists. They want to let this rebound run for as long as possible. And remember, those closest to Federal Reserve Chair Janet Yellen are now those that inhabit the halls of Constitution Ave. Be wary of the words of hawkish Fed presidents; they have been very misleading this year. 

Wednesday, October 05, 2016

Fed Watch: Hard To Say That November Is Really "Live"

Tim Duy:

Hard To Say That November Is Really "Live," by Tim Duy: If there is one thing that I am fairly sure that monetary policymakers hate, it is the idea that the outcomes of their meetings are preordained. November appears to be just such a meeting. To be sure, Fed hawks want to believe the meeting is "live." The sizable group that dissented - or would have dissented if they were voting members - likely sees the case for a rate hike in November as even more pressing than in September. Remember, it is all about preemptive policy action from that contingent. If you thought delay was bad in September, it must be worse in November. But the doves - including a powerful group of permanent voting members - will likely have none of it. From their point of view, the case for a rate hike is no more pressing in November than September. Indeed, according to the the dot-plot, at least three would be happy taking a pass in December as well. And, although they would be loathe to admit it, within the context of a risk management framework the timing of the election argues against a hike as well. As I see it, the best the hawks can hope for is a strong statement about December. The data would have to very quickly turn very strong to give the hawks an upper hand in November.

I did get a chuckle out of this last week:

The only way to reinforce the idea that November is a "live" meeting is to continue to hold out the hope of a rate hike. But unless the doves budge between now and November, a rate hike is not happening. And the doves aren't likely to budge anymore than the hawks. It's kind of a stalemate at the moment, and everyone knows it. So reinforcing the the idea that a hike is going to happen when it isn't is not really an effective communication strategy. It is not exactly good policy guidance.

Cleveland Federal Reserve President Loretta Master would also like you to believe November is "live." From Monday, via Bloomberg:

Federal Reserve Bank of Cleveland President Loretta Mester said the economy is ripe for an interest-rate increase and repeated that the Fed’s November meeting should be viewed as “live” for a policy decision, despite its proximity to the U.S. presidential election.

“I would expect that the case would remain compelling” for a rate hike when the Federal Open Market Committee gathers in Washington Nov. 1-2, the week before Americans head to the polls, she told Kathleen Hays in an interview on Bloomberg Television Monday. Mester added that politics wouldn’t affect the decision.

Of course she wants November to be "live." She wanted to hike rates at the last meeting. And I suspect she believes that unless the hawks can push up rate hike expectations to something closer to 50% (from the current 13% or so), they have no chance of pushing through a rate hike. Not that I think they have much of a chance even then. Seems that his amounts to trying to manipulate market expectations to obtain an advantage at the FOMC meeting. I sense this is what hawks have attempted more than once this year. In my opinion, this too is not a good communications strategy.

Like the outcome of the November meeting, Mester's dissent is also preordained.

Mester also repeats the "politics are irrelevant" story. And, broadly, I agree. I don't believe, for example, the Federal Reserve Chair Janet Yellen is holding rates low simply to help President Obama or enhance Hillary Clinton's election chances. That is ludicrous. So if you are saying that the Fed won't hike in November for those reasons, I think you are wrong.

But I am going to give some on this issue in another dimension. Elections are risk events, and a risk management strategy thus demands that they be considered when making policy. And we know that in fact the Federal Reserve considers elections when making policy. New York Times reporter Binyamin Appelbaum caught Yellen by surprise at the press conference with this question:

BINYAMIN APPELBAUM. Binya Appelbaum, the New York Times. In the run-up to the Brexit vote earlier this year, several Fed policymakers cited it as a reason that they were reluctant to raise rates in June because of the uncertainty associated with that vote. In the run-up to the presidential election, I have not heard any Fed policymaker give that as a reason that they might want to delay raising rates in November. Could you explain why the Fed regards Brexit as a greater danger to the American economy than the presidential election that’s actually happening here? And, second, there were three dissents at this meeting. Could you explain what the cause of disagreement was, what those policymakers thought?

CHAIR YELLEN. So we are very focused on evaluating, given the way the economy is operating, what is the right policy to foster our goals, and I’m not going to get into politics.

Appelbaum nailed that one - we can't credibly believe that the Brexit vote is a more relevant risk for the US economy than this presidential election. Yet the Fed is asking us to believe exactly that. If you can't comment on how US elections impact Fed policy, you shouldn't comment on how foreign elections impact Fed policy. Just chalk it up to "global economic uncertainty" and move one. The Fed really messed up by identifying the Brexit vote as a reason to hold rates steady.

This also doesn't seem like a win for the Fed's communication strategy. Live and learn.

Finally, when considering the risk management issues, don't let New York Federal Reserve President William Dudley's latest speech slip by you. He questions the effectiveness of unconventional monetary policy:

Given the initial novelty of unconventional monetary policy tools, central banks did not have a well-developed body of research to draw on to design the programs and calibrate their impact. While it will take time to build this body of work, research to date varies in terms of the estimated effectiveness of unconventional policy. Several studies indicate that the FOMC’s first asset purchase program helped to reduce long-term interest rates, while the subsequent programs had smaller though still significant effects on rates. However, Professor Summers, who is participating in our program, has recently questioned the effectiveness of the Fed’s asset purchase programs when financial markets are well-functioning.

And then he considers the implications for monetary policy (emphasis added):

There is a related concern given that the federal funds rate is still close to zero at this point in the expansion. While I’m on record as saying that expansions do not simply die of old age, some economists are concerned that the risk of a recession is increasing. As I indicated earlier, the FOMC was able to reduce the federal funds rate by more than 5 percentage points in an effort to offset the effects of the last recession. If another recession were to happen in the next few years, it is likely that the FOMC would be unable to respond with a cut of such magnitude. In this case, the effectiveness of unconventional monetary policy in providing accommodation would again become a central issue, as Chair Yellen discussed in her recent Jackson Hole speech. A risk management approach to monetary policy would suggest that the more concerned one is with the effectiveness of these policies at the zero lower bound, the more cautious one would be in the process of removing accommodation. So, even though we are now slightly off the zero lower bound, an assessment of the effectiveness of unconventional monetary policy has implications with respect to the current stance of monetary policy.

Recessions don't die of old age, that's true. But the fact that Dudley even mentions rising risks of recession among "some economists" is notable. And note the time horizon of his concerns - the next few years! He must have a tingle in the back of his head saying that we are closer to the end than the beginning, and we still don't have adequate policy room, nor can we get adequate policy room by hiking rates because that will only accelerate the onset of the next recession. So the only thing they can do is delay (although not clear why he should consider a rate hike wise at all if he concedes to recession concerns). Such an argument will continue to dominate over the preemptive strike argument (see Richmond Federal Reserve President Jeffrey Lacker for the extreme view on that point) in November.

My takeaways on Fed communications over the last week are thus:

  • If you are only going to hike once a year, it is difficult to see why that hike would come at a meeting without a press conference. Clearly, it is not as if the timing of that one hike is really all that critical. You just have to learn to live with the reality that it will be hard to describe all eight meetings a year as "live" when you hike in only one of them. Live with the fact that at least half will end up effectively as "dead." And guess what? You determined which were "dead" with the decision to only have a press conference at every other meeting.
  • Don't try to talk up a rate hike with the only purpose of keeping the drama surrounding the meeting alive. That is not helping market participants understand the factors driving policy.
  • Don't try to talk up the market odds of a meeting just to attempt to gain a tactical advantage at that meeting. That seems to me to be what Fed hawks have been doing this year. The doves just aren't buying the preemptive strike argument. And they won't if market odds for a meeting are 50% rather than 15%. Wait until December.
  • If US politics are off limits, then foreign politics need to be off limits. It is very hard to explain why US politics don't matter for policy when foreign politics do matter.

Bottom Line: I am hard pressed to see the way forward to a November rate hike. Seems that delay will still dominate over preemptive strikes in November.

Monday, September 26, 2016

Fed Watch: December Looking Good. But...

Tim Duy:

December Looking Good. But..., by Tim Duy: FOMC doves squeezed out another victory at last week’s meeting. But can they do it again in December?
As was widely expected, the Fed held rates steady at the September FOMC meeting. That said, the meeting was clearly divisive, with three dissents, all from regional bank presidents. And the accompanying statement leaned in a hawkish direction – the committee noted that near-term risks were “balanced” and that the case for a rate hike had “strengthened.” Moreover, only three of the participants did not expect a rate hike before year end.
And if that was not enough, during her press conference, Federal Reserve Chair Janet Yellen suggested the bar to a December rate hike was low:
…most participants do expect that one increase in the federal funds rate will be appropriate this year and I would expect to see that if we continue on the current course of labor market improvement and there are no major new risks that develop and we simply stay on the current course.
Sounds like December is a go. But markets are not entirely convinced, with participants pricing in a roughly 60% chance of a rate hike. Perhaps this pricing reflects post-election economic risk. Or perhaps it reflects the possibility that the doves can stare down the hawks one more time before the composition of the Board changes next year.
Can they? That question requires understanding what happened to squash the parade of Fed presidents looking for a rate hike in September. What happened were Federal Reserve Governors Lael Brainard and Daniel Tarrullo. Brainard in particular laid down the intellectual framework ahead of the FOMC meeting, arguing that the potential for further labor market improvement and asymmetric policy risks justified a steady hand at this meeting. Yellen and the rest of the Board bought into this story. The hawks could squawk all they wanted, but the votes just weren’t going to go in their favor.
This episode provided two important lessons. The first is that if you haven’t been taking Brainard seriously this past year – ever since her bombshell speech last October – you have been doing it wrong. The second is that a small group of governors can have a much larger influence on policy than a large group of presidents. There are lots of presidents, and they talk a lot, so their message is louder. But the power rests in the Board.
Indeed, this asymmetry of power is why the relative lack of speeches from Board members is one of the Fed’s biggest communication failures. The people driving policy shouldn’t be waiting until the Friday before the blackout period to begin delivering their message.
Now consider the dots. There remain three “no hike” dots for 2016. I think it is reasonable to believe those three dots belong to Tarullo, Brainard, and Chicago Federal Reserve President Charles Evans. If true, that suggests that Tarullo and Brainard are at the present time considering making another dovish stand at the December meeting. To do so, they need to keep Yellen on their side.
During the press conference, Yellen revealed that she remains attached to a preemptive view of policy. Since monetary policy operates with long lags, it is important that policy responds to inflationary threats before they emerge. She also rejected a “whites of their eyes” approach to policy, or the suggestion by Evans that they Fed waits until core inflation hits two percent before they hike rates. These concerns are balanced against Brainard’s argument that they can’t be sure they have yet achieved full employment.
Hence, and as I said ahead of the meeting, I think that if unemployment dips between now and December, or progress on underemployment resumes, or inflation moves closer to target, the hawks will win as Yellen’s support will shift toward a rate hike. And these things can all be reasonably expected given the current course of job growth, which is in excess of the Fed’s estimate of what is necessary to absorb labor force growth. For the doves to have a decent chance of holding back the hawks one more time, progress on these points needs to remain stalled.
Regardless of a December hike or not, the Fed continues to mark down the expected path of policy. The median projected Fed funds rate dropped 50bp for both 2017 and 2018, continuing the pattern of the Fed moving toward the market rather than vice-versa. And note that the changing composition of the FOMC next year will allow for this dovish message to come through. This meeting’s dissenters will all be replaced with presidents that are on average more dovish. Consider this ordering of monetary policy makers via Julia Coronado of Graham Capital, modified to show the shift of voters for next year:


Voting presidents will be more aligned with the preferences of the governors. This should help ease some of the recent communications challenges even if the governors maintain their relative silence.
Bottom Line: Doves on the Board continue to delay the preemptive strike on inflation. Stalling gains on unemployment and underemployment gave them the ammunition to stand their ground. If those gains resume, doves will fall prey to the hawks at the next meeting. But they will have an easier time maintaining a shallow path of policy next year, and hopefully are better set to communicate that path.

Tuesday, September 20, 2016

Fed Watch: Ahead Of The FOMC Meeting

Tim Duy:

Ahead Of The FOMC Meeting, by Tim Duy: A roundup of Fed-related stories and viewpoints ahead of the FOMC meeting. First, Jeanna Smialek at Bloomberg sees danger lurking in the new dot plot:

Janet Yellen will frame a decision this week to forgo an interest-rate increase as necessary to achieve the Federal Reserve’s economic goals. Donald Trump and his supporters are likely to frame it as political.

That’s because the central bank on Wednesday will also release fresh “dot plot” projections which will probably show policy makers see one quarter-point rate hike by the end of the year. Such a forecast would be widely interpreted as a sign that a hike is coming at the Fed’s December meeting, instead of at the November gathering, which comes a week before the U.S. presidential election and isn’t accompanied by one of the chair’s quarterly press conferences.

Problem is, having the dot plot signal a December move comes with political baggage...

The political baggage is the timing of the rate hike around a presidential election. Why wait on a rate hike now only to signal that one is coming in December? Detractors will claim that the Fed doesn't want to derail the economy and with it the Democrat's hope of retaining the White House. This despite, as Joe Gagnon notes in the article, politics has little if any impact on the rate setting decision. But this isn't about reality, it is about perception. And, politically, the optics just aren't great.

It seems to me that the Fed is taking a political hit on top of what is likely to be the communications hit if, as is reasonably assumed, the dot plot signals a quarter-point hike in December. That would be a pretty strong calendar-based signal of their intentions. Given there is only a few months left in the year, they have to be pretty confident in the outlook to send such a signal. Which raises the question that if you were so confident, why not hike rates now? And if you send such a strong signal now, is that lowering the bar on the kind of data you need to support a hike? And then are you hiking because of perceived past commitment, a need to maintain "credibility," rather than the data? But doesn't that make the Fed more susceptible to policy errors?

In my opinion, the dots outlived their usefulness when they signaled a pace of policy tightening that never happened. They were a great tool for credibly committing to zero for a long period. But that very credibility made them a terrible tool when the time came for tighter policy. They were perceived as a promise because such perception followed logically from the previous promise of low rates. Now they just appear as a series of broken promises. Worse yet, the Fed might feel tied to those promises when they shouldn't be.

The Fed really needs to rethink the dot plot. Use it as a tool when it can be most effective; pull it when it detracts from the message.

Meanwhile, former Minneapolis Federal Reserve President Narayana Kocherlakota, writing at Bloomberg View, says the Fed is about to make a mistake regardless of what they do:

More than seven years after the recovery began in mid-2009, inflation remains below the central bank's 2-percent target...Worse, markets appear to be losing confidence that the Fed will ever reach its target: Yields on Treasury bonds suggest that traders expect inflation to average less than 2 percent five to 10 years from now. As the experience of the Bank of Japan indicates, restoring such confidence is not easy...The Fed is also falling short of its goal of "maximum" employment.

Kocherlakota concludes that the Fed should be easing policy, so holding and raising rates are both mistakes at this juncture.

But one does not have to go far for an opposing view. The editorial board at Bloomberg has a different idea:

The best it can do is press cautiously ahead on normalizing monetary policy, explain what “normal” now means, and promise to keep an open mind as new information comes in. What this requires right now, it should also say, is a quarter-point rise in interest rates.

The editorial board dismisses Kocherlakota as missing the bigger picture:

What this kind of analysis leaves out is the growing threat to future financial stability. Very low interest rates (together with a massively enlarged central-bank balance sheet, courtesy of quantitative easing) have supported demand as intended, albeit with ever-diminishing effectiveness; at the same time, however, they’ve artificially boosted financial-asset prices and distorted normal patterns of risk-taking in financial markets.

Because interest rate are low, they must be "artificially" low and thus distorting something in the economy. The insinuation is that the Fed can simply raise interest rates and the economy will jump back into a happier equilibrium with no distortions and no negative impact. Good luck with that.

If interest rates were truly too low, then their should be much more economic activity and upward pressure on inflation than currently exists. Whatever distortions currently exist must not be exerting a broad impact and thus are fairly small; monetary policy is a blunt tool to use on small distortions. Nor is it evident that even a fairly large rate hike would stop an asset bubble - at least not without a cost. San Francisco Fed researchers concluded:

What is the takeaway then? Slowing down a boom in house prices is likely to require a considerable increase in interest rates, probably by an amount that would be widely at odds with the dual mandate of full employment and price stability. Moreover, the Fed would need a crystal ball to foretell house price booms. In restraining asset prices, while the power of interest rate policy is uncontestable, its wisdom is debatable.

So hiking rates now to try to stop a bubble will likely end in lower rates later. In other words, to use rate policy to try to calm financial markets, you better be very, very sure you are actually facing a widespread threat to the economy. And I don't see anything that justifies that level of certainty. The Financial Crisis was the last war; policymakers need to be wary about always fighting the last war.

Not everyone believes the Fed will hold steady tomorrow. Via Bloomberg:

Two of the Fed’s 23 preferred bond-trading partners -- Barclays Plc and BNP Paribas SA -- are betting against their peers and the bond market by forecasting officials will raise rates Wednesday. It’s the first time more than one dealer has gone against the consensus during the week of a policy meeting since last September, data compiled by Bloomberg show. Economists at both banks say traders have too steeply discounted officials’ intent to hike after the Fed has remained on hold for longer than expected.

I think this is highly unlikely. There are some heavy hitters pushing to holding rates steady. I would not underestimate the power of a few dovish board members, especially if they don't want to roll over on a rate hike like last December. Moreover, the Fed doesn't like to surprise market participants. They don't need 100% certainty, but they need something better than the current odds hovering between 10 and 20%. The hawks know this, and don't like the outcome of the meeting being a foregone conclusion. That said, if the Fed does hike, the handful of analysts who called for a rate hike will look brilliant. And they should get the credit where credit is due in that circumstance.

And for my views on the meeting, see my piece in Bloomberg this week.

Wednesday, September 07, 2016

Fed Watch: Is Pushing Unemployment Lower A Risky Strategy?

Tim Duy:

Is Pushing Unemployment Lower A Risky Strategy?, by Tim Duy: The unemployment is closing in on the Fed's estimate of the natural rate of unemployment:


Consequently, Fed hawks are pushing for a rate hike sooner than later in an effort to prevent the economy from "overhearing." This overheating is argued to set the stage for the next recession. For instance, see San Francisco Federal Reserve President John Williams:
History teaches us that an economy that runs too hot for too long can generate imbalances, potentially leading to excessive inflation, asset market bubbles, and ultimately economic correction and recession. A gradual process of raising rates reduces the risks of such an outcome. It also allows a smoother, more calibrated process of normalization that gives us space to adjust our responses to any surprise changes in economic conditions. If we wait too long to remove monetary accommodation, we hazard allowing imbalances to grow, requiring us to play catch-up, and not leaving much room to maneuver. Not to mention, a sudden reversal of policy could be disruptive and slow the economy in unintended ways.
In his Bloomberg View column, former Minneapolis Federal Reserve President Narayana Kocherlakota questions whether there is much theory behind this contention:
Some Fed officials worry that “overheating” could trigger a recession. (I don’t understand the precise economic mechanism, but let’s leave that aside.)
Kocherlakota was specifically referring to the risks of undershooting the natural rate of unemployment. New York Federal Reserve President William Dudley summarized his perception of that risk in January of this year:
A particular risk of late and fast is that the unemployment rate could significantly undershoot the level consistent with price stability. If this occurred, then inflation would likely rise above our objective. At that point, history shows it is very difficult to push the unemployment rate back up just a little bit in order to contain inflation pressures. Looking at the post-war period, whenever the unemployment rate has increased by more than 0.3 to 0.4 percentage points, the economy has always ended up in a full-blown recession with the unemployment rate rising by at least 1.9 percentage points. This is an outcome to avoid, especially given that in an economic downturn the last to be hired are often the first to be fired. The goal is the maximum sustainable level of employment—in other words, the most job opportunities for the most people over the long run.
I don't know that there is an economic mechanism at work here. I don't know that there is a law of economics where the unemployment can never be nudged up a few fractions of a percentage point. But I do think there is a policy mechanism at play. During the mature and late phase of the business cycle, the Fed tends to overemphasize the importance of lagging data such as inflation and wages and discount the lags in their own policy process. Essentially, the Fed ignores the warning signs of recession, ultimately over tightening time and time again.
For instance, an inverted yield curve traditionally indicates substantially tight monetary conditions. Yet even after the yield curve inverted at the end of January 2000, the Fed continued tightening through May of that year, adding an additional 100bp to the fed funds rate. The yield curve began to invert in January of 2006; the Fed added another 100bp of tightening in the first half of that year.
This isn't an economic mechanism at work. This is a policy error at work.
Kocherlakota offers another important point:
It's easy to imagine, though, that many people would be willing to trade the risk of recessionary pain in 2019 and 2020 for the near-term gain of 2017 and 2018. They might even believe there's some chance that policy 2 will generate an outstanding outcome -- if, for example, the long-run unemployment rate is actually lower than the Fed thinks it is.
The Fed seems to place almost zero weight on the probability that the natural rate of unemployment is significantly below their estimates. In their view, only bad things happen when the unemployment rate drifts much below 5%.  
Bottom Line: The Fed thinks the costs of undershooting their estimate of the natural rate of unemployment outweigh the benefits. I am skeptical they are doing the calculus right on this one. I would be more convinced they had it right if I sensed that placed greater weight on the possibility that they are too pessimistic about the natural rate. I would be more convinced if they were already at their inflation target. And I would be more convinced if their analysis of why tightening cycles end in recessions was a bit more introspective. Was it destiny or repeated policy error? But none of these things seem to be true.

Tuesday, September 06, 2016

Fed Watch: Rate Hike Hopes Fading Fast

Tim Duy:

Rate Hike Hopes Fading Fast, by Tim Duy: The next FOMC meeting is just two weeks away. Fed hawks had hoped that this was their moment in the sun. I suspect they will need to wait another three months before their next opportunity to act. Signs of a second half rebound are likely too tentative for the doves to tolerate a rate hike. I don't think they will roll over as easily as they did last December.
The August employment report was not terrible. Not by any measure. On the positive side, labor supply is reacting to both demographic changes and stronger demand:


The demographic shift - essentially, the aging of the Millennials toward their prime age working years - is I believe a powerful secular force supporting the economy. That said, the Fed needs to ensure cyclical forces do not undermine the economy. And that is where the story becomes tricky. Is the economy slowing sufficiently on its own that the Fed should refrain from rate hikes? Or is the slowing still insufficient to quell the inflationary pressures Fed hawks in particular believe to be building?
On first take, the slowing in payroll growth is modest:


And arguably sufficient to place additional downward pressure on the unemployment rate. Cleveland Federal Reserve President Loretta Mester recently repeated this view, which is widely held within the FOMC. Via Reuters:
Mester, a voting member on the Fed's policy-setting committee, had earlier in the day told a philanthropy conference that the U.S. economy probably needs to generate between 75,000 and 150,000 jobs per month to keep the jobless rate stable.
Hiring has been stronger than that this year and the U.S. jobless rate is currently at 4.9 percent.
"The economy is basically at full employment," Mester said.
This "full employment" view is also evident in the Fed's estimate of the natural rate of unemployment:


This, not inflation directly, seems to be driving Fed hawks toward a rate hike. See former Federal Reserve President Narayana Kocherlakota here. It is the perceived threat of inflation, not the actual, realized threat of inflation.
Fed hawks will also point toward wage growth as evidence of tighter labor markets that foreshadows inflationary pressures:


Fed doves, however, will not be without their own interpretation of the data. The flattening of the unemployment rate could indicate supply side pessimism on the part of the hawks. That is the positive story that still fits with a no hike scenario. A more negative story is that the flat unemployment rate is consistent with late cycle patterns:


Similarly, progress toward reducing underemployment has stalled noticeably, leaving underemployment at very high levels:


Perhaps the household data is picking up a degree of slowing not yet evident in the establishment data? And on the establishment side, temporary help services payrolls are holding in a late cycle pattern as well:


As far as wages are concerned, Fed doves will say that wage growth is still anemic in comparison with past cycles and - they should add - that wages are a lagging indicator. The Fed should be paying much more attention to forward indicators. And those forward indicators remain tentative at best. The hawks' basic case is not just that the economy is at full employment, but that a second half rebound will send it beyond full employment. And while consumer spending supports the second half rebound story:


the ISM reports draw that into question. Today's service sector report was particularly disconcerting with weakness across the board - the sharp drop in new orders should give FOMC members reason for caution. Doves will thus say the Fed can't count their chickens before they hatch. And this is especially important given that the Fed continues to miss its inflation target, and a misstep at this juncture with overly tight policy will basically guarantee they miss it for the next five years as well.
Indeed, while Fed hawks such as Vice Chair Stanley Fischer and Boston Federal Reserve President Eric Rosengren see progress toward the inflation goals, Peter Olson and David Wessel, writing in the WSJ, conclude:
The inflation rate is higher now than it was in 2015. But over the course of 2016 we’ve seen no apparent progress toward the 2% inflation target. If anything, the inflation rate in January was closer to the Fed’s goal than in July. So it’s increasingly difficult for Fed officials to rely on current inflation numbers as a justification for raising rates. Higher inflation might be just around the corner, but we haven’t seen it yet.
I agree. The "progress" that Fischer and Rosengren point to occurred early in the year, mostly in January. Recent trends have been less promising.


The hawks "inflation is here" story is not particularly compelling. Indeed, I would say it borders on disingenuous. Moreover, I suspect the inflation numbers will prompt strong opposition to a rate hike this month. Recall from the recent minutes:
A couple of members preferred also to wait for more evidence that inflation would rise to 2 percent on a sustained basis.
I suspect these two members were Governors Lael Brainard and Daniel Tarrullo. My guess is that neither will roll over on a rate hike as they did last December; I think they probably question the wisdom of the outcome of that meeting. Furthermore, I think they pull Governor Powell and ultimately New York Fed President William Dudley to their side. St. Louis Federal Reserve President James Bullard is ambivalent about when the next 25bp hike occurs; in his framework, the Fed is already within spitting distance of the correct policy stance. He won't push for a hike. And I suspect that Chair Janet Yellen will thus ultimately see too little consensus to support a rate hike.
Bottom Line: Despite being near the consensus view of full employment, incoming data on the second half remains too tentative to support a rate hike this month. This is especially the case given lost momentum in the labor market, particularly with regards to underemployment, and the weak inflation numbers. Hence I do not anticipate a rate hike in September. Why might I be wrong? Aside from just being wrong on the Fed's likely interpretation of the incoming data, perhaps because I have underestimated the Fed's perception that the risks are not really asymmetric - that they have all the tools they need to fight the next recession even if they are at the zero bound - or that the Fed views financial stability concerns as trumping the inflation outlook.

Thursday, September 01, 2016

Fed Watch: Thoughts Ahead Of The Employment Report

Tim Duy:

Thoughts Ahead Of The Employment Report, by Tim Duy: The August employment report has come to be seen as the deciding factor in the Fed's upcoming decision on rates. See Sam Fleming at the Financial Times here. Maybe this is the case, maybe not. I hope not. Hinging policy on the first print of nonfarm payrolls - a volatile, heavily revised number - would be pretty low quality policy making. 
I keep coming back to this by Federal Reserve Chair Janet Yellen from back in December: 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. Household spending growth has been particularly solid in 2015, with purchases of new motor vehicles especially strong.  
This was Yellen's way of justifying a rate hike last December in spite of faltering GDP numbers. Trouble is that PDFP continued a downward slide since then:


Final sales here are off roughly 1.5 percentage points from their cycle highs. That is a nontrivial swing. It is no wonder that job growth accelerated in 2013-14 and then decelerated in 2015:


I tend to think there is room for some further deceleration. Note too that progress on reducing underemployment slowed markedly:


and the unemployment rate is flattening out:


Now, you might say that the Fed needs to hike because wages are rising. But I would say that wages are a lagging indicator


and are likely to continue rising even after a recession begins. Overly shifting the policy focus to wage growth would a red flag in my opinion. I think the Fed tends to focus too much on lagging indicators in the later stages of a business cycle while ignoring their own policy lags. The end result is overly tight policy.
So when I look at the data, I don't see that the August employment report should be a critical factor in a rate hike decision. I think the critical factors should be the Fed's confidence that growth is set to rebound in the second half of the year and the balance of policy risks.
On the first point, while early signals on growth are positive - see the Atlanta Fed GDPNow measure, for example - they are still just early signals. And today's ISM release doesn't indicate that a manufacturing rebound is right around the corner, so maybe that rebound in investment spending just might take more time as well. And auto sales look to have peaked and are flattening out, so that is not likely to be a source of growth and might be slight drag. So, overall, I don't think we have enough data to be confident that growth will rebound just yet.
Regarding the balance of policy risks, that asymmetry has not magically gone away. The Fed has less room to ease than tighten. And inflation remains mired below target:


So I don't see that that the basic calculus here has changed. If the Fed errors by being too loose now, they have plenty of wiggle room on inflation and policy to respond. If they error on by being too tight, they don't have much policy room and they risk holding inflation below 2 percent for another decade. What's that going to do for inflation expectations?
All that said, there appears to be a movement among FOMC members to minimize the asymmetry of the policy risks. First you have Federal Reserve Vice Chair Stanley Fischer arguing that inflation is close enough to target that it shouldn't be a concern. Via Greg Robb at MarketWatch:
And the core measure of the personal consumption expenditure index — the Fed’s favorite measure of inflation — at 1.6% “is within hailing distance” of the central bank’s 2% target, Fischer added.
I starting to think Fischer is still living in the 1970s. But perhaps more disconcerting is Yellen's final line from her Jackson Hole speech:
But even if average interest rates remain lower than in the past, I believe that monetary policy will, under most conditions, be able to respond effectively.
She is playing down the asymmetric policy risk issue here. Given the experience of the past decade, she is way too complacent in my opinion. And her complacency hinges on the assumption that they now know they (nominal) natural rate of interest is 3 percent. But that has been a moving target. And I don't think that is the signal being sent by the long end of yield curve. 
Then there is the financial stability argument. All I will say on that is the Fed had better be damn certain that they are facing a real risk to the economy before they pull the trigger on that argument. And I don't see how they can be that certain.
Bottom Line: Regardless of the outcome of the employment report, good or bad, I don't see good case for moving next this month. Too many questions about the forecast, and they still face persistently low inflation and asymmetric policy risks. But all that said, there seems to be a large swath of voting members ready to get behind a rate hike. I think the low odds on a rate hike in September is the market's way of telling the Fed that if they do hike, it would be a mistake.

Friday, July 15, 2016

Fed Watch: Data Dump

Tim Duy:

Data dump, by Tim Duy: Interesting mix of data today that will give monetary policymakers plenty of food for thought. My guess is that it will probably drive a deeper division in the Fed between those who looking to secure two hikes this year rather and those good with just one or none at all.
Retail sales came in stronger than expected, although prior months were revised down. Various measures of sales excluding gas are perking up compared to last year:


While prior expansions churned out some better spending numbers, the consumer is clearly not in some kind of recessionary free-fall. Remember, 2% growth is the new 4%. These data will help reassure the Fed that the bulk of economic activity - that directed by consumers - remains solid.
Industrial production rose, albeit on the back of autos. Compared to a year ago, factory activity remains in negative territory. Still, softness in the sector does not exhibit the degree of dispersion typically experienced in recessions:


Still looks to me more like a mid-cycle slowdown like the mid-80s and 90s rather than a recession. Containing such a slowdown argues for keeping rates low for now.
Inflation as measured by the consumer price index continues to firm. Core CPI inflation came in at 0.2 percent m-o-m and 2.3 percent y-o-y. Of course, the Fed targets PCE inflation, and there the core number is weaker:


See Calculated Risk for more measures of inflation. The key point here is that the Fed's preferred measure is tracking lower than other measures. Watch for the hawks to press their case on those higher measures; the doves should keep a focus on PCE. The doves should win this battle. If they don't win, the Fed will be effectively targeting a different inflation rate than stated in their long-run policy objectives. That would then render those objectives and likely future similar missives essentially worthless.
The Atlanta Fed released its wage measures for June. These measures - which track persons steadily employed over the past twelve months - continue to exceed the average measures of the employment report:


The Atlanta Fed measure just about in the pre-recession territory; while the standard measures still have a ways to go. The Atlanta Fed measure tells the Fed that cyclical labor market dynamics are not terribly different than the past. When unemployment goes down, wage growth accelerates:


Demographic effects - the exit of higher earning Boomers from the labor force, replaced by lower earning Millennials - appear to be weighing on average wage growth. Which one is the better guide for monetary policy? Policymakers will again find themselves at odds along the obvious lines. The San Francisco Fed gives mixed guidance on the issue:
How to best gauge the impact of wage growth on overall inflation is less clear. As long as employers can keep their wage bills low by replacing or expanding staff with lower-paid workers, labor cost pressures for higher price inflation could remain muted for some time. If, however, these lower-wage workers are less productive, continued increases in unit labor costs could be hiding behind low readings on measures of aggregate wage growth.
On net, when the Fed faces a mixed message, they tend to move slower than faster. So given the low core-PCE environment, the doves will likely remain in control.
Separately, the Wall Street Journal has a story on which Fed speakers are most useful as policy guides. The article is behind the WSJPro paywall, but via Twitter came this graphic:


Granted, this type of list is always in flux. That said, I would definitely move Brainard, Powell, and Tarullo up with Yellen and Dudley. I find it very rare that you would learn less from a Board member than a regional president. This is especially true given the caliber of these three speakers. And remember that Tarullo doesn't talk a lot about monetary policy, but when he does you probably should listen. Brainard has been driving policy since last fall. Of the regionals, I would place Evans at the top. Williams has been too hawkish in his guidance the past couple of years; you really need to put a negative delta on any rate forecast you glean from him. Rosengren steered you wrong this year as he joined Williams in trying to set the stage for a June rate hike. I don't see where Lockhart should be in the top half of this list. And I don't know what to make of Fischer. He has leaned hawkish this cycle as well, to the point of being one who scolds markets for thinking differently. He appears to me to be an outlier on the Board at the moment, not one driving the policy debate.
Bottom Line: Generally solid data sufficient to keep the prospect of a rate hike or two alive for this year. But soft or mixed enough on key points to lean policy closer to the former than the latter.

Tuesday, July 12, 2016

Fed Watch: Catching Up

Tim Duy:

Catching Up: I snuck out of town last week and am catching up on Fed/economy news. Highlights from the past week:
1.) The labor report comes in better than expected. Nonfarm payrolls rose by 287k in June compared to the downwardly revised 11k gain in May. These results speak to the volatility typically seen in the employment data. See also Matthew Boesler on impact of end of the school year on the data. On a twelve month basis, job growth has eased only moderately. But on a three month basis, the slowdown is more pronounced:


You have to decide if this is one of those situations when the longer term trend is missing a more severe turning point in the data.
My sense is that these numbers are sufficient to convince many Fed officials that the unemployment rate will decline further in the months ahead. But many will also see reason for caution. First, as noted earlier, near term trends reveal a moderation in the pace of job growth. And the rate of improvement in the unemployment rate has slowed markedly in recent months:


This raises the prospect that job growth is actually not that much higher than that necessary to hold the unemployment rate constant. Moreover, progress toward reducing unemployment has slowed or stalled:


And while wage gains are accelerating, the pace remains tepid, roughly 100bp below the pre-recession rates:


It would be disappointing if wage growth stalled out here. Note also that the long-leading indicator of temporary help employment is tracking sideways to slightly down:


All of these indicators may be headed for upside breakouts in the months ahead, but at the moment I sense some loss of momentum in labor market improvement. This, I think, places the Fed on some precarious ground, something that the bulk of the FOMC likely recognizes. It's not that the fundamentals of the economy have necessarily broken down; it's that the Fed needs to maintain a sufficiently accommodative policy to allow those fundamentals to exert themselves.

2.) Influential policymakers urge patience. Federal Reserve Governor Dan Tarullo came out strongly against additional rate hikes at this time. Via MarketWatch:

“Inflation is not at our stated target, not near our stated target, and hasn’t been so in quite some time,” Tarullo said in a conversation at a Wall Street Journal breakfast.

“This is not an economy that is running hot,” he added.

“For some time now I thought it was the better course to wait to see more convincing evidence that inflation is moving toward and would remain around the 2% target,” Tarullo said.

“To this point, I have not seen that type of evidence,” he said.

It seems to me that Tarullo is looking for something close to the proposed Evans Rule 2.0 - no rate hikes until core-inflation hits 2 percent year-over-year. Even more interesting is this:

Tarullo said he didn’t think that the worry that low interest rates may fuel asset bubbles was an “immediate concern.”

The Fed governor, who is the quarterback of the Fed’s efforts to regulate banks, questioned whether raising rates would ease financial stability concerns in an environment where the market was pessimistic about the economic outlook.

“If markets do regard economic prospects as only modest or moderate going forward, then raising short-term rates is almost surely going to flatten the yield curve, which generally speaking is not good for financial intermediation, and in some sense could exacerbate financial stability concerns,” Tarullo said.

When rates are low, regulators should pay more attention to financial stability issues “but it doesn’t translate into ‘therefore raise rates and all will be well,’” he added.

Tarullo is obviously not pleased that the yield curve continues to flatten


and is not interested in hiking into such an environment. New York Federal Reserve President William Dudley echoes this concern:

Federal Reserve Bank of New York President William Dudley voiced concern Wednesday about very low yields on 10-year Treasury notes, which could be a sign that investor expectations for growth and inflation are waning. Mr. Dudley, who had been meeting with local leaders at Binghamton University in New York, said low yields weren’t “completely good news.”

This suggests these two policymakers would prefer to hike if long-term yield were rising, pulling the Fed along for the ride. Low yields are only feeding into the Fed's suspicion that their expectations of where rates are headed are wildly optimistic.

3.) Williams interview. Gregg Robb of MarketWatch has a long interview with San Francisco Federal Reserve President John Williams. The whole interview is worth a read. Two points. First, Williams is in the camp that the Fed need to act sooner than later to forestall the growth of imbalances:

The risk I think we face in waiting too long, or waiting maybe as long as some of these market expectations are, is that the economy is already pretty strong and if we wait too long in further removal of accommodation I do think imbalances will form more generally. It could show up as more inflation pressures down the road, we’re not seeing those yet, but I think that you do see some of this in terms of real-estate markets and other asset markets which are being priced to perfection based on an outlook of very low interest rates. You are seeing extremely high asset valuations in real estate, commercial real estate, the stock market is very strong relative to fundamentals. That is a natural result from low interest rates, that’s one of the ways monetary policy affects the economy. But if asset prices, real estate prices, continue to go further and further away from longer-term fundamentals I think that creates risk for the economy, I think it creates risks eventually for the financial system.

Note that this runs counter to Tarullo, who argued that the flattening yield curve could worsen, not improve, the financial stability situation. The need to rates rates in the name of financial stability is a growing fault line within the Fed.

Second, Williams gives his view of the disconnect between financial markets and the Fed:

In term of the private-sector forecasts, I think it’s very hard to fully understand what the Fed’s decision-making is given that we haven’t done many active policy steps in the last few years. I mean we did obviously as I mentioned the asset purchases during that period, but since we’ve ended that, we talked a lot about raising rates, we’ve given a lot of “dot plots” about raising rates, we did one rate increase in December, but then it has been over six whole months since then, and - I try to put myself in the shoes of a private sector forecaster - one of the hard things to do is kind of see what is our reaction function. What is it that is driving our decision?...

...Right now we’re just in a situation where there is just not a lot of data on actual actions because, for various reasons we’ve held off a long time on our first rate increase and then we held off so far on a second rate increase.

This I think is wrong; lack of action is a policy choice as much as action. Williams seems to think the only useful information about the Fed's reaction function comes when the Fed changes rates. This implies that holding policy steady conveys no information. I would argue that steady policy is in fact signaling the Fed's reaction function, and hence, in combination with the data flow, financial market participants are concluding that the Fed will continue at a glacial pace regardless of what the "dots" say. Indeed, I would say that financial market participants are signaling that the Fed's stated policy path would be a policy error, an error that they don't expect the Fed to make. I guess you could argue that the market doesn't think the Fed understands it's own reaction function. And given the path of policy versus the dots, the market appears to be right.

4.) Mester, seriously? Cleveland Federal Reserve President Loretta Mester dropped this line in a July 1 speech (emphasis added):

But there are also risks to forestalling rate increases for too long when we are continuing to make cumulative progress on our policy goals. Waiting too long increases risks to financial stability and raises the chance that we would have to move more aggressively in the future, which poses its own set of risks to the outlook. I believe waiting too long also jeopardizes our future ability to use the nontraditional monetary policy tools that the Fed developed to deal with the effects of the global financial crisis and deep recession. If we fail to gracefully navigate back toward a more normal policy stance at the appropriate time, then I believe there is a non-negligible chance that these tools will essentially be off the table because the public will have deemed them as ultimately ineffective. This is a risk to the outlook should we ever find ourselves in a situation of needing such tools in the future. Of course, such a risk is hard to measure and is not one we typically consider. But we live in atypical times, and we need to take the whole set of risks into account when assessing appropriate policy.

The part about low rates and financial instability is, as I noted earlier, a growing fault line within the Fed. But the next part about needing to "gracefully" return to a normal policy stance to regain policy effectiveness of nontraditional tools was unexpected. This a variation on a theme. There is a common misperception that policymakers need to raise rates not because the economy needs it, but because it needs tools to fight a future recession. Completely backwards logic, of course. Premature rate hikes only speeds up the arrival of next recession and ensures that policymakers lack room to maneuver. They don't, as Mester suggests, preserve your options. A central banker should know this.

5.) The minutes. My short takeaway from the minutes is that the divide among FOMC participants is greater than the divide among FOMC members. In other words, a larger percentage of participants are looking to hike rates sooner than members. Until the balance on the FOMC shifts, discount hawkish Fedspeak.

Bottom Line: I am keeping an eye on Tarullo; he has been more public on his monetary policy views in recent months. And those views are fairly dovish. My guess is that he and other doves regret taking one for the team last December and falling in line with a rate hike. They won't go down so easily this time around.

Wednesday, June 29, 2016

Fed Watch: Powell First Out Of The Gate

Tim Duy:

Powell First Out Of The Gate, by Tim Duy: The first Fed speaker of the post-Brexit era delivered a decidedly dovish message. Confirming the expectations of market participants, Federal Reserve Governor Jerome Powell made clear that the Fed was in a holding pattern until the dust settles. Much of the material is similar in content to his May speech, but the shift in emphasis and nuance indicate a substantially policy path.

Powell summarizes the economic situation as:

How should we evaluate our current performance against the dual mandate? I would say that we have made substantial progress toward maximum employment, although there is still some room for improvement. We have more work to do to assure that inflation moves back up to our 2 percent goal.

Both points are important. On the first point, Powell sees evidence of labor market slack in low participation rates, high numbers of part-time workers, and low wage growth. Recent labor reports concern him:

While I would not want to make too much of two monthly observations, the strength of the labor market has been a key feature of the recovery, allowing us to look through quarterly fluctuations in GDP growth. So the possible loss of momentum in job growth is worrisome.

My guess is that they will want to see a string of 2 or 3 solid labor reports before they breathe easier. Still, by acknowledging that the economy is operating near full employment, does he open the door to concerns about inflation? No:

When I was first exposed to macroeconomics in college, more than four decades ago, the view was that inflation was strongly influenced by the amount of slack in the economy. But the relationship between slack and inflation has weakened substantially over the years.

Or, in other words, the Phillips Curve is flat. Not quite flat as a pancake, but pretty darn flat. More important:

In addition, inflation depends importantly on the inflation expectations of workers and firms. A widely shared view among economists today is that, unlike during the 1970s, expectations are no longer heavily influenced by fluctuations in inflation, but are fairly constant, or anchored. For both these reasons, inflation has become less responsive to cyclical changes in the economy.

And what is happening to inflation expectations:

We measure inflation expectations through surveys of forecasters and the general public, and also through market readings on inflation swaps and "breakevens," which represent inflation compensation as measured by the difference between the return offered by nominal Treasury securities and that offered by TIPS. Since mid-2014, these market-based measures have declined significantly to historically low levels. Some of this decline probably represents lower risk of high inflation, or an elevated liquidity preference for much more heavily traded nominal Treasury securities, rather than expectations of lower inflation. Some survey measures of inflation expectations have also trended down.

The signs are worrisome:

Given the importance of expectations for determining inflation, these developments deserve, and receive, careful attention. While inflation expectations seem to me to remain reasonably well anchored, it is essential that they remain so. The only way to assure that anchoring is to achieve actual inflation of 2 percent, and I am strongly committed to that objective.

By downplaying the importance of slack while emphasizing the importance of inflation expectations, he is neutering the primary argument of Fed hawks who insist that approaching full employment necessitates higher interest rates to stay ahead of inflationary pressures. The line about achieving actual inflation of 2 percent could be a nod toward Evans Rule 2.0. Something to keep an eye on.

The impact of Brexit and the subsequent market turmoil is straightforward:

These global risks have now shifted even further to the downside, with last week's referendum on the United Kingdom's status in the European Union. The Brexit vote has the potential to create new headwinds for economies around the world, including our own. The risks to the global outlook were somewhat elevated even prior to the referendum, and the vote has introduced new uncertainties.

And the implication for monetary policy:

It is far too early to judge the effects of the Brexit vote. As the global outlook evolves, it will be important to assess the implications for the U.S. economy, and for the stance of policy appropriate to foster continued progress toward our objectives of maximum employment and price stability.

Notice that he does not warn that rate hikes are coming! Compare to his May speech:

If incoming data continue to support those expectations, I would see it as appropriate to continue to gradually raise the federal funds rate. Depending on the incoming data and the evolving risks, another rate increase may be appropriate fairly soon.

He is wisely now mum on the timing of the next rate hike. More Fed speakers will follow him than not.

But Brexit alone is not the only factor depressing the rate outlook:

I am often asked why rates remain so low now that we are near full employment. A big part of the answer is that, at least for the time being, the appropriate level of rates is simply lower than it was before the crisis. As a result, policy is not as stimulative as it might appear to be. Estimates of the real interest rate needed to keep the economy on an even keel if it were operating at 2 percent inflation and full employment--the "neutral rate" of interest--are currently around zero. Today, the real short term interest rate is about negative 1-1/4 percent, so policy is actually only moderately stimulative. I anticipate that the neutral rate will move up over time, as some of the headwinds that have weighed on economic growth ease.

The Fed increasingly recognizes that policy is not highly accommodative simply because rates are zero. The stance of policy is relative to the real interest rate, and a lower real rate means that policy is actually only "moderately" stimulative. Translation: There is no need to hike rates soon because policy is not particularly accommodative.

Missing now is this warning from May:

There are potential concerns with such a gradual approach. It is possible that monetary policy could push resource utilization too high, and that inflation would move temporarily above target. In an era of anchored inflation expectations, undershooting the natural rate of unemployment should result in only a small and temporary increase in the inflation rate. But running the economy above its potential growth rate for an extended period could involve significant risks even if inflation does not move meaningfully above target. A long period of very low interest rates could lead to excessive risk-taking and, over time, to unsustainably high asset prices and credit growth. Macroprudential and other supervisory policies are designed to reduce both the likelihood of such an outcome and the severity of the consequences if it does occur. But it is not certain that these tools would prove adequate in a financial system in which much intermediation takes place outside the regulated banking sector. Thus, developments along these lines could ultimately present a difficult set of tradeoffs for monetary policy.

By not reiterating this risk, Powell removes an argument to raise rates even inflation remains below target, the financial stability risk. But how much of a risk is it? If the natural rate of interest is lower, than the potential for financial market instability is also lower for a given interest rate. Or, in other words, since monetary policy is not as accommodative as previously believed, the risk of financial instability is lower.

Bottom Line: Powell embraces the lower real interest rate story as a reason that monetary policy is only moderately accommodative, warns that downside risks are rising, replaces expectations of a rate hike in the imminent future with only guidance that rates will be appropriate to foster economic growth, and drops concerns about the risks of a sustained low rate environment. The key takeaway - no expectation that an imminent rate hike will be needed. Gradual to glacial to just nothing.

Monday, June 27, 2016

Fed Watch: Fed Once Again Overtaken By Events

Tim Duy:

Fed Once Again Overtaken By Events, by Tim Duy: With global financial markets reeling in the wake of Brexit - Britain's unforced error as a political gamble went too far - the Fed is back on the sidelines. A July hike was already out of the question before Brexit, while September was never more than tenuous, depending on the data falling in place just right. Now September has moved from tenuous to "what are you thinking?" Indeed, the debate has shifted in the opposite direction as market participants weigh the possibility of a rate cut. The Fed is probably not there yet, but internally they are probably increasingly regretting the unforced error of their own - last December's rate hike.

The primary economic challenge now is the uncertainty created by the British decision. No one knows what the ultimate end game will be, and how long it will take to get there. Indeed, given the political vacuum in the UK, it appears that pro-Leave politicians really had no plan because they never thought it would actually happen. At lest partially in consequence, any exit promises to be a long process that if recent European history is any guide will prove to be repeated games of chicken between the UK and the EU.

So uncertainty looks to dominate in the near term. And market participants hate uncertainty. The subsequent rush to safe assets - and with it a tightening of financial conditions - is evident in plunging government bond yields and a resurgent dollar. The Fed's initial response was a fairly boilerplate statement:

The Federal Reserve is carefully monitoring developments in global financial markets, in cooperation with other central banks, following the results of the U.K. referendum on membership in the European Union. The Federal Reserve is prepared to provide dollar liquidity through its existing swap lines with central banks, as necessary, to address pressures in global funding markets, which could have adverse implications for the U.S. economy.

More direct action depends on the length and depth of the financial turmoil currently underway. I think the Fed is far more primed to deliver such action than they were a year ago. And that ultimately is good news for the economy as it will minimize the domestic damage from Brexit.

The Fed began 2015 under the direction of a fairly hawkish contingent that viewed rate hikes as necessary to be ahead of the curve on inflation. Better to raise preemptively than risk a sharper pace of rate hikes in the future. In other words, it was important to remove financial accommodation as the headwinds facing the economy receded and labor markets approached full employment. As the year progressed, however, the need for less financial accommodation never became evident. Indeed, I would argue that asset markets were telling exactly the opposite, that there was far less accommodation than the Fed believed. Fed hawks were slow to realize this, and, despite the financial turmoil of last summer, forced through a rate hike in December. I think this rate hike had more to do with a perceived need to be seen as "credible" rather than based in economic necessity. I suspect doves followed through in a show of unity for Chair Janet Yellen. They should have dissented.

Markets stumbled again in the early months of 2016, and, surprisingly, Fed hawks remained undeterred. Federal Reserve Vice Governor Stanley Fischer scolded financial market participants for what he thought was an overly dovish expected rate path. And even as recently as prior to the June meeting, Fed speakers were highlighting the possibility of a June rate hike, evidently with the only goal being to force the market odds of a rate hike higher.

But I think that as of the June FOMC meeting, the hawkish contingent has been rendered effectively impotent. Simply put, had they been correct, the US economy should have been surging ahead by now, with more evident inflationary pressures. The hawks were far too early with such a prediction. It became increasingly apparent that maybe the yield curve was telling an important story they should heed. Low long-term yields were never consistent with the Fed's outlook, and, when combined with tepid activity, suggested that the Fed's long-term guide, the natural rate of interest, was much lower than anticipated.

Consequently, I suspect the Fed will be much more responsive to the signal told by the substantial drop in long-term yields that began last Friday (as I write the 10 year is hovering about 1.46%) then they may have been a year ago. The drop in yields will feed into their current anxiety about the level of the natural rate of interest, and as a consequence they will more quickly realize the need to accommodate financial markets to limit any undesirable tightening of financial conditions. I expect some or all of the following options depending on the degree of financial market and real economic distress:

1.) Forward guidance I. Fed speakers will concur with financial market participants that policy is on hold until the dust begins to settle. Optimally, they will dispense with all talk of rate hikes as it is unnecessary and unhelpful at this juncture.

2.) Forward guidance II. They will reinforce point I in the next FOMC statement. Watch for the balance of risks to reappear - it seems reasonable to believe they have shifted decidedly to the downside.

3.) Forward guidance III. This would be an opportune time for Chicago Federal Reserve President Charles Evans to push through Evans Rule 2.0. No rate hike until core inflation hits 2% year-over-year. The Fed could justify such a move as a response to the uncertainty surrounding the natural rate. Essentially, rather than using an unknown variable as a guide, use a know variable.

4.) Forward guidance IV. A lower path of dots in the next Summary of Economic projections to validate market expectations.

5.) Rate cut. Former Minneapolis Federal Reserve President Narayana Kocherlakota argues that the Fed should just move forward with a rate cut in July. I concur; I continue to believe that the Fed has the best chance of exiting the zero bound at some point in the future by utilizing more aggressive policy now. That said, I don't expect this to be the Fed's first option. Moving beyond forward guidance will require evidence that the US economy is set to slow sufficiently to push the employment and inflation mandates further out of reach.

6.) If all else fails. If some combination of 1 through 5 were to fail, the Fed will turn to more QE and/or negative rates. I think the former before the latter because it is more comfortable for them.

Bottom Line. The Fed will stand down for the moment; where they go down the road depends upon the depth and length of current disruption. I think at this point it goes without saying that if you hear a Fed speaker talking about July being on the table or confidently warning about two or three rate hikes this year, you should ignore them. Perhaps we can have that conversation later with regards to the December meeting, but certainly not now. Most Fed officials will stick to the script and downplay the possibility of a rate hike and instead focus on the Fed moves to the sidelines angle. I still think an interesting scenario is one in which the Fed needs to accept above target inflation because global financial stability will depend on a very accommodative Federal Reserve, but that hypothesis will only be tested once inflation actually hits target.

Sunday, June 12, 2016

Fed Watch: Janet Yellen's Inflation Problem

Tim Duy:

Janet Yellen's Inflation Problem, by Tim Duy: Federal Reserve Chair Janet Yellen has been vexed by an inflation problem. Now she is also vexed by an inflation expectations problem. Last week she said (emphasis added):
Uncertainty concerning the outlook for inflation also reflects, in part, uncertainty about the behavior of those inflation expectations that are relevant to price setting. For two decades, inflation has been relatively stable, reacting less persistently than before to temporary factors like a recession or a swing in oil prices. The most convincing explanation for this stability, in my view, is that longer-term inflation expectations have remained quite stable. So it bears noting that some survey measures of longer-term inflation expectations have moved a little lower over the past couple of years, while proxies for these expectations inferred from financial market instruments like inflation-protected securities have moved down more noticeably. It is unclear whether these indicators point to a true decline in those inflation expectations that are relevant for price setting; for example, the financial market measures may reflect changing attitudes toward inflation risk more than actual inflation expectations. But the indicators have moved enough to get my close attention. If inflation expectations really are moving lower, that could call into question whether inflation will move back to 2 percent as quickly as I expect.
Subsequently, the University of Michigan's read on long-run inflation expectations plunged to a series low: INFEXP0616
Just for reference, consider the behavior of the inflation expectations during the last three tightening cycles:


Spot the odd man out.
This, one would think, should grab Yellen's attention. There is speculation of what this means for this week's FOMC statement. For example see here:
“The key thing to watch will be whether the Fed changes its language on inflation expectations” in the statement it publishes after its meeting, said Neil Dutta, head of U.S. economics at Renaissance Macro Research in New York.
They should change the language, but I don't think the will. The problem is that if the Fed acknowledges serious concern about declining inflation expectations, they have to deal with this line from the FOMC statement:
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.
It makes no sense to show concern with the possibility of unanchored inflation expectations to the downside while at the same time stating that you anticipate the next policy action will be a hike. If inflation expectations are no longer stable, then any rational central banker must act accordingly, and this this case that means easing policy. Anything else is simply irrational, and the Fed should be called out for it.
Do any of us believe the Fed is about to ease policy?
Chicago Federal Reserve President Charles Evans opened the door to an easier policy stance by offering Evans Rule 2.0: Commit to holding steady on rates until core inflation has reached the Fed's inflation target. But think of how big of a leap that would be for the Fed. The Chair just gave a relatively optimistic outlook for the US economy, reiterating her belief that higher rates were coming. Up until the May employment report (a report that Yellen downplayed), policy makers were falling over each other to put the June meeting in play, pushing the message that was eventually revealed in the minutes of the April meeting. Unemployment is at 4.7 percent, a level generally believed within the Fed as consistent with full employment. Second quarter growth looks to be respectable in the 2.0-2.5 percent range. Financial markets stabilized after a tumultuous first quarter. Oil prices moved higher. In short, there is a reason Fed officials put June into play.
It's hard to see the Fed moving from "we plan to hike rates as early as June" to "rate hikes are off the table until inflation hits 2 percent" in just a few weeks. Moreover, adopting Evans Rule 2.0 would dramatically jack up the odds that the Fed would subsequently need to hit the inflation target from above. But the Fed has shown little willingness to consider anything other than hitting the target from below. A shift to Evans Rule 2.0 would take a sea change of sentiment at the Fed. I don't see it happening in just a few weeks on the basis of essentially one number.
So my expectation is that the Fed does not change its inflation expectations language in this week's FOMC statement. If they do, they have to understand that they market participants will price out rate hikes until 2017. I don't think they want this; I think instead the Fed will be working to keep July in play (a tall order in my opinion).
There is now a natural press conference question to add to my existing list:
Chair Yellen, last week you said that inflation expectations were low enough to be on your radar. Now they have turned even lower, but the FOMC declined to acknowledge the weakness in this FOMC statement. Just how low do inflation expectations need to be before the Fed acts?
I would guess that this is the first question for Yellen.
Bottom Line: It is reasonable to think that the Fed will change their inflation expectations language at this week's FOMC meeting. Completely rational considering Yellen's comment last week. A comment that I suspect she now regrets. But a change to the language requires a policy response I don't think the Fed is ready to make. If I am wrong, if the Fed is much more dovish than recent comments, or the most recent minutes, suggest.

Friday, June 10, 2016

Five Questions for Janet Yellen

Tim Duy:

Next week's meeting of the Federal Open Market Committee (FOMC) includes a press conference with Chair Janet Yellen. These are five questions I would ask if I had the opportunity to do so in light of recent events.
1. What's the deal with labor market conditions?
You advocated for the creation of the Federal Reserve's Labor Market Conditions Index (LMCI) to serve as a broader measure of the labor market and as an alternative to a narrow measure such as the unemployment rate...
Continues at Bloomberg....

Monday, June 06, 2016

Fed Watch: Employment Report, Yellen, and More

Tim Duy:

Employment Report, Yellen, and More, by Tim Duy: Lot's of Fed news over the past few days that add up to a simple takeaway: June is off the table (again), the stars have to align just right for a July rate hike (not likely), and September is coming into focus as the next possible rate hike opportunity. September, however, assumes that the employment report is more of an outlier than part of a trend. that's what the Fed will be taking out of the data in the coming months.
Nonfarm payrolls grew by a disappointing 38K in May, low even after accounting for the Verizon strike. Downward revisions struck previous months, leaving behind a marked deceleration in job growth:


Slowest three-month average since 2011. Perversely, the unemployment rate dropped to 4.7 percent, breaking a long period of stagnate readings. The decline, however, was driven by an exit from the labor force - not exactly the improvement we were hoping for. Measures if underemployment continue to track generally sideways at elevated levels:


By these metrics, progress toward full employment has slowly noticeably. Wage growth, however, is showing signs of improvement, and should get a boost next month from base year effects:


How should we interpret the mess that is the May employment report? One take is to treat it as an anomaly, simply a bad draw. Federal Reserve Chair Janet Yellen leaned in this direction in today's speech. After characterizing the economy as near full employment, she added:
So the overall labor market situation has been quite positive. In that context, this past Friday's labor market report was disappointing...Although this recent labor market report was, on balance, concerning, let me emphasize that one should never attach too much significance to any single monthly report. Other timely indicators from the labor market have been more positive. For example, the number of people filing new claims for unemployment insurance--which can be a good early indicator of changes in labor market conditions--remains quite low, and the public's perceptions of the health of the labor market, as reported in various consumer surveys, remain positive...
Still, the data disappointed sufficiently to push her to the sidelines:
That said, the monthly labor market report is an important economic indicator, and so we will need to watch labor market developments carefully.
Later she adds:
Over the past few months, financial conditions have recovered significantly and many of the risks from abroad have diminished, although some risks remain. In addition, consumer spending appears to have rebounded, providing some reassurance that overall growth has indeed picked up as expected. Unfortunately, as I noted earlier, new questions about the economic outlook have been raised by the recent labor market data. Is the markedly reduced pace of hiring in April and May a harbinger of a persistent slowdown in the broader economy? Or will monthly payroll gains move up toward the solid pace they maintained earlier this year and in 2015? Does the latest reading on the unemployment rate indicate that we are essentially back to full employment, or does relatively subdued wage growth signal that more slack remains? My colleagues and I will be wrestling with these and other related questions going forward.
Will Yellen be able to answer these questions with enough confidence to hike in July? Doubtful, in my opinion. A strong report for May would have been sufficient to put them on track for a July hike. But now a July hike requires a sharp rebound in June payroll growth plus substantial upward revisions to the May numbers (in addition to the rest of the data falling into place). That is not likely, and may account for Yellen dropping the "coming months" language when referring to the expected policy path. June or July looked like reasonable possibilities last week, but not so much now.
A second interpretation, however, is more ominous. In this interpretation, the employment data is finally catching up with the slower pace of GDP growth:


The acceleration that began in 2013 looks to have played itself out by the middle of last year. Job growth remained strong, however, pushing productivity growth into negative territory. This, as David Rosenberg explains at Business Insider, was not sustainable. Something had to give, and the labor market finally gave. Similarly, wage growth is a lagging indicator - if the labor market is faltering, the current pace of gains will not be sustainable.
Similarly, note that the ISM services data looks to be catching up to this story as well:


In addition, temporary employment payrolls is flashing a yellow light:


If this is the story, the the Fed will move to the sidelines for an extended period of time, pushing out any hope of a rate hike until December. That assumes the Fed does not make a policy error by rushing to raise rates in these circumstances.
In other news, Federal Reserve Governor Daniel Tarullo, who rarely speaks publicly on monetary policy, defined the current dynamic within the FOMC as those looking to hike versus those looking not to hike. Via MarketWatch:
In an interview with Bloomberg TV, Tarullo said he is in the camp of Fed officials that backs further, gradual, rate hikes but said he is more cautious about a move than some others in that camp.
One group favoring gradual rate hikes wants to hike “unless there is a reason not to” in order to avoid problems with inflation later on, he said.
The other camp, where he sits, wants “an affirmative reason to move” and asks “why do we need” an interest rate hike. Tarullo said.
“The second approach I’ve been a little bit more inclined towards is to say ‘gee, you know, it is not clear what full employment is, we’re in a global environment that is not inflationary, we can perhaps get some more employment and some higher wages which will be particularly useful to those more on the margins of the labor force,’” Tarullo said.
Positioning himself ahead of the FOMC meeting as opposing a rate hike. And this was before the employment report.
Federal Reserve Governor Lael Brainard also put down her marker ahead of the meeting:
Prudent risk-management would suggest the risks from waiting until the totality of the data provides greater confidence in a rebound in domestic activity, and there is greater certainty regarding the "Brexit" vote, seem lower than the risks associated with moving ahead of these developments. This is especially true since the feedback loop through exchange rate and financial market channels appears to be elevated. In light of this amplified feedback loop, when conditions are appropriate for a policy move, it will be important that it be understood that any subsequent moves would be conditioned on further evidence confirming continued progress toward our objectives and not as inevitable steps on a preset course.
I think these are both key influencers within the FOMC; Brainard's resistance to rate hikes in particular is something that hawks would need to overcome to get their way. I don't think that will be easy.
Chicago Federal Reserve President Charles Evans called for an Evans Rule 2.0:
The question is whether such upside risks would increase substantially under a policy of holding the funds rate at its current level until core inflation returned to 2 percent. I just don’t see it. Given the shallow path of market policy expectations today, there is a good argument that inflationary risks would not become serious even under this alternative policy threshold. And when inflation rises above 2 percent, as it inevitably will at some point, the FOMC knows how to respond and will do so to provide the necessary, more restrictive financial conditions to keep inflation near our price stability objective.
So one can bet he would oppose a rate hike in June. Or July. And even St. Louis Federal Reserve President James Bullard has lost his appetite for a near-term rate hike. Via the Wall Street Journal:
Federal Reserve Bank of St. Louis President James Bullard said in an interview Monday that he is leaning against supporting a rate rise at the central bank’s coming meeting.
If the Fed is going to raise its short-term interest-rate target, “I’d rather move on the back of good news about the economy,” Mr. Bullard told The Wall Street Journal. And since the Fed will be meeting following the release of the underwhelming May jobs data, it is a “fair assessment” the argument for raising rates is now considerably weaker than it had been
Meanwhile, Atlanta Federal Reserve President Dennis Lockhart worked to keep July in play:
“I don’t personally see a lot of cost to being patient to the July meeting at least,” Lockhart said Monday in a Bloomberg Television interview with Michael McKee in New York. “I think we can be watchful and see how things develop over the next few weeks.”
There will be resistance to letting the markets price out July. That will play into the FOMC's crafting of their statement next week as well as Yellen's press conference.
Bottom Line: The May employment report killed the chances of a rate hike in June. And it was weak enough that July no longer looks likely as well. I had thought that, assuming a solid May number they would set the stage for a July hike. That seems unlikely now; they will probably need two months of good numbers to overcome the May hit. The data might bounce in the direction of July, to be sure. Hence Fed officials won't want to take July off the table just yet, so expect, in particular, the more hawkish elements of the FOMC to keep up the tough talk.

Wednesday, June 01, 2016

Fed Watch: Waiting For The Employment Report

Tim Duy:

Waiting For The Employment Report, by Tim Duy: Last week Federal Reserve Chair Janet Yellen gave the green light for a rate hike this summer. Via the Wall Street Journal:
“It’s appropriate…for the Fed to gradually and cautiously increase our overnight interest rate over time, and probably in the coming months such a move would be appropriate,” she said during a panel discussion at the Radcliffe Institute for Advanced Study at Harvard University.
This follows on the back numerous Fed speakers, as well as the minutes of the last meeting, that helped place June into play. Of course, Yellen's "coming months" could easily be beyond June, and I suspect that her concern about underemployment and low wage growth will induce her to proceed cautiously and take a pass on June. That said, the meeting is clearly in play and the bar for the next rate hike appears relatively low.
The personal income and spending report bolstered the hawkish position that first quarter economic jitters were much ado about nothing. Real spending jumped 0.6 percent on the back of a lower savings rate, helping to put a floor under the year-over-year numbers:


The consumer stubbornly refuses to believe that a recession is underway.
Inflation firmed somewhat for the month:


Two of the last three monthly readings on the core were just above 2 percent annualized, something that will also give confidence to Fed hawks that their inflation forecast will play out (they will assume headline will head in that direction). Compared to a year ago, however, core inflation continues to languish below target.
The ISM report came in somewhat better than expected considering weak regional surveys. Most of the action was in suppliers delivers (slower), customers' inventories (flat), and prices (higher). New orders held up well; employment still a touch below 50:


On net, neither a great relief nor a disaster. But then it is probably too early to expect the healing touch of a weaker dollar and stronger oil to be evident in the manufacturing data.
In addition, construction spending was down (see Calculated Risk), which, in addition to the ISM report brought the Atlanta Fed estimate of Q2 GDP growth down to a still respectable 2.5 percent from 2.8 percent. If the Fed could be confident in the number, they would have a strong incentive to hike. But I suspect they will wanted an even clearer picture that won't be available until the July meeting at the earliest.
The Beige Book was fairly uneventful on most accounts. Growth was still just "modest" but with an optimistic outlook:
Information received from the 12 Federal Reserve Districts mostly described modest economic growth since the last Beige Book report. Economic activity in April through mid-May increased at a moderate pace in the San Francisco District, while modest growth was reported by Philadelphia, Cleveland, Atlanta, Chicago, St. Louis, and Minneapolis. Chicago noted that the pace of growth slowed, as did Kansas City. Dallas reported that economic activity grew marginally, while New York characterized activity as generally flat since the last report. Several Districts noted that contacts had generally optimistic outlooks, with firms expecting growth either to continue at its current pace or to increase.
There was some anecdotal evidence that hawks will use to justify a rate hike:
Employment grew modestly since the last report, but tight labor markets were widely noted; wages grew modestly, and price pressure grew slightly in most Districts.

In my opinion, modest wage growth and slight price pressures do not sound particularly worrisome.

Auto sales ran at estimated 17.4 million annual rate in May. Bloomberg suggested that the numbers might scare the Fed straight:
U.S. auto sales were softer than predicted in May, a bellwether month that may help Federal Reserve decision makers determine whether the economy can handle an interest-rate hike this summer.
My guess is that the Fed already knows that auto sales are leveling out and are not likely to be a significant source of growth going forward. In other words, I have to imagine it is already in the forecast.

Another Bloomberg story to keep an eye on:

Softening apartment rents in New York and San Francisco have forced landlord Equity Residential to lower its revenue forecast for the second time this year, as newly signed leases aren’t meeting the company’s expectations.
Equity Residential said it expects revenue growth from properties open at least a year to be no higher than 4.5 percent this year, according to a statement Wednesday. The reduction follows one made in April, when the Chicago-based real estate investment trust set the upper limit at 5 percent, down from a previous estimate of 5.25 percent.
Two thoughts. First is that maybe multifamily construction has finally caught up with demand, thus rent growth will slow and so will its impact on inflation. Second thought is that if demand for apartments is tapering off, then it may be that millennials are growing out of apartments and into single family housing. This handoff is thus likely to continue:


Look for softer underwriting conditions and marketing campaigns to help encourage this shift.
The Verizon strike likely negatively impacted the headline nonfarm payrolls numbers in the May employment report, so adjust your expectations accordingly. I would pay special attention to the unemployment rate and metrics of underemployment; the Fed would be more inclined to hike rates if progress on these from resumed.
Bottom Line: Nothing here suggests to me that the Fed will soon reject their expectation of a rate hike in the "coming months."

Thursday, May 26, 2016

Fed Watch: Powell, Data

Tim Duy:

Powell, Data, by Tim Duy: Federal Reserve Governor Jerome Powell kept the prospects for a near-term rate hike alive and well in a speech today:

For the near term, my baseline expectation is that our economy will continue on its path of growth at around 2 percent. To confirm that expectation, it will be important to see a significant strengthening in growth in the second quarter after the apparent softness of the past two quarters. To support this growth narrative, I also expect the ongoing healing process in labor markets to continue, with strong job growth, further reductions in headline unemployment and other measures of slack, and increases in wage inflation. As the economy tightens, I expect that inflation will continue to move over time to the Committee's 2 percent objective.
If incoming data continue to support those expectations, I would see it as appropriate to continue to gradually raise the federal funds rate. Depending on the incoming data and the evolving risks, another rate increase may be appropriate fairly soon.
Will these conditions be met for Powell by the time of the next FOMC meeting in June? On one hand, the Atlanta Fed tracking estimate for Q2 is up solidly:


That said, the tracking estimate is famously volatile and could easily collapse after the June meeting. So while a hopeful sign, I would not take it for granted yet that Q2 GDP will come in at a 3 percent pace. And given that Powell views this rebound as an "important" signal, I suspect he will want to be more certain of the Q2 results than allowable by the data available on June 14-15.
Note also he is expecting "further reductions in headline unemployment and other measures of slack" to justify a rate hike. This echoes my recent theme that stagnating progress toward full employment should be something that stays the Fed's hand for the moment. Powell also identifies evolving risks as an important factor in the timing of the next rate hike. As I said earlier this week, I think FOMC members need to shift to a balanced risk assessment prior to hiking. They were closer in April than March on that point, but I still think will fall short in June. Or at best are balanced in June and thus can justify setting the stage for a July hike. Either way, Powell made clear that if the data holds, he would support a rate hike in the near-term.
Powell tempers the rate hike message with a reminder that the path forward is likely to be very, very slow:
Several factors suggest that the pace of rate increases should be gradual, including the asymmetry of risks at the zero lower bound, downside risks from weak global demand and geopolitical events, a lower long-run neutral federal funds rate, and the apparently elevated sensitivity of financial conditions to monetary policy. Uncertainty about the location of supply-side constraints provides another reason for gradualism.
Earlier in the speech Powell, while commenting on slow productivity growth, said:
Lower potential growth would likely translate into lower estimates of the level of interest rates necessary to sustain stable prices and full employment. Estimates of the long-run "neutral" federal funds rate have declined about 100 basis points since the end of the crisis. The real yield on the 10-year Treasury is currently close to zero, compared with around 2 percent in the mid-2000s. Some of the decline in longer-term rates is explained by lower estimates of potential growth, and some by other factors such as very low term premiums.
I suspect that ongoing low productivity growth will lead to further reductions in the Fed's estimates of the longer run federal funds rate. I further suspect that this, combined with Powell's other concerns that limit the pace of rate hikes, means the likely medium-term path forward will be more shallow than the Fed anticipates. In other words, given current conditions, the Fed is still likely to move to the markets over the medium-term even if markets have moved somewhat toward the Fed in the near-term.
Housing data came in strong this week, including a jump in home home sales:


The shift from multifamily to single family looks well underway. While I wouldn't exactly expect sales to climb back up to 1.4 million units, there is clearly room for more upside here given a long period of under-building and high demand for housing. The latter was confirmed by the strong numbers in existing home sales. See Calculated Risk for more.
Initial unemployment claims was once again your weekly reminder that if you are looking for recession, you need to look somewhere else:


But the durable goods data was mixed, with an OK-ish headline but a weak core:


This weakness is consistent with soft regional ISM survey data that foreshadow a soft national ISM manufacturing number for May (to be released next week). Manufacturing data is likely to remain weak until the impacts of lower oil prices and a stronger dollar (both reversing this year) work their way through the sector, hopefully (keep your fingers crossed) by later this year.
While I do not believe current manufacturing numbers are indicative of a US recession, I would not be eager to hike rates into manufacturing weakness either. Moreover, if I were concerned about low productivity, like Powell and other FOMC participants, I would not be eager to hike into the low business investment numbers suggested by the core durable goods figures. Tend to think that this argues against June.
Bottom Line: Fed officials believe the data is lining up for a rate hike in the near future. Ultimately, I think they pass on June. Strategically, July offers a lot to like. They can wait for a more clear view of the 2nd quarter. They can use the June meeting and press conference to set the stage for July. They can broker a compromise between hawks and doves. The former should be happy because a strong signal in June is effectively a rate hike, the latter because it becomes an easily reversed rate hike (by skipping July if necessary) and they can bolster their case for gradualism. And a July hike will end the belief that the Fed can only hike on meetings with press conferences. My personal preference is to delay until September, but I don't run the show. All of the above assumes, of course, that data and financial conditions hold.

Wednesday, May 25, 2016

Fed Watch: Should The Fed Tolerate 5% Unemployment?

Tim Duy:

Should The Fed Tolerate 5% Unemployment?. by Tim Duy: In recent posts I highlighted the stagnant unemployment rate. I believe the Fed is on thin ice by raising rates when unemployment is moving sideways, especially when there exists evidence of substantial underemployment (see also this FEDS note). But there is also evidence of growing wage pressures, in particular the Atlanta Fed wage measure:


Would wage growth continue to accelerate if unemployment persisted at current levels? If so, would this mean the Fed had reached a tolerable equilibrium? My answers are "possibly" to the former question, and "probably not" to the latter.
Another way to consider the data is via a wage Phillips curve:


I suspect the black dots around 4 percent unemployment are effectively incompatible with a 2 percent inflation target given current productivity growth. The economy is currently operating at the light blue dot. My expectation is that when when conditions are sufficiently tight to raise wage growth to the 4 percent range, they will also be sufficiently tight to raise inflation to the Fed's target. It is possible that this occurs near 5 percent unemployment - essentially a vertical move from the current position.
But while this might be possible (wage growth might just stall out at current levels of unemployment), I hesitate to say that it was optimal. Points up and to the left - lower unemployment but the same wage growth are likely consistent with the Fed's inflation target and thus obviously preferable as they entail higher levels of employment.
Getting to such points, however, includes a higher possibility of overshooting the inflation target (although I would suggest that the magnitude of the overshooting would be no more excessive than the magnitude of undershooting the Fed is currently willing to tolerate). So, and this is reiterating a point from yesterday, I would say that if the Fed slows activity now, they risk settling the economy into a suboptimal outcome with lower employment and, maybe, lower inflation than their mandate. This would seem to be the policy approach of a central bank hell-bent on approaching the inflation target from below. By avoiding further rate hikes until it is clear that activity is in fact sufficient to induce further declines in the unemployment rate, the Fed will maximize its odds of meeting its mandates, but at the cost of some risk of overshooting its inflation target.
It seems to me then that a central bank with a symmetric inflation target would choose to refrain from further rate hikes when progress toward full employment had clearly decelerated:


(or even stalled):


and inflation remains below target:


We will soon see if the Fed agrees.

Tuesday, May 24, 2016

Fed Watch: Curious

Tim Duy:

Curious, by Tim Duy: I find the Fed's current obsession with raising interest rates curious to say the least. The basic argument for rate hikes is that the economy, and in particular the labor market, sustained its momentum in the last two quarters better than market participants believe. Given that the economy is near or beyond full employment, the lack of excess slack will soon manifest itself in the form of inflationary pressures. Hence, to remain ahead of the inflation curve and maximize the chance that rate hikes will be gradual, they need to soon raise rates.
For instance, St. Louis Federal Reserve President today, from his press release:
“By nearly any metric, U.S. labor markets are at or beyond full employment,” Bullard said. For example, he noted that job openings per available worker are at a cyclical low, unemployment insurance claims relative to the size of the labor force are at a multi-decade low, and nonfarm payroll employment growth has been above longer-run trends. In addition, the level of a labor market conditions index created by staff at the Board of Governors continues to be well above average.
In a recent speech, Boston Federal Reserve President Eric Rosengren argued that employment was close to entering the danger zone:
However, the unemployment rate is now at 5 percent – relatively close to my estimate of full employment, 4.7 percent – and net payroll employment growth is averaging over 200,000 jobs per month over the past quarter. My concern is that given these conditions, an interest rate path at the pace embedded in the futures markets could risk an unemployment rate that falls well below the natural rate of unemployment. We are currently at an unemployment rate where such a large, rapid decline in unemployment could be risky, as an overheating economy would eventually produce inflation rising above our 2 percent goal, eventually necessitating a rapid removal of monetary policy accommodation. I would prefer that the Federal Reserve not risk making the mistake of significantly overshooting the full employment level, resulting in the need to rapidly raise interest rates – with potentially disruptive effects and an increased risk of a recession.
Both these claims appear to me to be hasty. I think this narrative rang true through last summer. But, by my read of the data, since then progress toward full employment has stalled. For instance:


Part-time employment and long-term unemployment look to be moving sideways since the middle of last year, while progress in the U6 unemployment rate has decelerated markedly. And these shifts in momentum are occurring while at levels above those prior to the recession. Moreover, U3 unemployment is now moving sideways at a level above the Fed's estimate of full employment:


I understand that this flattening is attributable to rising labor force participation. That fact, however, should not induce the Fed to tighten. Quite the opposite in fact, as it suggests that available slack is deeper than imagined and hence requires an even longer period of low rates.
To me then, it appears that by raising rates now the Fed is risking falling short on its employment mandate at a time when the price mandate is also challenged. And falling short on the employment mandate now suggests an economy with sufficient slack to prevent reaching that price mandate. And that is without considering neither the balance of risks to the outlook nor the possibility that escaping the zero bound requires approaching the inflation target from above rather than below. Consequently, it seems that the case for a rate hike in June should be quite weak.
I would think that Federal Reserve Chair Janet Yellen should also find it quite weak. But the minutes of the April FOMC meeting and recent Fedspeak indicate that a large number of monetary policymakers find the case for a rate hike quite compelling. Given her past concerns regarding underemployment, I would have expected Yellen to lean stronger in the opposite direction. But I don't know that she is in fact leaning against the logic driving a rate hike. I am hoping we learn as much via her upcoming speaking engagements.
But, Yellen aside, what is driving so many FOMC participants to the rate hike camp? I think they are driven in part by two ideas that I believe to be erroneous. First, they believe that tapering and ending QE was not tightening, and hence essentially they have removed no accommodation. I think tapering was tightening as it reduced expectations about the ultimate size of the Fed's balance sheet and signaled a tighter future path of monetary policy. One place to see the tighter stance of policy is the Wu-Xia shadow rate:


Second, the Fed may be too enamored with the end game, the idea of normalization itself, as reflected in the dot-plot. They have already decided that the equilibrium fed funds rate is north of 3 percent, and hence assume that the current rate is highly accommodative. They thus see a large distance that needs to be covered, and feel an urge to start sooner than later.
Bottom Line: I don't find it surprising that some Fed policymakers are eager to hike rates. I am surprised that such sentiments are widespread throughout FOMC participants. It does not seem consistent with my understanding of the Fed's reaction function. They seem to be dismissing the recent lack of progress in reducing underemployment. This I think also might help explain the previously wide distance between financial market participants and the policymakers. And that might perhaps be why financial market participants largely ignored the warnings that rate hikes were likely until the release of the April minutes.

Sunday, May 22, 2016

Fed Watch: This Is Not A Drill. This Is The Real Thing.

Tim Duy:

This Is Not A Drill. This Is The Real Thing, by Tim Duy: The June FOMC meeting is live. That message came through loud and clear in the minutes, and was subsequently confirmed by New York Federal Reserve President William Dudley. Last week, via Reuters:

"We are on track to satisfy a lot of the conditions" for a rate increase, Dudley said. He added, though, that a key factor arguing for the Fed biding its time a little was the potential for market turmoil around Britain’s vote in late June about whether to leave the European Union...

..."If I am convinced that my own forecast is sort of on track, then I think a tightening in the summer, the June-July time frame is a reasonable expectation," said Dudley, a permanent voting member of the Fed's rate-setting committee.

Boston Federal Reserve President Eric Rosengren, the canary in the coal mine that was long ago alerting markets that they were underestimating June, subsequently gave a strong nod to June in his interview with Sam Fleming of the Financial Times:

We are still a month away from the actual meeting. We are going to get another employment rate in early June. We are going to get a second retail sales report. So I want to be sensitive to how the data comes in, but I would say that most of the conditions that were laid out in the minutes as of right now seem to be . . . on the verge of broadly being met...

Clearly, the Fed will be debating a rate hike at the next FOMC meeting. Will they or won't they? To answer that question, I need to begin with my main takeaways from the minutes:

1.) The Fed broadly agrees that the economic recovery remains intact. Overall there is broad agreement at the Fed that outside of manufacturing (for both domestic and external reasons), economic activity has moderated but remains near or somewhat below their estimates of potential growth and hence is sufficient to drive further improvement in labor markets. The weak first quarter numbers were largely statistical noise attributable to faulty seasonal adjustment mechanisms. Data since the April meeting generally supports this story. The economy is not falling over a cliff, recession is not likely, nothing to see here, folks.

2.) A contingent, however, disagreed with the benign scenario:

However, some participants were concerned that transitory factors may not fully explain the softness in consumer spending or the broad-based declines in business investment in recent months. They saw a risk that a more persistent slowdown in economic growth might be under way, which could hinder further improvement in labor market conditions.

This group will want fairly strong evidence that the first quarter was an anomaly before the sign off on the next rate hike.

3.) There was broad agreement of the obvious - global and financial market threats waned since the previous meeting. The Fed recognized that their hesitation to hike rates helped firm markets. It's important that they recognize that if the economy weathers a bout of financial market turbulence, it is often with the aid of easier Fed policy. Some Fed speakers appeared not to recognize this relationship earlier this year.

4.) Still, the risks are either balanced or to the downside. Apparently, none of the participants saw risks weighed to the upside. While some participants believe the threats had lessened sufficiently to justify a balanced outlook:

Several FOMC participants judged that the risks to the economic outlook were now roughly balanced.

the view was not widely shared:

However, many others indicated that they continued to see downside risks to the outlook either because of concerns that the recent slowdown in domestic spending might persist or because of remaining concerns about the global economic and financial outlook. Some participants noted that global financial markets could be sensitive to the upcoming British referendum on membership in the European Union or to unanticipated developments associated with China's management of its exchange rate.

It seems reasonable that this large group will need to see further diminishment of downside risks to justify a hike in June. Brexit doesn't derail a June hike unless it looks to be negatively impacting financial markets.

5.) The question of full employment deeply divides the Fed. Who wins this debate is critical to defining the policy path going forward. One group thinks the economy is not at full employment:

Many participants judged that labor market conditions had reached or were quite close to those consistent with their interpretation of the Committee's objective of maximum employment. Several of them reported that businesses in their Districts had seen a pickup in wages, shortages of workers in selected occupations, or pressures to retain or train workers for hard-to-fill jobs.

But others saw room for further improvement:

Many other participants continued to see scope for reducing labor market slack as labor demand continued to expand.

The Fed's plan had been to let the economy run hot enough for long enough to eliminate underemployment. One sizable camp within the Fed thinks this largely been accomplished. This is the group that is itching for more hikes earlier. This is a place where Federal Reserve Chair Janet Yellen should have an opinion and be willing to guide on that opinion. In the past, she has sided with the "still underemployment" camp.

6.) The Fed is also split on the inflation outlook but most believe inflation is set to trend toward target. A nontrivial contingent saw downside risks to the inflation outlook due to soft inflation expectations:

Several commented that the stronger labor market still appeared to be exerting little upward pressure on wage or price inflation. Moreover, several continued to see important downside risks to inflation in light of the still-low readings on market-based measures of inflation compensation and the slippage in the past couple of years in some survey measures of expected longer-run inflation.

But the majority were either neutral or dismissive of the signal from expectations:

However, for many other participants, the recent developments provided greater confidence that inflation would rise to 2 percent over the medium term.

7.) June is on the table. I have long warned that market participants were underestimating the odds of a rate hike in June. This came across loud and clear in the minutes:

Participants agreed that their ongoing assessments of the data and other incoming information, as well as the implications for the outlook, would determine the timing and pace of future adjustments to the stance of monetary policy. Most participants judged that if incoming data were consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the Committee's 2 percent objective, then it likely would be appropriate for the Committee to increase the target range for the federal funds rate in June.

Consider that the Fed's modus operandi is to delay an expected policy change for two meetings in the face of market turmoil. Hence given calmer financial markets, June could not be so easily dismissed. But it was not just the financial markets that stayed the Fed's hand. It was also softer Q1 data. As of April, participants had not concluded that they would see what they were looking for to justify a rate hike.

Participants expressed a range of views about the likelihood that incoming information would make it appropriate to adjust the stance of policy at the time of the next meeting. Several participants were concerned that the incoming information might not provide sufficiently clear signals to determine by mid-June whether an increase in the target range for the federal funds rate would be warranted. Some participants expressed more confidence that incoming data would prove broadly consistent with economic conditions that would make an increase in the target range in June appropriate.

Moreover, these are participants, not committee members. The actual voters members appeared less committed to June, saying only:

Regarding the possibility of adjustments in the stance of policy at the next meeting, members generally judged it appropriate to leave their policy options open and maintain the flexibility to make this decision based on how the incoming data and developments shaped their outlook for the labor market and inflation as well as their evolving assessments of the balance of risks around that outlook.

Here are my thoughts, assuming of course the data and the financial markets hold up over the next few weeks:

A.) There is a rate hike likely in the near-ish future. There seems to be broad agreement that, at a minimum, the pace of activity remains sufficient to bring the Fed's goals - both maximum employment and price stability - closer into view. Close enough that most voters will soon think another rate hike is appropriate. The doves can't push it off forever.

B.) The Fed will consider June, and there is likely some support among the voting members for a June hike. But ultimately, I think most will want a more complete picture of the second quarter before hiking rates. Also, the contingent that remains less convinced by the inflation outlook will press for more time. Moreover, they will also need broad agreement that the risks to the outlook are at least balanced. It would indeed be silly to plow forward with rate hikes if most members thought the risks were still weighted to the downside, even if the data were broadly consistent with the Fed's forecast. That agreement of balanced risks just might not be there by June.

C.) Fed doves might, however, need to strike a compromise to hold the line on June and avoid more than one or two dissents. That compromise could be a strong signal about the July meeting via the statement, the press conference, or, most likely, both. A July hike would also serve to end the idea that the Fed can't hike rates without a press conference.

D.) The reason compromise might be necessary is the possibility of a fairly stark divide between voting members. Assume Esther George, Eric Rosengren, and James Bullard will push for a rate hike in June. Furthermore, assume that Lael Brainard opposes a rate hike, and has sufficient leverage to pull Dan Tarullo and William Dudley to her side. Janet Yellen might prefer to negotiate a compromise rather than face the prospect of multiple dissents from either camp.

E.) Of all the divisive points above, I think the most important is the debate over the level of full employment. The ability of the doves to slow the pace of subsequent rate hikes will hinge on their willingness to push for below NAIRU unemployment to alleviate underemployment. If the doves maintain the upper hand, the path of subsequent rate hikes will be very, very shallow. I cannot emphasize enough that this is a debate in which Janet Yellen has the opportunity to take leadership that fundamentally defines her preferred rate path going forward. Does she stick with the bottom dots?

Bottom Line: This is not a drill. This meeting is the real thing - an undoubtedly lively debate that could end with a rate hike. I think we narrowly avoid a rate hike, but at the cost of moving forward the next hike to the July meeting.

Thursday, May 19, 2016

Fed Watch: Minutes Say June Is On The Table

Tim Duy:

Minutes Say June Is On The Table, by Tim Duy: There is quite a bit of material in the minutes of the April 2016 FOMC meeting to work with, more than I have time for tonight.

The central message of the minutes was that financial market participants were too complacent in their expectations that the Fed would stand pat in June. The Fed clearly made no such decision in April. Instead, meeting participants hotly debated the likelihood that a rate hike would be appropriate in June:

Participants agreed that their ongoing assessments of the data and other incoming information, as well as the implications for the outlook, would determine the timing and pace of future adjustments to the stance of monetary policy. Most participants judged that if incoming data were consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the Committee's 2 percent objective, then it likely would be appropriate for the Committee to increase the target range for the federal funds rate in June.

Most participants, but not necessarily most voting members, thought a June hike would be appropriate if the economy firms as anticipated. Still, it was not clear to participants that the economy would evolve as expected:

Participants expressed a range of views about the likelihood that incoming information would make it appropriate to adjust the stance of policy at the time of the next meeting. Several participants were concerned that the incoming information might not provide sufficiently clear signals to determine by mid-June whether an increase in the target range for the federal funds rate would be warranted.

This has been essentially my position - that the Fed would not have sufficient data on Q2 at the time of the June meeting to justify a rate hike. Other were more optimistic:

Some participants expressed more confidence that incoming data would prove broadly consistent with economic conditions that would make an increase in the target range in June appropriate.

Note that "several" is greater than "some." Those same "some" were also likely those that expressed this concern:

Some participants were concerned that market participants may not have properly assessed the likelihood of an increase in the target range at the June meeting, and they emphasized the importance of communicating clearly over the intermeeting period how the Committee intends to respond to economic and financial developments.

This should have come as no surprise. Policymakers have repeatedly said as much in recent weeks. Too many participants in April felt June was a real possibility if the data cooperated - and it largely has cooperated - to so easily dismiss the possibility of a June hike.

Committee members were a bit more circumspect with respect to action in June:

Regarding the possibility of adjustments in the stance of policy at the next meeting, members generally judged it appropriate to leave their policy options open and maintain the flexibility to make this decision based on how the incoming data and developments shaped their outlook for the labor market and inflation as well as their evolving assessments of the balance of risks around that outlook. It was noted that communications could help the public understand how the Committee might respond to incoming data and developments over the upcoming intermeeting period. Some members expressed concern that the likelihood implied by market pricing that the Committee would increase the target range for the federal funds rate at the June meeting might be unduly low.

But it is clearly under consideration.

My initial reaction to the minutes was to call the June meeting a toss-up. Via Sam Fleming at the FT:

Hazards are still lurking overseas, and the minutes made it clear they are weighing on the inflation prospects in the minds of a number of policymakers. Tim Duy, a close Fed watcher who is a professor at the University of Oregon, still puts the odds of a move in June at just 50-50.

On further thought, I should have said toward 50-50. I don't like saying 50-50, because that just means you can't make a decision. And re-reading the minutes, I think the odds given the current data are less than 50% but more than 30%. Ultimately, the decision will depend on the willingness of the committee to move with only a partial view of Q2. I think that ultimately the partial view will not be sufficient.

Instead, I see a strong possibility that sufficiently good data makes a July hike probable. I had been thinking they would pass on July due to the lack of press conference, favoring September instead. But a strong signal about July might represent the compromise position between those members ready to hike and those that want a more complete picture of Q2 before acting. The press conference could then be used to clear the way for July. And it would have the added bonus of ending the idea that the Fed can only hike rates at a meeting with a press conference.

One final note. Consider this paragraph:

Labor market conditions strengthened further in recent months. Increases in nonfarm payroll employment averaged almost 210,000 per month over the first three months of 2016. Although the unemployment rate changed little over that period, the labor force participation rate moved up and the pool of potential workers, which includes the unemployed as well as those who would like a job but are not actively looking, continued to shrink. Many participants judged that labor market conditions had reached or were quite close to those consistent with their interpretation of the Committee's objective of maximum employment. Several of them reported that businesses in their Districts had seen a pickup in wages, shortages of workers in selected occupations, or pressures to retain or train workers for hard-to-fill jobs. Many other participants continued to see scope for reducing labor market slack as labor demand continued to expand. In that regard, a number of participants indicated that the recent rise in the participation rate was a positive development, suggesting that a tighter labor market could potentially draw more individuals back into the workforce on a sustained basis without adding to inflationary pressures and thus increase the productive capacity of the economy. It was also noted that businesses might satisfy increases in labor demand in part by converting involuntary part-time jobs to full-time positions.

There are two clear views here: One group feels the economy is near full employment, while another sees room for further improvement. The former group will want more hikes sooner, the latter fewer hikes later. Federal Reserve Chair Janet Yellen should be taking a side in this critical debate and thus driving the direction of policy. Watch for her to provide guidance on this and inflation when she speaks on June 6.

Bottom Line: June is a live meeting. Really. Many Fed officials think the US economy has proven sufficiently resilient to resume hiking rates and would like to retain the option for 3 gradual hikes this year. That leaves June in play. Ultimately, I think they pass on June, but harmony is maintained only by placing a bullseye on July. Meeting participants will be positioning themselves ahead of the meeting. A divided Fed leaves Yellen with a new challenge. Will she lead the FOMC, or will it lead her?

Tuesday, May 17, 2016

Fed Watch: Fed Officials Come Looking For A Fight

Tim Duy:

Fed Officials Come Looking For A Fight, by Tim Duy: Incoming data continues to support the narrative that the US economy is not, I repeat, not, slipping into recession. Instead, the US economy is most likely continuing to chug along around 2 percent year over year. Not exciting, but not a disaster by any means. Indeed, for Fed officials thinking the rate of potential growth is hovering around 1.75 percent, it is enough to keep upward pressure on labor markets, pushing to economy further toward full employment.
And if you think you want to hit the inflation target from below, then you need to hit the employment target from above. Which means a non-trivial contingent of the Fed does not want to leave June off the table. That is a message that came thorough loud and clear today.
Industrial production surprised on the upside, gaining 0.7 percent. Still down on a year over year basis, but it is worth repeating that the weakness is narrowly concentrated:


In a recession, the weakness is broadly concentrated. Hence the softness in manufacturing is still best described as a sector specific shock, not an economy-wide shock.
Housing starts for April were also above expectations. The upward grind since 2011:


Notably, the housing market is transitioning from multifamily to single family construction:


Plenty of room to run in that direction, providing underlying support for the US economy. See Calculated Risk for more.
Inflation rose on the back of higher gas prices. Headline CPI gained 0.4 percent, although core rose a more modest 0.2 percent. Core CPI inflation is hovering just above 2 percent:


Fed hawks will be nervous that rising gas prices will quickly filter through to core inflation; doves will remind them that the Fed's target is PCE inflation, which remains well below 2 percent.
Fedspeak was decidedly hawkish today, with both Atlanta Federal Reserve President Dennis Lockhart and San Fransisco Federal Reserve President John Williams insisting that market participants are wrong to assume the Fed will pass on the June meeting. Via Greg Robb at MarketWatch:
Atlanta Fed President Dennis Lockhart and San Francisco Fed President John Williams, in a joint appearance at a lunch sponsored by the news site Politico, said that the decision on whether to raise rates at the June 14-15 meeting depends on the data.
June “certainly could be a meeting at which action could be taken,” Lockhart said.
“I think it is a little early at second-quarter data to draw a conclusion, so I am at this stage inconclusive about how I am going to be thinking about June, but I wouldn’t take it off the table,” Lockhart said.
He said he assumes there will be two to three rate hikes this year...
...Williams said he agreed with Lockhart and said he thought the economy was “doing great.”
“I think the incoming data have actually been quite good and reassuring in terms of policy decisions, so, in my view, June is a live meeting,” Williams said.
He added that there will a lot more data reported before the meeting.
In an interview with the Wall Street Journal prior to the Politico lunch, Williams said raising rates two or this times this year “makes sense.”
Separately, Dallas Federal Reserve President Robert Kaplan argued for a rate hike in June or July. Via Ann Saphir at Reuters:
"Whether that’s June or July, I can’t say right now," Kaplan told reporters after a speech. He said would prefer to pause after that first 2016 rate hike to assess conditions, and while he would "hope" to continue to normalize rates thereafter, the pace of rate hikes will depend on incoming economic data.
None of these three are voters. Still, there is a message here - many FOMC participants want to go into the June meeting with a reasonable chance that they will hike rates. They don't want the outcome of this meeting to be a foregone conclusion. Two other thoughts:
1.) The more hawkish Fedspeak could be foreshadowing that the minutes of the April FOMC meeting will have a hawkish tilt.
2.) Kaplan puts July on the table. I had been thinking that July was off the table due to the lack of a press conference. That said, I should be open to the possibility that they use the June press conference to clear the way for July.
Market participants raised the probability of a June rate hike to 15% today. Still probably less than the probability assigned by the median FOMC participant. Meanwhile, the yield curve flattened further - signaling that the Fed needs to move very cautiously. At the moment, the Fed doesn't have much room before they invert the yield curve. In my opinion, the bond market continues to signal that Fed's expectation of normalizing short rates in the 3.5 - 4.0 percent range are wildly - and dangerously - optimistic.
Bottom Line: Today's Fed speakers came looking for a fight with financial market participants. They don't like the low odds assigned to the June meeting. I don't think June is a go; the data isn't quite there yet. But odds are greater than 15%, in my opinion.

Monday, May 16, 2016

Fed Watch: Fed Not As Convinced About June As Markets

Tim Duy:

Fed Not As Convinced About June As Markets, by Tim Duy: Market participants place less than 10 percent chance of a rate hike in June. In contrast, San Francisco Federal Reserve President John Williams continues hold out hope for a third. Via Reuters:
Two to three rate increases this year "definitely still makes sense," he said...
Williams, a centrist whose views are generally in line with those of Fed Chair Janet Yellen, said he has not yet conferred with his staff economists over whether the next rate increase would be best made in June, July or September...
...With most gauges of the labor market suggesting the United States is at or nearly at full employment, he said, and inflation set to rise to the Fed's 2 percent target in two years, "things are definitely looking good."
Delaying rate hikes for months, he said, "would force our hands a little bit to move much more quickly in 2017."
Williams follows on the heels of Kansas City Federal Reserve President Esther George and Boston Federal Reserve President Eric Rosengren. The former clearly wants a rate hike, the latter, like Williams, not convinced that June is off the table. Williams adds the possibility that market participants are in for a rude awakening come June:
"Hopefully, if the markets understand our strategy, understand the data the way we do, then they won’t be too surprised by what we do," Williams said. "I definitely don’t think we need to go into a meeting with the markets convinced that we are going to raise rates in order for us to raise rates."
I think the Fed increasingly believes the data is lining up in their favor. Friday's retail sales report likely went a long-way toward dispelling any lingering concerns they might have over the strength of the consumer. The tenor of that data has picked up markedly in the last few months:


Note that one should not read much into the problems of department store retailers like Macy's. They are simply playing a losing game:


This among other data, is pulling upward the Atlanta Fed's estimates of Q2 growth:


Here though I would urge caution - this estimate can come down as quickly as it went up. If the Fed were confident that growth was in fact 2.8% in Q2, then they would move in June. But the reality is they are not likely to have sufficient data to justify that degree of confidence. That leaves me concluding that June is still not likely to happen.
But given the direction of the data, the improvement in financial markets, and the predisposition of a significant number of policymakers to raise early to raise slow, I would not be surprised that market participants revise their expectations that June is a sure thing. Remember that if we assume July and October are off the table (lack of press conferences and/or proximity to election), then retaining the option to hike three times requires a hard look at June. I think that will lead to a much more extensive discussion of a rate hike at the June meeting than many market participants appear to expect.
In the meantime, despite an improving Q2 outlook and healthier financial markets, the yield curve flattened further:


The 10-2 spread was just 95bp at the end of last week. Now, before anyway panics and screams that this implies slow growth, it is worth remembering that the spread was consistently below 100bp in the last half of the 1990s. And that was not exactly a slow growth period.
So why is the curve flattening? My story is this: The yield curve flattens whenever the Fed is in a tightening cycle. And the Fed most assuredly remains in a tightening cycle. They have not backed off their fundamental story that rates are headed higher. They see normalized interest rates on the short end as well above the current yield on the long-end. This seems entirely inconsistent with signals from the bond market and the global zero interest rate environment. In my opinion, the Fed continues to send signal that they intend to error on the side of excessively tight monetary policy.
That is the message of the dot plot. There is absolutely no reason the Fed needs to take stand on the level of short-term interest rates three years hence. They don't know any better than anyone else. So why pretend otherwise? Why not do as William's suggests and trust the markets to reach the right conclusion? In my opinion, the Fed's insistence on signaling an interest rate well above anything consistent with long-run rates isn't just bad policy. It is just plain stupid policy.
To expect the curve to steepen at this juncture, I think at a minimum you need the Fed to more aggressively commit to approaching the inflation target from above. You need to overshoot. That I think would be essentially an easing at this point. Chicago Federal Reserve President Charles Evans is already there. I think that Federal Reserve Chair Janet Yellen is getting there, but can't say it.
And even then, I don't know that approaching the target from above is enough. The dominance of the dollar in international finance means the Fed has a preeminent role in fostering global financial stability. A 2 percent US inflation target may not be consistent with global financial stability. And if not consistent with global financial stability, then not with US financial stability and thus not solid US economic performance. Which means if the Fed is the world's central bank, they need to adopt an inflation target consistent with maintaining global growth. That might be higher than 2 percent. And they aren't going down that road without a long and nasty fight.
Bottom Line: I don't think the data lines up to support a June rate hike. But I don't think the case will be as clear-cut as signaled by the low odds financial market participants place on a hike.

Thursday, May 12, 2016

Fed Watch: Fed Speak, Claims

Tim Duy:

Fed Speak, Claims, by Tim Duy: The Fed is not likely to raise rates in June. But not everyone at the Fed is on board with the plan. Serial dissenter Kansas City Federal Reserve President Esther George repeated her warnings that interest rates are too low:
I support a gradual adjustment of short-term interest rates toward a more normal level, but I view the current level as too low for today’s economic conditions. The economy is at or near full employment and inflation is close to the FOMC’s target of 2 percent, yet short-term interest rates remain near historic lows.
Her motivation stems primarily from concerns about financial imbalances:
Just as raising rates too quickly can slow the economy and push inflation to undesirably low levels, keeping rates too low can also create risks. Interest-sensitive sectors can take on too much debt in response to low rates and grow quickly, then unwind in ways that are disruptive. We witnessed this during both the housing crisis and the current adjustments in the energy sector. Because monetary policy has a powerful effect on financial conditions, it can give rise to imbalances or capital misallocation that negatively affects longer-run growth. Accordingly, I favor taking additional steps in the normalization process.
Separately, Boston Federal Reserve President Eric Rosengren, currently in a post-dove phase, reiterated his warning that financial markets just don't get it:
In my view, the market remains too pessimistic about the fundamental strength of the U.S. economy, and the likelihood of removing monetary accommodation is higher than is currently priced into financial markets based on current data.
He does see benefits from the current stance of policy:
I believe that one of the benefits of our current accommodative monetary policy, even as we approach full employment, is that it fosters continued gradual improvement in labor markets. As I have noted in the past, it is quite appropriate to probe on the natural rate of unemployment to see how low it might be, given the benefit to workers. We have seen workers rejoin the labor force, many of them previously having given up looking for work.
But, like George, the risks of imbalances are growing too large for his liking:
However, there can be potential costs to accommodation if rates stay too low for too long. One cost involves the potential of very low interest rates encouraging speculative behavior. One area where I have some concern in this regard is the commercial real estate market.
In addition, he worries that unemployment threatens to descend too far below the natural rate:
A second possible cost of keeping rates too low for too long relates to the limits we see in monetary policy’s ability to “fine tune” the economy...Once unemployment has reached its low point in the economic cycle, it is unusual for it to proceed smoothly back to the natural rate...There are no episodes in which unemployment rose a bit and remained stable at its natural employment rate. Instead, relatively soon after the periods shown here with red highlighting, unemployment rises significantly – that is, we experience a recession, as indicated by the gray shading.
The chart strongly suggests that it has proven difficult to calibrate policy so as to gradually increase the unemployment rate, gently nudging it back toward full employment. The lesson is that policymakers should avoid significantly overshooting their best estimates of the natural rate of unemployment.
Here I would suggest that the failure of policymakers to better manage the economy at turning points is not because it is impossible, but because they have overtightened in the latter stage of the cycle, forgetting to pay attention to the lags in policy they think are so important during the early stages of the cycle. He continues:
Today, the unemployment rate is still somewhat above my estimate of the natural rate, 4.7 percent. But waiting too long to have more normalized rates risks possibly overshooting on the unemployment rate, and needing to tighten more quickly than would be desirable.
Note that Rosengren is not deterred by the flattening of the unemployment rate:


because he pegs his estimate of sustainable job growth at 80-100k per month, well below current rates of growth. Thus he expects the unemployment rate will soon resume its decline. I would say that he should be cautious of that estimate when labor force participation is rising.
I think it likely George will dissent again in June while Rosengren, a nonvoter, at a minimum would like to keep the June meeting alive. In an important difference from George and Rosengren, New York Federal Reserve President William Dudley is less concerned with potential financial imbalances at this point (be sure to read Gavyn Davies for more on Dudley):
I would say at this point I don’t see a lot of things that disturb me. The things that would disturb me would be things that are very excessive in terms of valuation and very large in terms of the weight that they carry for the economy. If you think back to the financial crisis, you had a big bubble for the U.S. housing sector which was very large and affects lots of people, so that was a huge bubble in terms of the consequences for the economy. Obviously it was magnified by the fact that there were structural weaknesses in the financial system that, rather than dampen the impact of the decline in housing, actually tended to amplify it. I don’t see anything like that today. There are some areas you might point to and say that those look excessive, but some of the areas you might have pointed to six months ago, they’ve actually sort of self-corrected.
Hence, Dudley remains more cautious on raising rates. His view is actually fairly optimistic:
My view is still that we’re looking for 2 percent real G.D.P. growth over the next year. If that’s right, the labor market should continue to improve. We should continue to see tightening of the U.S. labor market, probably a gradual acceleration in wages as the labor market gets tighter. And if that’s how the economy plays out, then I think we’re going to see further moves by the Fed to gradually normalize interest rates.
Note that 2 percent is above his estimate of potential growth (and Rosengren's, who puts it at 1.75 percent), and hence if he gets that as expected, it is reasonable to expect two rates hikes:
The expectations that were shown in the March summary of economic projections, the median of two rate hikes, seems like a reasonable expectation. But it depends on how the economy evolves. Two seems like a reasonable number sitting here today, but it could be more if the economy is stronger and inflation comes back more quickly, or it could be less if the economy disappoints.
Two is of course greater than market expectations, hence he is not inconsistent with Rosengren. But he doesn't feel the need to warn on this as strongly as Rosengren, nor does he share the concern regarding the financial imbalances. And Dudley still sees value in letting the economy somewhat "hot," suggesting more willingness to embrace a modest decline in unemployment below the natural rate. Hence he is less eager to raise rates. 
Finally, an bit on initial claims. Claims rose to their highest level in a year, but this was driven by a bump in New York that appears related to the Verizon strike and spring break schedules. Dispersion of claim weakness remains very low overall:


In other words, move along, nothing to see here.
Bottom Line: Ultimately, I suspect the FOMC will not find sufficient reason in the data before June to convince the Fed that growth is sufficiently strong to justify a hike. Hence I anticipate that they will pass on that opportunity to raise rates. Look for an opportunity in September, assuming that growth firms to 2% and the unemployment rate resumes its decline over the summer. I doubt, however, that most on the Fed are pleased that market participants have already priced out a June hike on the basis of the April employment report. Even Dudley claims it did little to change his expectations. While they won't raise rates in June, they do not see the outcome as already preordained.