Category Archive for: Fed Watch [Return to Main]

Thursday, July 31, 2014

Fed Watch: On That ECI Number

Tim Duy (see Dean Baker too):

On That ECI Number: The employment cost index is bearing the blame for today's market sell-off. Sam Ro at Business Insider reports:
...traders agree that today's sell-off is probably due to one stat: the 0.7% jump in the employment cost index (ECI) in the second quarter.

This number, which crossed at 8:30 a.m. ET, was a bit higher than the 0.5% expected by economists. And it represents a year-over-year growth rate of over 2%.

It's a big deal, because it's both a sign of inflation and labor market tightness, two forces that put pressure on the Federal Reserve to tighten monetary policy sooner than later.

The ECI gain was driven by the private sector (compensation for the public sector was up just 0.5%, same as the first quarter), and I would be cautious about reading too much into those numbers. The Fed will take the Q2 reading in context of the low Q1 reading:


The first two quarters averaged a just 0.46% increase, pretty much the same as recent trends of the past five years. And look at the year-over-year-trend:


Nothing to see here, folks. Move along. Benefit costs for private sector workers also accelerated, but I think the Fed will likely interpret this as an anomaly:


Again, not out-of-line with readings both before and after the recession.
Bottom Line:  I understand why market participants might be a little hypersensitive to anything related to wages. Indeed, wage growth is the missing link in the tight labor market story.  But I don't think the Fed will react much to these numbers; they will place them in context of recent behavior, and in that context they are not much different than current trends.  Watch the upcoming employment reports for signs of diminishing underutilization of labor - that is where the Fed will be looking.

Wednesday, July 30, 2014

Fed Watch: FOMC Statement

Tim Duy:

FOMC Statement, by Tim Duy: At the conclusion of this week's FOMC meeting, policymakers released yet another statement that only a FedWatcher could love. It is definitely an exercise in reading between the lines. The Fed cut another $10 billion from the asset purchase program, as expected. The statement acknowledged that unemployment is no longer elevated and inflation has stabilized. But it is hard to see this as anything more that describing an evolution of activity that is fundamentally consistent with their existing outlook. Continue to expect the first rate hike around the middle of next year; my expectation leans toward the second quarter over the third.
The Fed began by acknowledging the second quarter GDP numbers:
Information received since the Federal Open Market Committee met in June indicates that growth in economic activity rebounded in the second quarter.
With the new data, the Fed's (downwardly revised) growth expectations for this year remain attainable, but still requires an acceleration of activity that has so far been unattainable:


Despite all the quarterly twists and turns, underlying growth is simply nothing to write home about:


That slow yet steady growth, however, has been sufficient to support gradual improvement in labor markets, prompting the Fed to drop this line from the June statement:
The unemployment rate, though lower, remains elevated.
and replace it with:
Labor market conditions improved, with the unemployment rate declining further. However, a range of labor market indicators suggests that there remains significant underutilization of labor resources.
While the unemployment rate is no longer elevated, this is a fairly strong confirmation that Federal Reserve Chair Janet Yellen has the support of the FOMC. As a group, they continue to discount the improvement in the unemployment rate. And as long as wage growth remains tepid, this group will continue to have the upper hand.
The inflation story also reflects recent data. This from June:
Inflation has been running below the Committee's longer-run objective, but longer-term inflation expectations have remained stable...The Committee sees the risks to the outlook for the economy and the labor market as nearly balanced. The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.
became this:
Inflation has moved somewhat closer to the Committee's longer-run objective. Longer-term inflation expectations have remained stable...The Committee sees the risks to the outlook for economic activity and the labor market as nearly balanced and judges that the likelihood of inflation running persistently below 2 percent has diminished somewhat.
Rather than something to worry over, I sense that the majority of the FOMC is feeling relief over the recent inflation data. It is often forgotten that the Fed WANTS inflation to move closer to 2%. The reality is finally starting to look like their forecast, which clears the way to begin normalizing policy next year. Given the current outlook, expect only gradual normalization.
Finally, we had a dissent:
Voting against was Charles I. Plosser who objected to the guidance indicating that it likely will be appropriate to maintain the current target range for the federal funds rate for "a considerable time after the asset purchase program ends," because such language is time dependent and does not reflect the considerable economic progress that has been made toward the Committee's goals.
We probably should have seen this coming; Philadelphia Fed President Charles Plosser raised this issue weeks ago. Clearly he is not getting much traction yet among his colleagues. I doubt they want to change the language before they have settled on a general exit strategy (which was probably the main topic of this meeting and will be the next). Somewhat surprising is that Dallas Federal Reserve President Richard Fisher did not join Plosser given Fisher's sharp critique of monetary policy in Monday's Wall Street Journal. Note to Fisher: Put up or shut up.
Bottom Line: Remember that we should see the statement shift in response to the data relative to the outlook. In short, the statement needs to remain consistent with the reaction function. The changes in the July statement reflect that consistency. The data continues to evolve in such a way that the Fed can remain patient in regards to policy normalization. We will see if that changes with the upcoming employment report; focus on the underlying numbers, as the Fed continues to discount the headline numbers.

Tuesday, July 15, 2014

Fed Watch: Yellen Testimony

Tim Duy:

Yellen Testimony, by Tim Duy: Fed Reserve Chair Janet Yellen testified before the Senate today, presenting remarks generally perceived as consistent with current expectations for a long period of fairly low interest rates. Binyamin Applebaum of the New York Times notes:
Ms. Yellen’s testimony is likely to reinforce a sense of complacency among investors who regard the Fed as convinced of its forecast and committed to its policy course. She reiterated the Fed’s view that the economy will continue to grow at a moderate pace, and that the Fed is in no hurry to start increasing short-term interest rates.
A key reason that Yellen is in no hurry to tighten is her clear belief that an accommodative monetary policy is warranted given the persistent damage done by the recession:
Although the economy continues to improve, the recovery is not yet complete. Even with the recent declines, the unemployment rate remains above Federal Open Market Committee (FOMC) participants' estimates of its longer-run normal level. Labor force participation appears weaker than one would expect based on the aging of the population and the level of unemployment. These and other indications that significant slack remains in labor markets are corroborated by the continued slow pace of growth in most measures of hourly compensation.
Another reminder to watch compensation numbers. Without an acceleration in wage growth, sustained higher inflation is unlikely and hence the Fed sees little need to remove accommodation prior to reaching its policy objectives.
The only vaguely more hawkish tone was that identified by Applebaum:
But Ms. Yellen added that the Fed was ready to respond if it concluded that it had overestimated the slack in the labor market, a more substantial acknowledgment of the views of her critics than she has made in other recent remarks.
The exact quote:
Of course, the outlook for the economy and financial markets is never certain, and now is no exception. Therefore, the Committee's decisions about the path of the federal funds rate remain dependent on our assessment of incoming information and the implications for the economic outlook. If the labor market continues to improve more quickly than anticipated by the Committee, resulting in faster convergence toward our dual objectives, then increases in the federal funds rate target likely would occur sooner and be more rapid than currently envisioned. Conversely, if economic performance is disappointing, then the future path of interest rates likely would be more accommodative than currently anticipated.
Her choice of words is important here. Note that she does not say "If the labor market improves more quickly". Yellen says "continues to improve more quickly" which means that the economy is already converging towards the Fed's objective more quickly than anticipated by current forecasts. This is a point repeatedly made by St. Louis Federal Reserve President James Bullard in recent weeks. For example, via Bloomberg:
Federal Reserve Bank of St. Louis President James Bullard said a rapid drop in joblessness will fuel inflation, bolstering his case for an interest-rate increase early next year.
“I think we are going to overshoot here on inflation,” Bullard said yesterday in a telephone interview from St. Louis. He predicted inflation of 2.4 percent at the end of 2015, “well above” the Fed’s 2 percent target.
“That is a break from where most of the committee seems to be, which is a very slow convergence of inflation to target,” he said in a reference to the policy-making Federal Open Market Committee.
His picture:


With Yellen at least acknowledging this point, it brings into question whether or not the Fed should maintain its "considerable period" language:
The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends...
Fed hawks, such as Philadelphia Federal Reserve President Charles Plosser, increasingly see the need to remove this language from the statement, and for some good reason. The Fed foresees ending asset purchases in October and can reasonably foresee raising interest rates in the first quarter given the trajectory of unemployment. Hence it is no longer clear that a "considerable period" between the end of asset purchases and the first rate hike remains a certainty.
To be sure, there will be resistance to changing the language now - the Fed will want to ensure that any change is interpreted as the result of a change in the outlook rather than a change in the reaction function. But the hawks will argue that the communications challenge is best handled by dropping the language sooner than later - later might appear like an abrupt change and be more difficult to distinguish from a shift in the reaction function. This I suspect is the next battlefield for policymakers.
Bottom Line: A generally dovish performance by Yellen today consistent with current expectations. But notice her acknowledgement of her critics, and watch for the "considerable period" debate to heat up as October approaches.

Thursday, July 10, 2014

Fed Watch: QEInfinity Not

Tim Duy:

QEInfinity Not, by Tim Duy: The Federal Reserve released the minutes of the June FOMC meeting today, but the contents had little in the way of groundbreaking news. Most interesting was that Fed officials tired of being pestered about the "October or December" question regarding the end of the QE and decided to more or less commit to the earlier date:
Some committee members had been asked by members of the public whether, if tapering in the pace of purchases continues as expected, the final reduction would come in a single $15 billion per month reduction or in a $10 billion reduction followed by a $5 billion reduction. Most participants viewed this as a technical issue with no substantive macroeconomic consequences and no consequences for the eventual decision about the timing of the first increase in the federal funds rate--a decision that will depend on the Committee's evolving assessments of actual and expected progress toward its objectives.
In other words, who cares about that last $5 billion? The Fed's answer was to take away the mystery:
In light of these considerations, participants generally agreed that if incoming information continued to support its expectation of improvement in labor market conditions and a return of inflation toward its longer-run objective, it would be appropriate to complete asset purchases with a $15 billion reduction in the pace of purchases in order to avoid having the small, remaining level of purchases receive undue focus among investors.
with, of course, the usual "data dependent" caveat. Thus the predictions of QE Infinity come to an end. In other news, the Fed fretted over market complacency:
However, participants also discussed whether some recent trends in financial markets might suggest that investors were not appropriately taking account of risks in their investment decisions. In particular, low implied volatility in equity, currency, and fixed-income markets as well as signs of increased risk-taking were viewed by some participants as an indication that market participants were not factoring in sufficient uncertainty about the path of the economy and monetary policy.
I find this somewhat irritating. What is "sufficient" uncertainty? I find it especially irritating given that, as Josh Zumbrun at the Wall Street Journal reports, Fed officials themselves appear to have less uncertainty regarding the outlook:


If the Fed has a well-communicated reaction function, and there is little uncertainty about the outlook, why should there be uncertainty about the path of monetary policy? The Fed's unease about complacency seems misplaced. The goal of the communications strategy should be to limit uncertainty regarding the path of monetary policy by clearing defining the objective function. The only residual uncertainty will be economic uncertainty. And even that arguably is reduced by establishing a well-communicated reaction function.
In any event, the Fed concluded that even if complacency is a problem, there is not much they can do about it:
They agreed that the Committee should continue to carefully monitor financial conditions and to emphasize in its communications the dependence of its policy decisions on the evolution of the economic outlook; it was also pointed out that, where appropriate, supervisory measures should be applied to address excessive risk-taking and associated financial imbalances. At the same time, it was noted that monetary policy needed to continue to promote the favorable financial conditions required to support the economic expansion.
Very similar to Federal Reserve Chair Janet Yellen's recent comments:
Taking all of these factors into consideration, I do not presently see a need for monetary policy to deviate from a primary focus on attaining price stability and maximum employment, in order to address financial stability concerns. That said, I do see pockets of increased risk-taking across the financial system, and an acceleration or broadening of these concerns could necessitate a more robust macroprudential approach.
If the Fed wants to increase uncertainty and, presumably, reduce potential financial instability, they could do so by changing the reaction function in a hawkish direction. The Fed, however, is not yet sufficiently concerned about complacency to attempt to gain more financial stability at the cost of economic growth.
Inflation remains well below target:


But the Fed believes we have seen the lows:
Readings on a range of price measures--including the PCE price index, the CPI, and a number of the analytical measures developed at the Reserve Banks--appeared to provide evidence that inflation had moved up recently from low levels earlier in the year, consistent with the Committee's forecast of a gradual increase in inflation over the medium term. Reports from business contacts were mixed, spanning an absence of price pressures in some Districts and rising input costs in others. Some participants expressed concern about the persistence of below-trend inflation, and a couple of them suggested that the Committee may need to allow the unemployment rate to move below its longer-run normal level for a time in order keep inflation expectations anchored and return inflation to its 2 percent target, though one participant emphasized the risks of doing so. In contrast, some others expected a faster pickup in inflation or saw upside risks to inflation and inflation expectations because they anticipated a more rapid decline in economic slack.
Seems like broad agreement that inflation rates bottomed out, but less agreement on where they head from here. Toward target, to be sure, but at what speed? That question, like all the forecasts, feeds into future policy decisions:
Some participants suggested that the Committee's communications about its forward guidance should emphasize more strongly that its policy decisions would depend on its ongoing assessment across a range of indicators of economic activity, labor market conditions, inflation and inflation expectations, and financial market developments. In that regard, circumstances that might entail either a slower or a more rapid removal of policy accommodation were cited. For example, a number of participants noted their concern that a more gradual approach might be appropriate if forecasts of above-trend economic growth later this year were not realized. And a couple suggested that the Committee might need to strengthen its commitment to maintain sufficient policy accommodation to return inflation to its target over the medium term in order to prevent an undesirable decline in inflation expectations. Alternatively, some other participants expressed concern that economic growth over the medium run might be faster than currently expected or that the rate of growth of potential output might be lower than currently expected, calling for a more rapid move to begin raising the federal funds rate in order to avoid significantly overshooting the Committee's unemployment and inflation objectives.
Is there any new information here? I think not. The current expected path of rates is data dependent, and as that data changes, so too will the expected rate path. The pattern of rate forecasts in the Summary of Economic Projections largely reflects differing forecasts rather than differing reaction functions. As the data evolves, the pattern of rate forecasts will converge as one of the paths becomes more obvious.
My own view is:
  1. The existing mix of data and forecasts suggest the first rate hike in the second quarter of 2015 with a gradual increase in rates thereafter. This is my baseline.
  2. If unemployment continues to drop at the same rate as recent months, bring forward the rate hike to the first quarter but continue to assume a gradual increase.
  3. If core-PCE inflation exceeds 2.25% and wage growth is accelerating , expect first quarter liftoff and a steeper path of rate hikes.

Obviously, the data could suggest a delay in the first rate hike, but I do not believe the risks are weighted in that direction. I think the risks are weighted toward tighter than expected policy.

Bottom Line: Fairly straightforward minutes. Policy is data dependent. The Fed, like all of us, are simply waiting to see how that data evolves.

Wednesday, July 09, 2014

Fed Watch: When The Fed Starts Raising Rates

Tim Duy:

When The Fed Starts Raising Rates, by Tim Duy: Via Twitter, modest proposal summarizes my last post:
Shorter @TimDuy, short the front end not the 10 year because the Fed will tighten before inflation is a problem
— modest proposal (@modestproposal1) July 7, 2014
This made me think about the last tightening cycle. For those that hope to use tighter monetary policy to bolster the case against equities, recall that patience may be required:


For those making the bear case against long bonds, recall that initially long rates fell, and over the entire cycle rose just (roughly) 50bp:


The short end of the curve suffered, and the yield curve inverted:


How does this compare to now? If we consider last December's taper the beginning of this tightening cycle (the Fed does not; they prefer to think of it at reducing financial accommodation), stocks continue to power higher:


The 10 year bond initially fell on the taper talk and the yield curve steepened through the 10 year. But that steepening ended when the taper began:


More interesting is the flattening of the very long end after the taper began:


It looks like rates are signalling that the Fed will act to contain activity such that the economy does not overheat. Which, assuming the Fed maintains its current reaction function, tends to support modest porposal's interpretation - favor the long end of the curve over the short end.
I think the flattening of the yield curve should be a concern to the Fed. It suggests that while we frequently hear Janet Yellen described as a dove, the expectation is that her actual policy approach will be cautious bordering on hawkish. Not good if you think like Andy Harless:
I will consider Yellen's tenure a failure if the economy does not overheat.
— Andy Harless (@AndyHarless) July 5, 2014
I am sympathetic to this view. I would be a little more optimistic that the Fed would have more room to maneuver in the next recession if the long-end of the yield curve was signalling that the Fed was a little behind instead of a little ahead. And for more on why that is important, see Brad DeLong and his 17 tweet bear case for inflation.

Monday, July 07, 2014

Fed Watch: Inflation Hysteria Redux

Tim Duy:

Inflation Hysteria Redux, by Tim Duy: I am in general agreement with Calculated Risk on this point:

I also think the economy is picking up, and I agree that as slack diminishes, we will probably see real wage growth and an uptick in inflation.

Moreover, note that this is largely consistent with the Federal Reserve's outlook as well. Recall St. Louis Federal Reserve President John Williams from April, via Bloomberg:

Williams, who forecast the Fed will start raising interest rates in the second half of next year, said inflation has “bottomed out” and will gradually accelerate to the central bank’s 2 percent target. He said prices have been held down by temporary forces such as a slowdown in health care costs.

The Federal Reserve has consistently predicted higher inflation, and consistently been surprised that that inflation has not yet arrived despite rapidly falling unemployment rates. It would appear, however, that their forecasts are finally coming true. Hence, I also agree with Calculated Risk when he says:

On inflation: I'm sympathetic to people like Joe Weisenthal at Business Insider who is looking for signs of inflation increasing; I'm starting to look for signs of real wage increases and inflation too. I just think inflation isn't a concern right now (Weisenthal was correct on inflation over the last several years in contrast to the people who were consistently wrong on inflation).

It is enough to simply say that inflation is coming. That in and of itself is insufficient. Any inflation call needs to be placed in the context of magnitude and expected monetary policy response. Regarding both, follow Calculated Risk's warning:

Monetary policy can't halt the violence in Iraq or make it rain in California - and this is why it is important to track various core measures of inflation.

The Fed doesn't target core inflation. They target headline inflation. But they also believe that headline inflation will revert to core, and as such tend to be more concerned with core inflation in excess of 2%. Consider the history of core inflation since 1985:


I included a 25pb "forecast error" band around the Federal Reserve stated 2% target for PCE inflation; no one believes they can consistently hit 2% in the short-term, hence it is a medium term target. The most obvious feature is that for the last twenty years, core measures of inflation have more often than not been at or below the the upper range of the Fed's error band, especially for core-PCE inflation. Average core-PCE inflation: 1.7%. Average core-CPI inflation: 2.2%. Indeed, if core-PCE were the target, it is fairly clear that the Fed would have been on average undershooting its objective for the past two decades.
It is simply difficult for me to become too worried about inflation given the history of the past twenty years - twenty years in which the US economy was at times substantially outperforming the current environment no less. Underlying inflation simply has not be a problem.
It was not a problem because the Federal Reserve tightened policy multiple times to preempt inflation. Expect the same during this cycle as well - the Fed will begin to gradually raise interest rates sometime next year, and they will maintain a gradual pace of tightening as long as they believe core-PCE will consistently average 2.25% or less. Currently, I anticipate the first rate hike will occur in the second quarter of 2015. If the unemployment rate falls to 5.5% by the end of this year, I would expect the first hike to be in the first quarter of 2015.
What about headline inflation? Headline inflation is at the mercy of the Middle East and the weather, leaving it more volatile than core:


Average PCE inflation since 1994: 1.9%. Average CPI inflation since 1994: 2.4%. Arguably a pretty good track record. It is really no wonder that it is so difficult to motivate the inflation lectures in Principles of Macroeconomics. All the students are twenty or less years old. They simply have no experience with inflation as a troubling 1970s-style phenomenon.
How will headline inflation influence monetary policy? If you combine headline inflation well in excess of 2.25% (I suspect something more like 3%) with tight labor markets and rapid wage/unit labor cost growth, I think the Fed will accelerate the pace of tightening (indeed, the second two conditions alone would probably do the trick). If we experience high headline inflation in the context of weak wage growth, expect the gradual pace of tightening to continue. Under those circumstances, the Fed will believe that headline inflation will depress demand and lessen inflationary pressures endogenously.
Bottom Line: If you are making a short-term bet on higher headline inflation, primarily you are making a bet on energy and food. That bet is about the Middle East and weather, not monetary policy. I don't have an opinion on that bet. If you are betting on inflation over the medium-term, primarily you are making a bet on higher core inflation. More to the point, you are betting against the Fed. You are essentially betting that the Fed will not do what it has done since Federal Reserve Chair Paul Volker - tighten policy in the face of credible inflationary pressures. I would think twice, maybe three times before making that bet.

Thursday, July 03, 2014

Fed Watch: June Employment Report

Tim Duy:

June Employment Report, by Tim Duy: The BLS reported solid numbers for the labor market in June, although there may be somewhat less acceleration than meets the eye. On net, the ongoing rapid fall in the unemployment rate nudges forward my expectation of when the Fed makes history and begins to lift rates from the zero bound. Still, there does not appear to be sufficient reason yet to believe the Fed will steepen the pace of increases.
Nonfarm payrolls rose by 288k, ahead of expectations for 211k. Job growth was broad-based and earlier months were revised higher. The three-month average for job growth is at its highest since 2011 while the 12-month average is slowly crawling up and now stands above 200k:


It is worth remembering that in order to maintain constant percentage changes over time, the absolute change has to increase. Indeed, the acceleration in percentage terms over the past year looks less than impressive:


Still somewhat below that experienced at the height of the housing bubble, clearly weaker then the late 1990s, and note in particular the acceleration in the early 1990's. It was that kind of acceleration that caught the Fed's attention. We are not seeing anything like that yet.
Also note that while hours worked has recovered from the winter doldrums, it too is not growing at some blockbuster pace:



In short, in some sense the excitement over the recent improvement in absolute job growth says less about an acceleration in actual activty and more about our diminished expectations for this recovery.
The persistent decline in the unemployment rate will undoubtedly cause consternation among the more hawkish FOMC members:


Recall St. Louis Federal Reserve President James Bullard recent warning:
The Federal Open Market Committee is closer to its goals for full employment and low and stable inflation than many investors realize, Bullard said. He predicted the pace of economic growth will accelerate to 3 percent this year after an unexpectedly deep first-quarter contraction.
“Inflation is picking up now. It is still below target but it has been moving up in recent months,” he said in response to a question at a forum organized by the Council on Foreign Relations. “I don’t think financial markets have internalized how close we are to our ultimate goals, and I don’t think the FOMC has internalized how close we are.”
Bullard's story in a picture:


As the Fed closes in on its traditional policy goals, the pressure from the hawks, and even the center, for a rate increase will increase. Still, the doves are not without a defence. Federal Reserve Chair Janet Yellen's measures of underemployment are still underwhelming:


In particular, wage growth has stalled, adding additional credence to the argument that substantial labor market slack remains despite the decline in the unemployment rate:


Also note that there is nothing here yet to challenge the more general consensus among policymakers that equilibrium interest rates are lower than in past cycles.
Bottom Line: The jobs report is generally good news, albeit I would argue there remains room for substantial improvement. That room for improvement continues to restrain the Fed from dramatically tighter policy. My expectations for the first rate hike center around the middle of next year. On net, this report drags my expectations forward somewhat and suggests a higher probability of a hike before June than after June. Score one for the FOMC hawks. But I also see little here yet to suggest the need for any dramatic tightening; I doubt FOMC's expectation of a long, gradual tightening cycle is much altered. That's one for the doves.

Monday, June 23, 2014

Fed Watch: Inflation Hysteria

Tim Duy:

Inflation Hysteria, by Tim Duy: It appears that a case of inflation hysteria is gripping Wall Street. Joe Weisenthal at Business Insider sums up the current state of play:
Here's what's on Wall Street's mind right now: Inflation is finally happening, and the Fed will end up being behind the curve.
...there were two big moments this week.
1) There was the jump in Core CPI that was the biggest since 2009.
2) And then there was the Janet Yellen press conference, in which she said that the CPI jump could be just "noise" and that the recent drop in the unemployment rate was not actually reflective of the true state of the labor market (which she regards as considerably weaker due to measures of worker discouragement).
In other words, despite data showing that the Fed is getting close to hitting its economic goals, Yellen doesn't believe the numbers.
But Wall Street does believe the numbers. 
Hence the view that the Fed will be behind the curve.
Goodness, you would think it is 1975. It is probably instructive to stop and see what all the fuss is about:


Missed it?  Maybe we should zoom in:


Although core-CPI is about to brush up on 2%, core-PCE remains well below, and it is the latter that is most important to policy. You might note that the Fed was raising interest rates in the late 1990s despite sub-2% core PCE, apparently responding to high CPI inflation. But that episode needs to be considered in light of the job market at the time, which, if you recall, was clearly on fire. There was no concern that broader measures of unemployment were signalling excess slack:


The current situation is different - there is excess slack in the labor market, as revealed by restrained wage growth. This is important. Wall Street might believe the CPI numbers that Yellen dismissed, but that is jumping the gun in any event.  As Across the Curve explains succinctly:
The labor market remains less than robust and wage gains are stagnant. Until we see consistent wage gains which would foster spending which fosters revenue and net income and then the virtuous cycle fulfills itself via business investment it is hard to imagine that we get a sustained uptick in inflation.
Which is essentially what Federal Reserve Chair Janet Yellen explained in her press conference:
You know, I see compensation growth broadly speaking as having been very well contained. By most measures, compensation growth is running around 2 percent. So that's real wage growth or real compensation growth that's essentially flat rather than rising, and real wage growth really has not been rising in line with productivity. My own expectation is that as the labor market begins to tighten, we will see wage growth pick up some to the point where real wage growth, where compensation or nominal wages are rising more rapidly than inflation, so households are getting a real increase in their take home pay. And within limits--well, that might be signs of a tighter labor market. Within limits, it's not a threat to inflation because consistent with the level of inflation we have for our 2 percent inflation objective, we could see wages growing at a more rapid rate and a somewhat more rapid rate. And indeed, that would be part of my forecast of what we would see as the labor market picks up. If we were to fail to see that, frankly I would worry about downside risk to consumer spending. So I think part of my confidence and the fact we'll see a pickup in growth relates to the fact that I think consumer spending will continue to grow at a healthy rate. And in part, that's premised on some pickup in the rate of wage growth so that it's rising greater more than inflation.
So what is going on here?  Inflation is not a sustained phenomenon in the absence of participation from wage dynamics.  If inflation accelerates while wage growth remains stagnant, demand will soften and so too will any incipient price pressures. Hence why Yellen sees the potential for downside risk for consumer spending in the absence of stronger wage growth.  Moreover, as she notes, wage growth itself is not inflationary. We would expect wage growth should exceed inflation such that real wages grow to account for rising productivity. We might then expect inflation to be correlated with unit labor costs, and it is:


If you expect to see sustained higher inflation, you need to see sustained higher unit labor cost growth.  No way around it. And even then you need to assume that firms respond by raising prices, rather than seeing profit erode.  Note in particular sustained high unit labor cost growth in the late 1990s. 
In short, you shouldn't be looking at the inflation numbers without understanding the underlying wage dynamic. It isn't until wages start to push higher that inflation becomes a more interesting issue.  
So how should we be thinking about this? The Fed recognizes that they are coming closer to meeting their goals based on their traditional unemployment metrics. They are discounting those metrics for the moment, and with good reason. In the absence of accelerated wage growth, pops of inflation are just noise. They anticipate that wage growth will not emerge more forcefully until after underemployment measures fall to more normal levels. Hence as the measures approach normal levels - sometime next year - they will begin raising interest rates. I suspect this will be prior to a substantial acceleration in wage growth, on the assumption that they will feel a need to be somewhat ahead of the curve.  
What would accelerate this process? First, a more rapid improvement in underemployment. Second, sufficient wage acceleration such that they are confident labor market slack has been eliminated prior to normalization of unemployment measures (in essence, the acceptance of permanent damage from the recession). If conditions one and two hold, but core-PCE measures hold below 2.25%, they will likely raise rates gradually. If core-PCE accelerates beyond 2.25%, the pace of rate increases will accelerate. 
Finally, the Fed will likely be watching 5-year, 5-year forward inflation expectations as a gauge of how far they are falling behind the curve. I can't imagine they are worried yet:


Bottom Line:  Tighter policy is coming. If you are worried the Fed will accelerate the timing and pace of tightening (and I do believe the risk is weighted in this direction), your focus should be on the labor market and wage growth dynamic. Note too that if Wall Street believes the Fed will need to tighten more aggressively than currently planned on the basis of recent inflation readings, market participants must clearly expect that Yellen and Co. take the 2% inflation target more than seriously.  

Thursday, June 19, 2014

Fed Watch: Janet Yellen the Hawk

One more from Tim Duy:

Janet Yellen the Hawk, by Tim Duy: Yesterday I wrote a fairly conventional analysis of the outcome of the FOMC meeting and the subsequent press conference by Federal Reserve Chair Janet Yellen.  I think that analysis is consistent with that of the median policymaker on Constitution Avenue:  As long as the economy continues to grind upward at a moderate pace and inflation pressures remain constrained, the expected path of short term interest rates is one of a slow rise with the first hike somewhere around a year away.
That view is, of course, data dependent, and given the current readings on inflation and unemployment, combined with a policy stance that is basically ignoring both in favor of untested measures of underemployment, the risk is that the rate path is steeper, and the first hike comes sooner, than currently anticipated.  Under the current circumstances, I expect the median policymaker's willingness to risk falling behind the curve will decrease during the next six months. 
Moreover, I would caution against interpreting Yellen's soft inflation outlook as her being soft on inflation.  I think quite the opposite message came through at yesterday's press conference.  Yellen was showing her hawkish side. 
First, note that the Fed's terminal Federal Funds rate edged down to 3.75% from 4% in March, a consequence of falling estimates of potential growth.  The Fed thus appears to be conforming to the "new normal" in which equilibrium interest rates have fallen.  In short, the Fed appears to take the terminal Fed Funds rates as exogenous.  
The terminal Fed Funds rates, however, is not exogenous.  It is an inflation markup over estimates of potential growth.  The Fed could allow interest rates to return to normal by allowing expected inflation to rise.  From the Fed's point of view, however, the inflation rate is really not an endogenous choice.  They view the 2% target is essentially exogenous, a number handed down in scripture, an element of the Ten Commandments.  That the Fed should allow estimates of the terminal Fed Funds rate to fall is a testament to their commitment to the 2% target.
Second, it is not clear that the potential growth rate is entirely exogenous.  In her press conference, Yellen commented that lower potential growth estimates are a consequence of slower investment (less capital formation) and persistent damage to the labor market.  In the secular stagnation scenario, however, these are arguably the consequences of holding real interest rates too high and deliberately allowing the cyclical damage to become structural.  But at the zero bound, the Fed would need to target higher inflation expectations to lower the real interest rate further.  That is not on the table.  The lower bound on real interest rates is -2% because the upper bound on inflation is 2%.
In other words, Yellen and Co. are so committed to the 2% inflation target that they are willing to tolerate a persistently lower level of national output to maintain that target.   That sounds pretty hawkish to me.
Finally, Yellen's willingness of allow overshooting of the inflation target are, in my opinion, less than meets the eye.  Financial reporters very much need to pin her and other policymakers down on this topic.  I suspect when they say overshooting, what they mean is no more than 25bp over target in the context of anchored inflation expectations.  If inflation expectations are anchored, however, expected real interest rates are not changing.  The loose comments about overshooting are nothing more than a commitment to not overreact to forecast errors.  It doesn't mean that the Fed will not raise interest rates in the face of overshooting, only that they will calibrate the rate of increase relative to their confidence that the overshooting is a forecast error.
Bottom Line:  Soft on the inflation forecast is not the same as soft on inflation.  Don't underestimate the Fed's commitment to the 2% target.  That commitment is what pushes the risk to the hawkish side of the policy equation in the current environment.

Fed Watch: Still a Dove

Tim Duy:

Still a Dove, by Tim Duy: The FOMC delivered as expected today, with virtually no change to policy.  The tapering continues with another $10 billion cut to the pace of asset purchases, which was essentially the only change to the FOMC statement aside from the description of the economy.  The Wall Street Journal tracks the changes here.
The Fed downgraded their GDP forecast, as expected given the weak Q1 numbers.  They did not include any upward offsets in subsequent years.  Consequently, the expected trajectory of output falls further short of current estimates of potential:


Expect estimates of potential output to come down even further.  In contrast, the unemployment forecast was revised to the more optimistic side:


while the inflation forecast was virtually unchanged.  As might be expected given an improving unemployment outlook, the interest rate projections were slightly more hawkish.  Still, Yellen cautioned against reading this as a change in the outlook, instead attributing it to a change in FOMC members.  The unstated implication is that the FOMC has moved in a slightly more hawkish direction, raising the possibility that Yellen could become more isolated in the months ahead in her generally dovish stance, assuming of course that the tension between the Fed's stated policy goals and the stance of policy continues to grow.
And, as Joe Weisenthal at Business Insider notes, Yellen again proves she is indeed a dove.  She dismissed recently higher inflation readings as noise, specifically drew attention to broad measures of unemployment, and said (correctly) that wage growth itself does not necessarily indicate inflation pressures would be far behind.  No indication that she is in any rush to raise rates whatsoever.
Bottom Line:  Policy remains the same - the Fed continues to expect a long-period of relatively low interest rates.  Given current unemployment and inflation numbers, I continue to expect the risk remains on the more hawkish side of that story.  But that is my assessment of the risk, not of the baseline.
Sorry for the quick post - scheduled to be in Portland in a few hours. 

Monday, June 16, 2014

Fed Watch: FOMC Preview

Tim Duy:

FOMC Preview, by Tim Duy: The FOMC is set this week to cut another $10 billion from its asset purchase program.  The statement itself will most likely point toward additional confidence that the first quarter slowdown was an aberration, and may even point to signs that inflation has bottomed and is headed higher.  Both will give the Federal Reserve more confidence in their existing forecasts.  The forecasts will likely be very similar to those issued in January, albeit with some modifications.  The output forecast may be adjusted to account for Q1 weakness, while the unemployment forecast is likely to be edged down once again.  The latter is more important; the expected timing of the first rate hike may be pulled forward slightly.  The addition of new board members puts something of a wildcard into play, but my expectation is that if a policy change is brewing, it would more likely to show itself in Federal Reserve Chair Janet Yellen's post-FOMC press conference rather than the statement itself.
Incoming data continues to indicate the extreme weakness of the first quarter - estimates continue to fall, with Goldman Sachs now expecting -1.9% - was temporary.  Job growth has proved to be resilient, albeit I still feel it remains fairly restrained.  The recent bounce above the longer term trend does not signal to me a sizable acceleration in underlying economy:


Neither does the path of aggregate weekly hours:


Nor the growth of retail sales:


Nor industrial indicators:


The JOLTS report is a little more reassuring with the gain in job openings:


In short, maybe the economy is set to take-off as Joe Weisenthal at Business Insider expects, but my read is a little more cautious.  Regardless, the data are sufficient for Federal Reserve members to hold true to the basic outline of their January forecasts.  Any lingering thought of delaying the taper is long gone.  
Nor do I think that even if the economy does accelerate the Fed will step up the pace of tapering.  It is all about the calendar - by the time the Fed is confident that stronger growth is sustainable, the asset purchase program will be almost complete anyway.  At best it would impact the size of the final cut - $15 billion in October or $5 billion in December.  Little difference in either case.  For the most part, when and if stronger growth shows up in policy, it will show up in the form of moving forward the first rate hike and accelerating the pace of subsequent rate hikes.
The question on my mind is the possibility the Fed turns more hawkish in the months ahead even if output progresses along their existing expectation.  Even along the tepid pace of growth seen to date, the combination of falling unemployment:


and inflation potentially bottoming out and turning up:


means the Federal Reserve is closer to meeting their stated policy goals, a point made by St. Louis President James Bullard with pictures like this:


And note too that traditional indicators of monetary policy also continue to point higher:


This kind of data will put increasing strain on the underemployment story.  To date, the Fed has been committed to that story on the basis of low wage growth:


Increasingly the Fed will be concerned that the balance of risks is shifting from prematurely reducing financial accommodation to concern about falling behind the curve.  And that transition may be abrupt - not unlike what we witnessed recently on the other side of the pond.  Via Bloomberg:
Mark Carney said rising U.K. mortgage debt may threaten Britain’s recovery as he signaled interest rates might start to rise earlier than anticipated.
While investors don’t see the Bank of England’s benchmark rate increasing until next April, the central bank governor said it “could happen sooner than markets currently expect.” Higher borrowing costs could stretch over-leveraged households and undermine financial stability, he said.
All that said, if such a change were to occur, it will not be in this week's statement.  My expectation is that Yellen sticks to the fairly dovish tune she has been singing.  If there are clues that the tenor of the tune is changing I think they would be subtle.  Watch for any language from Yellen regarding proximity to goals, optimism on the JOLTS numbers, or references to inflation bottoming out and turning higher.  These would be hints that the Fed is increasingly concerned of the possibility of falling behind the curve.  Such talk would also hint at the possibility that the new Board members seek to edge policy in a different direction.
On the other side of the coin, look for policymakers to make note of geopolitical risk.  The mess in Iraq is already pushing oil prices higher, which the Fed should read as more likely to soften the recovery rather than fuel inflation
Bottom Line:  My baseline expectation is minimal policy changes this week.  Moreover, my baseline remains a still long period of low rates.  I think the Federal Reserve would like to hold onto the "low wage growth means plenty of slack and no inflation story" as long as possible.   Watch also the geopolitical risk, as that will tend to reinforce the Fed's existing path.  Overall, the situation altogether still argues for the first rate hike in the second half of next year.  The Fed's low rate story, however, will come under increasing pressure as the Fed gets closer to reaching its policy goals.  And that pressure will only intensify if growth does in fact accelerate.  That leaves me feeling that the risk to my baseline assumption is that the first rate hike comes sooner than currently anticipated.

Wednesday, May 28, 2014

Fed Watch: Policy Induced Mediocrity?

Tim Duy:

Policy Induced Mediocrity?, by Tim Duy: Why did the Federal Reserve lean against their optimistic 2014 forecast? It seems that monetary policy over the past year can be summarized as a missed opportunity to supercharge the recovery, thereby locking the US economy into a suboptimal growth path.
Last week's speech by New York Federal Reserve President William Dudley noted the reasons monetary policymakers expected the economy to improve this year:
Since the downturn ended in mid-2009, real GDP growth has averaged only 2.2 percent per year despite a very accommodative monetary policy. This performance reflects three major factors—the significant headwinds resulting from the bursting of the housing bubble, the shift of fiscal policy from expansion toward restraint, especially in 2012 and 2013, and a series of shocks from abroad—most notably the European crisis.
The good news is that all three of these factors have abated. With respect to the headwinds resulting from the financial crisis, they are gradually becoming less severe. In particular, the sharp decline in household wealth due to the decline in housing prices and the weakness in equity prices has been largely reversed...On the fiscal side, the amount of restraint has diminished sharply. For 2014, the projected drag is about ½ percent of GDP, roughly half the level of 2013. Moreover, much of this restraint was frontloaded into the beginning of the year...In terms of the outlook abroad, the circumstances are more mixed.
The Federal Reserve could have chosen to lean into this generally upbeat forecast. Yet instead they chose to lean against it by turning to tapering and setting the stage for interest rate hikes. And the data so far suggests that once again the turn toward policy normalization was premature. The weak first quarter report is more suggestive of holding the recent pace of growth over the next year rather than an acceleration of activity. What is remarkable is that the Federal Reserve understood that their forecasts have tended toward optimism. Dudley again:
But, there remains considerable uncertainty about that forecast and, given the persistent over-optimism about the growth outlook by Federal Reserve officials and others in recent years, we shouldn’t count our chickens before they hatch.
Yet they choose to act prior to data confirmation. Why? I really don't quite know. Sure, we can tell a story about the declining unemployment rate and expected subsequent inflation pressures, but ultimately the turn toward less policy accommodation never made sense in the context of the Fed's own forecasts and questions about the degree of slack in the economy. It makes me wonder how seriously the Fed is truly interested in closing the output gap:


It seems reasonable to believe that if the economy regains potential output by the end of at best 2016, it will be attributable only to further downward revisions to potential output. And I even wonder whether the Fed would act to achieve their current growth forecasts or ultimately be content to continue along the current trend. The economy appears to be already molding itself around the lower output path. Despite the housing troubles and related weak rebound in construction, and the declines in government hiring, job growth is, on average, plugging along at a rate roughly consistent to that during the housing boom:


With that growth labor slack gradually steadily declines by any measure, the Fed appears reasonably comfortable with the resulting path. To be sure, arguably there still remains substantial slack. The failure of wage gains to accelerate is consistent with that story. But the Fed seems content to use that story only to justify its current policy path rather than justify an even easier policy to more quickly reduce slack.
Given the generally consistent overall reaction of the labor market to the current growth path, it is reasonable to believe that the faster pace of growth in the Fed's forecast would accelerate the pace of labor utilization and thus place upward pressure on inflation forecasts. In this case, we would expect the Fed to pull forward and steepen the pace of rate hikes to moderate the pace of activity. Thus, ultimately the Fed's commitment to regaining potential output could be even less than we have come to believe.
But even more telling would be the monetary policy reaction if growth continues along its current path. The weak first quarter results already place the forecast at risk, and the housing recovery is not progressing as smoothly as initially believed. Yet neither event prevented the Fed from continuing to cut asset purchases at the last FOMC meeting. Moreover, I still can't see any reason to expect the Fed will slow the tapering process unless the economy falls decisively off its current path. It could be that by the time they are sufficiently convinced growth will continue to fall short of forecast, asset purchases will be almost complete anyway. And I think the bar to restarting asset purchases would be very high. They want out of that business.
And if neither fiscal or monetary policy makers are interested in accelerating the pace of growth, should we really expect the pace of growth to accelerate? In other words, it appears to me that monetary policy largely amounts to setting expectations that reinforce the current growth path. Which was a recent topic of Bloomberg's Rich Miller who, reporting on the Fed's diminished expectations, quotes me:
By lowering its assessment of how fast the economy can expand and conducting policy accordingly, the Fed runs the risk of locking the U.S. into a slow-growth path, said Tim Duy, a former Treasury Department economist who is now a professor at the University of Oregon in Eugene...
...“They offset fiscal austerity on the downside but then arguably also offset the upside,” Duy said. “They seem to have lost interest in speeding the pace of the recovery.”
Bottom Line: The Federal Reserve has set reasonably clear expectations that rates will remain low for a long time. That path, however, seems to be a consequence of doing too little now to ensure a stronger recovery. In other words, the Fed seems to be taking a lower-rate future as a given rather than as a result of insufficient policy. Instead of acting to ensure a stronger forecast, they seem more interesting in acting to lock-in the lower path of activity. And that in turn will tend to lock in a low level of long-term rates. This, I think, is the best explanation for the inability of markets to sustain higher rates. It is simply reasonable to expect that the conditions which justify higher long rates will be met with tighter policy sufficient to contain growth to something closer to the current path of output than to current estimates of potential output.

Wednesday, May 21, 2014

Fed Watch: Dudley Revisits Exit Strategy

Tim Duy:

Dudley Revisits Exit Strategy, by Tim Duy: Today New York Federal Reserve President William Dudley gave what was both an interesting and depressing speech. Interesting in that he provides some new thoughts on the exit strategy. Depressing in that he outlines a case for persistently low interest rates. One wonders why, given such an outlook, the Fed is so firmly focused on the exit strategy to begin with, rather than accelerating the pace of the recovery.
Dudley tries to sound an optimistic note regarding the outlook, including dismissing the first quarter GDP report, but his optimism is tempered, very tempered:
With the fundamentals of the economy improving and fiscal drag abating, I expect the economy to get back on to a roughly 3 percent growth trajectory over the remainder of this year, with some further strengthening likely in 2015. But, there remains considerable uncertainty about that forecast and, given the persistent over-optimism about the growth outlook by Federal Reserve officials and others in recent years, we shouldn’t count our chickens before they hatch.
Three percent growth is not exactly anything to write home about; the only thing exciting about 3 percent is that we just can't seem to get there. Dudley specifically notes weak capital spending and housing markets as key concerns. He senses that the capital spending issue is transitory, but housing less so:
I think housing has been weaker than anticipated because several significant headwinds persist for this sector. First, mortgage credit is still not readily available to households with lower credit scores. Second, some people are coping with higher student loan debt burdens that have delayed their entry into the housing market as first-time homebuyers. This, in turn, makes it more difficult for existing homeowners to sell and trade-up. Third, there may be some ongoing difficulties increasing housing supply. The housing downturn was very deep and protracted. It takes time to shift resources back into this area. Also, in some markets house prices still appear to be below the cost of building a new home. Thus, in those markets, it remains uneconomic to undertake new home construction. Although I expect that the housing recovery will resume, the pace will likely be slow, especially relative to past economic recoveries.
Notice that he does not mention the mortgage rate increase over the past year, instead focusing on issues largely outside the control of the Federal Reserve. In other words, housing is a problem that they can't fix and thus will simply contribute to weak growth. Regarding inflation, Dudley is optimistic that the trajectory will prove to be in the right direction, but sees little reason to expect any sharp increases. There is simply too much slack in the labor market, evidenced by low wage growth. Here he paints a bleak picture and lays down some markers:
...the trend of labor compensation is running at only about a 2 percent annualized pace. This is far below the roughly 3½ percent pace that would be consistent with trend productivity growth of 1 to 1½ percent and the FOMC’s 2 percent inflation objective.
Trend productivity growth of just 1 to 1.5 percent is very, very low and feeds into the Fed's belief that potential growth is in the 2.2 to 2.3 percent range. Dudley's expected 3 percent growth thus hardly eats into excess capacity. Still surprises me that the Fed remains focused on policy firming when arguably conditions require a delay in the tapering process.
On that inflation target, Dudley argues against the "2 percent is a ceiling" hypothesis:
...once we reach 2 percent, I would expect that we would spend as much time slightly above 2 percent as below it, recognizing that we will hardly ever be exactly at 2 percent because of the inherent volatility in prices. If inflation were to drift above 2 percent, all else equal, then we would tend to resist such a rise. But, if inflation were slightly above 2 percent even as unemployment remained far above levels consistent with maximum employment, then the unemployment consideration would dominate because we would be further from the unemployment objective than we are from the inflation objective. This should not surprise anyone. This is what our “balanced approach” implies.
The operative word here is "slightly." What is "slightly" above 2 percent? My guess is that as long as inflation remains below 2.25 percent and employment outcomes remain subpar, the Fed will remain on a low-interest rate path (though not a zero rate path). Above 2.25 would be more disconcerting but, realistically, it is unlikely that the US economy would experience higher inflation in the absence of clear evidence that labor market slack had evaporated. In other words, I suspect that if inflation were above 2.25 percent, the Fed would not need to choose between the elements of the dual mandate; the case for a higher rate trajectory would be clear.
Dudley anticipates that the tapering process will continue, and thus turns his attention to the lift-off from the zero bound. Here he admits the reality of the situation. They really have no idea when the first rate increase will occur:
Turning first to the timing of lift-off, how the outlook evolves matters. We currently anticipate that a considerable period of time will elapse between the end of asset purchases and lift-off, but precisely how long is difficult to say given the inherent uncertainties surrounding the outlook.
I would congratulate him for avoiding the use of a date, but then he includes a footnote pointing to the March Summary of Economic Projections and the embedded anticipation that rates will rise in the middle of next year. Fed officials simply can't decide whether those projections are meaningful or not.
As far as the pace of timing, that too is data dependent, although given the current forecasts Dudley anticipates a tame trajectory:
With respect to the trajectory of rates after lift-off, this also is highly dependent on how the economy evolves. My current thinking is that the pace of tightening will probably be relatively slow. This depends, however, in large part, not only on the economy’s performance, but also on how financial conditions respond to tightening.
And he too expects rates will be subdued over the longer term, laying out three reasons:
First, economic headwinds seem likely to persist for several more years...Second, slower growth of the labor force due to the aging of the population and moderate productivity growth imply a lower potential real GDP growth rate as compared to the 1990s and 2000s. Because the level of real equilibrium interest rates appears to be positively related to potential real GDP growth, this slower trend implies lower real equilibrium interest rates even after all the current headwinds fully dissipate...Third, changes in bank regulation may also imply a somewhat lower long-term equilibrium rate.
When it comes to the Fed's exit from extraordinary monetary policy, Dudley throws in a new twist. Conventional wisdom is that the Fed would stop reinvesting the principal payments on assets held by the Fed prior to raising rates. Dudley suggests this might not be a wise decision. First, he argues that this might send the wrong signal to financial markets:
Ending reinvestments as an initial step risks inadvertently bringing forward any tightening of financial conditions as this might foreshadow the impending lift-off date for rates in a manner inconsistent with the Committee’s intention.
Second - which seems to be in contradiction to the first - it that he prefers lifting rates to enhance policy flexibility:
Second, when conditions permit, it would be desirable to get off the zero lower bound in order to regain some monetary policy flexibility. This goal would argue for lift-off occurring first followed by the end of reinvestment, rather than vice versa. Delaying the end of reinvestment puts the emphasis where it needs to be—getting off the zero lower bound for interest rates. In my opinion, this is far more important than the consequences of the balance sheet being a little larger for a little longer.
Dudley is saying that the Fed can reduce accommodation via raising rates or reducing the balance sheet, and they should should begin with the former to normalize policy. This reveals his confidence in being able to manage the balance sheet while raising rates, the topic of which takes up the remainder of his speech. Note the qualifier "when conditions permit." This is not about tightening policy simply in order to get rates higher; it is about how to tighten policy - what mix of tools to use - when the time to tighten comes.
I don't quite see the communications challenges Dudley describes. In order to prevent expectations of an earlier rate hike we should hike rates rather than end reinvestments? Not sure this makes much sense. Maybe better to just say that they will reduce accommodation further when appropriate, and that process will involve some mix of rate hikes and balance sheet reduction, the exact mix to be determined by evolving economic and financial conditions.
Bottom Line: Dudley reinforces expectations that the low rate environment will persist long into the future. The data flow is not providing reason to think otherwise at this point; we would need to see higher inflation numbers coupled with real reason to believe labor market slack was rapidly evaporating, probably in the form of stronger wage growth. It remains interesting that the Fed does not view their own outlook as reason to accelerate the pace of activity. They seem relatively content to accept what they themselves acknowledge is an ongoing disappointment.
[PS: Still in light blogging mode. Preoccupied with teaching this term.]

Monday, May 05, 2014

Fed Watch: Difficult Labor Report

Tim Duy:

Difficult Labor Report, by Tim Duy: The headlines numbers from the April employment report are at first blush a challenge to the Fed's low rate commitment.  One doesn't have to dig much deeper into the data, however, to see that the near term implications are minimal as the Fed maintains its strong focus on measures of labor market slack.  Still, the rapid drop in unemployment - if it continues - will leave policymakers increasingly anxious that their one-way bet on labor market slack will quickly turn sour.
Nonfarm payrolls grew pay 288k, well above expectations of 215k.  While this numbers pushes the three-month moving average higher, the longer-term trend remains the same:


Maybe this is the month the acceleration begins.  Maybe not.  Either way, the report supports the dismissal of the weak first quarter growth numbers (now tracking in negative territory) as transitory.  Just as has been the case for the last three years, there is nothing here to suggest a dramatic change in the pace of underlying economic activity.
The unemployment rate decline was a bit more intersting as it collapsed to 6.3% on the back of falling labor force participation:


The downward trend accelerated in the second half of 2013, pushing us ever closer to levels traditionally associated with greater inflationary pressures and with those pressures tighter monetary policy.  Policymakers, however, appear to remain content dismissing the unemployment rate in favor of a wider range of labor market indicators that suggest plenty of slack left in the economy.  Federal Reserve Chair Janet Yellen's current four favorites:


The wage story is, in my opinion, the key.  It is hard to argue against the labor slack story when employees can't push wages significantly higher.  That alone should be enough to stay the Fed's hand.  And if it isn't enough, they can always draw additional comfort from the inflation figures:


Inflation is, at best, only in the process of bottoming.  
All that said, policymakers will be a little anxious that they are too quickly dismissing traditional metrics that would indicate they should be  be adjusting their inflation forecasts higher in light of the unemployment decline.  As I am relatively confident will be much discussed this week, variants of the Taylor rule suggest that policymakers should already be raising rates:


In this environment, policymakers will increasingly worry about the policy lags.  They will want to hold rates low, but the further unemployment drops, the more they will fear that they risk falling behind the curve - that by the time the pace of wages growth accelerates, inflationary pressure will already be well established.  This is especially the case if they view the 2% target as a ceiling.  Hence I remain concerned that the risk is that policy turns sharply tighter relative to current expectations.  
I am also challenged to see why I should not expect the now-infamous dots in the summary of economic projections to be pulled forward on the basis of the falling unemployment rate.  I am looking forward to the next FOMC meeting for that alone.
I emphasize, however, that any substantially tighter policy remains only a "risk," not a baseline. I anticipate that in her Congressional testimony this week, Yellen will emphasize the alternative measures of labor market slack and the Fed's expectation that policy rates will remain well below "normal" rates for a protracted period.  As a general rule one report doesn't change policy.
Bottom Line: Overall, the general contours of the employment report suggest reason to (very) modestly bring forward expected rates hikes, but little to suggest any dramatic change to the Fed's reaction function overall.  Policymakers, however, will worry that the current reaction function is overly dependent on dismissing the unemployment rate as an indicator of inflationary pressure. And there is a risk that they will move quicker than expected if that bet starts to sour.  Risk, not baseline.

Thursday, April 10, 2014

Fed Watch: When Will The Fed Change Its Reaction Function?

Tim Duy:

When Will The Fed Change Its Reaction Function?, by Tim Duy: The March FOMC minutes were generally interpretted as having a dovish tenor, contrasting with the generally hawkish reception for the statement and ensuing press conference. Overall, the Fed appears committed to a long period of low interest rates and I continue to think this should be the baseline view. But actually policy seems to remain hawkish relative to the Fed's rhetoric. By its own admission, the Fed is missing badly on both its mandates. Why then the push to reduce accommodation by ending asset purchases and laying the groundwork for the first rate hike? This leaves me wary the Fed could turn dramatically more hawkish with little provocation from the data. At the same time, one can imagine the Fed realizes that the current reaction function remains inconsistent its desired goals, and policy consequently shifts in a dovish direction.

Consider the Fed's take on labor markets:

In their discussion of labor market developments, participants noted further improvement, on balance, in labor market conditions.

Fair enough. But where is the majority of policymakers on the issue of slack?

While there was general agreement that slack remains in the labor market, participants expressed a range of views regarding the amount of slack and how well the unemployment rate performs as a summary indicator of labor market conditions. Several participants pointed to a number of factors--including the low labor force participation rate and the still-high rates of longer-duration unemployment and of workers employed part time for economic reasons--as suggesting that there might be considerably more labor market slack than indicated by the unemployment rate alone.

The opposing view was held by just a "couple" of participants. The "high slack" contingent holds of the upper hand, in my view, given the limited wage pressure to date:

Several participants cited low nominal wage growth as pointing to the existence of continued labor market slack. Participants also noted the debate in the research literature and elsewhere concerning whether long-term unemployment differs materially from short-term unemployment in its implications for wage and price pressures.

It seems fairly clear that the dominant view on the Fed is that labor markets contain more than sufficient slack to contain wage and inflation pressures. And inflation pressures are, by their own admission, nonexistent. But this concern is not as widespread:

Inflation continued to run below the Committee's 2 percent longer-run objective over the intermeeting period. A couple of participants expressed concern that inflation might not return to 2 percent in the next few years and suggested that a protracted period of inflation below 2 percent raised questions about whether the Committee was providing an appropriate degree of monetary accommodation.

Why is the majority not concerned? Because even as they use low wages to justify claims of sufficient slack in the labor market, they use a forecast of higher wages to dismiss the inflation numbers:

A number of participants noted that a pickup in nominal wage growth would be consistent with labor market conditions moving closer to normal and would support the return of consumer price inflation to the Committee's 2 percent longer-run goal.

But how long will the process take? A long time:

Most participants expected inflation to return to 2 percent over the next few years, supported by stable inflation expectations and the continued gradual recovery in economic activity.

The Federal Reserve is clearing communicating the willingness to endure a sustained period of suboptimal outcomes on both the employment and price stability metrics. This suggest that actual policy - entirely directed at reducing accommodation - is considerably more hawkish than dictated by data. It sounds like policy fatigue. The Fed wants out of asset purchases and zero rates and are willing to dismiss the dual mandate to move in this direction. No wonder then that Chicago Federal Reserve President Charles Evans is worried that policymakers will push too hard to normalize rates too early. Via the Wall Street Journal:

“One of the big risks is that we withdraw our accommodative policies prematurely,” Mr. Evans said during a panel discussion at the International Monetary Fund’s spring meetings. “I think it’s just human nature to start thinking we’ve been doing this for a long time.”

The Fed’s benchmark short-term interest rate has been pinned near zero since late 2008, which could prompt some policy-makers to think “that must have been long enough. Maybe it’s time to start the process of renormalizing,” Mr. Evans said. Most Fed officials indicated last month they expect to start raising rates next year.

Consider also the Fed's willingness to continue the taper despite persistent low inflation in the context of this from Federal Reserve Governor Daniel Tarullo:

Last week Chair Yellen explained why substantial slack very likely remains. I would add to her explanation only the observation that, in the face of some uncertainty as to how best to measure slack, we are well advised to proceed pragmatically. We should remain attentive to evidence that labor markets have actually tightened to the point that there is demonstrable inflationary pressure that would place at risk maintenance of the FOMC's stated inflation target (which, of course, we are currently not meeting on the downside). But we should not rush to act preemptively in anticipation of such pressures based on arguments about the potential increase in structural unemployment in recent years.

Arguably, tapering implies that are already acting prematurely. Combine with this commentary by David Zeros via Business Insider:

"As the market prices in higher short-term yields and lower long-term yields, it is really making a bet that the Fed, by tapering our punchbowl drip, is increasing the risk of deflation," says Zervos.

"And at this stage of the game, with inflation BELOW target and plenty of slack in labor markets, that could very well be a mistake. The most important point here is to recognize that low long-term yields are not a sign of a healthy economy."

Indeed, it is reasonable to believe the Fed will make a mistake in the hawkish direction (or already has) given that policy already seems inconsistent with the dual mandate. In other words, the Fed has a hawkish reaction function.

Regarding that reaction function, the now infamous dots were also a topic of discussion. Policymakers knew exactly the implications of the dots:

A number of participants noted the overall upward shift since December in participants' projections of the federal funds rate included in the March SEP, with some expressing concern that this component of the SEP could be misconstrued as indicating a move by the Committee to a less accommodative reaction function.

The next line, however, is not particularly helpful:

However, several participants noted that the increase in the median projection overstated the shift in the projections.

This begs the question of "why?" Some dots moved forward. Why does that overstate the shift? That said, some participants noted that the shift should not be cause to worry:

In addition, a number of participants observed that an upward shift was arguably warranted by the improvement in participants' outlooks for the labor market since December and therefore need not be viewed as signifying a less accommodative reaction function.

This was my interpretation - the upward shift of the dots were consistent with a change in the unemployment projections given the Fed's reaction function. But that doesn't quite explain why the reaction function is so tight to begin with. This is I think the best explanation:

In their discussion of recent financial developments, participants saw financial conditions as generally consistent with the Committee's policy intentions. However, several participants mentioned trends that, if continued, could become a concern from the perspective of financial stability. A couple of participants pointed to the decline in credit spreads to relatively low levels by historical standards; one of these participants noted the risk of either a sharp rise in spreads, which could have negative repercussions for aggregate demand, or a continuation of the decline in spreads, which could undermine financial stability over time. One participant voiced concern about high levels of margin debt and of equity market valuations as well as a notable shift into commodity investments. Another participant stressed the growth in consumer credit to less creditworthy households.

I think the Fed's reaction function now includes some financial stability variable, but the Fed is loath to discuss that variable and the related parameters impacting policy. That said, we are fairly confident that the push to end asset purchases and plan the exit from zero rates were a response to bubbling financial stability concerns at the Fed. They simply hid that behind the "progress toward goals" language.

More surprisingly is that not only did they begin the exit from extraordinary stimulus in the face of clearly suboptimal labor outcomes, they did so in the face of clearly suboptimal inflation outcomes. Now, though, they may be realizing the error of their ways. Via Jon Hilsenrath at the Wall Street Journal:

Federal Reserve officials are growing concerned the U.S. inflation rate won't budge from low levels, the latest sign of angst among central bankers about weakness in the global economy.

So what comes next? To answer that, we again need to divide policy into movements along the reaction function and shifts of the reaction function. We should recognize that the SEP dots will shift in response to the data. If data comes in stronger than anticipated, then the dots will move forward. If weaker, then backward.

A more hawkish reaction function - the dots moving up and forward independent of the forecast - would most likely occur due to heightened financial stability concerns. A less likely cause is that inflation expectations suddenly jump.

What about a more dovish reaction function? I think it was expected that new Federal Reserve Chair Janet Yellen would have already pushed forward a more dovish reaction function given her expressed concerned for the unemployed. So far, she has disappointed such expectations. Factors that could still trigger a downward shift include 1.) a desire to accelerate the pace of improvement in labor markets, 2.) a lessening of financial stability concerns, 3.) a heightened concern about the negative impacts of persistently low inflation.

The inflation concern is my leading candidate at the moment. Still, I would not want to overestimate the chance of such a shift. It is easy to see that ongoing improvements in labor markets could be sufficient to contain inflation concerns to low rumblings.

Bottom Line: Fed policy - dovish those it seems - is maddenly disconnected from their actual forecasts. What does that mean for future policy? Given the relatively dovish forecast, I am concerned that the balance of risk lies on the upside, which implies tighter policy along the existing reaction function. But at the same time I remain open to the possibility that even if the economy evolves as expected, the Fed could extend the low interest rate horizon via shifting the reaction function down. That said, I suspect there is a fairly high bar to such a shift. As unemployment drops further, they will become increasingly concerned about being caught behind the curve given the level of financial accommodation already in place.

Friday, April 04, 2014

Fed Watch: One For the Doves

Tim Duy:

One For the Doves, by Tim Duy: The March employment report came in pretty much in line with expectations. Nonfarm payrolls gained by 192k, and January and February were both revised higher. If you can discern any meaningful change in the underlying pace of economic activity from the nonfarm payrolls numbers, you have sharper eyes than me:


You could almost draw that twelve month trend with a ruler. The unemployment rate moved sideways:


In the past, sharp declines in the unemployment rate have been followed by periods of relative stability. I suspect we are currently in one such period.
The internals of the household report were generally positive. The labor force rose by 503k, pushing the participation rate up by 0.2 percentage points. And the labor market appeared to absorb those new participants nicely, with employment rise by 476k while the ranks of unemployed grew by just 27k. Measures of underemployment remain consistent with recent trends:


As might be expected if there remains plenty of slack in labor markets, wage growth remained largely unchanged:


I would say that on average, this report fits nicely with the view outlined by Federal Reserve Chair Janet Yellen earlier this week. The labor market continues to improve at a moderate pace, a pace that remains insufficient to rapidly alleviate the issues of underemployment and low wage growth. Indeed, combined with the readings on inflation:



I think the real policy question should be why is the Fed engaged in reducing policy accommodation in the first place? If Yellen is as concerned about the plight of labor as she purports to be, and if she and her colleagues are as committed to the 2% inflation target as they purport to be, then it seems like there is a strong argument for slowing the pace of the taper and using a rules based approach to taket the risk of earlier-than-anticipated rate hikes off the table. In short, there seems to be a disconnect between the Fed's rhetoric and the general policy direction. They seem to have lost interest in speeding the pace of the recovery.

Persistently low inflation, however, may push them into action. St. Louis Federal Reserve President James Bullard opened up the door to slowing the taper if inflation does not prove to be bottoming. Via Bloomberg:

“I still think it is important to defend the inflation target from the low side,” Bullard, who doesn’t vote on policy this year, said today in a Bloomberg Radio interview with Kathleen Hays and Vonnie Quinn in St. Louis. “If inflation takes another step down, that will put heavy pressure” on policy makers “to take further action.”

That said, take this in context of a Fed that fundamentally wants out of the asset purchase business. Moreover, this is not Bullard's baseline forecast. Via Reuters:

"Mine is in the first quarter of 2015, as far as liftoff for the funds rate," St. Louis Federal Reserve Bank President James Bullard told Reuters Insider television, when asked for his view on when the U.S. central bank should make its first rate hike since 2006.

"You have to keep in mind I tend to be a more optimistic member of the committee," he said. "I have a probably, a somewhat stronger forecast and a view about policy that suggests that maybe we should get up a bit faster than what some of the other members have."

This labor report, however, is not exactly consistent with such a view, but that is also still a year away. In contrast San Franscisco President John Williams reiterated his view, which is much more consistent with the general consensus. Via Reuters:

"Given the economic outlook, and given also my view that we need accommodative policy relative to historical norms, we need to have relatively low levels of interest rates for quite some time," San Francisco Federal Reserve Bank President John Williams told Reuters. "My own view is it makes sense to start raising rates in the second half of 2015."

But the pace of rate increases, in Williams' view, should be extremely slow, with rates ending 2016 well below the historical norm of 4 percent, "with the first digit being a '2,'" he said.

Of course, the second half of 2015 is a fairly big window, and I suspect that any conditions that draw the first rate hike to the front end of that forecast, and certainly to Bullard's forecast, will be followed by a more rapid pace of tightening than currently anticipated. But that again is a matter for the data to decide. That and financial stability concerns; such concerns seem to be having a bigger impact on policy than officials like to admit.

Bottom Line: The doves win this round. One wonders, however, why, if they hold such a strong hand, they have been unable or unwilling to stop the systematic reduction in accommodation that began with the tapering talk of last year?

Thursday, April 03, 2014

Fed Watch: Employment Report Ahead

Tim Duy:

Employment Report Ahead, by Tim Duy: Sorry for the light blogging this week - just getting back into the swings of things during the first week of spring term. But nothing like an employment report to pull me out of hibernation.
It is no secret that the employment report has a significant impact on monetary policy. And we need to make increasingly deeper dives at the data to discern the implications for policy. Federal Reserve Chair Janet Yellen made that clear in her speech this week when she outlined a number of indicators - part-time but want full-time, wages,long-term unemployment, and labor force participation - as evidence of slack in the labor market. Such slack is sufficient, in her view, to justify maintaining accommodative policy for a considerable period (although note that accommodative does not mean zero rates).
Yellen, I think, outlined the most dovish case possible given the current information set. This suggests to me that the risk lies in the hawkish direction. Moreover, I think that Yellen and the remaining doves are losing the internal policy battle, leaving policy with a generally overall hawkish tone. Gone is the Evans rule and explicit allowance for above target inflation, gone, it seems, is a low bar for slowing the taper, gone is quantitative guidance in favor of qualitative guidance, gone is rules-based policy in favor of ad-hockery. And now departing Governor Jeremy Stein leaves behind an intellectual legacy that raises the importance of financial stability concerns when setting policy. Altogether, the stage is set for the Fed to move in a sharply more hawkish direction with just a little push from the data.
That said, that little push from the data is important. While I believe that the Fed has a hawkish bias, that bias will not be realized in the absence of data that is reasonably stronger than the Fed's forecasts. Which brings us to the next employment report. In general, the consensus view that the labor market shook off the winter doldrums with a 206k gain in nonfarm payrolls and 6.6% unemployment rate is probably pretty close to the Fed's expectations. The forecast range for payrolls, however, is skewed to the upside, with a range from 175k to 275k. The possibility of upside surprise follows from an expectation of a sharper bounce from earlier weather-related softness. This was evident in the employment component of the ISM Services report:


In addition, weekly initial claims have improved in recent weeks, lending additional credence to expectations for a better-than-expected report:


Finally, the ADP number for private employment growth came in at a solid 191k for the month (noting of course, the less than perfect signal ADP provides). My quick and dirty approach - which admittedly was not particularly effective in recent months - points at a nfp gain of 199k in March, in line with consensus expectations:


As always, usual caveats apply. Guessing the preliminary numbers of a heavily revised data series is by itself something of a questionable game, a game we all play nonetheless.
As I noted earlier, however, headline numbers won't tell the whole story. The Fed will be looking deeper into the numbers for evidence of greater slack than indicated by the unemployment rate. My opinion is that if the slack is diminishing faster than the Fed doves expect, it is most likely we will see wage growth accelerate. If wage growth remains low, then the Fed will be confident that there is little incipient inflation pressure to justify a more aggressive reduction of policy accommodation.
Bottom Line: The baseline case remains zero rates until the middle to end of 2015, followed by a gentle pace of rate hikes. That said, it is all data dependent, and the baseline case appears to be contingent on a particularly dovish forecast. It seems to me that the risk thus lies in a less than dovish reality. SIgns that wages are increasing more rapidly would suggest just that. Still stagnant wage growth, however, gives the Fed more room to stick with the current policy path.

Monday, March 24, 2014

Fed Watch: Williams Acknowledges Forecast Change

Tim Duy:

Williams Acknowledges Forecast Change, by Tim Duy: Earlier today I said:

Fourth, the dots undeniably moved forward and steeper, which means individual outlooks on the definitions of "considerable period" or "accommodative" did in fact change in meaningful ways. I am surprised, however, that this was not anticipated by market participants given the rapid decline in the unemployment rate. Along any given Fed objective function, one would expect that a more rapid decrease in unemployment would move forward and steepen the interest rate trajectory, even if just by 25 or 50pb.

The Washington Post's Ylan Mui had a sitdown with Federal Reserve President John WIlliams:

Logically, given that the unemployment rate is a little bit lower, that suggests a little bit higher interest rate in 2016. Is that a big shift in the timing of the first rate increase? We’re talking about a relatively small change in terms of the forecast, and I wouldn’t see that as a significant shift.

When I look at the SEP projections for 2015, I just don’t see much of a change in the views on policy -- definitely not the kind of change in views on policy that represents some shift in our policy framework. The fact that unemployment has come down since December a little more than we thought, this is not news. Everybody knows that.

Also, regarding financial stability, I said Friday:

In short, if you believe that the Fed will not use monetary policy to address financial stability concerns, I think you might not be paying attention. They are already using monetary policy to address those concerns by not taking more aggressive action. Don't look to what they will do in the future for confirmation; look to what they are not doing right now.

I meant "aggressive action" as policy to speed the pace of the recovery, whereas current policy is geared toward ending asset purchases and paving the way for rate hikes. Williams on the topic:

I think our policies are doing about as well as we can without creating excessive risks down the road, either for the economy or financial stability. I think there is a little bit of a tradeoff between trying to push this economy now even harder and maybe having some unintended consequences down the road -- not today, not next year, probably not the year after -- and also the potential of making the exit out of our very accommodative policies a little more difficult to navigate.

Also, if you get a chance, read Gavin Davies at the Financial Times:

But in a wider sense there has been an unmistakable shift in the FOMC’s centre of gravity in the past few months. The key to this shift is that the mainstream doves who have dominated policy decisions in the past few years have now essentially stopped arguing against either the tapering of the balance sheet or the start of rate hikes within about a year from now. Only the isolated Narayana Kocherlakota remains in the aggressive dovish corner.

Bottom Line: Those who expected Federal Reserve Chair Janet Yellen to push for a more dovish policy path continue to be dissapointed.

Fed Watch: Post-FOMC Fedspeak

Tim Duy:

Post-FOMC Fedspeak, by Tim Duy: Some thoughts on post-FOMC activity as we head into Monday.

First, I did not cover Federal Reserve Chair Janet Yellen's definition of a "considerable period" as six months in my review of the FOMC statement. I did not highlight the issue because when I went back to the tape, it looked clear to me that the bulk of the bond market response came at the release of the statement and projections. To be sure, the equity market stumbled, but here I completely agree with Felix Salmon:

But here’s the thing: the market didn’t freak out....last Thursday, for instance, the yield fell by a good 10bp when John Kerry made noises about imposing sanctions on Russia. And overall, the yield has stayed comfortably in a range between 2.6% and 2.8%.

What’s more, the big FOMC-related move in the 10-year bond yield happened immediately at 2pm, when the statement was released. Yellen’s “gaffe” caused barely a wobble.

So why does everybody think that Yellen blundered? The answer is simple: they were looking at the stock market (which doesn’t matter), rather than the bond market (which does). Stocks fell, briefly; not a lot, and not for long, but enough that people noticed.

It is the bond market response that is important, and that response was pre-Yellen. It is not entirely clear that the six months timeline was new information. Or, at least, it wasn't to St. Louis Federal Reserve President James Bullard:

“That wasn’t very different from what we had heard from financial markets, so I think she’s just repeating that at that time period,” Bullard said at a roundtable at the Brookings Institution. Bullard doesn’t vote on policy this year.

Second, the more important issue appears to be the interest rate projections, the now infamous dot chart. In her press conference, Yellen attempted to deny the projections contained much useful information in her testimony:

But more generally, I think that one should not look to the dot-plot, so to speak, as the primary way in which the committee wants to or is speaking about policies to the public at large. The FOMC statement is the device that the committee as a policy-making group uses to express its – its opinions. And we have expressed a number of opinions about the likely path of rates.

Dallas Federal Reserve President Richard Fisher went further. Via Bloomberg:

Fisher suggested investors were placing too much emphasis on the change in forecasts, which the Fed illustrates as dots plotted on a chart.

There is a “fixation if not a fetish on the dots,” he said at the London School of Economics. The change in forecasts by Fed officials came before this week’s meeting, he said.

“Somehow, this was read as a massive shift,” Fisher said. “These are our best guesses.”

The Fed wants markets to focus on the distance between the bulk of the dots and participants view of normal. Back to Yellen:

Looking further out, let's say if you look at toward the end of 2016, when most participants are projecting that the employment situation, that the unemployment rate will be close to their notions of mandate-consistent or longer-run normal levels. What you see -- I think if you look, this time if you gaze at the picture from December or September, which is the first year that we showed those dot-plots for the end of 2016, is the massive points that are notably below what the participants believed is the normal longer-run level for nominal shortterm rates. And the committee today for the first time endorsed that as a committee view.

That said, it is clear the dots moved:

So I think that's significant. I think that's what we should be paying attention to. And I would simply warn you that these dots -- these dots are going to move up and down over time, a little bit this way or that. The dots moved down a little bit in December relative to September. And they moved up ever so slightly. I really don't think it's appropriate to read very much into it.

What should we take away from all of this? Well, first of all, I think it is absolutely ludicrous that the Fed is trying to claim the dots have no value. Seriously, can they work any harder to raise the act of bungling their communications strategy to an art form? If the dots have no value, then why force feed this information to market participants in the first place?

Second, yes, the dots do not represent the FOMC consensus. The statement represents the consensus. But the consensus is vague about what defines a "considerable period" or "accommodative" policy. Each individual participant has their own definition of these terms, and the dots thus provide value by quantifying the vagueness of the consensus. That is the real problem here - as a group, the Fed wants qualitative discretionary policy, and the dots provide quantifiable guidance. If they want qualitative discretionary policy, they need to pull all the numbers from their communications.

Third, Yellen needs to accept responsibility for mangling communications. She has been pushing her optimal control story for a long, long time. In the process, she has convinced market participants on the importance of the forward projections of economic variables. Yet now forward projections are meaningless?

Fourth, the dots undeniably moved forward and steeper, which means individual outlooks on the definitions of "considerable period" or "accommodative" did in fact change in meaningful ways. I am surprised, however, that this was not anticipated by market participants given the rapid decline in the unemployment rate. Along any given given Fed objective function, one would expect that a more rapid decrease in unemployment would move forward and steepen the interest rate trajectory, even if just by 25 or 50pb.

Why, why, why should Federal Reserve participants be permitted to change their outlooks but the Fed believes financial market participants are not allowed to follow suit?

Perhaps it is that while - and I believe this - the Fed's reaction function did not change, I suspect there is a very good chance that market participants expected it to change in a more dovish direction. This follows directly again from Yellen's optimal control story. How many analysts were expecting a September lift-off on the basis of her charts? How many expected Yellen push for a more dovish reaction function? I think you need to throw any analysis that explicitly allowed for above target inflation out the window - and that includes the optimal control framework.

In my opinion, some financial market participants are resisting abandoning their dovish interpretation of Fed policy. For instance, Jan Hatzius of Goldman Sachs continues to hold to its 2016 rate hike call. Via the Wall Street Journal:

“Rate hikes are far off,” wrote Jan Hatzius, Goldman’s chief Fed watcher, in a note to clients late Thursday. “Our central forecast for the first hike remains early 2016, although the risks now tilt in the direction of a slightly earlier move.”

Recall, however, Goldman's view from November:

According to an analysis from Jan Hatzius, chief economist at Goldman Sachs, the two Fed papers actually would imply an earlier reduction of QE than planned—perhaps as soon as December—while the zero-bound interest rates could remain in place until 2017 and kept below normal into "the early 2020s."

Why? Because of extensions of the optimal control framework.

"The studies suggest that some of the most senior Fed staffers see strong arguments for a significantly greater amount of monetary stimulus than implied by either a Taylor rule or the current 6.5 percent/2.5 percent threshold guidance," Hatzius wrote. "Given the structure of the Federal Reserve Board, we believe it is likely that the most senior officials—in particular, Ben Bernanke and (Chair-elect) Janet Yellen—agree with the basic thrust of the analysis."

And more from Hatzius from Bill McBride at Calculated Risk:

It is hard to overstate the importance of two new Fed staff studies that will be presented at the IMF's annual research conference on November 7-8. The lead author for the first study is William English, who is the director of the Monetary Affairs division and the Secretary and Economist of the FOMC. The lead author for the second study is David Wilcox, who is the director of the Research and Statistics division and the Economist of the FOMC. The fact that the two most senior Board staffers in the areas of monetary policy analysis and domestic macroeconomics have simultaneously published detailed research papers on central issues of the economic and monetary policy outlook is highly unusual and noteworthy in its own right. But the content and implications of these papers are even more striking.

...[O]ur initial assessment is that they considerably increase the probability that the FOMC will reduce its 6.5% unemployment threshold for the first hike in the federal funds rate, either coincident with the first tapering of its QE program or before.
[O]ur central case is now that the FOMC will reduce the threshold from 6.5% to 6% at the March 2014 FOMC meeting, alongside the first tapering of QE; however, a move as early as the December 2013 meeting is possible, and if so, this might also increase the probability of an earlier tapering of QE.

In comparison to these expectations, the Fed is downright hawkish despite no change to their reaction function. The point is that, in my opinion, reality is starting to set in and financial market participants are walking back on their caricaturization of Yellen and the most dovish of all doves.

Bottom Line: The Fed is pushing back on the dots because they don't want quantitative guidance, and they forgot they were giving it. Expectations that Yellen will push for a more dovish reaction function are being disappointed. Note that the interest rates forecasts are just that - forecasts. They will evolve in one direction or the other in response to incoming data. But incoming data on unemployment undeniably pushes in the direction of an earlier liftoff and, subsequently, a steeper trajectory for rates. If they want to lean against those expectations, the Fed does need to change its reaction function, but to a more dovish one. That, I think, is not the direction of policy at this point.

Saturday, March 22, 2014

Fed Watch: Kocherlakota's Dissent

Tim Duy:

Kocherlakota's Dissent, by Tim Duy: Minneapolis Federal Reserve President Narayana Kocherlakota defended his dissent at the March FOMC meeting. I thought it was quite remarkable. The reason of the dissent itself is not particularly unexpected:

I dissented from the new guidance for two reasons. The first reason is that the new guidance weakens the credibility of the Committee’s commitment to target 2 percent inflation. The second reason is that the new guidance fosters policy uncertainty and thereby suppresses economic activity.

I have already discussed the implications of dropping the Evans rule in regards to inflation. It implies an intention to approach the inflation target from below as well as a lack of tolerance for above target inflation. As far as the second point, Kocherlakota is arguing that the lack of quantitative guideposts increases uncertainty about the path of policy and that uncertainty tends to make economic agents risk adverse. Market participants, for example, might rationally believe they should react to that risk by moving up their expectations of the first rate hike, which by itself induces somewhat less accommodative policy.

More interesting, in my opinion, was Kocherlakota's alternative language. Consider for a moment the Evans rule as it was in January:

The Committee also reaffirmed its expectation that the current exceptionally low target range for the federal funds rate of 0 to 1/4 percent will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.

Now consider Kocherlakota's version of the Evans rule:

For example, the Committee could have adopted language of the following form: “the Committee anticipates keeping the fed funds rate in its current range at least until the unemployment rate has fallen below 5.5 percent, as long as the one-to-two-year-ahead outlook for PCE inflation remains below 2 1/4 percent, longer-term inflation expectations remain well-anchored, and possible risks to financial stability remain well-contained.”

Kocherlakota has to come up with something he can sell to the rest of the FOMC. It says something about the rest of the FOMC that the most he thinks he can sell is a meager 25bp bump above the Federal Reserve inflation target. It says even more if that's the most he could sell to himself. If the most dovish member of the FOMC can tolerate no more than a 25bp upside miss on inflation, what does it say about the other FOMC members? Regardless of whether this is Kocherlakota's max or the best he thinks he can get, it tells you that 2% is really a ceiling, not a target. Now, generously, it maybe that the FOMC believes that they cannot exceed 2% politically given the amount of extraordinary stimulus already in place. But that still leaves 2% as a ceiling.

Moreover, look at the addition of the "possible risks to financial stability remain well-contained" language. It is no longer just about the length of accomodative policy, but about the first rate hike itself. It suggests that a rate hike to snuff out financial stability is clearly on the table. Moreover, if Kocherlakota thinks the only way he can sell his new version of the Evans rule is address financial stability, it means that such concerns are already an impediment to even more supportive monetary policy. This is something I noted yesterday with respect to Yellen's comments about the tapering debate last spring.

In short, if you believe that the Fed will not use monetary policy to address financial stability concerns, I think you might not be paying attention. They are already using monetary policy to address those concerns by not taking more aggressive action. Don't look to what they will do in the future for confirmation; look to what they are not doing right now.

Bottom Line: Kocherlakota's dissent paints the rest of the FOMC as surprisingly hawkish.

Thursday, March 20, 2014

Fed Watch: Unintentionally Hawkish

Tim Duy:

Unintentionally Hawkish, by Tim Duy: The outcome of the FOMC meeting was pretty much as I anticipated. Asset purchases were cut by $10 billion. The Evans rule was dumped. And forward guidance was enhanced to emphasize that rates would be low for a long, long time. All seems pretty much in-line with the general consensus.

Yet financial market participants took a hawkish view of the news. Bonds were trounced - the 5 year Treasury yield lept almost 15bp. Market participants clearly saw something they didn't like. This despite what was a reasonably dovish inaugural press conference by Federal Reserve Chair Janet Yellen. Indeed, she strongly emphasized the new forward guidance language:

When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.

This makes clear that low rates may persist after the unemployment rate hovers closer to 5.5%. In other words, in the absence of clearly higher inflation or a reasonable forecast of higher inflation, the Fed is in no rush to push rates to a more normalish 4%.

Low rates, however, are not the same as near zero interest rates. And the interest rate forecasts seems to imply tighter policy in 2015 and 2016 than implied by the December projections. But during the press conference, Yellen denied the little dots contained any meaningful forecast information. Again, she pointed to the statement as the relevant guidance. And the statement clearly says to expect a period of low interest rates and takes no firm position on the exact timing of the first rate hike. Sounds pretty dovish.

Moreover, it is not clear that the patterns of the dots represent a meaningful change in policy even if taken at face value. Consider the dots in the context of this line from the statement:

The change in the Committee's guidance does not indicate any change in the Committee's policy intentions as set forth in its recent statements.

The dots always made clear that rates would remain low even as unemployment fell. Arguably, the Fed did nothing more in the statement than turn unofficial policy into official policy. And the slight move forward in the rate forecast was completely reasonable given the optimistic forecast of the unemployment rate. Assuming the Fed is following some Taylor-type rule, a lower unemployment rate would be sufficient to nudge forward the timing of the first rate hike. That seems perfectly consistent with the Fed's reaction function as detailed in recent statements.

All in all, it seems relatively easy to make a case that this was a dovish policy decision and a dovish press conference. Others will make the case, and offer more details, I expect, about things such as Yellen's emphasize on a wide array of labor market indicators as evidence of slack. What about a hawkish version?

If I am making a hawkish interpretation, it starts with the end of the Evans rule. Everyone seems focused on the unemployment part of the Evans rule, while my attention is on the inflation part. The Evans rule allowed for the Fed to reach their inflation target from above. It provided wiggle room on the target as long as unemployment was above 6.5%. With the end of the Evans rule, the Fed sends a signal that they no longer find it acceptable to reach the target from above. They intend to reach it from below. 2% is officially once again a ceiling. Indeed this is pretty much made explicit in the statement:

The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.

Low rates are only guaranteed if inflation remains below 2%. Above 2%, you had better expect a fast and furious reaction. Moreover, Minneapolis Federal Reserve President Narayana Kocherlakota's dissent makes clear the topic on the table is a below-target approach for inflation:

Voting against the action was Narayana Kocherlakota, who supported the sixth paragraph, but believed the fifth paragraph weakens the credibility of the Committee's commitment to return inflation to the 2 percent target from below and fosters policy uncertainty that hinders economic activity.

Responding to a question about the dissent, Yellen did emphasize that she did not want to undershoot inflation, but she made no mention of a willingness to overshoot inflation. Ceiling.

Moreover, the new-found 2% ceiling puts a cloud over the importance of Yellen's optimal control theory. The whole point of that exercise was that the cost of allowing inflation to rise above 2% was less than the cost of high unemployment. Seems like this idea is abandoned when you explicitly rule out the ability to reach the target from above.

The whole tenor of the policy discussion has a hawkish tone as well. As the Washington Post's Ylan Mui notes, the policy focus has shifted entirely to the timing of the first rate hike:

The nation’s central bank said Wednesday it will look at a broad swath of indicators – including job market data, inflation expectations and financial developments – as it determines when to raise rates for the first time since the recession hit. The deliberately vague wording is a retreat from the Fed’s concrete promise to leave rates untouched. Though they disagree on when to act – targets range from this year to 2016 – the statement signals the moment has finally come within striking distance.

There is no longer any reasonable expectation that the Fed has any interest in accelerating the pace of the recovery to more quickly alleviate poor labor market conditions. Barring a sharp change in economic conditions, the Fed is headed in only one direction.

Finally - and I don't think that many caught this - toward the end of the press conference, Yellen explicitly states that the higher term-premiums triggered by the tapering discussion hurt economic activity by slowing the housing recovery. But then she credited the move with reducing financial instabilities. In other words, she willingly traded growth for financial stability. Something to think about as equities plow higher.

Bottom Line: If you focus on the "low rates for a long time" language, you walk away with dovish interpretation. If you focus on the implications of the end of the Evans rule on the Fed's inflation target, I think you can walk away with a hawkish interpretation. Moreover, if you believe that 2% is now a ceiling, you probably should think the risk of inflation triggering a Fed response is higher than under the Evans rule, and adjust your forecast accordingly.

Wednesday, March 19, 2014

Fed Watch: That Train Left the Station

Tim Duy:

That Train Left the Station, by Tim Duy: I was re-reading some of the recent overshooting debate and it occurred to me that it is comical that we are even having this discussion. The Fed is not going to deliberately overshoot inflation, period. That train left the station long ago. So long ago that you can't even here the rumble on the tracks.
The train left the station on January 25, 2012, with this statement by the Federal Reserve:
The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate.
On that day, the Federal Reserve locked in the definition of price stability. They locked it in specifically to prevent even the appearance they might deliberately overshoot as a result of extraordinary monetary policy. They locked it in as a commitment device to tie the hands of future policymakers as they would need to justify changing the definition of price stability, presumably a very high bar for any central banker to cross.
On that day, the Federal Reserve took higher inflation expectations off the table. They pulled it from the toolkit. They made clear there is one and only one inflation target for all time. The only tolerable deviations from that target are essentially forecast errors. That's it.
Moreover, I would argue that their behavior has been entirely consistent with maintaining that expectation. Inflation expectations - as measured by TIPS - have been more volatile than prior to the recession, but have cylced around pre-recession levels, or, arguably, a little below:


There is no reason to believe that the Fed has acted to try to sustain inflation expectations beyond those in place prior to the recession. Perhaps thay came close in late-2012, as measured by the five year, five year forward breakevens:


But that was soon met by official pushback. Via Bloomberg:
“Distant inflation expectations from the TIPS market seem to suggest that investors do not completely trust the Fed to deliver on its 2 percent inflation target,” Bullard said today in a speech in Memphis, Tennessee, referring to Treasury Inflation-Protected Securities...
...The five-year, five-year forward break-even rate, which projects the pace of price increases starting in 2017, rose to 2.88 percent on Sept. 14, the day after the FOMC announced a third round of quantitative easing. That was up half a percentage point from July 26. It dropped to 2.77 percent on Oct. 2.
Soon thereafter began the tapering chatter that ultimately culminated in then-Chairman Ben Bernanke's press conference in which he introduced the 7% trigger for asset purchases. The result was a sharp snap-back in real yields:


If the Fed has already proved they can't stomach inflation expectations hovering just below 3% (remember that this is on a CPI basis by which TIPS are calculated, not on a PCE basis that is the Fed's target) for even a few months, they really can't wrap their minds around inflation actually reaching 3% as suggested by Karl Smith:
The Evans Rule was nice, but addressing the overshoot directly would be better. For example, a statement like: “In the committee’s view the appropriate path for the federal funds rate would, in the medium term, allow inflation to rise above 2 per cent, but not above 3 per cent, for a period no less than three months but no greater than one year. Within those parameters the committee will continue to adjust the target for the federal funds rate so as to achieve maximum employment and keep long term inflation expectation well anchored.”
And note that I am being generous by trusting that the Fed's inflation target is actually 2%. David Beckworth suggests it is actually the range of 1% to 2%.
Ultimately, I think Robin Harding correctly identifies the mood at the Fed:
Even Janet Yellen, in her “optimal control” speeches in 2011 and 2012, never argued that the Fed should promise extra inflation in the future. There has never been much support for it on the FOMC and the Fed’s statement of long-run goals would have to be modified to allow for it. At this stage in the game, when the Fed is slowing down its stimulus via asset purchases, it makes little sense to add more stimulus in another way.
What remains the case is that Fed doves think there is slack in the labour market and are willing to risk some above target inflation – while targeting 2 per cent – in order to bring joblessness down more rapidly. I think the centre of the committee under Janet Yellen agrees (and their fairly aggressive forward rate path reflects that). In an ideal world, though, the Fed would gracefully stabilize inflation at 2 per cent with no overshoot or undershoot, creating a soft landing as the economy regains full employment.
The Evans rule was never about higher inflation expectations. It only clarified the acceptable range of forecast errors around the 2% target for a given unemployment rate. And note that it is clear that a forecast error in the other direction is also acceptable with below target outcomes in the labor market. That acceptability is evident in the eagerness to end asset purchases and telegraph the first rate hike. Does anyone believe that the Fed would find a 2.5% inflation rate acceptable if unemployment is at 6%? Or would it be cause of worry and hand-wringing among policymakers? The latter, I think. Yes, they are willing to risk some above target inflation, but should it actually emerge, they would act quickly to snuff it out.
Bottom Line: Expect the Fed to manage policy to contain disinflation and deflationary expectations. But overshooting in the sense of raising inflation expectations to lower the real interest rate further? It very much seems like they made clear long ago that wasn't an option.

Tuesday, March 18, 2014

Fed Watch: FOMC Meeting Begins

Tim Duy:

FOMC Meeting Begins, by Tim Duy: The FOMC meeting begins today and ends tomorrow, followed by the traditional statement and Chair Janet Yellen's first press conference. The Fed will also update its forecasts - important because ultimately the forecast drives the policy decisions. I don't anticipate large changes to the growth or inflation forecasts. We should see modest downward revisions to the unemployment rate forecast. What will be more interesting is the impact those changes will have on the interest rate forecast. The bulk of the FOMC expects the first rate hike will be in the range of mid- to late-2015, with a handful earlier or later. A lower unemployment rate forecast may prompt some to move up their forecast. That said, I do not expect large changes in either direction.
As far as policy itself is concerned, it is widely anticipated that the Fed will continue to taper asset purchases and slice another $10 billion from the monthly total. There is no reason to think that the economy has shifted dramatically in either direction to alter the Fed's current strategy for ending asset purchases. We know also that forward guidance will be on the table. Sometime soon - and I think the odds are better than even that "soon" is tomorrow - the Fed will need to address the Evans rule. My expectation is that they ditch numerical guidance for qualitative, discretionary guidance. The new guidance, however, should make it clear that rates will remain low for a long time.
Regarding low rates, I think it is worth reiterating a theme that the Wall Street Journal's Jon Hilsenrath has been pushing this week: At this point, the Federal Reserve expects a long period of low interest rates even after they initiate the first hike. From Monday's Grand Central Station:
...The central banks are projecting an economy that looks on its face like it is returning to normal in the next couple of years...Yet most Fed officials are projecting the target for short-term interest rates will be below 2%, much less than the 4% level that officials think is appropriate in normal times.
How can the Fed expect to maintain short-term rates so far below normal when its main metrics of economic vitality look like they’re back to normal?...
The economy is not getting back to normal, officials like Mr. Dudley are essentially arguing. It’s just getting to something a little less vulnerable. Watch out for the persistent headwinds argument in the Fed’s policy statement Wednesday or in Fed Chairwoman Janet Yellen’s press conference. It is the linchpin to the Fed’s assurance that rates won’t rise much in the next couple of years, even after they start inching up from zero. It is also one of the next battlegrounds in the Fed’s policy debates.
I am not entirely sure I like this characterization. The economy could have shifted into a new normal, and that new normal is characterize by a different constellation of prices, exchanges rates, and interest rates than the old normal. The new normal for interest rates may simply be lower than the old normal. Remember that we are still in the midst of a long-term secular decline in the level of interest rates:


Peak cycle interest rates - both short and long rates - have been on a steady decline since the 1980's. And notice that the well-telegraphed Fed tightening in the last cycle had very little impact on long-rates. This raises the possibility that the big move in long-rates (after the tapering talk began) is already behind us. Thus, long-rate might not rise much if at all even as the Fed raise short rates. We will know the answer to that if buyers keep coming out of the woodwork whenever rates approach 3%.
This also implies that although the Fed may think they are running a looser policy than normal because short-rates are historically low, the reality is that the policy is equally tight in relative terms. Thus even though they will argue that rates are low even after they begin raising rates, they will still be reinforcing the continuation of the new normal.
Bottom Line: The Fed will continue with tapering by cutting another $10 billion from asset purchases. They will most likely alter the guidance but continue to signal an extended period of low interest rates. Low rates might simply be part of the "new normal" the economy is settling into, a new normal that the Fed may be unintentionally reinforcing.

Tuesday, March 11, 2014

Fed Watch: On That Hawkish Wage Talk

Tim Duy:

On That Hawkish Wage Talk, by Tim Duy: The issue of the degree of labor market slack in the US economy is now a hot topic. Joe Weisenthal and Matthew Bosler at Business insider have been pushing the debate forward, see here and here, for example. This is an important concern for monetary policy as the general consensus on the Fed is sufficient slack will continue to justify an extended period of low interest rates. Hence, rate hikes can be delayed until mid- to late-2015, or even 2016 as suggested by Chicago Federal Reserve President Charles Evans. There exists, however, considerable uncertainty about the amount of slack in labor markets. My feeling is that path of rates currently expected by policymakers assumes a great deal of slack. As a consequence, indications that slack is less than expected will tend to move forward the timing of the first rate hike and, perhaps the pace of subsequent tightening. Wage pressures are likely to be an early indicator that slack is diminishing.
I see two flavors of uncertainty regarding the amount of excessive slack. First is the question about the value of the unemployment rate as a signal of tightness. The decline in the labor force participation rate has clearly placed additional downward pressure on the unemployment, leading to speculation that the unemployment rate is signaling a tighter labor market than exists in reality. Under this scenario, an improving economy will trigger a flood of entrants into the labor force to provide additional slack. Thus, the unemployment rate is underestimating the degree of slack.
This argument, however, is becoming less persuasive by the day. Evidence seems to be mounting (see here and here) that retirement and illness/disability are a dominant reason for labor force exits since the recession began. Consequently, the decline in the labor force participation will be a persistent phenomenon. The Fed, I think, has largely moved in this direction.
The next issue is the degree of underemployment with the labor market. The dovish view is that the underemployed and long-term unemployed represent considerable slack:


The hawkish view is that this is not a cyclical problem but a structural one. The long-term unemployed, by this theory, simply lack the currently needed skills. This is countered by indications of discrimination against the long-term unemployed. Such discrimination effectively means that you need to have a job to get a job. The ability of firms to engage in such discrimination could be viewed as a cyclical problem. Firms could not be so choosy in a stronger labor market.
Regarding underemployment, I see evidence of the structural explanation in a comparison in the reasons for part time employment:


Those employed part time for clearly cyclical reasons are falling. Those employed part time because they could not find full time work is holding steady. It may be that the skill set of those workers is not consistent with the current types of full time jobs.
Doves will point to the lackluster data of the Jobs Openings and Labor Turnover (JOLTS) report to support the claim of weak labor markets with plenty of slack. The numbers are certainly not impressive:


That said, the counterpoint is the number of unemployed to job openings:


My view is that wage growth will ultimately settle the debate. Wage acceleration tends to occur as unemployment approaches 6%. If that wage acceleration does not occur, then the degree of labor market slack remains is high. The much longer and established data on hourly wages for production and nonsupervisory workers, however, appears to indicate some bubbling wage pressures:


My belief is that if this is happening for lower paid workers, it is only a matter of time before it happens for higher paid workers as well. That said, I am open to the possibility that the limited improvement we are seeing may not persist. It is, however, an issue that I think is of critical importance.
How will - versus how should - indications of tighter labor markets influence Fed policy? As I have said in the past, the Fed typically tightens policy ahead of inflationary pressures. In practice, that has meant hiking rates around the time wage growth bottoms out:


Is this time any different? Well, let's replace "tightens" policy above with "reduces accommodation" since the Fed would not claim that a 25bp increase in rates from 1% was tightening. They would describe it reducing the amount of financial accommodation to make policy less expansionary. This, arguably, describes what happened when the Fed began the tapering discussion. Inflation expectations fell:


And real interest rates rose:


Higher real interest rates and lower inflation expectations looks like a less accommodative/expansionary policy. The Fed began make policy less accommodative in the context of below target inflation and above target unemployment, but unemployment had fallen far enough that they felt it necessary to alter the level of accommodation to prevent incipient inflation pressures. And soon after it became evident that wage growth had bottomed. Coincidence? Probably not. In other words, so far the Federal Reserve is behaving just as they would in any other tightening cycle, with the only difference being that the first step is ending asset purchases rather than raising interest rates.
Moreover, it seems to be clear that the Evans rule was a diversionary tactic. The Fed never foresaw an instance where they would raise rates above as long as unemployment was above 6.5%. Moreover, as is clear from the tapering process, the inflation forecasts, and the interest rate forecast, there was never an intention to target inflation greater than 2.5%. The extra 0.5% was only an allowance for forecast error under the assumption that expected inflation would remain at 2%. They always expected inflation would hit its target from below, and never intended to risk overshooting on inflation.
Simply put, the Fed began unwinding policy pretty much exactly where you would expect given the behavior of unemployment and wage growth. So it is reasonable to believe that if they continue unwinding policy in a historically consistent manner, then there will not be a substantial pause between the end of asset purchases and the beginning of rate hikes. The date of the first rate hike will need to be moved forward by this theory.
They are more likely to move that date forward if they see less slack in labor markets than they currently believe. Furthermore, accelerating wage growth is likely to be the first conclusive evidence of that outcome. Hence my focus on wage growth. I suspect they will argue that if they don't move forward the date, they will be at risk of having to do more later.
Is the Fed pursuing the right policy? Should they allow wage to rise further before reducing financial accommodation? Well, I would say it is already too late for that. But could they delay rate hikes? I would like to see them do so because absent running the labor market at a red hot pace, I don't see obvious way to shift the balance of power to labor and reverse this trend:


That said, I would also add that the last two cycles leave me wary about the potential financial stability issues from such a policy. In the absence of a greater fiscal roll, however, we are left with leaning on monetary policy and risking the financial fallout.
Bottom Line: The Federal Reserve's policy path is dependent on a particular view of a labor market suffering from excessive slack that will continue to be a problem long into the future. It is reasonable to expect that evidence that slack is dissapating more quickly than expected will trigger a fresh assessment among policy makers regarding the appropriate policy path. Next week is probably too soon; later meetings are more likely. Given that wages already appear to be on the rise - a key sign of tightening labor markets - that change could happen quickly. This is not a call for higher rates; it is a warning that higher rates might be coming. This is especially the case if the Fed wants to avoid overshooting. I would argue that their actions to date - the signaling of a shift in policy when still missing on both parts of the dual mandate - suggest an intention to avoid overshooting similar to that of previous cycles.

Friday, March 07, 2014

Fed Watch: Upward Grind in Labor Markets Continues

Tim Duy:

Upward Grind in Labor Markets Continues, by Tim Duy: The employment report for February modestly beat expectations with a nonfarm payroll gain of 175k, leaving the recent trends pretty much intact:


Did the labor market shake off the impact of a cold and snowy winter? No. Aggregate hours worked turned over during the winter, sending the year-over-year gains southward as well:


Looks like the weather was less about hiring, and more about people not being able to get to their jobs.
The unemployment rate edged up:


I suspect we are seeing something like we saw in late 2011 when the unemployment rate fell sharply and then moved sideways for a few months. If there is less excess slack in the labor market than Fed doves believe we should soon be seeing greater upward pressures on wages. Hints of this emerge in the acceleration of wage gains for production and nonsupervisory workers:


Note that this comes even as the number of long-term unemployed rose. I think there is a very real possibility - as was suspected long ago would happen - that persistently high cyclical unemployment we saw during the recession and its aftermath has evolved into structural unemployment. Former Federal Reserve Chair Ben Bernanke in 2012:
I also discussed long-term unemployment today, arguing that cyclical rather than structural factors are likely the primary source of its substantial increase during the recession. If this assessment is correct, then accommodative policies to support the economic recovery will help address this problem as well. We must watch long-term unemployment especially carefully, however. Even if the primary cause of high long-term unemployment is insufficient aggregate demand, if progress in reducing unemployment is too slow, the long-term unemployed will see their skills and labor force attachment atrophy further, possibly converting a cyclical problem into a structural one.
More structural unemployment combined with evidence that the fall in labor force participation is increasingly attributable to retirement suggests less labor market slack. Fed officials will be watching this issue very closely. It is the most likely reason we would expect to see the expected date of the first rate hike moved forward in 2015. (For more on the structural/cyclical issue, I recommend Cardiff Garcia here).
We will see commentators ignore the production and nonsupervisory series in favor of the all employees series. The latter has yet to turn upward as aggressively as the former. The all employees series, however, has a much shorter history. Federal Reserve policymakers will be more comfortable with the longer and familiar production and nonsupervisory workers series. Moreover, I doubt they believe we should expect meaningful and persistent deviations between the two series over time. After all, if the wages of your lowest paid employees are rising, it is reasonable to believe that it is only a matter of time before that same trend hits your better paid employees.
Bottom Line: The employment report indicates ongoing slow and steady improvement in the economy sufficient to generate consistent job growth and drive the unemployment rate lower. The report has no implications for tapering because tapering is on a preset course (New York Fed President William Dudley confirmed what was long suspected yesterday). This one report by itself also says little about the first rate increase - still mid to late 2015. But watch the wage growth numbers and listen to the reaction of Fed officials. In my opinion, this is a key factor in the timing of rate policy. Traditionally, the start tightening prior or near to an acceleration in wages. The longer they stay still as unemployment falls and wage growth rises, the more nervous they will become that they are falling behind the curve. And they especially don't want to fall behind the curve given the size of their balance sheet. They talk a good game, but I think they are more worried about unwinding that balance sheet then they claim in public.

Fed Watch: Unemployment, Wages, Inflation, and Fed Policy

Tim Duy:

Unemployment, Wages, Inflation, and Fed Policy, by Tim Duy: I apologize if that was a misleading title.  This post is not a grand, unifying theory of macroeconomics.  It is instead a quick take on two posts floating around today.  The first is Paul Krugman's admonishment to the Federal Reserve against raising interest rates before wages rise:
So far, no clear sign that wage growth is accelerating. Even more important, however, wages are growing much more slowly now than they were before the crisis. There is no argument I can think of for not wanting wage growth to get at least back to pre-crisis levels before tightening. In fact, given that we’ve now seen just how dangerous the “lowflation” trap is, we should be aiming for a significantly higher underlying rate of growth in wages and prices than we previously thought appropriate.
I don't think that you should be surprised if the Federal Reserve starts raising rates well before wage growth returns to pre-crisis rates.  I think you should be very surprised if the Fed were to do as Krugman suggests.  Historically, the Fed tightens before wages growth accelerates much beyond 2%:


As I have noted earlier, wage growth tends to accelerate as unemployment approaches 6 percent, and so if you wanted to be ahead of inflation, they would be thinking about the first rate hike in the 6.0-6.5% range.  That 6.5% threshold was not pulled out of thin air.  
The second point is that the tightening cycle is usually topping out when wage growth is in the 4.0-4.5% range.  One interpretation is that the Fed continues to tighten policy to prevent workers from gaining too much of an upper-hand, thereby contributing to growing wage inequality.  Of course, I doubt they see it that way.  They see it as tightening monetary conditions to hold inflation in check.  Either way, the end is the same.  It would represent a very significant departure from past policy if the Fed waited until wage growth was at pre-recession rates before they tightened policy or if they allow conditions to remains sufficiently loose for wage growth to eventually rise above pre-recession rates.
If you want the Fed to make such a departure, start laying the groundwork soon.  The best I can offer is my expectation that Fed Chair Janet Yellen is more inclined than the average policymaker to wait until wages actually rise before acting.  I have trouble believing that even she would wait until wage growth accelerates to pre-recession trends.
Second, the Washington Post's Ylan Mui has this:
But a funny thing happens once unemployment hits 6.5 percent: The behavior of inflation starts to become random, as illustrated in this chart by HSBC chief U.S. economist Kevin Logan.


The black line represents the average annual unemployment rate for the past 30 years. You can see that in all but two cases (both of which were temporary shocks), inflation declined when the jobless rate was above 6.5 percent. But when unemployment rate fell below that point, inflation was almost as likely to increase as it was to decrease. In other words, what happens to inflation below the Fed’s threshold is anybody’s guess.
I would take issue with the idea that inflation behavior becomes "random" at unemployment rates below 6.5%.  You need to consider this kind of chart in the context of expected inflation and expected policy.  If inflation expectations are stable, and if the Federal Reserve provides policy to ensure that stability, you would expect random errors around expected inflation.  Couple this with downward nominal wage rigidities, and you should expect the same even under circumstances of high unemployment.  Here is my version of the same chart:


The data is monthly.  This y-axis is the change in inflation from a year ago, where inflation is measured as the year-over-year change in core-pce.  Unsurprisingly, since 2000, changes in core-inflation vary around zero.  Stable and low inflation expectations.  During periods of the 1970's and 1980's you see the impact of unstable expectations as the relationship circles all over the place.  But you also see the general pattern of disinflation since the early 1980's with the downward sloping relationship and many inflation observations, even at low unemployment rates, below zero.
Now it is fairly easy to put both of these posts together.  The Fed, wanting to ensure stable inflation expectations, begins raising interest rates well before wage rates begin rising.  This is turn controls the growth of actual inflation so that inflation rates do not rise as unemployment falls further.  The deviations of inflation from expectations are then just noise.  But actual inflation is not "random."  It is the result of specific monetary policy.
Bottom Line:  If the Fed follows historical behavior, they will beginning tightening before wages rise and in an environment of low inflation such that inflation remains stable even as unemployment falls.  In other words, in recent history that have not exhibited a tendency to overshoot.  Explicit overshooting would represent a very significant shift in the Fed's modus operandi

Thursday, March 06, 2014

Fed Watch: Tapering is Sooo 2013

Tim Duy:

Tapering is Sooo 2013, by Tim Duy: New York Federal Reserve President William Dudley had a sit down with the Wall Street Journal in which he provides some key insights into Fed thinking. First, regarding the tepid pace of data, it's the weather:
Mr. Dudley said that he still expects, "the economy should do better" relative to last year, growing at around 3% this year.
He said, however, it appears very likely that harsh weather slowed economic growth in the first quarter to under a 2% annual rate.
See also this Wall Street Journal report on weak February retail sales. As expected, the Fed will dismiss soft numbers as an artifact of the cold. (although I think the acceleration at the end of 2013 was less than meets the eye to begin with). That means the pace of tapering is not going to change at the next meeting. But guess what? Tapering is not really data dependent in any event. It is more appropriately described as "outlier dependent":
"If the economy decided it was going to grow at 5% or the economy decided it wasn't going to grow at all, those would be the kind of changes in the outlook that I think would warrant changing the pace of taper," Mr. Dudley said Thursday.
How this is really any different from a fixed time-line is beyond me. If the range of acceptable outcomes to justify tapering is anywhere between 0 and 5% growth, the FOMC statement can be reduced by simply admitting that asset purchases are on a preset course. As I have said many times, the Fed wants out of the asset purchase business. It's all about interest rates now:
Mr. Dudley affirmed that nothing's changed when it comes to the short-term interest rate outlook. He said "we have a long time to go before we have to think about raising short-term interest rates."
Sometime in 2015. The weaker the data, the deeper into 2015 is the first rate hike, all else equal.
Finally, look for changes in the next FOMC statement to reflect what has been true for some time:
The 6.5% marker "is already a little bit obsolete in the sense we are really close to it," Mr. Dudley said. The level is "not really providing a lot of value in terms of our communications."
The meeting later this month would be a "a reasonable time to revamp (the) statement to take out that 6.5% threshold," he said. The Fed has amended its guidance to say rates could stay near zero well past that point as long as inflation remains in check.
The 6.5% marker is not a "little" obsolete. It is a "lot" obsolete. It became obsolete the minute the Fed made clear it was irrelevant as they had no intention of raising rates at that point. The are not going to replace it with another numerical guide. It will be replaced with qualitative, and ultimately discretionary, guidance.
Meanwhile, Dallas Federal Reserve President Richard Fisher made clear his view that asset bubbles are brewing left and right:
...there are increasing signs quantitative easing has overstayed its welcome: Market distortions and acting on bad incentives are becoming more pervasive.
Stock market metrics such as price to projected forward earnings, price-to-sales ratios and market capitalization as a percentage of GDP are at eye-popping levels not seen since the dot-com boom of the late 1990s. In the words of James Mackintosh, writer of the Financial Timescolumn “The Short View,” a not insignificant number of stocks in the S&P 500 have valuations “that rely on belief in a financial fairy.” Margin debt is pushing up against all-time records. And, in the bond market, narrow spreads between corporate and Treasury debt reflect lower risk premia on top of already abnormally low nominal yields. We must monitor these indicators very carefully so as to ensure that the ghost of “irrational exuberance” does not haunt us again.
Interestingly, former Federal Reserve Chairman Alan Greenspan writes today that such bubbles are just part of the territory:
Successful financial policy, in my experience, ironically spawns the emergence of bubbles. There was never anything resembling financial euphoria, or the bubbles it creates, in the old Soviet Union, nor is there in today’s North Korea. At the Federal Reserve during my tenure, we often joked that our greatest fear was that policy might be too successful. Achieving an underlying stable rate of growth and low inflation appears to have been a necessary and sufficient condition for the emergence of a bubble. We would conclude with mock seriousness that optimum monetary policy for bubble prevention was to create destabilizing inflation.
There is much of interest in the Greenspan piece (including his claims that the 1994 tightening was an attempt to derail the bubble of the 1990s) and little time to take it up now. As if on cue, the Federal Reserve release the latest flow of funds data. Check out net worth:


Approaching the high seen in the last asset price bubble. Doesn't mean it can't go higher.
Tomorrow is employment report day. The general expectation is that weather played a starring role in depressing job growth while the ACA had a supporting role. Consensus is for 150k gain in payrolls with forecasts ranging from 80k to 203k. My recent track record has been a little (lot) shaky on this number of late, but maybe third time is a charm. Usual caveats apply about the insanity of forecasting a heavily revised rounding error of the massive monthly churn in the labor market. I will take the under this month and am looking for a gain of 118k:


More interesting will be the unemployment rate (what is the impact of the end of extended benefits?) and wage growth (are we seeing any yet?).

Bottom Line: Barring the outlier outcomes of either recession or explosive growth, tapering is on autopilot. Rate guidance is now qualitative and actual policy is discretionary. Incoming data is interesting for what it says about the timing of the first rate hike. So far, though, it is not telling us much given the Fed's belief that weak data is largely weather related. The degree to which asset bubbles are a concern varies greatly accross Fed officials but the general consensus is that such concerns are of second or third order magnitude compared to missing on both sides of the dual mandate.

Tuesday, March 04, 2014

Fed Watch: Fed Talk Shifts to Higher Rates

Tim Duy:

Fed Talk Shifts to Higher Rates, by Tim Duy: First off, sorry for the limited blogging of recent weeks. In the weeds at the office and the time to complete my winter to-do list before spring break is growing short.
With the end of asset purchases in sight (and assuming activity does not lurch downward) Fed officials will increasingly turn the discussion toward raising interest rates. It is not as if the anticipated time line has been any secret. The Fed's forecasts clearly show an expectation of higher rates in 2015 with the exact timing and pace of that tightening dependent upon each participant's growth and inflation forecast. Fed officials would want to clearly telegraph such a move well in advance. Hence they will pivot from talk of sustained low rates to raising rates. Of course, we would expect hawks to be first in line, as they have been. For instance, Philadelphia Federal Reserve President said last week (via the Wall Street Journal):
“Most formulations of standard, simple policy rules suggest that the federal funds rate should rise very soon–if not already,” Mr. Plosser told a conference sponsored by the University of Chicago‘s Booth School of Business.
Such warnings from Plosser are not new. More notable is San Fransisco Federal Reserve President John Williams' interview with Robin Harding at the Financial Times. Williams is generally seen as a dove, but he was also was one of the first to telegraph the end of asset purchases. Williams on the forecast:
In his own economic forecast, Mr Williams said, the Fed will raise interest rates in the middle of next year with the unemployment rate at about 6 per cent, inflation at 1.5 per cent and “everything moving in the right direction”.
“At that point if we don’t start to adjust monetary policy there’d be a risk of overshooting,” he said. “You don’t wait until you’re at full employment before you start to raise interest rates from zero.”
There is a lot to think about in those two paragraphs. First is a forecast of 6% unemployment 15 months or so from now. Given the rapid drop in the unemployment rate, it is completely believable that we reach 6% before asset purchases are predicted to end later this year. Given Williams' forecast, this suggests to me that the risk here is a more rapid tapering or earlier rate hike. The second is the idea of raising rates when inflation is only 1.5%. This to me suggests that Williams is expecting to reach the 2% target from below, not above. This seems clear from the next point: Williams wants to take the possibility of overshooting off the table.
Note that Williams' position differs greatly from that of Chicago Federal Reserve President Charles Evans. From a speech last week:
A slow glide toward our goals from large imbalances risks being stymied along the way and is more likely to fail if adverse shocks hit beforehand. The surest and quickest way to get to the objective is to be willing to overshoot in a manageable fashion. With regard to our inflation objective, we need to repeatedly state clearly that our 2 percent objective is not a ceiling for inflation. Our “balanced approach” to reducing imbalances clearly indicates our symmetric attitudes toward our 2 percent inflation objective.
Evans is obviously willing to overshoot, where Williams is not. Whether the consensus sides with Williams or Evans is critical to the timing of the first rate hike. If the consensus is set on hitting the inflation target from below, then we have have to consider the Fed's own forecasts as suspect. They will find themselves moving sooner than they expect.
I would say, however, it is widely believed, on the basis of her "optimal control" analysis, that Federal Reserve Chair Janet Yellen leans toward Evans. Any suggestion that Yellen leans toward Williams on the overshooting question would be notable.
Regarding asset purchases, Williams joins the chorus indicating the bar to change is high:
Mr Williams said it would take a “substantial change in the outlook” before he was willing to revisit the Fed’s plan to slow purchases by $10bn at each meeting, and despite some weak data, that has not yet happened. “We haven’t really changed our basic outlook for the economy.”...
...Mr Williams said that as long as average monthly jobs growth stays well above 100,000 then unemployment will continue to come down. “What would worry you is if you don’t have an explanation for why it’s weaker and you get multiple months below that,” he said.
I don't think this should come as a surprise. The Fed has been looking to get out of the asset purchase business since the beginning of 2013. The end is now in sight, and only the most disconcerting of data will change that. They may say they are data dependent (Williams of course adds that he could envision circumstances in which the Fed slow or even reverse tapering), but the reality is they have a bias against asset purchases.
The desire to exit asset purchases only increases as the unemployment rate falls. I think that Joe Weisenthal is on the money here when he points out that economists are gravitating toward the idea the the changes in the labor market are largely structural. In other words, as St. Louis Federal Reserve puts it (via the Wall Street Journal):
“I think that unemployment is really sending the right signal about the labor market” and the decline in the labor force participation rate is largely a demographic issue that will play out over a long time horizon, he said.
I think that Fed officials have long seen the risk that this might be true, which is one factor that biases them against asset purchases. Increasing, though, I suspect they do not see is as a risk, but as reality. Again, the consequence is that rates might be rising sooner than Fed officials currently anticipate. It is worth repeating this chart:


In the past, wage growth accelerates as unemployment hits 6%. With unemployment well above 6%, it was difficult to conclusively say much one way or another about the exact amount of slack in the labor market as there was certainly enough slack to keep wage growth in check. If the unemployment rate is no longer the appropriate indicator of labor market slack, then we should not expect to see upward wage pressure as 6% looms. If that pressure does emerge, then I think we learn something about the amount of slack. From the Fed's point of view, if they see wage growth, they will suspect their isn't much. Wage growth will raise concerns about unit labor costs, which will in turn raise concerns about inflation.
Weisenthal, however, adds:
The view from the left is basically: Even if the labor market is getting tight (which they deny), the Fed should press hard on the gas pedal, so that employers start to employ the long-term unemployed.
And that might be the proper path, and if there's anyone who has the stomach to engage in the strategy, it's probably Janet Yellen.
Once again, this implies that Yellen is willing to risk overshooting. Her views on overshooting are critical to the evolution of policy at this point.
Bottom Line: Put aside the possibility of an international crisis-fueled collapse in activity. The Fed's baseline view is that economic growth continues this year at a pace sufficient to end the asset purchase program. The Fed will resist changing that plan for any minor stumble in activity. The pace of job creation itself might not be that critical; it simply needs to be fast enough to lower unemployment to justify continuing the taper. Moreover, we are reaching a point where the Fed will need to decide to what extent it will risk overshooting. That was never really a risk of overshooting above 6% unemployment. Soon it will be an interesting question. The timing of the first rate hike and the subsequent tightening is dependent upon the consensus on overshooting. If wage growth starts to accelerate, the Fed's focus will shift from fears of too much to too little slack. If they are concerned about overshooting, they will need to accelerate the tightening time line. Where Yellen ultimately falls on the issue is critical.

Wednesday, February 26, 2014

Fed Watch: Tarullo on Monetary Policy and Financial Stability

Tim Duy is helping to fill the void -- thanks Tim:

Tarullo on Monetary Policy and Financial Stability, by Tim Duy: Federal Reserve Governor Daniel Tarullo tackled the issue of financial stability in a speech that I think is well worth the time to read. The starting point is that many lessons have been learned over the past two cycles, including the perils of ignoring financial stability issues. But how should such concerns be incorporated into the policymaking process? Tarullo:

While few today would take the pre-crisis view common among central bankers that financial stability should not be an explicit concern of monetary policy, there is considerable disagreement over--among other things--the weight that financial stability concerns should carry compared with traditional monetary policy goals of price stability and maximum employment.

Tarullo begins with a brief overview of the financial crisis and the Fed's response, declaring partial victory:

...while the recovery has been frustratingly slow and remains incomplete, there has been real progress, despite the fact that in the past couple of years a restrictive fiscal policy has been working at cross-purposes to monetary policy, and that balance sheet repair and financial strains in Europe have made it more difficult for the economy to muster much self-sustaining momentum.

As Tarullo notes, the Fed's actions have not come without backlash. Of much focus is the size of the balance sheet, and the likelihood of unwinding the resulting liquidity should inflation rear its head. Tarullo quickly dismisses this concern as no longer of major concern given the expansion of the Fed's toolkit. He turns his attention toward bigger game:

The area of concern about recent monetary policy that I want to address at greater length relates to financial stability. The worry is that the actual extended period of low interest rates, along with expectations fostered by forward guidance of continued low rates, may be incentivizing financial market actors to take on additional risks to boost margins, thereby contributing to unsustainable increases in asset prices and a consequent buildup of systemic vulnerabilities. Indeed, in the years preceding the crisis, a few prescient observers swam against the tide of conventional wisdom to argue that a sustained period of low rates was inducing investors to "reach for yield" and thereby endangering the financial system.

Policymakers currently anticipate the Fed will hold interest rates near zero into 2015, followed by only a gradual path of tightening. The concern is that such a long period of low rates will spawn an asset bubble, or bubbles, similar to the process that many feel fueled the housing boom last decade. The eventual unwinding of any bubbles would likely be unpleasant. But, presumably, the period of low rates occurred for a reason - to support economic activity. Therein lies the conundrum for policymakers:

The very accommodative monetary policy that contributed to the restoration of financial stability could, if maintained long enough in the face of slow recovery in the real economy, eventually sow the seeds of renewed financial instability. Yet removal of accommodation could choke off the recovery just as it seems poised to gain at least a bit more momentum.

So how can the Federal Reserve protect against financial instability? Tarullo here makes a point I think the Fed will frequently reiterate:

As a preliminary matter, it is important to note that incorporating financial stability considerations into monetary policy decisions need not imply the creation of an additional mandate for monetary policy. The potentially huge effect on price stability and employment associated with bouts of serious financial instability gives ample justification.

By addressing financial instability risks, they are attempting to minimize deviations in inflation and unemployment. In effect, they might slow the pace of activity on the upside in return for minimizing the downside. This, however, is easier said then done, as it is difficult to sell delaying progress on the real problems of low inflation and high unemployment to fight against a phantom downturn:

Of course, this preliminary observation underscores the fact that the identification of systemic risks, especially those based on the putative emergence of asset bubbles, is not a straightforward exercise. The eventual impact of the bursting of the pre-crisis housing bubble on financial stability went famously underdiagnosed by policymakers and many private analysts. But there would be considerable economic downside in reacting with policy measures each time a case could be made that a bubble was developing.

The Fed is actively paying attention to markets in the search for stability risks. Tarullo reports the outcome of the Fed's new macroprudential efforts:

At present, our monitoring does find some evidence of increased duration and credit risk, but the increases appear relatively moderate to date--particularly at the largest banks and life insurers. Moreover, valuations for broad categories of assets such as real estate and corporate equities remain within historical norms, suggesting that valuation pressures, if present, are confined to narrower segments of assets. For example, valuations do appear stretched for farmland, although recent data are suggesting some slowing, and for the equity prices of some small technology firms.

No broad-based concerns such as the equity surge of the 1990s or the housing boom of the 2000s. Just pockets of issues here and there. That said, all is not perfect:

Still, there are areas where investors appear to have been very sanguine regarding certain types of exposure and modest in their demands for compensation to assume such risk. High-yield corporate bond and leveraged loan funds, for instance, have seen strong inflows, reflecting greater investor appetite for risky corporate credits, while underwriting standards have deteriorated, raising the possibility of large losses going forward.

Weak underwriting for risky, leveraged assets that investors seem eager to acquire for unusually little reward. This is the kind of situation, especially with leveraged assets, that will repeatedly gain the Fed's attention going forward. What action has the Fed taken? Tarullo:

In these circumstances, it has to date seemed appropriate to rely on supervisory responses. For example, in the face of substantial growth in the volume of leveraged lending and the deterioration in underwriting standards, the Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation issued updated guidance on leverage lending in March 2013. This guidance outlined principles related to safe and sound leveraged lending activities, including the expectation that banks and thrifts originate leveraged loans using prudent underwriting standards regardless of their intent to hold or distribute them.

In addition, the Federal Reserve, alongside other regulators, has been working with the firms we supervise to increase their resilience to possible interest rate shocks...Our analysis to this point (undertaken outside of our annual stress test program) suggests that banking firms are capitalized to withstand the losses in asset valuations that would arise from large spikes in rates, which, moreover, would see an offset from the increase in the value of bank deposit franchises. This finding is consistent with the lack of widespread stress during the period of May through June 2013 when interest rates increased considerably. The next set of stress-test results, which we will release next month, will provide further insight on this point, both to regulators and to markets.

Some enhanced guidance and additional stress tests. I think it would be reasonable to describe this response as underwhelming. Would "additional guidance" have deterred lending activity during the housing bubble? I somehow doubt it. Indeed, Tarullo has his doubts:

While ad hoc supervisory action aimed at specific lending or risks is surely a useful tool, it has its limitations. First, it is a bit too soon to judge precisely how effective these supervisory actions--such as last year's leveraged lending guidance--have been. Second, even if they prove effective in containing discrete excesses, it is not clear that the somewhat deliberate supervisory process would be adequate to deal with a more pervasive reach for yield affecting many areas of credit extension. Third, and perhaps most important, the extent to which supervisory practice can either lean against the wind or increase the overall resiliency of the financial system is limited by the fact that it applies only to prudentially regulated firms. This circumstance creates an incentive for intermediation activities to migrate outside of the regulated sector.

The last point is critical. Increased regulatory activity might just push more activity into the shadow banking realm. There the threat of financial instability might increase exponentially, but without a regulator as a backstop. I think this issue will tend to restrain the Fed's interest in heavy-handed regulatory activity.

Tarullo follows with a discussing of time-varying policies, citing the example of increased loan-to-value requirements for mortgages as lending accelerates. This is an area to watch, as Tarullo sees value in this approach:

...I would devote particular attention to policies that can act as the rough equivalent of an increase in interest rates for particular sources of funding. Such policies would be more responsive to problems that were building quickly because of certain kinds of credit, without regard to whether they were being deployed in one or many sectors of the economy...

Such policies could slow the progress of an asset bubble and, as Tarullo points out, provide additional time for policymakers to determine if the situation requires a change in overall monetary policy. Ultimately, however, Tarullo is a realist. He doesn't intent to put all his eggs in the macroprudential basket:

The foregoing discussion has considered the ways in which existing supervisory authority and new forms of macroprudential authority may allow monetary policymakers to avoid, or at least defer, raising interest rates to contain growing systemic risks under circumstances in which policy is falling well short of achieving one or both elements of the dual mandate. However, as has doubtless been apparent, I believe these alternative policy instruments have real limitations.

As he later says, this means that the Fed should not take the direct monetary policy action "off the table" when it comes to addressing financial instability. What does that mean for policy in the near term? Tarullo:

As I noted earlier, I do not think that at present we are confronted with a situation that would warrant a change in the monetary policy we have been pursuing...

Not terribly surprising. After all, given that policymakers expect a long period of low rates, they obviously are not expecting sufficient financial instability to justify changing that outcome. But expect more talk about the topic:

...But for that very reason, now is a good time to consider these issues more actively. One useful step would be development of a framework that would allow us to make a more analytic, less instinctual judgment on the potential tradeoffs between enhanced financial stability and reduced economic activity. This will be an intellectually challenging exercise, but in itself does not entail any changes in policy.

Bottom Line: The Fed continues to explore the role of monetary policy in addressing asset bubbles. But engaging such concerns head on with tighter policy remains a secondary option. The first option is a variety of macroprudential tools. Moreover, policymakers believe they have the time to explore such tools, much as they have had time to consider managing their expanded balance sheet. They will also remain cautious to act out fear of increasing the risk of instability by driving activity out from under their purview. At this point, my gut reaction is that by the time the Fed feels they are left with no other option but to tighten policy to limit financial instability risks, the damage will already have been done.

Wednesday, February 12, 2014

Fed Watch: Yellen's Debut as Chair

Tim Duy:

Yellen's Debut as Chair, by Tim Duy: Janet Yellen made her first public comments as Federal Reserve Chair in a grueling, nearly day-long, testimony to the House Financial Services Committee. Her testimony made clear that we should expect a high degree of policy continuity. Indeed, she said so explicitly. The taper is still on, but so too is the expectation of near-zero interest rates into 2015. Data will need to get a lot more interesting in one direction or the other for the Fed to alter from its current path.
In here testimony, Yellen highlighted recent improvement in the economy, but then turned her attention to ongoing underemployment indicators:
Nevertheless, the recovery in the labor market is far from complete. The unemployment rate is still well above levels that Federal Open Market Committee (FOMC) participants estimate is consistent with maximum sustainable employment. Those out of a job for more than six months continue to make up an unusually large fraction of the unemployed, and the number of people who are working part time but would prefer a full-time job remains very high. These observations underscore the importance of considering more than the unemployment rate when evaluating the condition of the U.S. labor market.
A visual reminder of the issue:


This is a straightforward reminder of the Fed's view that the unemployment rate overstates improvement in labor markets and thus should be discounted when setting policy. Consequently, policymakers believe they have room to hold interest rates at rock bottom levels for an extended period. To be sure, there are challenges to this view, both internally and externally. For instance, Philadelphia Federal Reserve President Charles Plosser today reiterated his view that asset purchases should end soon and also fretted that the Fed will be behind the curve with respect to interest rates. Via Bloomberg:
“I’m worried that we’re going to be too late” to raise rates, Plosser told reporters after a speech at the University of Delaware in Newark. “I don’t want to chase the market, but we may have to end up having to do that” if investors act on anticipation of higher rates.
That remains a minority view at the Fed. Matthew Boesler at Business Insider points us at UBS economists Drew Matus and Kevin Cummins, who challenge Yellen's belief that the long-term unemployed will keep a lid on inflation:
We do not view the long-term unemployed as necessarily "ready for work" and therefore believe that their ability to restrain wage pressures is limited. In other words, the unusually high number of long-term unemployed suggests that the natural rate of unemployment has increased. Indeed, when we have tested various unemployment rates' ability to predict inflation we found that the standard unemployment rate outperforms all other broader measures reported by the Bureau of Labor Statistics. Although we disagree with Yellen regarding the long-term unemployed, our research does suggest that, perhaps unsurprisingly, the number of part-timers does have an impact on restraining inflation.
I tend to think that we will not see clarity on this issue until unemployment approaches even nearer to 6%. That level has traditionally been associated with rising wages pressures in the past: 

NfpD020714The Fed would likely see a faster pace of wage gains as lending credence to the story that the drop in labor force participation is mostly a structural story. At that point the Fed may begin rethinking the expected path of interest rates, depending on their interest in overshooting. But in the absence of such early signs of inflationary pressures, the Fed will be content to raise rates only gradually.

With regards to monetary policy, Yellen reminds everyone that she helped design the current policy:
Turning to monetary policy, let me emphasize that I expect a great deal of continuity in the FOMC's approach to monetary policy. I served on the Committee as we formulated our current policy strategy and I strongly support that strategy, which is designed to fulfill the Federal Reserve's statutory mandate of maximum employment and price stability.
Yellen makes clear that the current pace of tapering is likely to continue:
If incoming information broadly supports the Committee's expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings.
Later, during the question and answer period, Yellen does however, open the door for a pause in the taper. Via Pedro DaCosta and Victoria McGrane at the Wall Street Journal:
“I think what would cause the committee to consider a pause is a notable change in the outlook,” Ms. Yellen told lawmakers...
...“I was surprised that the jobs reports in December and January, the pace of job creation, was running under what I had anticipated. But we have to be very careful not to jump to conclusions in interpreting what those reports mean,” Ms. Yellen said. Recent bad weather may have been a drag on economic activity, she added, saying it would take some time to get a true sense of the underlying trend.
The January employment report was something of a mixed bag, with the unemployment rate edging down further to 6.6% while nonfarm payrolls disappointed again (!!!!) with a meager gain of 113k. That said, I still do not believe this should dramatically alter your perception of the underlying pace of activity. Variance in nonfarm payrolls is the norm, not the exception:


Her disappointment in the numbers raises the possibility - albeit not my central case - that another weak number in the February report could prompt a pause. My baseline case, however, is that even if it was weak, it would not effect the March outcome but instead, if repeated again, the outcome of the subsequent meeting. Remember, the Fed wants to end asset purchases. As long as they believe forward guidance is working, they will hesitate to pause the taper.
Yellen was not deterred by the recent turmoil in emerging markets:
We have been watching closely the recent volatility in global financial markets. Our sense is that at this stage these developments do not pose a substantial risk to the U.S. economic outlook. We will, of course, continue to monitor the situation.
Yellen reiterates the current Evans rule framework for forward guidance, giving no indication that the thresholds are likely to be changed. Jon Hilsenrath at the Wall Street Journal interprets this to mean that when the 6.5% unemployment rate threshold is breached, the Fed will simply switch to qualitative forward guidance. I tend to agree.
Bottom Line: Circumstances have not change sufficiently to prompt the Federal Reserve deviate from the current path of policy.

Thursday, February 06, 2014

Fed Watch: Another Month, Another Employment Report

Tim Duy:

Another Month, Another Employment Report, by Tim Duy: Tomorrow brings the January 2014 employment report. The usual caveats apply:

  • The monthly change in payrolls is a net number and represents only a fraction of the churn in the labor market.
  • The employment data is heavily revised. The preliminary number can greatly understate or overstate actual labor market behavior.
  • Nasty weather might also have impacted the numbers. Robin Harding at the Financial Times identifies other factors - expiration of unemployment benefits and annual revisions - that can also scramble the final numbers in the report.
  • Forecasting the change in payrolls is thus something of a fool's game. A game we all play nonetheless.

With all that said, I will venture a guess of a 200k gain in nonfarm payrolls for January:


This is a bit over consensus of 181k, but pretty much right in the middle of the range of estimates (125k-270k). Full disclosure: Last month my forecast was wildly optimistic. Still, I think that report was an outlier. Overall I don't see that the pace of improvement in the labor market has changed dramatically one way or another in the last few months. The economy have been generating 180-200k jobs a month for two years despite the ups and downs in the data. I suspect underlying activity continues to support a similar trend. Any improvements that were evident prior to the December report were likely modest. Indeed, I am skeptical that the pace of activity overall has dramatically improved either.
As far as monetary policy, it is likely that only a very, very weak report would deter Fed officials from the current tapering agenda. Even that is in question given that we will see another employment report - not to mention a plethora of other data - before the mid-March FOMC meeting. It seems that hawks and doves alike want to wind down the asset purchase program, with the only difference being the pace of tapering. Atlanta Federve Reserve President Dennis Lockhart sums up what I believe is the consensus view:
Absent a marked adverse change in the outlook for the economy, I think it is reasonable to expect a progression of similar moves, with the asset purchase program completely wound down by the fourth quarter of the year...
...But given my current views on the economy, I like the current positioning of policy.
It's in the right place for now, in my opinion. I think we policymakers should be patient—not too quick to respond to zigs and zags in the data.
Hawks, of course, would like a more rapid pace of tapering. Philadelphia Federal Reserve President Charles Plosser basically said "enough is enough" yesterday:
Notice that even though we are reducing the pace at which we are purchasing longer-term assets, we are still adding monetary policy accommodation. As I noted earlier, I believe the economy has already met the criteria of substantial improvement in labor market conditions, and the economic outlook has improved as well. So my preference would be that we conclude the purchases sooner rather than later...
...If the unemployment rate continues to drop at that pace, we will soon be at the 6.5 percent threshold in our forward guidance for interest rates.
Although the FOMC has indicated that it doesn't anticipate raising rates when the economy crosses that threshold, I do believe that we will have complicated our communications if we are still purchasing assets at that point. What is the argument for continuing to increase monetary policy accommodation when labor market conditions are improving rapidly, inflation has stabilized, and the outlook is for it to move back to goal?
Plosser would like to end asset purchases prior to hitting the unemployment threshold. Problem is, that threshold could easily be hit tomorrow if not at the next meeting. So, I guess all I can say to Plosser is "good luck with that."
Bottom Line: Even a weak employment report may not be immediately pivotal for monetary policy; there is still another report to go before the next FOMC meeting. A solid report, however, will further entrench the Fed's commitment to the current policy path.

Wednesday, February 05, 2014

Fed Watch: No End To Tapering Yet

Tim Duy:

No End To Tapering Yet, by Tim Duy: Yesterday I said:
Altogether, the desire to end asset purchases suggests to me that what we have seen so far is insufficient to prompt the Fed to change their plans. That is especially the case if the data does not soften further - if, for example, the next employment report shows a rebound in payroll growth and a further decline in the unemployment rate.
Today we learn via Bloomberg:
“The hurdle ought to remain pretty high for pausing in tapering,” Richmond Fed President Jeffrey Lacker said after a speech today in Winchester, Virginia. Chicago’s Charles Evans said in Detroit that policy makers probably face “a high hurdle to deviate” from $10 billion cuts in monthly bond buying at each of their next several meetings. Evans and Lacker don’t vote on policy this year.
One hawk, one dove, both concluding that the bar to stopping the taper is quite high. Things need to get worse. This just won't cut it:


Also take note of Jon Hilsenrath's view via the Wall Street Journal:
Last summer, as U.S. stock prices and emerging markets wobbled, the Federal Reserve was at the center of the turmoil. This time, the Fed might be just a bystander in the stock market selloff and not the proximate cause...
...The market, in short, is now pricing in a much easier Fed, not a tighter Fed. Movements in 10-year Treasury notes are telling the same story. Last summer, 10-year yields were rising because investors saw a tighter Fed. Now they’re falling. Investors seem to be reading a string of soft economic data – weaker car sales, a manufacturing slowdown, disappointing job growth – and concluding the economic coast is not as clear as it appeared just a few weeks ago.
I would suggest that the decline in rates indicates the Fed is too tight, not too easy. Indeed, we would hope that they would only be tapering in the context of a rising interest rate environment as it would suggest that market participants were anticipating higher growth and inflation. But the Fed doesn't see it that way. They see lower rates as a signal that policy is easier. And hence are not inclined to react to ease policy further by stopping the taper.
Moreover, I don't think the Fed believes that the end of asset purchases is impacting global markets because they are convinced that tapering is not tightening. If it is tightening, then why should global markets react? And even if it was tightening, the Fed wouldn't see it as their problem in the first place. (To be sure, you may or may not agree, and I suggest you read Izabella Kaminska, Frances Coppola, and Felix Salmon for further insight into the topic.)
Bottom Line: The Fed isn't ready to change course. Recent turbulence is enough to peak their curiosity, not enough to suggest that tapering was premature.

Tuesday, February 04, 2014

Fed Watch: Markets Tumble. How Will the Fed React?

Tim Duy:

Markets Tumble. How Will the Fed React?, by Tim Duy: The financial markets are not being kind to freshly minted Federal Reserve Chair Janet Yellen. The level of scrutiny she will face when she makes what is likely to be her first public appearance as Chair next week was already high, and is rising by the minute. Global markets are faltering, and US equity markets tumbled Monday, with the weak ISM numbers reported to be the proximate cause of the sell-off:


The decline was driven by what can only be described as a jaw-dropping decline in the new order component:


Weather is suspected in the decline, and the ISM report offered some anecdotal support in that direction:

  • "Poor weather impacted outbound and inbound shipments." (Fabricated Metal Products)
  • "Good finish to 2013, but slow start to 2014, mostly attributed to weather." (Petroleum & Coal Products)
  • "We have experienced many late deliveries during the past week due to the weather shutting down truck lines." (Plastics & Rubber Products)

That said, this is arguably more than about just weather, and at least partially should trigger a fresh assessment on the strength of the US economy. To be sure, 2013 finished off with strong GDP numbers, strong enough to give the Fed hope that their 2014 forecast will be realized:


I suspect, however, that it is a bit too early to break out the bubbly. Recent gains have been driven by inventory build-up. Underlying growth still seems a bit tepid, in my view:


Moreover, concerns about the health of the global economy are growing. Indeed, Ambrose Evans-Pritchard sees the threat of a global policy tightening in the making:
We now have a situation where the world's two biggest economies – the US and China – are both winding down stimulus in lockstep. Call it simultaneous G2 tightening if you want. Europe is tightening passively as its balance sheets shrinks, and M3 money fizzles out. So let us call it G3 tightening (even if the Europeans are doing it by mistake)
This amounts to something of a shock to large parts of the emerging market nexus. Is it therefore proper for these EM states to further compound the shock with pro-cyclical monetary (or fiscal) tightening, and to do so on a scale that could ultimately push the global economy closer to a deflation trap?
Sounds very similar to my concerns from last week:
Funny thing is that what the Fed sees as no tightening is evolving into a global tightening now as central banks rush to raise rates. Consequently, money surges into the global safe asset - US Treasuries. And, interestingly, I think that you can argue that this is much, much more disconcerting than last year's taper tantrum. This seems to me to be a pretty clear global disinflationary shock. And it isn't like inflation was on a runaway train to begin with.
To reiterate the last point, the Fed's decision to taper despite the obvious challenge to their inflation target looks increasingly questionable:


Fed policymakers don't even really have any positive near-term trends to hang their hats on:


Across the Curve points us to the Wall Street Journal's anecdotal account of intense pricing pressures (and still weak demand) facing firms:
Executives from companies as varied as General Electric Co. ,Kimberly-Clark Corp. and Royal Caribbean Cruises Ltd. said some prices slipped in the last three months of the year—sometimes significantly—amid intense competition, weaker demand and pressure from cost-conscious customers.
Falling prices for adhesives weighed on Eastman Chemical Co., cheaper packaged coffee dragged on Starbucks Corp. , and “value and discounts” hit McDonald’s Corp. in the fourth quarter in what the fast food chain called a “street fight” for market share. Xerox Corp. is eyeing acquisitions that can “help us be more competitive on price pressure.”
Corporate revenues are showing the strain, whether from lower prices, weak demand or a combination of the two.
Despite the Fed's claim that tapering is not tightening, that it is the stock of assets held, not the flow, that matters, that they could change the policy mix without changing the level of accommodation, market participants are acting as if tapering is indeed tightening. Five year, five year forward inflation expectations have tumbled:


And bond market participants, who had been starting to get optimistic that improving economic conditions would prompt the Fed to tighten sooner than later are now rethinking that scenario:


If this keeps up, it looks like Yellen will face an early test in her first few weeks as Chair. And I would say there is a good chance this does keep up until the Fed changes direction and decides that the US economy may not have reached escape velocity as believed. Of course, the early voice was a hawkish voice which signaled exactly the opposite, as reported by Michael Derby at the Wall Street Journal:
With regard to Fed policy, “I can’t say that things have changed just because of this market action,” Mr. Fisher said in an interview on Fox Business Network after the markets closed Monday.
The hawks fought long and hard for the taper; they will not be easily dissuaded from by a few sloppy days on Wall Street. Remember, the hawks believe asset purchases are fueling a potential asset bubble to begin with. Falling stock prices will only verify their bias and justify the policy.
Of course, the hawks will not be driving a policy shift. That shift would come from the center. But I sense that the center have something in common with the hawks - the center wants out of asset purchases too, which makes me think the bar to holding asset purchases steady at the next meeting is relatively high. Still, a deflationary shock should make them think twice. Then again, already low inflation should have made them think three or four times before tapering in the first place. Altogether, the desire to end asset purchases suggests to me that what we have seen so far is insufficient to prompt the Fed to change their plans. That is especially the case if the data does not soften further - if, for example, the next employment report shows a rebound in payroll growth and a further decline in the unemployment rate.
Another problem we have at the moment is the transition at the Federal Reserve. In many respects, Yellen is still an unknown commodity. Will she live up to her dovish reputation, or will she surprise on the hawkish side? I have to imagine that Yellen is not thrilled by this turn of events. Of course, no one would be, but she is in the unfortunate position of facing the House Financial Services Committee for the first time next week, and her words will carry an extra weight. If she opens the door to tapering the taper, so to speak, odds are she will be credited for a global rally - but then she has to follow through. If she acts as if the Fed is moving full steam ahead, then she will be blamed for the turmoil that ensues - and maybe have to reverse course after all.
Bottom Line: The Fed is once again in a familiar place. They try to pull back on policy, and markets tumble. Tightening has repeatedly proved to come too early; one wonders if the Fed would have had to keep doing more if they didn't keep promising to do less. If history is any guide, they will eventually reverse course. But that same history would suggest that they need to see conditions deteriorate further before they act.

Thursday, January 30, 2014

Fed Watch: And The Taper Continues

Tim Duy:

And The Taper Continues, by Tim Duy: The FOMC meeting came and went with the expected result - the tapering process continued on schedule, undeterred by the current emerging market turmoil. Of course, the Fed doesn't want to be seen as reacting to every gyration financial markets. But even more importantly, the Fed wants out of the asset purchase business on the belief that a.) tapering is not tightening and b.) even if it was tightening, they could compensate via forward guidance. The global stumble, however, is challenging that thinking. Regardless of financial markets or US data, the Fed was not likely to launch into a new policy direction on the eve of incoming Chair Janet Yellen's coronation. It's her show now.

The statement acknowledged the better tone of the data:

Information received since the Federal Open Market Committee met in December indicates that growth in economic activity picked up in recent quarters.

while at the same time giving a nod to weak job growth in December:

Labor market indicators were mixed but on balance showed further improvement.

Inflation is low, but that is offset by stable expectations:

Inflation has been running below the Committee's longer-run objective, but longer-term inflation expectations have remained stable.

Upside and downside risks are equally weighted:

The Committee sees the risks to the outlook for the economy and the labor market as having become more nearly balanced.

Low inflation is an issue they are assessing, but it is not sufficiently worrisome to alter the pace of the taper:

In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in February, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $30 billion per month rather than $35 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $35 billion per month rather than $40 billion per month.

At these rates, inflation is only a deterrent against higher interest rates, not tapering.

Despite the plunge in the unemployment rate, the combination of the Evans rule and enhanced forward guidance remains unchanged:

The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal.

I think we can be confident that much of the conversation centered around forward guidance, but there was not quite a pressing need to end or alter the Evans rule with unemployment still above 6.5%. Moreover, any change to the forward guidance needs to be owned by Janet Yellen, and she will not have that opportunity for another six weeks. Which will not be just her first meeting as chair, but also her first press conference as chair. Trial by fire.

The Fed did not, as some supposed they might, react to sliding overseas markets. This, combined with the tempered reaction to weak job growth and the absolute abandonment of the inflation target, speaks to the Fed's determination to end asset purchases. We will need to see the emerging market downturn lapping up more directly on US shores before the Fed reacts. The downturn in US equities is not yet enough. Not only does the Fed not react to every dip in the market, they probably would not be surprised by a correction in any event. The are inclined to believe that while not a bubble, stock prices were getting a little ahead of earnings.

Recent market action is very revealing, in my opinion. First and foremost is that fears that without the Fed "no one will buy US debt" have proved to be completely unfounded. Everyone knows that the Fed is eager to end asset purchases this year, and yet magically there are enough buyers to keep 10 year rates locked below 3%. Without much, much faster growth and a real threat of inflation, we are stuck in a low interest rate world. Get used to it. Indeed, even when the Fed starts raising interest rates, I expect most of the impact will be in the center of the yield curve. We need to jump to a higher equilibrium path to boost long rates sustainably higher.

Also evident is that regardless of the Fed's intentions, tapering is tightening, at least on a global scale. To be sure, emerging markets are under pressure from a number of directions. The yen's decline over the past year was eventually going to pressure emerging market currencies. Commodity prices are softer than expected. Remember just a few years ago when the global commodity super-cycle would propel prices ever higher? That story appears to have come to an end. The ongoing adjustment in the Chinese economy is not helping matters either. Arguably, the Fed is only the icing on the cake.

But it is a cake of their own making. Ambrose Evans-Pritchard reminds us that emerging markets spent years leaning into the Fed's low rate policies instead of leaning against. Now they are caught in the classic currency crisis trap - they try to raise rates to stem currency declines, but higher rates crush the local economy and, by extension, equity markets, which aggravates the currency decline. The process continues until the economy settles into a lower equilibrium. It isn't pretty. Never is.

Funny thing is that what the Fed sees as no tightening is evolving into a global tightening now as central banks rush to raise rates. Consequently, money surges into the global safe asset - US Treasuries. And, interestingly, I think that you can argue that this is much, much more disconcerting than last year's taper tantrum. This seems to me to be a pretty clear global disinflationary shock. And it isn't like inflation was on a runaway train to begin with.

Bottom Line: The Fed wants out of quantitative easing. Policymakers want to normalize policy by bringing it back to interest rates. That sets a high bar to delaying the tapering process. Moreover, the leadership transition at the Federal Reserve also left policy on autopilot from December until March, raising the bar even further. That seemed to sink in today. They lack of offsetting on the part of emerging markets to easy Fed policy is now exacerbating the impact of tapering, creating a more significant monetary tightening than expected by the Fed. It is not clear when this alters the path of Fed policy. But what seems more clear is that the US is about to be hit by another disinflationary shock. That deserves careful attention, because inflation, I think, is at this moment the most important variable to watch as far as Fed policy is concerned. The Fed is pushing forward with tapering on only the forecast of future inflation. That forecast appears under threat.

Tuesday, January 21, 2014

Fed Watch: The Week That Was

Tim Duy:

The Week That Was, by Tim Duy: Plenty of data and Fedspeak to chew on last week, the sum total of which I think point in the same general direction. Economic activity is on average improving modestly, the Federal Reserve will push through with another round of tapering next week, and low inflation continues to hold back the threat of rate hikes.

After stripping out the auto component, retail sales were solid in December:


I think we are at or nearing the point where auto sales will generally move sideways and thus induce some additional volatility in the headline number. Consequently, it will be increasingly important to focus on core sales ("core" meaning less autos and gas). Looking at the three-month change, we see a modest acceleration in the back half of 2013:


Likewise, industrial production accelerated in the final months of 2013:


The initial read on consumer sentiment was modestly disappointing but not a cause for worry. In general, consumer sentiment has been weaker than what would be suggested by the pace of spending since the recovery began:


Housing starts stumbled in December after surging the previous month:


Housing activity continues to grind higher, with plenty of room left to climb. Increasingly, the gains seem likely to be coming from the single family side of the equation; multifamily has already experienced a solid rebound:


None of the above is meant to imply that we are experiencing runaway growth. Instead, the Beige Book probably sets the right tenor:
Reports from the twelve Federal Reserve Districts suggest economic activity continued to expand across most regions and sectors from late November through the end of the year. Nine Districts indicated the local economy was expanding at a moderate pace; among these, the Atlanta and Chicago Districts saw conditions improve compared with the previous reporting period. Boston and Philadelphia cited modest growth, while Kansas City reported the economy held steady in December. The economic outlook is positive in most Districts, with some reports citing expectations of "more of the same" and some expecting a pickup in growth.
The JOLTS report showed an uptick in the quits rate, something that will likely warm the heart of incoming Federal Reserve Chair Janet Yellen:


It's another quadrant of that chart that is showing improvement, which probably gives Fed officials confidence that they are moving in the right direction by slowly ending the asset purchase program. That said, inflation prevents the Fed from putting their foot on the brakes:


Until we see meaningfully higher inflation numbers, the Fed will be hesitant to deviate from their current expected rate trajectory. Putting aside any financial stability concerns, I am thinking the risk is that unemployment drops to closer to 5.5% when inflation starts to pick up, and policymakers respond with a steeper rate increase fearing they are behind the curve.
Dallas Federal Reserve President Richard Fisher offered-up another colorful speech stressing financial stability concerns. He also revealed he wanted to see the Fed cut asset purchases by $20 billion a month:
I was pleased with the decision to finally begin tapering our bond purchases, though I would have preferred to pull back our purchases by double the announced amount. But the important thing for me is that the committee began the process of slowing down the ballooning of our balance sheet, which at year-end exceeded $4 trillion. And we began—and I use that word deliberately, for we have more to do on this front—to clarify our intentions for managing the overnight money rate.
For all the concerns that the hawks will be persistent policy dissenters, Fisher does not appear to be a likely dissent just yet. For him, it is important just to know the program will end this year.
On the other side of the coin is Minneapolis Federal Reserve President Narayana Kocherlakota. In an interview with Robin Harding at the Financial Times, Kocherlakota makes clear his disappointment with the current policy trajectory:
“We’re running the risk of being content with inflation running consistently below our target. That’s inappropriate,” said Narayana Kocherlakota, who votes on Fed monetary policy this year, in an interview with the Financial Times. “Right now we’re sitting with an outlook for inflation that even by 2016 . . . is not getting back to 2 per cent.”
Importantly, he offers an alternative to the defunct Evans rule:
“We would say we intend to keep the Fed funds rate extraordinarily low in that interval between 6.5 and 5.5 per cent as long as the medium-term outlook for inflation stays sufficiently close to 2 per cent,” he said. “I definitely feel it is important to be numerical about it. Words are always subject, I think, to multiple interpretations.”
The idea of an "interval" gives some insight into the general consensus at the Fed. There does not seem to be considerable support for changing the threshold to 5.5%. Kocherlakota knows this and hopes that he can disguise changing the threshold by calling it an interval. But once you cross 6.5%, the idea of an interval is irrelevant. 5.5% becomes the focus, just as if the threshold has been changed.
Moreover, notice also the change in the inflation threshold from 2.5% to "sufficiently close" to 2%. My sense is that such a change would be interpreted hawkishly. But I think also reveals why policymakers are opposed to changing the unemployment threshold. I am thinking that below 6.5% unemployment, they are less willing to tolerate 2.5% inflation because they worry about falling behind the curve.
I think it is easier to see Kocherlakota dissenting than any of the hawks. It is clear that policy is moving fundamentally in the wrong direction in his opinion:
Mr Kocherlakota said he would not refight the Fed’s decision to taper asset purchases by about $10bn a month. “My point is simply we need to do more. If the committee chose to do that through more asset purchases that’d be fine with me. But we have to be doing more.”
The hawks might want a more rapid end to asset purchases, but at least for them policy is heading in the right direction.
San Francisco Federal Reserve President John Williams questioned the role of asset purchases as part of the Federal Reserve toolkit. Victoria McGrane at the Wall Street Journal has the story here. Williams highlights the uncertain impacts of quantitative easing:
Mr. Williams, who has been supportive of the Fed’s three rounds of bond purchases, said the measures “have proven a potent but blunt tool, with uncertain effects on financial markets and the economy.” The Fed’s bond-buying program, also known as quantitative easing, or QE, aims to lower long-term interest rates in hopes that will spur borrowing, hiring and investment.
Surveying the body of research on such bond purchases, Mr. Williams found that studies consistently find that the purchases have a significant impact on long-term bond yields but it’s harder to tell if they’re doing much to help the overall economy.
“Estimating the effects of large-scale asset purchases on the economy – as opposed to financial markets – is inherently much harder to do and is subject to greater uncertainty,” he said.
WIlliams also acknowledges the difficulties of implementing forward guidance:
“Experience has shown that it is impossible to convey the full reach of factors that influence the future course of policy. As a result, forward guidance ends up being overly simplified and prone to misinterpretation,” Mr. Williams said in his paper. What’s more, markets may not believe promises about policy made several years in advance since the policymakers making those statements could leave, he noted.
Again, isn't the Evans rule something of an oversimplification that has resulted in confusion? Perhaps a simpler target is needed:
A new framework such as nominal GDP-targeting could, in theory, could work better at communicating the Fed’s policy plans than the current approach, he said, but it might have costs as well.
And then comes the third rail of central banking:
Finally, Mr. Williams also said new research should address whether the Fed and other central banks with a 2% inflation target should aim higher. “[D]oes the 2 percent inflation target … provide a sufficient cushion to allow monetary policy to successfully stabilize the economy and inflation in the future?” he asked in his paper.
All of which sums up to: We are still learning from the crisis and thus we will see consideration of even more innovations to central banking going forward.
And last but not least, Federal Reserve Chairman Ben Bernanke made another victory lap at the inaugural event of the new Hutchins Center on Monetary Policy at the Brookings institute (also where Williams presented). For those of you with four hours to set aside, video is here.
Bottom Line: The US economy is grinding forward. Policymakers are generally comfortable with the pace of tapering at $10 billion per meeting. That could be reconsidered if we see sustained weakness in future data, but I don't think that should be the base case. Not everyone is happy at the Fed, however, and arguably the center has shifted toward the hawks as the doves are clearly not pleased that both asset purchases are ending and the Evans rule does not have an heir apparent. I think it is reasonable to believe the primary conflict at the next FOMC meeting is not over asset purchases, but on the communications strategy. The direction and nature of "enhanced forward guidance" is becoming a contentious issue now that the unemployment rate is just a breath away from the 6.5% threshold.

Tuesday, January 14, 2014

Fed Watch: Lockhart Greenlights Tapering

Tim Duy:

Lockhart Greenlights Tapering, by Tim Duy: Atlanta Federal Reserve President Dennis Lockhart presented his 2014 forecast in a speech today. In short, he expects modestly better growth, ongoing improvement in labor markets, and inflation to gradually rise to the Fed's target. Pretty much the standard 2014 outlook, and with the usual caveats: There is still much progress to be made in labor markets, and inflation is currently on the low side. And, assuming all goes according to plan:

If all goes as expected, there is a policy transition under way from a QE world, so to speak, to a post-QE world. As I said, that decision was made in December.

Some of his more interesting comments come in the post-speech conversation with journalists. Michael Derby at the Wall Street Journal has the story. While the December employment number was a disappointment, it is not itself likely to deter policymakers from tapering plans:

...Mr. Lockhart told reporters what happened in the job market last month has not shaken his monetary policy outlook. “I don’t think we should overreact to one month” and should bear in mind employment data frequently undergoes notable revisions, he said.

Lockhart's views on stock prices are intriguing:

In response to audience questions, Mr. Lockhart rejected the idea that big gains in stock prices over the course of the last year mean the equities market has lost its moorings. When taking stock of what has happened, “I don’t see it as a bubble,” the official said, although he added he would like to see company earnings validate the advances the market has experienced. The official also said “we are watching very carefully to make sure we don’t get into bubble territory.”

He seems to be implying that he believes stock prices are reasonable only if earnings rise. Which is the same thing as saying he really doesn't believe that stock prices are exactly reasonable. They are just not sufficiently unreasonable to define as a "bubble." Combined with the careful "watching," one could interpret Lockhart as saying that the Federal Reserve believes stock markets are starting to get ahead of themselves. They are watching the financial stability issue like pun intended.

Regarding the Evans rule, Lockhart admits what already should be evident to everyone:

...The Fed says that it will not raise short term interest rates until the jobless rate falls well under 6.5% so long as inflation remains contained. Mr. Lockhart said the fast approach to that level–unemployment was at 6.7% in December, from 7% the prior month– threatens to complicate the central bank’s message.

Rate hike guidance was supposed to be “easy” to understand, but given what’s happening, it will now require central bankers to have to explain more why they aren’t raising rates when the threshold is crossed, Mr. Lockhart said. He noted the Fed may need to revisit the guidance and refine it to deal with the current “challenges in communications,” and that may mean the central bank may need to make the jobless threshold less connected to the jobless rate.

The Evan's rule is defunct. Like I said yesterday, the Federal Reserve thought the Evans rule would be easy to understand, but the rapid drop in unemployment has greatly complicated their communications strategy. I like the part about making the jobless threshold less connected to the jobless rate. That is pretty much already the case. It seems increasingly evident that Fed communications strategy is at a major inflection point. Do they replace the Evans rule with fresh, specific numerical based guidance? Do they continue to specify labor market indicators? Does the statement get more or less wordy? And shouldn't these changes happen at the December meeting, rather than after unemployment plunges below 6.5%?

Moreover, wouldn't the Fed's communication strategy be easier if they just dropped mention of the employment mandate and focused on the inflation target? As Lockhard notes in his speech:

Over the past 12 months, inflation has averaged only 0.9 percent. Indeed, the broad patterns in the price data suggest we have been on a disinflationary trend for about two years, as shown in this slide.

Continued disinflation could pose risks to economic performance. This slide shows the trend of one key measure of inflation (the personal consumption expenditures inflation index) over the last four years. At the Fed, we follow a number of inflation indices, and they show basically the same picture.

The inflation situation shown here seems disconnected from the recent growth momentum and the outlook that it will continue.

As I mentioned earlier, I think inflation will stabilize and begin to move back in the direction of the FOMC's 2 percent objective as the economy gathers momentum. So I'm interpreting the soft inflation numbers as a risk signal. Through the lens of prices, the economy could be weaker than we currently believe.

The inflation rate alone gives them license to hold rates near zero without the complications of devining the message of the decline in the labor force participation rate. And he also suggests that low inflation is a signal that economic growth is weaker than commonly believed, again suggesting that there is no reason to rate rates.

So why not just focus on the inflation rate? I suspect because the Federal Reserve envisions the possibility that they may raise interest rates even if inflation is low. It's not the base case by any means (no rate hike until 2015 in the absence of real evidence of inflation is the base case), but it is something they don't want to ignore as well. An alternative situation is if unemployment declines further and the Fed fears they will fall behind the curve if they don't tighten. Another situation is that the Fed fears they will need to tighten policy to stifle potential bubbles. Indeed, the latter possibility probably already leads the Fed to hesitate before lowering the unemployment threshold.

In short, I think the Fed is looking to maintain maximum discretion with regards to rate policy; to the extent they want to find a new rule, it will almost certainly be a rule that, like the Evans rule, they were sure they would not want to break. In other words, they would like to find a rule that is clearly time consistent and easy to communicate. But as markets bubble and unemployment drops further, I think it is increasingly difficult for them to find such a rule. Suggestions anyone? And yes, I know one suggestion will be an NGDP target. I don't think the Fed is there yet.

Bottom Line: Another Fed speaker downplaying the December nonfarm payroll number, essentially giving the green light for another $10 billion cut in the pace of asset purchases. Pencil in $10 billion a meeting. But that's not really the big story at this point. The big story is the communications strategy. The era of transparency has arguably delivered only more complicated and confusing targets, thresholds, and statements. With the Evans rule turning into a pumpkin soon, they will need to decide if they want to double-down on this strategy or move onto something else. But what is that something else? Whatever it is, it must be near the top of incoming Chair Janet Yellen's to-do list.

Monday, January 13, 2014

Fed Watch: Employment Report Keeps Policymakers on Their Toes

Tim Duy:

Employment Report Keeps Policymakers on Their Toes. by Tim Duy: Just about everyone (myself included) who ventured a payrolls forecast was crushed by the scant December gain of just 74k. How much should you adjust your outlook on the basis of just this one number? Not much, if at all. It is important to watch for trends in the data, and always keep Barry Ritholtz's warning in the back of your mind:
...we know from each month’s revisions that the initial read is off, often by a substantial amount. It’s a noisy series, subject to many errors and subsequent corrections.
To put this into some context, consider what it is we are measuring: The change in monthly hires minus fires. A monthly change in a labor force of more than 150 million people. That turns out to be a tiny net number relative to the entire pool -- about one tenth of one percent.
This is why I continually suggest ignoring any given month, and paying attention to the overall trend. That is the most useful aspect of the monthly NFP data...if you focus on the monthly numbers, you will be given so many false signals and head fakes that you cannot possibly trade on this information in an intelligent manner.
Indeed, the December number was mitigated by an upward revision to November, leaving the growth pattern looking very familiar:


One interpretation of the December outcome was that it was largely weather related. One would think, however, that such an event would have a forecastable negative impact on payrolls. Regardless, the bigger message is that the monthly change in payrolls is a volatile series, and one should be wary of putting too much emphasis on either small or large gains.
Perhaps the real story then is that another existing trend in the data, the downward pressure on the unemployment rate from a falling labor force participation rate, continues unabated:


Moreover, the pace of improvement in alternative measures of labor utilization is not accelerating and arguably appears to be slowing as might be expected if the formally cyclically unemployed increasingly become structurally unemployed:


Altogether, I think the report can be neatly summed up as 1.) indicative of a more modest improvement in activity than suggested by actual and estimated GDP numbers for the final half of 2013 and 2.) suggestive of structural change in labor markets.
The employment report generally complicates monetary policymaking. Not the nonfarm payrolls numbers so much; that number will largely be written off as anomalous in the context of the overall trend. Indeed, this was the first word from Fed officials. St. Louis Federal Reserve President James Bullard, via the Wall Street Journal:
"I would be disinclined to react to one month's number. I think it's important to get future jobs reports and see if new trends are developing," said Mr. Bullard at a press briefing following remarks here to local business leaders.
Richmond Federal Reserve President Jeffrey Lacker offered similar sentiments:
“As a general principle, it’s wise not to overreact to one month’s employment report,” Lacker said. “Employment has been growing along a pretty steady trend this year. It takes a lot more than one labor-market report to be convincing that the trend has shifted, and in my experience one employment report rarely has an effect by itself on monetary policy.”
I think the Fed is generally committed to winding down asset purchases this year, and will not want to be overly sensitive to just one report (that said, they will be overly sensitive to one number if it fits their preferred policy path). Only a more significant change in the overall tenor of the data will alter the pace of tapering.
The drop in the unemployment rate, however, is something more of a challenge. The Evans rule simply isn't looking quite so clever anymore:


Monetary officials generally believed not only that 6.5% unemployment was far in the future, but also that policy would become much more obvious as we approached that target because inflation pressures would be evident. Neither has been true. Not only has unemployment fallen more quickly than anticipated, but inflation remains stubbornly low. With regards to the former, officials increasingly see the decline in labor force participation as largely structural and outside the purview of monetary policy. Bullard, via the article quoted earlier:
Mr. Bullard signaled he wasn't particularly alarmed by a decline in labor force participation, saying it appears at the right level given current demographics.
And, via a nice Wall Street Journal interview with San Francisco President John Williams by Jon Hilsenrath:
We’re still working hard on this issue of employment-to-population. Everybody is struggling with the puzzle of why the employment-to-population ratio has stayed low. To what extent are movements in labor force participation structural or cyclical? And to what extent can monetary policy have an influence on those developments? I think the majority of the decline in the participation rate is due to structural factors related to the aging of the population and people going into disability. Very few people come back into the labor force from that. I do think part of it is cyclical. The data in the next year or so are going to inform us better about what is the trend.
With each passing month policymakers are increasingly comfortable taking the unemployment rate at face value. That means they increasingly expect the inflation numbers to pick up. Back to Williams:
As the unemployment rate continues to come down, utilization continues to go up, as the economy continues to improve, I would expect the underlying inflation rate to track back towards 2%.
But he clearly recognizes the potential for inflation to remain low:
The second question is why is inflation so low? To what extent does it reflect just some transitory influences, such as health care costs, and to what extent is it really reflecting a persistent ongoing inflation trend that is too low? And again how can monetary policy affect that? We’re in this world where inflation doesn’t move around a lot around 2%. It has become hard to model and to know exactly what are the factors causing inflation to be too low and which are the ones that are going to help bring it back to 2%. That gets to the downside risk question. If inflation does stay stubbornly low, that obviously is an argument for more monetary accommodation than otherwise.
Likewise, Bullard shares these concerns:
Mr. Bullard said he continues to watch inflation closely, saying it should rise as the economy picks up and the jobless rate continues to fall. But the central banker added he wants to actually see that rise come to fruition as the Fed assesses further tapering of its bond-buying.
"If inflation stepped lower in a clear way, I think that would give me some pause," Mr. Bullard said. "I'm looking for signs inflation is going to come back."
So where does this leave us? First of all, I think the Evans rule is already for all intents and purposes defunct. The unemployment rate is just a hair away from 6.5%, and the Fed has no intention of considering raising rates anytime soon. Second, there probably isn't a replacement for the Evans rule in the works. Bullard:
He expects the Fed for now to hold its threshold for unemployment at 6.5%. The Fed has said it won't increase interest rates until the jobless rate falls below that level so long as inflation stays contained.
"Moving (thresholds) around too much is likely to damage our credibility," Mr. Bullard said
And Williams on not setting a lower bound for inflation:
My view is the current [Fed policy] statement does a good job of capturing the fact that once unemployment gets below 6.5%, then obviously we’ll be taking seriously what is happening in inflation, we will be looking at what is happening with employment and growth and everything, and then we’ll be judging what is the appropriate stance of policy. It just gets very complicated quickly when you start adding more and more clauses about what conditions would you or would you not raise interest rates. Unfortunately, that is the game we’re playing … the FOMC statement has gotten awfully long. It has gotten awfully complicated. The statement is probably better used to try to emphasize the key points as opposed to trying to explain everything in our thinking.
My sense is that they thought the Evans rule was clever and simple, but it turns out that fixed numerical objectives are not quite so simple. Well, multiple numerical objectives are not quite so simple. The ironic outcome to the Evans rule experiment is that policy communication would arguably have been smoother if the Fed simply emphasized an inflation target. Policymakers could have been agnostic on the reasons for the declines in labor force participation; it was irrelevant given the path of inflation. Perhaps the focus on the unemployment rate was something of an unnecessary complication that now needlessly leaves the impression that policy will soon turn more hawkish than is the case.
Thus, the third takeaway is that policy is now largely about inflation (although arguably it always is always about inflation). Ann Saphir and Jonathon Spicer at Reuters:
Stubbornly weak inflation is shaping up as the wild card for U.S. monetary policy makers this year, with top Federal Reserve officials stumped by why it has lingered so low for so long and at odds as to what to do about it.
As the Fed wrestled through last year with deciding when to start trimming its massive bond-buying stimulus, the bulk of attention was focused on the unemployment rate, which until recently has been slow to fall following its spike up to 10 percent during the recession.
By last month, policy makers had grown confident enough in the job market to dial back on the program. Figures released Friday showed the jobless rate fell to a five-year low of 6.7 percent in December, despite the smallest monthly job gains in three years. With much of the hiring slowdown attributed to bad weather, however, many analysts say the Fed will stay on track with plans to end bond buying by late this year.
But there is a hitch: inflation has been drifting down for much of the last two years, measuring a feeble 1.1 percent in November by the Fed's preferred gauge.
As long as inflation reverts to target slowly (with a caveat to be noted below), the Fed will not be quick to hike rates. But the Fed will be increasingly nervous that a sudden burst of inflation means they are behind the curve. Williams:
Whether we cut purchases by 10 billion a month or not, we still have a very accommodative stance of policy and that is going to stay with us for quite some time. That is where I worry. If the economy really picks up or inflation or risks to financial stability really do start to emerge in a serious way, we need to be able to move policy back to normal, or adjust policy appropriately, in a timely manner. It’s always a difficult issue. This time it is just a much greater risk because we’re in a much more accommodative stance of policy.
I think it will be the sensitivity to positive inflation surprises that has the potential to add a hawkish tenor to policymaking. Without those surprises, policy will continue along current expectations. There is a caveat - note that Williams essentially admits that the possibility and willingness to use monetary policy to address financial stability. Triple mandate. Watch for it.
Bottom Line: I don't see much in the employment report to indicate any fundamental change to existing trends. Nor do I anticipate any change in policy. Tapering is likely to continue at its modest pace. As expected, the Evans rule is defunct, and it doesn't seem like policymakers are inclined to replace it with another set of fixed numerical guidelines. The primary driver of policy is now the pace of incoming data relative to the inflation outlook. Financial stability is probably something like a third-order concern at this point, at least as far as monetary policy is concerned. But that could change.

Thursday, January 09, 2014

Fed Watch: Next Up: Employment Report

Tim Duy:

Next Up: Employment Report, by Tim Duy: Another quick post between appointments. Tomorrow is the all-important employment report release day for December. I say "all-important" partly in jest. I would caution against placing too much weight on a preliminary number that is well-known to be heavily revised. But the Federal Reserve seems to place an unusually high weight on the most recent month of data, so we must too.

Since it worked well last time, my quick-and-dirty estimate is a 245k gain for nonfarm payrolls in December:


Use with caution, usual caveats apply. Forecasting the preliminary nonfarm payroll gain is akin to throwing darts. And my prior is that something that worked well last month probably will not work well this month. That said, while this technique might not predict the exact number, I think it tells us that:

  1. The labor market is improving modestly.
  2. Any large deviation from a gain of 245k - either positive or negative - is likely not indicative of the underlying trend in labor markets.

For comparison, this is a decidedly above consensus forecast. Consensus is for 200k with a range of 120k to 225k. 245k would be a large upward surprise.

Finally, when considering the policy implications of the report (unless I happen to be up at 5:30am tomorrow, I won't get a chance to review the report until well after the market closes), consider the tension between incoming chair Janet Yellen's preferred preferred measures of labor market slack/tightness:


The improvement on the left exceeds that on the right. That argues for policy inertia unless policymakers shift their focus toward on side or the other. The obvious concern is that improvement on the left becomes too much for policymakers to easily ignore.

Fed Watch: FOMC Minutes - The Quick Review

Tim Duy:

FOMC Minutes - The Quick Review, by Tim Duy: Running short on time tonight (a problem that I don't think will be resolved until the next week). Still, I want to make some quick comments - disjointed as they may be - on the minutes of the December 2013 FOMC meeting.

Near the beginning of the minutes, the staff presents a survey on the expected costs and benefits of the asset purchase program. I feel I need to highlight this section since I have complained that the Fed is leaving us in the dark on the cost/benefit calculus. Now I know why they are leaving us in the dark - they are pretty much in the dark themselves. They sense that the math still favors ongoing purchases:

Most participants judged the marginal costs of asset purchases as unlikely to be sufficient, relative to their marginal benefits, to justify ending the purchases now or relatively soon; a few participants identified some possible costs as being more substantial, indicating that the costs could justify ending purchases now or relatively soon even if the Committee's macroeconomic goals for the purchase program had not yet been achieved.

Still, they are worried about financial stability:

Participants were most concerned about the marginal cost of additional asset purchases arising from risks to financial stability, pointing out that a highly accommodative stance of monetary policy could provide an incentive for excessive risk-taking in the financial sector.

And they really don't know what they are doing:

It was noted that the risks to financial stability could be somewhat larger in the case of asset purchases than in the case of interest rate policy because purchases work in part by affecting term premiums and policymakers have less experience with term premium effects than with more conventional interest rate policy.

Some continue to think of the Fed's balance sheet like that of a regular bank:

Participants also expressed some concern that additional asset purchases increase the likelihood that the Federal Reserve might at some point suffer capital losses.

But common sense prevails:

But it was pointed out that the Federal Reserve's asset purchases would almost certainly provide significant net income to the Treasury over the life of the program, especially when the effects of the program on the broader economy were taken into account, and that potential reputational risks to the Federal Reserve arising from any future capital losses could be mitigated by communicating that point to the public.

I think it silly to complain about potential future losses without acknowledging the current profits; the asset purchase program needs to be evaluated across its entire lifespan. Moreover, it's silly to think the Federal Reserve needs to make a "profit" as if it were a regular bank. The Federal Reserve does not exist to make a profit. It exists to conduct the monetary policy of the nation. But I digress. In any event, policymakers should actually understand this, and hopefully recognize that the only reason for concern on this point is the public optics.

Then comes the issue of exit:

Further, participants noted that ongoing asset purchases could increase the difficulty of managing exit from the current highly accommodative policy stance when the time came.

But in general they feel prepared:

Many participants, however, expressed confidence in the tools at the Federal Reserve's disposal for managing its balance sheet and for normalizing the stance of policy at the appropriate time.

The success with the "reverse repo" facility (noted in the minutes) probably bolsters their confidence on this point. Regarding the benefits of the program, they understand the communications value of quantitative easing:

Regarding the marginal efficacy of the purchase program, most participants viewed the program as continuing to support accommodative financial conditions, with a number of them pointing to the importance of purchases in serving to enhance the credibility of the Committee's forward guidance about the target federal funds rate.

Still, their faith in the program is wavering:

A majority of participants judged that the marginal efficacy of purchases was likely declining as purchases continue, although some noted the difficulty inherent in making such an assessment.

Basically, they don't really have any basis for quantifying the marginal benefits of the program now. That said, there is push back:

A couple of participants thought that the marginal efficacy of the program was not declining, as evidenced by the substantial effects in financial markets in recent months of news about the likely path of purchases.

The great QE debate of 2013 was evidence of the program's communication value, but arguably if they change the policy mix such that communication is provided by forward guidance, then the benefits of the asset purchase program will fade, and with them the rational for the program. Overall, I don't see a lot of cohesion around any method to quantify the cost/benefit trade-off of the program. It seems they are just taking the position that they will know the math has shifted against the program when they see it. Which of course make assessing their likely policy path something of a challenge.

Participants still struggle with the reasons for the drop in labor force participation. Structural or cyclical? Really just covering much of the same ground:

Some participants cited research that found that demographic and other structural factors, particularly rising retirements by older workers, accounted for much of the recent decline in participation. However, several others continued to see important elements of cyclical weakness in the low labor force participation rate and cited other indicators of considerable slack in the labor market, including the still-high levels of long-duration unemployment and of workers employed part time for economic reasons and the still-depressed ratio of employment to population for workers ages 25 to 54. In addition, although a couple of participants had heard reports of labor shortages, particularly for workers with specialized skills, most measures of wages had not accelerated. A few participants noted the risk that the persistent weakness in labor force participation and low rates of productivity growth might indicate lasting structural economic damage from the financial crisis and ensuing recession.

The healthy debate on this topic likely leaves them wary to change the unemployment threshold. Unsurprisingly, inflation was also a topic of conversation. They remain convinced that the current trend will soon be reversed:

Inflation continued to run noticeably below the Committee's longer-run objective of 2 percent, but participants anticipated that it would move back toward 2 percent over time as the economic recovery strengthened and longer-run inflation expectations remained steady.

That said, there were broad concerns on this outlook:

Nonetheless, many participants expressed concern about the deceleration in consumer prices over the past year, and a couple pointed out that a number of other advanced economies were also experiencing very low inflation. Among the costs of very low or declining inflation that were cited were its effects in raising real interest rates and debt burdens. A few participants raised the possibility that recent declines in inflation might suggest that the economic recovery was not as strong as some thought.

Inflation isn't just low in the United States - it's low in many parts of the world. Europe, in particular comes to mind. They must be concerned that low inflation abroad will translate to low inflation at home, even if the economy is strengthening as expected. And then there is another possibility. Although everyone is getting warm and fuzzy about the pace of the recovery, perhaps the inflation numbers are telling the real story. I still think it is odd that they overlooked such concerns and pulled the trigger on the taper, justifying it, as I thought they would, with the forecast and stable inflation expectations. Indeed, the inflation concern was prominent in the taper debate:

...most participants saw a reduction in the pace of purchases as appropriate at this meeting and consistent with the Committee's previous policy communications. Many commented that progress to date had been meaningful, and some expressed the view that the criterion of substantial improvement in the outlook for the labor market was likely to be met in the coming year if the economy evolved as expected. However, several participants stressed that the unemployment rate remained elevated, that a range of other indicators had shown less progress toward levels consistent with a full recovery in the labor market, and that the projected pickup in economic growth was not assured. Some participants also questioned whether slowing the pace of purchases at a time when inflation was running well below the Committee's longer-run objective was appropriate. For some, the considerable slack remaining in the labor market and shortfall of inflation from the Committee's longer-run objective warranted continuing asset purchases at the current pace for a time in order to wait for additional information confirming sustained progress toward the Committee's objectives or to promote faster progress toward those objectives.

Ultimately, the tiny taper combined with discretion in the pace of future reductions won the day:

Among those inclined to begin to reduce the pace of asset purchases at this meeting, many favored a modest initial reduction accompanied by guidance indicating that decisions regarding future reductions would depend on economic and financial developments as well as the efficacy and costs of purchases. Some other participants preferred a larger reduction in purchases at this meeting and future reductions that would bring the program to a close relatively quickly. A few proposed that the Committee lay out, either at this meeting or subsequently, a more deterministic path for winding down the program or that it announce a fixed amount of additional purchases and an expected completion date, thereby reducing uncertainty about the trajectory of the purchase program.

They simply were uncertain enough about the cost and benefits of the asset purchase program that they wanted to use the "progress toward goals" provision as an excuse to do a trial run on the exit.

Stepping back a bit in the minutes, the issue of financial stability makes another appearance:

Participants also reviewed indicators of financial vulnerabilities that could pose risks to financial stability and the broader economy. These indicators generally suggested that such risks were moderate, in part because of the reduction in leverage and maturity transformation that has occurred in the financial sector since the onset of the financial crisis.

What are policymakers looking for?

In their discussion of potential risks, several participants commented on the rise in forward price-to-earnings ratios for some small-cap stocks, the increased level of equity repurchases, or the rise in margin credit. One pointed to the increase in issuance of leveraged loans this year and the apparent decline in the average quality of such loans.

And what will financial stability issues means for future policy? Read carefully:

A couple of participants offered views on the role of financial stability in monetary policy decisionmaking more broadly. One proposed that the Committee analyze more explicitly the potential consequences of specific risks to the financial system for its dual-mandate objectives and take account of the possible effects of monetary policy on such risks in its assessment of appropriate policy. Another suggested that the importance of financial stability considerations in the Committee's deliberations would likely increase over time as progress is made toward the Committee's objectives, and that such considerations should be incorporated into forward guidance for the federal funds rate and asset purchases.

The idea of using monetary policy tools to combat financial instability is in its infancy, but is certainly something to watch. My sense is the majority of the FOMC believes they can address financial stability via macroprudential regulation. Hence I believe the Fed is a long way from turning the dual-mandate of monetary policy into a triple-mandate. But the baby was born alive and well on Constitution Ave.

Finally, at least for me tonight, the idea of lowering the unemployment thresholds was considered and rejected in favor of enhanced forward guidance:

Participants debated the advantages and disadvantages of lowering the unemployment rate threshold provided in the forward guidance. In the view of the few participants who advocated such a change, a lower threshold would be a clear signal of the Committee's intentions and was an appropriate adjustment in light of recent labor market and inflation trends. In contrast, a few others expressed concern that any change in the threshold might be confusing and could undermine the credibility of the Committee's forward guidance. Most were inclined to retain the current thresholds for the unemployment and inflation rates and to instead provide qualitative guidance regarding the Committee's likely behavior after a threshold was crossed.

Bottom Line: I am not sure the minutes provide many surprises. Overall, I think they reveal a very divided Federal Reserve, and the result is that every policy choice is a middle ground. This strikes me as a recipe for policy inertia. No abrupt changes to the pace of tapering. No abrupt changes to the interest rate outlook. No abrupt changes to the Evan's rule. But I wonder if the middle ground is more like a knife edge - that general policy fatique means the FOMC would shift its stance rapidly if the data broke decisively higher. This, I think, is something that might keep a bond trader up at night.

Tuesday, January 07, 2014

Fed Watch: How Divided is the Fed?

Tim Duy:

How Divided is the Fed?, by Tim Duy: The minutes of the December 2013 FOMC meeting will be released Wednesday. I am looking for divisions within the FOMC on key topics, notably likely timing of the first rate hike, likely pace of rate hikes, and discussion of what follows the Evans rule. I am not so much concerned with the tapering process at this point. In my mind, that is now something of a dead issue. Barring any large shifts in the pace of economic activity, I think the Fed is largely committed to winding down that program this year. And I think that the Fed is likely committed to low interest rates through 2014. It's in the 2015 policy outlook that the real divisions start to show.
As far as quantitative easing is concerned, I think the Federal Reserve is looking to end the program. Although they have not fully explained the calculus in the background, I think the cost/benefit analysis shifted against asset purchases. Moreover, the markets did not collapse after policymakers pulled the trigger on the taper, and everyone (all right, everyone but Boston Federal Reserve President Eric Rosengren) seems relatively comfortable with the pace at with asset purchases are expected draw to a close. Sure, arguably the hawks would like to see it brought to a close sooner than later, but are really just happy to see a path out, a clear indication that there is no such thing as QEInfinity.
With regards to interest rates in 2014, here again I think the vast majority of FOMC members are comfortable with the idea that short term rates will most likely hold near zero for the remainder of the year. Even if the US economy receives a faster than expected burst of cyclical activity, the still large output gap and high unemployment rate suggest there is room to let the growth engine run on all cylinders for awhile This is especially the case given the inflation numbers.
There is enough uncertainty about inflation, however, that I think the Fed will hesitate to lower the unemployment threshold. Unless they change the threshold, the Evan's rule becomes defunct in just 0.5 percentage points. I tend to think that the Fed does not want to change the threshold, and would like to let such specific, numerical rules-based guidance die a quiet death. Of course, that leaves as an open question of what would be the nature of any rules based guidance going forward.
This could be a place where fundamental divisions among policymakers would be important. Most policymakers could get on board with Evans rule considering the special circumstances - the ongoing Great Recession - and the reality that a 6.5% threshold was in some sense not likely to be meaningful in the first place. I doubt more than one or two policymakers thought that the Fed would be hiking rates anytime before 6.5%. In effect, it was a promise that was easy to keep. Not changing the threshold, however, suggests they they can't agree on any other promise would be easy to keep. In any event, I am watching the minutes to see if there is more support for a specific change to the Evan's rule than I currently expect.
That leaves 2015. Here, I think, we tend to be overlook the wide range of expectations for 2015 (and 2016, for that matter):


Yes, in 2015 there is a weight on the dovish side of the Fed - but even within that side there is a range of 100bp. Which means some relatively dovish policymakers still think a rate hike toward the beginning of 2015 is likely. And 2016 offers an even wider spread of rate expectations - forecasts of the pace of rate hikes vary widely across policymakers. This suggests deep divisions.
But what is the source of these divisions? If the divisions simply represent different economic forecasts, they might not be very interesting. Presumably, as economic forecasts converge so too would the rate forecasts. In other words, as long as most FOMC members are working with roughly the same reaction function, they really won't be divided when it comes to actually setting policy - they will line up on the dovish or hawkish side as data dictates. So your view of rate policy is driven by your forecast, and how strongly the Fed leans against that view is dependent how closely they believe the incoming data matches that forecast.
More interesting is the possibility that some of the difference represents fundamentally different reaction functions. To be sure, this is already likely the case to some extent, and is visible in the 2014 forecasts. Even more interesting is the possibility that some of the difference is attributable not just to differing reaction functions regarding inflation and unemployment, but to difference opinions regarding the importance of financial stability in the formation of monetary policy. In other words, do some policymakers desire to accelerate the pace of rate increases to step in front of potential financial instabilities that may be brewing?
Such a camp would be expected to include Kansas City Federal Reserve President Esther George and Dallas Federal Reserve President Richard Fisher. Neither of them, however, have sufficient intellectual weight to move the needle. Governor Jeremy Stein, however, is another matter. He is an intellectual force. And while there is a widespread hope that macroprudential regulation is sufficient to address stability concerns, Stein has already shown a willingness to consider using the tools of monetary policy as an alternative:
Nevertheless, as we move forward, I believe it will be important to keep an open mind and avoid adhering to the decoupling philosophy too rigidly. In spite of the caveats I just described, I can imagine situations where it might make sense to enlist monetary policy tools in the pursuit of financial stability....
Second, while monetary policy may not be quite the right tool for the job, it has one important advantage relative to supervision and regulation--namely that it gets in all of the cracks.
Could Stein bring incoming Chair Janet Yellen and others along to accepting a more aggressive policy to prevent the financial instabilities we have seen in recent cycles (assuming he heads in that direction himself)? The presumption is that Yellen will shy away from using the tools of monetary policy to achieve financial stability. Neil Irwin at the Washington Post, however, see this as Yellen's greatest challenge:
...Yellen confronts an old dilemma, the same one that she and current chairman Ben Bernanke have been wrestling with for the last three years or so. The tools they have to try to pump up growth are deeply flawed and can create dangerous side effects. But the central bank is the only policymaking entity in Washington focused on encouraging growth at all.
So the debate has been this: Do we use the tools in our arsenal, even aware of the risks? Or do we allow growth to underperform its potential, leaving millions of jobless by the wayside when we may just be able to help, out of fear of some theoretical risks of a new credit bubble and ensuing crisis.
The Fed's answer this past three years -- with strong support from Yellen -- has been that the unemployment crisis is so severe and the risks from interventionism are small and theoretical enough that, yes, the Fed should employ its full set of tools to try to boost growth. But as financial markets get closer to levels that suggest they are fully valued, and flirt with bubble territory, the cost-benefit analysis may well change.
I don't know where Yellen's thoughts will evolve on this topic. What I do know is this: She has been built up as an dove of the highest order. Consequently, I can't help but think there is only one surprise she could possibly deliver. Since I think it would be virtually impossible for her policy direction to be more dovish than anticipated (the outcome of optimal control-based policy orientation), the only surprise that seems possible is that she is more hawkish than anticipated.
Bottom Line: What I am watching for in the minutes - signs of division. Division on the forecasts themselves will make it hard to agree to a successor to the Evans rule. Divisions on the reaction function will make it even harder. And the possibility that monetary policy could have a role in pouring cold water on financial markets; it is hard to see how they lower the unemployment threshold while keeping that option open. And, of course, I am wary of the opposite as well - maybe they surprise me and lean toward lowering the unemployment threshold soon. There may still be more dovish tricks in the old magic hat after all.

Monday, January 06, 2014

Fed Watch: A Weekend of Fedspeak

Tim Duy:

A Weekend of Fedspeak, by Tim Duy: Federal Reserve speakers were out in force this weekend at the American Economic Association's annual meeting in Philadelphia. The first rumblings from Fed speakers came from the hawkish-side of the aisle. Via MarketWatch:

Philadelphia Fed President Charles Plosser warned Friday that the central bank may have to be "aggressive" in lifting interest rates and may have to chase market rates higher, if banks were to quickly release reserves. He also suggested the expectations of his colleagues by the end of 2016 that calls for Fed funds rates to be below 2% even when the job market is back to normal may be too low.

This should come as no surprise - Plosser has tended to be wary of the Fed's accommodative stance. There is nothing here we don't already know. As it stands today, the Fed is comfortable with a steep yield curve. They are willing to tolerate rising long-rates to the extent that the increases are not driven by shifting expectations of Fed policy. But clearly, if the economic circumstances improve markedly, the Federal reserve will be inclined to raise short-term rates sooner than expected. That's how monetary policy works. So all Plosser is telling us is that his inflation forecast differs from the FOMC as a whole, and if his forecast is realized, then policy will change accordingly.

More interestingly, in a later speech Plosser challenged incoming Federal Reserve Chair Janet Yellen's preferred policy framework:

...there are several different ways to interpret the economic dynamics we have seen in recent years, and those perspectives would call for different policy responses. Some view the shocks hitting the economy as transitory and potential GDP as stable. Others view the shocks as being more permanent, affecting both actual and potential output.

In addition, there are alternative concepts of the output gap itself, some of which focus on the efficient level of output instead of potential output...

This state of affairs has led me to be skeptical of relying on gaps in general as well as optimal control exercises that are derived from specific models. Instead, I have long advocated that we should think in terms of robust policies that yield good economic outcomes across a variety of models and frameworks.

What such framework would Plosser suggest? From 2010:

So, if we have problems in measuring output gaps, what type of rule should we use? I believe it makes more sense to use an interest rate rule that responds aggressively to movements in inflation relative to a target and, if it responds to real economic activity, responds to a measure of the change in economic activity itself rather than some deviation from unobserved potential.

But, but, but...why then is Plosser so hawkish? Inflation has been moving away from target, so it would seem that he should be taking a dovish stance. How exactly is he going to mount a challenge to a Yellen Fed's basic policy approach? By jointly arguing that policy is too loosely and suggesting a rule that, if followed, would loosen policy further? I am just not seeing it, and thus not seeing how Plosser would be effective in affecting Fed policy. As such, I am not convinced that Plosser's ascension to voting status this year will make much difference other than providing journalists/economists/etc. with a dissenting voice.

Outgoing Federal Reserve Chair Ben Bernanke took his victory lap with an overview of his tenure. Too much here to cover adequately in this post, so I will skip to some of his comments on tapering:

...the FOMC's decision to modestly reduce the pace of asset purchases at its December meeting did not indicate any diminution of its commitment to maintain a highly accommodative monetary policy for as long as needed; rather, it reflected the progress we have made toward our goal of substantial improvement in the labor market outlook that we set out when we began the current purchase program in September 2012.

No surprise here either. The Fed has been pushing to divorce asset purchases from interest rate policy, and are cautiously optimistic they have done so successfully. Regarding the ability of the Federal Reserve to extricate itself from its current position:

Once the economy improves sufficiently so that unconventional tools are no longer needed, the Committee will face issues of policy implementation and, ultimately, the design of the policy framework. Large-scale asset purchases have increased the size of our balance sheet and created substantial excess reserves in the banking system. Under the operating procedures used prior to the crisis, the presence of large quantities of excess reserves likely would have impeded the FOMC's ability to raise short-term nominal interest rates when appropriate. However, the Federal Reserve now has effective tools to normalize the stance of policy when conditions warrant, without reliance on asset sales. The interest rate on excess reserves can be raised, which will put upward pressure on short-term rates; in addition, the Federal Reserve will be able to employ other tools, such as fixed-rate overnight reverse repurchase agreements, term deposits, or term repurchase agreements, to drain bank reserves and tighten its control over money market rates if this proves necessary. As a result, at the appropriate time, the FOMC will be able to return to conducting monetary policy primarily through adjustments in the short-term policy rate.

All sounds so easy, doesn't it? In contrast, Mike Derby at the Wall Street Journal reports that the person responsible for making it happen isn't quite to confident:

Speaking as part of a panel in Philadelphia on the activities of the regional Fed banks, Mr. Dudley acknowledged a lot is still unknown about how the bond buying works. His observation is important because he has long been a supporter of aggressive Fed actions to help the economy.

The New York Fed leader has for some time expressed support for continuing the purchases, even as he also voted in favor of the Fed’s decision last month to cut back.

Referring to the Fed’s stimulus program, Mr. Dudley said, “we don’t understand fully how large-scale asset-purchase programs work to ease financial market conditions—is it the effect of the purchases on the portfolios of private investors, or alternatively is the major channel one of signaling?”...

...Mr. Dudley also said that when it comes time to unwind the Fed’s easy-money stance, uncertainty is again a major issue facing central bankers.

“There could be unintended consequences” about moving to a more normalized state of monetary policy, he said.

I tend to think that such uncertainty runs deeper than it appears at the Fed, which is why policymakers are eager to end asset purchases. The more they buy, the more they risk "unintended consequences" at exit time.

Bernanke also threw cold water on the long-run forecast even as his was relative optimistic for faster growth in 2014:

For example, over the past year unemployment has declined notably more quickly than we or other forecasters expected, even as GDP growth was moderately lower than expected a year ago. This discrepancy reflects a number of factors, including declines in participation, but an important reason is the slow growth of productivity during this recovery; intuitively, when productivity gains are limited, firms need more workers even if demand is growing slowly. Disappointing productivity growth accordingly must be added to the list of reasons that economic growth has been slower than hoped...The reasons for weak productivity growth are not entirely clear: It may be a result of the severity of the financial crisis, for example, if tight credit conditions have inhibited innovation, productivity-improving investments, and the formation of new firms; or it may simply reflect slow growth in sales, which have led firms to use capital and labor less intensively, or even mismeasurement. Notably, productivity growth has also flagged in a number of foreign economies that were hard-hit by the financial crisis. Yet another possibility is weak productivity growth reflects longer-term trends largely unrelated to the recession. Obviously, the resolution of the productivity puzzle will be important in shaping our expectations for longer-term growth.

Richmond Federal Reserve President Jeffery Lacker offered similar concerns:

...Adding up all these categories of spending yields a forecast for GDP growth of just a little above 2 percent — not much different from what we've seen for the last three years.

That's my forecast for this year, but when thinking about growth prospects, I believe it's important to keep an eye on longer-run trends as well. To do that, it's useful to break down real GDP growth into the sum of the growth in labor productivity — that is, output per worker — and the growth in the number of workers. It turns out both of these components have slowed since the Great Moderation. If growth in overall output is going to rise substantially, then we would need to see an increase in labor productivity growth, or in employment growth, or both.

Lacker sees 1% growth in both labor force and productivity combining to deliver roughly 2% underlying growth for the near future, which is also his 2014 forecast - he is less optimistic about a cyclical burst of activity than Bernanke. The central issue is that there is widespread uncertainty about the breakdown of cyclical versus structural factors in the current environment. This is not an impediment to accommodative policy with unemployment at 7%. And the Fed forecasts give the cyclical issues the benefit of the doubt, which allows for policymakers to believe they can delay any rate hikes until 2015. But the uncertainty over the structural/cyclical divide is sufficient to prevent policymakers from dropping the unemployment threshold to 6% or lower and shifting their forward guidance from a forecast to a promise. As of yet, there is no replacement for the Evan's rule, leaving forward guidance more vulnerable to challenges from markets. Markets get ahead of the Fed, Fed beats them back, markets get ahead of the Fed, etc.

Bottom Line: Fedspeak over the weekend was generally consistent with my priors. Policymakers don't want to undershoot the recovery, but I don't sense they want to overshoot either. That points toward cautious withdrawal of accommodation. Pencil in somewhat stronger growth in 2014. Pencil in a steady reduction in the pace of asset purchases until the program winds down at the end of the year. Pencil in an extended period of low rates. But also recognize that the tide of monetary policy is now receding - albeit ever so slightly - with the Fed's first step of ending the asset purchase program. They don't want to do more if they can avoid it, and I don't think the risks are weighted toward a reversal of of their current expected policy path. The data flow would need to turn sharply weaker to prompt the Fed to turn tail and increase the pace of asset purchases. Same too, I think, for changing the unemployment threshold. They would need to be very confident that a new threshold was not locking them into a policy they thought to be too accommodative. Instead, I tend to think the risks are weighted in the other direction, that a positive change in the pace of activity would precipitate a more aggressive withdrawal of accommodation. This is especially the case given the Fed's concerns over the size of the balance sheet, uncertainty with regards to the degree of structural changes to the economy, and resulting hesitancy to lower the unemployment threshold. That said, there will be limits to the degree of hawkishness the Fed would be willing to adopt in the absence of a real change in the inflation outlook. The challenge for the Fed will be containing the idea of a more hawkish policy stance to a risk to the outlook rather than allowing it to become the baseline scenario. With the high tide of policy now in the past, and the discussion turning back to when will policymakers do less, expect financial market participants to keep testing and retesting policymaker resolve.

Tuesday, December 31, 2013

Fed Watch: What Comes After the Evans Rule?

Tim Duy:

What Comes After the Evans Rule?, by Tim Duy: Since the last FOMC meeting, market participants have grown cautious about the near term path of monetary policy, sending two year rates higher even as the Fed lowers their expectation of the policy path. Is this entirely justified by the economic data, or is another explanation at work? I suggest that the Evans rule has turned hawkish and will increasingly be a challenge for Federal Reserve policy. In short, the nature of forward guidance is very much a question for 2014.

I believe it was David Andolfatto who first recognized the hawkish nature of the Evans Rule:

As Chairman Bernanke stressed in his press conference, the new policy does not imply that the Fed will necessarily raise its policy rate should the unemployment rate fall below the 6.5% threshold...But surely, if the unemployment rate crosses this threshold, the perceived probability of an imminent rate hike is likely to spike up. Absent the unemployment rate threshold, the market would likely expect the policy rate to instead remain low for a longer period of time. This is the hawkish nature of the Evans rule.

Take this in light of Accross the Curve's commentary today:

Several participants with whom I have spoken have expressed concern about the unemployment rate and how much it will drop when those jobless whose benefits expired drop out of the work force. That will be a participation rate event but since the FOMC did not tamper with threshold some are concerned about a big drop in the rate.

As I noted yesterday, there was some disappointment that the Fed did not change the thresholds. The Fed wants it both ways - they want the impact of changing the threshold without actually changing the threshold. Hence this sentence appears in the statement:

The Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal.

The Fed does want to be bound by rules; they want discretion. That is exactly what this sentence is meant to provide. Why don't they want rules? Because they don't know what the rule should be. Remember Federal Reserve Chairman Ben Bernanke's press conference - he thinks the decline in the labor force participation rate is largely structural and that current wage growth is sufficient to deliver a 2% inflation rate. He doesn't doesn't sound like he wants his hands tied by some rule, because he doesn't know where to draw the line. 6.5 percent is easy. Is 5.5 percent?

Indeed, those who want the Fed to have rules should pay attention to San Francisco President John Williams:

That said, I expect that the explicit link between future policy actions and specific numerical thresholds, as in the recent FOMC statements, will not be a regular aspect of forward guidance, at least when the federal funds rate is not constrained by the zero lower bound. This guidance has proven to be a powerful tool in current circumstances, when conventional policy stimulus has been limited by the zero lower bound. But such communication is difficult to get right and comes with the risk of oversimplifying and confusing rather than adding clarity. Therefore, in normal times, a more nuanced approach to policy communication will likely be warranted. I see forward guidance typically being of a more qualitative nature, highlighting the key economic factors that affect future policy actions.

This isn't the description of a rule. "Nuance" is equal to "discretion." Rules? We don't need no stinkin' rules! Rules are just an artifact of the zero bound. Once the economy is off the zero bound, Williams is looking to revert to business as normal - loose, discretionary forward guidance, nothing that locks down policy like the Evans rule.

The Fed is faced with a problem here. There is a high probability of smashing through the 6.5% threshold by midyear, rendering the Evans rule pointless. But what replaces the Evans rule? They do not want to lower the threshold unless they were absolutely positive they would not hike rates before that point. But they are not absolutely positive, so they hesitate. At the same time, they do not want the markets to front-run policy. But without a rule, and with a very clear desire to end their other non-conventional tool, asset purchases, can they control expectations? Once we hit 6.5%, we are in a zone in which the Fed is NOT committed to zero interest rates. We enter a zone where the null hypothesis must be that the Fed is biased towards raising rates simply because they are not willing to commit to a rule that suggests otherwise.

Another way to think about this is now that they set a rule, markets will evaluate policy against that rule. It is not easy to just pretend the rule never existed and slip back into discretionary policy.

In the absence of rules, we are looking at the possibility of a volatile year in bond markets as participants attempt to front-run the Fed, and in response the Fed tries to front-run the markets. This is exactly what happened with quantitative easing. Because it was not rule-based but instead discretionary (whatever definition of "stronger and sustainable" the Fed believes is appropriate at the moment), expectations for future policy, and with it interest rates, shifted throughout the year. Once we pass through 6.5 percent unemployment, we are right back there. Although we all know the Fed has said they expect to hold rates at zero for an extended period, they haven't promised to do so. Without that promise, challenges should be expected. The stronger the data, the bigger the challenge.

Bottom Line: The end of the Evans rule is fast approaching. The Fed does not have a backup plan other than talk. Are there new rules ahead? Or is it all discretion? And could you get a divided Fed to agree to new dovish rules in any event? They don't seem eager to change the thresholds. How much stress will force their hand? Might be tough times for Fed communications ahead.

Monday, December 30, 2013

Fed Watch: Inflation, Wages, and Policy

Tim Duy:

Inflation, Wages, and Policy, by Tim Duy: As something of a addendum to my last piece, I wanted to follow up on the take-down of the inflation story by Ethan Harris of BAML as reported by Sam Ro at Business Insider. Harris' argument is that there is plenty of slack in the labor market, so there is no reason to worry that wage growth-fueled inflation is just around the corner. Fair enough; I have always said that the ultimate test of the theory that labor markets were tight would be higher wages. The part I wanted to follow up on was this quote:
Moreover, even if wages do inch higher, we are a long way from the normal 3 or 4% rate that could start to create serious pricing pressure.
I think this overlooks an important point - the Federal Reserve has historically tightened policy at or before wage growth turns upward and the policy peak occurs when wage growth is hovering in the 4-4.5 percent range:


In other words, we don't need to see wage growth high enough to create price pressures to trigger tighter monetary policy. Typically, the Fed is tightening policy ahead of higher wage growth. This, I think, is one reason to question the Fed's stated policy path and also explains why the Fed would be hesitant to embrace a lower unemployment threshold. The fact that wages are rising while unemployment remains high is probably something of a puzzle to them, and lends credence to the stories that the labor market is currently affected by severe structural issues even though they see the same measures of labor market slack that Harris identifies.
So it is not that the Fed is currently behind the curve, but that the upturn in wage growth will make them worry that they will need to act to prevent them from falling behind the curve. It is also another reason why they want to extract themselves from QE as soon as possible; they want to be prepared to act quickly should they find they took an overly dovish view of the labor market. I think there is a lot of uncertainty regarding unemployment/wage/inflation dynamics at the moment, and that uncertainty is not making the Fed happy given the size of the balance sheet.
Also consider also Federal Reserve Chairman Ben Bernanke's justification for expecting inflation to trend toward the Fed's 2 percent target. From his press conference (emphasis added):
First, there are some special factors, such as health-care costs and some other things, that have been unusually low and might be reversed. Secondly, if you look at the fundamentals for inflation, including inflation expectations, whether measured by financial markets or surveys; if you look at growth, which we now anticipate will be picking up both in the U.S. and internationally; if you look at wages, which have been growing at 2 percent and a little bit higher according to many indicators—all of these things suggest that inflation will gradually pick up.
In short, although as Harris states we would not expect significant price pressures until wage growth accelerates further, wage growth is already at a rate that biases the Federal Reserve toward tighter policy (or, at a minimum, less accommodative policy). Even the current meager wage growth rate is used as justification to ignore the inflation trend and initiate a plan to end asset purchases. What then might be the possibilities for policy from even slightly higher wage growth?

Fed Watch: On Challenging the Fed

Tim Duy:

On Challenging the Fed, by Tim Duy: At first blush, the Federal Reserve looked to have pulled off an almost seamless hand-off of accommodation from quantitative easing to forward guidance at the last FOMC meeting. The announcement of the long-awaited taper was met with a subdued bond market reaction while stocks soared. Since then, however, bond yields have climbed, breaching the three percent mark at the end of last week. Mortgage rates have been pulled along for the ride, and if they continue higher, the sustainability of the housing recovery will again be questioned. As discussed earlier by Matt Boesler at Business Insider, this very much looks like a challenge to the Federal Reserve's forward guidance. Or is it? It is not really a "challenge" if it simply reflects expectations of what a data-dependent policymaker would do in the face of a stronger than expected economy. I think a little of both is happening.
Policymakers will be alert to signs that recent gains in rates look to be driven by expectations that the Fed will hike rates sooner than suggested by the Fed's own forward guidance. Relying on the separation principle so well defined by Gavyn Davies, the Fed would be less concerned with rate increases driven by a higher term premium. Using the two year Treasury rate as a proxy for the forward path of short rates, however, it looks clear that market participants are fundamentally reassessing Fed policy:


Note too that recent movements are not in response to higher expected inflation, and thus represent rising real rates:


What is somewhat remarkable about higher short-term rates is that at their December meeting the Fed lowered the expected path of interest rates. The average of rate expectations for year end 2015 was 106bp, down from 125bp in September. In effect, the Fed and the market are moving in different directions.
What could account for the difference? Of most concern to the Fed is that market participants simply do not believe the Federal Reserve is committed to a sustained low rate path. But what has changed to make markets doubt the Fed? To answer this, consider that the low rate story was driven by a combination of faith in the optimal control framework championed by incoming Federal Reserve Chair Janet Yellen and the belief that the decline in the unemployment rate was overstating the improvement in the labor market. I tend to think that Federal Reserve Chairman Ben Bernanke threw cold water on both ideas in his final press conference.
In the press conference, Robin Harding jumps on the Fed's tapering decision in light of the optimal control framework:
ROBIN HARDING. Robin Harding from the Financial Times. Mr. Chairman, your inflation forecasts never get back to 2 percent in the time horizon that you cover here, out to 2016. Given that, why should we believe the Fed has a symmetric inflation target? And, in particular, why should we believe you’re following an optimal policy—optimal control policy, as you’ve said in the past—given that that would imply inflation going a bit above target at some point? Thank you.
CHAIRMAN BERNANKE. Well, again, these are individual estimates, there are big standard errors implicitly around them and so on. We do think that inflation will gradually move back to 2 percent, and we allow for the possibility, as you know, in our guidance that it could go as high as 2½ percent. Even though inflation has been quite low in 2013, let me give you the case for why inflation might rise...
After explaining why the Fed expects inflation to move higher, Bernanke adds:
CHAIRMAN BERNANKE. Well, even under optimal control, it would take a while for inflation—inflation is quite—can be quite inertial. It can take quite a time to move. And the responsiveness of inflation to increasing economic activity is quite low. So—and particularly given an environment where we have falling oil prices and other factors that are contributing downward forces on inflation, it’s difficult to get inflation to move quickly to target. But we are, again, committed to doing what’s necessary to get inflation back to target over the next couple of years.
In other words, don't believe all those nice little charts Yellen has been touting that show inflation smoothly rising above two percent. We are not trying to recreate those charts, so don't expect us to maintain accommodation even if inflation is below two percent. And, by the way, we aren't really trying to drive inflation above two percent, we are just making clear that we will not panic if inflation is up to 50bp above target. Moreover, a symmetric target also means that we will not panic if inflation is 50bp below target, and it is easy to see how we get to that minimum level.
I don't really believe they will not panic if inflation crosses two percent. I think that, given the size of the balance sheet, they will panic. In my mind, the decision to taper only reinforces my belief that the Fed is more comfortable with inflation below two percent than above it. The target is not symmetric.
Regarding unemployment, read carefully:
MURREY JACOBSON. Hi. Murrey Jacobson with the NewsHour. On the question of longer-term unemployment and the drop in labor force participation, how much do you see that as the result of structural changes going on in the economy at this point? And to what extent do you think government can help alleviate that in this environment?
CHAIRMAN BERNANKE. I think a lot of the declines in the participation rate are, in fact, demographic or structural, reflecting sociological trends. Many of the changes that we’re seeing now, we were also seeing to some degree even before the crisis, and we have a number of staffers here at the Fed who have studied participation rates and the like. So I think a lot of the unemployment decline that we’ve seen, contrary to sometimes what you hear, I think a lot of it really does come from jobs as opposed to declining participation.
That being said, there certainly is a portion of the decline in participation, which is related to people dropping out of the labor force because they are discouraged, because their skills have become obsolete, because they’ve lost attachment to the labor force, and so on. The Fed can address that, to some extent, if—you know, if we’re able to get the economy closer to full employment, then some people who are discouraged or who have been unemployed for a long time might find that they have opportunities to rejoin the labor market.
But I think, fundamentally, that training our workforce to fit the needs of 21st-century industry in the world that we have today is the job of both the private educational sector and the government educational sector...
With each passing month, the Fed is moving closer and closer to the belief that the decline in unemployment is not to be dismissed as simply a cyclical decline in labor force participation that will soon be reversed. Indeed, I suspect this is why the Fed is not likely to lower the unemployment threshold anytime soon. And if the Fed is now taking the unemployment rate decline at face value, consider the implications for policy given the path of unemployment:


It doesn't take much to believe that policymakers will find themselves hiking interest rates sooner than anticipated as they increasingly believe that a rise of labor force participation is not coming - and it doesn't sound like Bernanke expects to see much of a rise. Do others? Does Yellen?
In short, it is easy to see why financial market participants would be rethinking the path of short-term rates given that the Fed is dismissing the low inflation numbers and embracing the structural explanations for declining labor force participation. Furthermore, there was some expectation that the Fed would change the unemployment thresholds as an "action" to cement the forward guidance and to counter the "action" of reducing the pace of asset purchases. The Fed disappointed on that front. The old adage "actions speak louder than words" comes to mind. It comes back to the problem the Fed faced this summer - how essential is the tool of quantitative easing in controlling the path of short-term interest rates? Can the Fed effectively promise an interest rate path that is not consistent with past behavior without the "action" tool of asset purchases to put muscle into their words?
If the Fed believes that market participants are fundamentally misreading their intentions, they will want to push back against the current rise in short term rates. They will try to do so verbally at first; I believe they will be very resistant to reversing the taper or lower the unemployment threshold. Those are tools that I anticipate the Fed will use only if they believe they have completely lost control of the expectations for short rates.
Another possibility, however, is that the Fed validates the rise in rates by pointing to signs of stronger growth. After all, the Fed's forecast is data dependent - it is not truly a challenge to the Fed's forward guidance if economic conditions change such that a different path of short term rates is appropriate. Almost certainly you should expect the hawks to embrace this explanation. More interesting, and with the possibility of creating significantly more volatility in bond markets, is the situation in which doves also embrace the "stronger growth" explanation for higher short-term yields. This, I suspect, would lead market participants to further reject the current forward guidance.
As a final possibility, consider that the recent market movements may simply reflect trading in thin holiday markets, in which case the current "markets challenging the Fed" theme would be expected to disappear quickly in the new year.
Bottom Line: The Fed's stated expected rate path looks overly dovish relative to policymakers' growing belief that the declining unemployment rate should be taken at face value and their dismissal of low inflation when making the decision to taper. Consequently, short rates are moving higher, taking long rates with them. The interpretation of these moves is complicated by stronger economic data, suggesting not that the Fed is being challenged, but that a data dependent Fed will find its current expectations inconsistent with actual path of the economy. I tend to think some of both factors are at play - that any lingering doubts about the Fed's commitment are only aggravated by better data. How doves react to rising rates is critical. They will cement the shifting expectations if they embrace the rise as an expected response to stronger data.

Wednesday, December 18, 2013

Fed Watch The Beginning of the End for Quantitative Easing

Tim Duy:

The Beginning of the End for Quantitative Easing, by Tim Duy: In his final press conference, Federal Reserve Chairman Ben Bernanke announced and explained the plan to end the quantitative easing, beginning with a $10 billion reduction in the pace of asset purchases. This policy action is something of a fitting end to Bernanke's tenure, as it marks the exit from the unconventional efforts that characterized monetary policy during the crisis. And at first blush, Bernanke and his colleagues managed the process deftly in comparison to Bernanke's ill-fated press conference in June as stock markets surged to new highs while Treasury yields edged down. Attention will now shift to the timing of the first rate hike, still not expected to arrive until 2015.

It has been long known that the Federal Reserve desperately wanted to end the asset purchase program; the issue for months has been timing the first step in that direction in coordination with market acceptance that tapering is not tightening. To that end, the Fed has leaned heavily on forward guidance to entrench expectations of the path of short term interest rates to cap the rise in long-term rates. We knew that the time for such a move was soon at hand, with analysts largely split on the exact date between the next three meetings, with no forecast coming with much conviction (I thought they would wait until after the New Year).

To justify tapering, the Fed cited progress toward goals. From the statement:

In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions, the Committee decided to modestly reduce the pace of its asset purchases.

The last labor report and its reported decline in the unemployment rate, were the final straw. Moreover, they have greater confidence in the sustainability in the pace of job gains. First, fiscal policy is on a less contractionary path:

Fiscal policy is restraining economic growth, although the extent of restraint may be diminishing.

Second, FOMC members see the risks as largely balanced rather than tilted to the downside

The Committee expects that, with appropriate policy accommodation, economic growth will pick up from its recent pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate. The Committee sees the risks to the outlook for the economy and the labor market as having become more nearly balanced.

The Federal Reserve essentially disregarded the trajectory of inflation in this decision, falling back on stable inflation expectations and their forecasts to support the policy shift.

The Fed did not, as some expected, cut the thresholds, instead choosing to enhance the forward guidance to emphasize the expectation that rates would remain low:

The Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal.

Policy makers do not seem to be inclined to change the threshold. If they can accomplish the same expectations for rates without changing the threshold, they retain flexibility and the ability to change the threshold at some point in the future if needed.

There was no hint of lowering interest on reserves. Bernanke might not believe this would have much impact. During the press conference, he said that credit was not tight. Instead, willingness and ability to borrow were the cause of weak lending. Basically, he might see this as a demand side problem, and lower interest on reserves is a supply side tool.

We learned that, assuming growth is more or less in line with the Fed's forecasts, we can pencil in a $10 billion reduction at subsequent meetings until the program is wound down at the end of 2014. To be sure, Bernanke emphasized the data dependent nature of the program, but it was clear that this is the expectation of the FOMC members.

We also learned that the Fed does not view quantitative easing as a natural extension of policy when rates hit zero, but instead it is a separate, supplemental policy. Quantitative easing works via lowering the term premium, but in normal times this impact can be mimicked with forward guidance. Moreover, quantitative easing comes along with some additional costs, including uncertainty of managing policy via the term premium and managing a greatly expanded balance sheet. The Fed would like to wind down the asset purchase program before the costs outweigh the benefits, and note the benefits have fallen now that they have held rates down via forward guidance.

Bottom Line: Another historic moment for a Federal Reserve that has had its share of historic moments in the past several years. Most likely, we can now move past the issue of tapering and asset purchases. Barring a dramatic change in the data, I doubt the Fed will reverse course. The issue now is to what extent incoming data impact our expectations of the first rate hike.

Monday, December 16, 2013

Fed Watch: FOMC Meeting Something of a Nail Biter

Tim Duy:

FOMC Meeting Something of a Nailbiter, by Tim Duy: Tapering will be on the table at this week's FOMC meeting, but will the Fed take the first step to ending the asset purchase program or let it ride into the new year? Wall Street analysts, economists, and pundits are all over the map on the tapering question, via Supeed Reddy at the Wall Street Journal. My own position is that while the Fed wants to taper, they will pass on this opportunity - although I admit I don't hold that position with any great conviction. The data flow in my opinion, is rather ambiguous in regards to tapering. Given that ambiguity, other factors will comes into play. One factor is the potential for disrupting bond markets during a traditionally illiquid month. We know from this summer's experience that the Federal Reserve is very sensitive to market functioning. Another factor is the institutional shake-up underway at the Fed. There is a potential continuity risk in changing policy now given the number of new faces among the voting members next year. In the absence of a dire rush to taper, it is reasonable to think the Fed will defer judgement until the crop of officials who will actually be carrying out the asset purchase wind down are all seated at the table.
Regarding the ambiguity of the data, I am hard-pressed to say that the economy has changed radically since September. To be sure, the employment data is arguably firmer, but this really speaks more to the tendency of Fed officials to be overly sensitive to the last data point than any real change in the underlying pace of activity. Compare the 12-month and 3-month trends in nonfarm payroll growth:


Job growth has been cycling around the 180-200k mark for 2 years. And even that cycle is suspect, partly an artifact of the impact of the recession on the seasonal adjustment procedures. Those impacts may be lessening (as they should over time) as indicated by the smaller fluctuations around the 12-month average. In short, the Fed has tended to define "stronger and sustainable" on the basis of the last two or three months of data, which thus opens the door again to tapering. It seem, however, that looking at the underlying trend the job market is neither more nor less "stronger and sustainable" now than any other time in the last two years.
Beyond employment data, broad industrial activity is rising at a relatively tepid pace:


Seems to be bouncing around 3% year-over-year. Nothing to suggest a dramatic change in pace since 2011. If anything, perhaps a bit weaker. As far as household spending is concerned, consider growth of retail sales excluding volatile auto and gasoline components:


Growth seems to have settled into the 4% year-over-year range. Broad household spending after inflation has also settled into a pattern of tepid growth:


Likewise, if you think of underlying growth as close to the average of GDP and GDI growth, that too is reasonably stable:


If you take anything but the most near-term look at the data, there is little to suggest much has changed one way or another. It's no real surprise that the Beige Book continues to describe activity as "modest to moderate." Move alone, nothing to see here, folks. But if monetary policymakers focus on the most recent few months of data, then they can argue that what they are seeing is "stronger and sustainable."
Where they might see more promise is that the forecast for fiscal policy in 2014 is brighter. The budget deal is consistent with reduced fiscal drag next year while eliminating the possibility of another budget crisis. Indeed, I think a good story can be told that 2014 is an inflection point for economic activity. Still, we have told that story before, and with that lessen in mind it seems too early to declare "sustainable" without some actual 2014 data to work with. Where the Fed might find more traction is with beginning tapering on the basis of progress toward goals with a focus on unemployment:


That said, if one of the goals is price stability, that pesky dual mandate thing is rearing its ugly head with the falling inflation numbers:


I would say the Fed needs to abandon low-inflation concerns if they taper with these numbers, instead falling back on stable inflation expectations and a forecast of rising inflation. That forecast, however, really hasn't worked out yet.
Overall, "stronger and sustainable" and "progress toward goals" are in the eye's of the beholder. Same too with "progress toward goals." It depends the goal. No wonder then that Fed officials appear so ridiculously noncommittal with regards to tapering. And no wonder then that market participants are also noncommittal over the outcome of this next meeting.
Given that ambiguity, the Fed may have a difficult time communicating any policy changes. Does the tiny taper suggest a more hawkish Fed considering the path of inflation? Or a more dovish Fed considering the path of unemployment? With no strong market expectations, the Fed may worry that any action they take would be misinterpreted in the thin holiday trading. Perhaps they believe that Federal Reserve Chairman Ben Bernanke could smooth out any issues during the press conference, but there is no certainty in that prediction. It's not like he cleared much up with the June press conference. The importance of communication is even more important given that the nature of tapering itself is on the table - no longer are we guaranteed a data-dependent policy as the calendar-dependent suggestion is on the table. Hence there is a good case to be made for leaving policy broadly unchanged with the exception of modification to the forward guidance while setting the stage for a policy shift next year.
Finally, another reason to hold policy steady is the institutional changes raining down on the Federal Reserve. Next year we see a new chair, and new vice chair, a new governor, a new president, and a change in the FOMC that brings two hawkish voices into voting positions. Presumably, policymakers should be concerned that the policies they enact today will be consistent with the desires of the policymakers of two months from now. This is especially the case when policy is at an inflection point as it is now. In the absence of pressing need, it is thus easy to make the case that policy changes should be deferred to the next group of policymakers. Now, clearly the Fed would not let such an issue dissuade it from acting during a financial crisis, or in the face of incipient inflation risks. But neither of those are on the table right now, so there is no pressing need to act. Of course, some might argue that given the impending changes, this is this Fed's last opportunity to leave its mark on policy - completely the opposite conclusion. More ambiguity.
Bottom Line: Unless you are living in a cave, you shouldn't be surprised if the Fed decides to taper this week. At the same time, you shouldn't be surprised if they do not taper. Even if they don't at this meeting, they soon will.

Monday, December 09, 2013

Fed Watch: Bullard Offers Up The Tiny Taper

Tim Duy:

Bullard Offers Up The Tiny Taper, by Tim Duy: The employment report put the December taper squarely on the table. But what about inflation? Does low inflation take the December taper off the table? That is the question I asked last week, and Gavyn Davies at the FT follows up on the theme. Davies draws attention to this line from the FOMC statement:

In judging when to moderate the pace of asset purchases, the Committee will, at its coming meetings, assess whether incoming information continues to support the Committee's expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective.

As Davies notes, surely low inflation must create a headache for central bankers desperately seeking to taper. In the US, not only is inflation not trending back up to the Fed's objective, it is actually trending away from the objective. St. Louis Federal Reserve President James Bullard acknowledges the difficult position the Fed finds itself in:

While labor market outcomes have been considerably better than those predicted at the time of the September 2012 decision, Bullard noted that inflation has surprised to the downside. “There is no widely accepted reason why inflation is running as low as it is in the face of extraordinarily accommodative policy from the Fed,” he said.

They don't know why inflation is falling, only that it is. What should they do with respect to policy? Bullard offers a solution:

“A small taper might recognize labor market improvement while still providing the Committee the opportunity to carefully monitor inflation during the first half of 2014,” Bullard said. “Should inflation not return toward target, the Committee could pause tapering at subsequent meetings,” he added.

The tiny taper is back. What makes this extraordinary is that Bullard is an inflation hawk in the sense that he typically defends the inflation target from above or below. He is believed responsible for this addition to the FOMC statement:

The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance...

Seems like he is easing back on his low inflation concerns, perhaps thinking that inflation *must* turn upward soon considering the decline in the unemployment rate.

Note, though, that he offers up the tiny taper in the context of leaving the asset purchase progam data dependent. Other policymakers, however, want to shift the QE to a calendar dependent program. This I suspect Bullard would only be willing to accept if inflation was on a clear upward trajectory.

Bullard also discussed options for forward guidance:

He discussed three possible options for altering forward guidance, including lowering the unemployment threshold. However, Bullard cautioned, this “puts the credibility of the thresholds approach at risk.” He said another option would be to establish an inflation floor at 1.5 percent, which would be symmetric with the current forward guidance on inflation and which could be helpful if inflation continues to behave in an unusual manner. The third option would be to state verbally that the FOMC is unlikely to raise rates even after the 6.5 percent unemployment threshold is crossed, which Chairman Ben Bernanke has already done. This option is “less complicated and possibly just as effective,” Bullard said.

There seems to be a general resistance to changing the unemployment threshold, in part I suspect because there is lingering concern that the Phillip's Curve will rear its head before unemployment hits 5.5% or even 6%. And I would think that the erratic behavior of inflation is exactly why they would avoid tying their hands with an inflation floor. After all, arguably the "erratic" behavior of unemployment has already given them enough of a headache. I tend to think the FOMC will come around to the third option of verbally reinforcing the existing thresholds. It is indeed less complicated, as Bullard notes.

Bottom Line: The Federal Reserve wants to taper. Wants very badly to taper, in my opinion. The recent employment reports seem to be giving a green light, and I suspect they are coming around to the idea that the decline in the labor force participation rate is largely permanent at this point, which will only increase their angst about the asset purchase program. But inflation is a thorn in their sides. The Fed will need to do a 180-degree turn on its current inflation concerns. If they dismiss the inflation concern in their drive to taper, I suspect they will lean on the stable inflation expectations and Phillips Curves arguments to justify a forecast that has inflation quickly reversing course and trending to target. I still tend to believe the Fed will delay tapering until 2014. Whether December or January or later, policy is close to an inflection point with a shift from more to less accommodation in the works.

Friday, December 06, 2013

Fed Watch: Stronger and Sustainable, But...

Tim Duy:

Stronger and Sustainable, but..., by Tim Duy: The employment report produced a modest upside surprise with a gain of 203k jobs in November, remarkably close to my estimate of 211k from yesterday, which I might as well enjoy because it will never happen again. In addition, the unemployment rate fell to 7% while the labor force participation rates ticked up 0.2 percentage points. Smells like a tapering report. And with that in mind the market reaction to the news should please Fed official, as bond markets were flat while stocks gained. That too should be something of a green light to taper. I can't help but think, however, that today was something of a goldilocks days for markets, because while the labor report was solid, both headline and core inflation are still headed south. How will the Fed react to the inflation numbers? That seems to be the real question.
In my opinion, the employment report confirms what I said yesterday: The trend of improvement in labor markets remains intact. Indeed, on a twelve-month basis nfp growth is very, very steady:


In the context of the Yellen charts, the steady nfp growth is contributing to a similarly steady decline in the unemployment rate, while the the hiring and quit rates are barely edging higher:


The drop in the unemployment rate reveals the challenges with the Fed's forward guidance. As Victoria McGrane at the WSJ notes, Federal Reserve Chairman Ben Bernanke gave a clear signal earlier this year that the Fed expected its bond buying plan to be wound down by the time the unemployment rate hit 7%. We haven't even started the taper yet. I tend to think the 7% marker was the single biggest communications failure on the part of the Fed, and contributed greatly to the bond market volatility earlier this year. Of course, it is an error the Fed will never admit to.
The steady recent gains in job growth coupled with the decline in the unemployment rate certainly put tapering on the table at the next FOMC meeting. But a policy move at that point seems premature. The issue of tapering is currently wrapped up with a host of issues as noted by Jon Hilsenrath at the WSJ:
Fed officials are likely to debate at their December 17-18 meeting whether to go ahead and pull back on the bond-buying program then or wait until the January 28-29 meeting, Ben Bernanke’s last as Fed chairman, or even later. Waiting until January will give them a little more time to confirm their increasing optimism about the economy and more time to finalize their exit strategy from the bond program and prepare markets for how they’ll proceed. They still have lots of questions to answer about the overall thrust of their policies and how they communicate their plans. Some officials want to put a cap on the overall amount of bonds they plan to buy, rather than leave it open-ended. They’ve also been debating for several months whether to once again alter their guidance to the public about when they’ll raise short-term interest rates.
I tend to believe that they will want to firm up their communications stance prior to tapering, so I have tended to push my tapering expectations into next year. Moreover, the Personal Income and Outlays report leave me cautious about a December taper. The data don't suggest an acceleration of household spending activity:


More worrisome is that inflation continues to fall:


And some of the improvement we saw earlier this year has faded:


It seems premature to expect tapering while inflation is still trending down. Indeed, Chicago Federal Reserve President Charles Evans expressed some caution today:
The official, a voting member of the monetary policy setting Federal Open Market Committee, also said he was “nervous about inflation developments” describing the data as being “substantially” short of the Fed’s 2% target.
He said the Fed had to be prepared to defend the target from above and below.
I suspect Minneapolis Federal Reserve President Narayana Kocherlakota and St. Louis Federal Reserve President James Bullard with have similar concerns. If ultimately everything hinges on price stability over the long-run, the inflation decline should be very disconcerting to the entire FOMC.
Altogether, we have the makings of a very contentious FOMC meeting. Consider the issues at hand:
  • The Fed will update their forecasts, which will have an impact on their policy stance.
  • Do they focus on "stronger and sustainable," "progress toward goals," "dual-mandate", or "cost vs. efficacy" when assessing the large scale asset purchase program?
  • Taper or not? When they taper, do they switch from data-dependent policy to a calendar-dependent policy?
  • How do they balance the labor market improvement versus the inflation rate deterioration?
  • Leave the current thresholds in place? If so, do they enhance forward guidance? Do they put in place an inflation floor?
  • Cut the interest rate paid on reserves?
I don't sense broad agreement among FOMC participants on any of these issues. And all of these issues appear to be tied together in the context of an overall strategy for monetary policy, which means agreement and action on just one item leaves open the door for future conflict and communication failures. It seems too much to expect the December meeting to produce sufficient agreement to justify changing policy; instead, it seems like the best we should expect is that they lay the groundwork to next year's policy path.
Bottom Line: The employment report raises the odds of a December taper. But does the inflation report lower the odds by the same amount? Seems like that is a recipe for bond market stability. Overall, I tend to believe the range of contentious issues yet to be decided on leaves the odds of tapering below 50%. You kind of have to throw-out half the dual mandate, or make an argument that tapering is about labor markets only, to pull the trigger on tapering with inflation still trending down. That seems like it should be a problem for the FOMC.

Thursday, December 05, 2013

Fed Watch: Ahead of the Employment Report

Tim Duy:

Ahead of the Employment Report, by Tim Duy: Another first Friday, another employment report. Although the general expectation is that the Fed holds its currently policy in place, there is speculation that the monetary policymakers could pull the trigger on tapering this month if we see another employment report that could be deemed sufficient to declare the labor recovery "stronger and sustainable." After all, it is not unreasonable to expect that, after tomorrow, three of the four most recent readings on the labor market revealed job growth in excess of 200k per month.
That said, caution would be warranted before taking an overly optimistic position based on these data. The gains may not be sustainable if US growth slows in the final quarter of the year as expected (indeed, the third quarter spurt is less than meets the eye). Moreover, Fed officials must be somewhat wary of reading too much into the data given the pattern of fall/winter strength seen in recent years. With these considerations in mind, it seems that sufficient certainty to justify tapering would not be evident until late in the first quarter of next year. This assumes, of course, the Fed doesn't pull a different rabbit out of its hat - progress toward goals or cost/benefit analysis - to justify tapering sooner than anticipated.
Forecasting the employment report is a notoriously hazardous activity. One quick and dirty method is a regression based on the ADP report, the ISM nonmanufacturing employment Index, and initial unemployment claims:


The one-step ahead forecasts since 2004 closely match the actual data:


The model predicts payroll growth of 211k for November, somewhat higher than consensus of 180k. But of course there are still occasions of particularly large errors. And this type of analysis is conditioned on the revised data. Tomorrow we get the preliminary report - the market moving report. It seems that no one cares much if you correctly anticipate the revised data; by the time that is released, the focus is on the next preliminary numbers. Overall, my takeaway is that is that this kind of model tells us that we should expect job growth consistent with that seen in past months. I don't read much into the specific forecast.
The Fed might be sensitive to the most recent report, which is why fears of imminent tapering will arise if the number surprises strongly to the upside. Still, one number should not make a policy decision. Indeed San Francisco Federal Reserve President John WIlliams seemed to have a relatively high bar for tapering in an interview with Reuter's Ann Saphir:
As for the Fed's massive asset-purchase program, Williams said the Fed should only reduce it once it is "completely confident that the economy is on the right track."
I have difficulty imagining that one number could leave the Federal Reserve "completely confident" about the pace of activity. The Beige Book, for example, gives no hints that the pace of activity has changed much at all. Like October, the economy was described as "modest to moderate" with no inflation to be seen despite continuing concerns about the supply of "qualified workers":
Hiring showed a modest increase or was unchanged across Districts. Difficulty with finding qualified workers, especially for high-skilled positions, was frequently reported. Upward pressure on wages and overall price inflation were contained. Contacts in many Districts voiced concern about future cost increases attributable to the Affordable Care Act and other types of federal regulation.
I still find talk of tapering frustrating in the context of the FOMC forecast. Inflation is well below target and there is no imminent threat of it accelerating to the 2.5% threshold. Unemployment remains unacceptably high. And their forecasts are likely to show that a return to potential output remains years away. One reason they seem to be focused on tapering is the expectation that the fiscal drag will ease in 2014, thus eliminating the need for QE. But that would seem to be a missed opportunity to give the economy a turbo boost to more quickly meet the Fed's policy objectives. What exactly is the pressing need to end the asset purchase program?
The need, I still suspect, could be found in the Fed's double-secret analysis of the costs/efficacy of QE. I would appreciate an entire speech on this topic, complete with a list of specific, quantified costs and benefits so that we can track understand the calculus underlying the Fed decision making.
Until we see that calculus, we need to fall back on the data dependent nature of all the Fed's programs. And if that data didn't support tapering in September, I am hard-pressed to say that enough stronger data has arrived to change that decision. I really hope I don't have to eat those words tomorrow!
In any event, the Fed would like us to shift our attention from tapering to interest rates. Indeed, it very well might be the case that the big tapering market move is behind us, and the Fed can now taper with little implication for financial markets. Thus would set the stage for the sort-of-normalization of policy. Williams was pushing in this direction:
"My view would be that we would not be raising the funds rate even if the unemployment rate was below 6.5 percent as long as inflation continued to be low, for some time," Williams said. "We need to be communicating more about the post-6.5-percent world now, because it could be with us much sooner than we expect, and I don't want market participants to be surprised."
The interview does not indicate that Williams is pushing to change the unemployment threshold. This seems more consistent with my view that the FOMC is more interested in strengthening the "threshold not trigger" language in the statement. What happen's after the unemployment rate hits 6.5% is going to be interesting; at that point, if they don't want to change the thresholds, I expect they have to get rid of the thresholds altogether. The unemployment threshold itself would be nonsensical at a 6.4% unemployment rate.
If there are any substantive policy changes in the FOMC, I expect they will be in the nature of the forward guidance. I think they want to confirm they have a firm hold on the short end of the yield before they taper. There is the possibility that they drop the rate of interest on reserves. Williams again:
Williams said he also supported cutting the interest paid to banks on the excess reserves they keep at the central bank as a way to signal the Fed's commitment to low rates. "I think it would make sense," he said, although he acknowledged that policymakers have considered, and rejected, the idea several times over the years.
As Williams notes, this idea comes in and out of fashion at the Fed. Policymakers apparently don't view it as having the potential for a huge boost, but they seem to be viewing it as less risky than previously thought.
Finally, one other thing of note from the William's interview:
...once the Fed decides the economy is strong enough for the Fed to reduce its $85 billion in monthly bond purchases, it should announce an end date and a purchase total for the program, Williams said.
This follows in the thinking of hawk Philadelphia Fed President Charles Plosser, who argued that the Fed cap the size of the program to enhance it's credibility (not sure how this works; ultimately credibility is built on meeting the Fed's objectives, which are not currently in danger, and least in the direction Plosser seems to believe). If this kind of proposal does gain favor, note that it represents a shift from a data dependent policy to another time dependent policy. Once some threshold is reached, the program shifts into automatic. Didn't the Fed just spend the summer convincing us that policy was not time dependent? Why change now? If they do change, why should we believe the same change will not occur with rate policy? Just food for thought.
Bottom Line: Another month, another employment report. With the fiscal shutdown in the rear-view mirror, Fed officials are turning their attention back to policy normalization. They want to taper, but remain wary of pulling the trigger on tapering too quickly. I tend to believe that, on balance, the FOMC needs to see a few more months of data given the uncertainty about the path of GDP before they were completely comfortable tapering. That said, one can make a reasonably solid argument for tapering if the November employment report adds to the recent string of 200k+ payroll gains. My expectation is that even a positive report will not trigger a taper with month; instead, the statement is most likely to evolve to reflect a new emphasis on forward guidance. But I can't rule out a tapering surprise.

Thursday, November 21, 2013

Fed Watch: Desperate to Taper

Tim Duy:

Desperate to Taper, by Tim Duy: The minutes of the October FOMC meeting leave little doubt that the Fed increasingly desires to end the asset purchase program, enough so to contemplate tapering regardless of seeing satisfactory improvement in labor markets. It is that desire - or perhaps desperation - that puts an element of random chance into the policymaking process and keeps the expectation of near-term tapering alive despite efforts of policymakers to reassure market participants that it is all data dependent. Trouble with that story is simple - it is not only data dependent. The Fed has already admitted as much.
Policy planning and communication strategy were the hot topic of this FOMC meeting, and the discussion of the specifics of the asset purchase program began with:
During this general discussion of policy strategy and tactics, participants reviewed issues specific to the Committee's asset purchase program. They generally expected that the data would prove consistent with the Committee's outlook for ongoing improvement in labor market conditions and would thus warrant trimming the pace of purchases in coming months.
The mythical taper - just a few months away. And it will always be just a few months away given the broad weakness in the labor chart. Recall the Yellen Charts:


Unless they narrow their focus to only the unemployment rate, the argument to taper is challenged to say the least. It is even more challenged considering inflation indicators. Knowing that the data continuously refuses to cooperate, the Fed explores plan B:
However, participants also considered scenarios under which it might, at some stage, be appropriate to begin to wind down the program before an unambiguous further improvement in the outlook was apparent.
To be sure, some doves shrieked:
A couple of participants thought it premature to focus on this latter eventuality, observing that the purchase program had been effective and that more time was needed to assess the outlook for the labor market and inflation; moreover, international comparisons suggested that the Federal Reserve's balance sheet retained ample capacity relative to the scale of the U.S. economy.
It may be premature, but if they are going to go down that road, they had better have an explanation:
Nonetheless, some participants noted that, if the Committee were going to contemplate cutting purchases in the future based on criteria other than improvement in the labor market outlook, such as concerns about the efficacy or costs of further asset purchases, it would need to communicate effectively about those other criteria.
And there it is - the missing piece. We know the Fed has been looking to pull the plug on asset purchases, they just haven't explained why. Well, not exactly. Federal Reserve Chairman Ben Bernanke was more direct on the subject in his speech this week:
..though a strong majority of FOMC members believes that both the forward rate guidance and the LSAPs are helping to support the recovery, we are somewhat less certain about the magnitudes of the effects on financial conditions and the economy of changes in the pace of purchases or in the accumulated stock of assets on the Fed's balance sheet. Moreover, economists do not have as good an understanding as we would like of the factors determining term premiums; indeed, as we saw earlier this year, hard-to-predict shifts in term premiums can be a source of significant volatility in interest rates and financial conditions. LSAPs have other drawbacks not associated with forward rate guidance, including the risk of impairing the functioning of securities markets and the extra complexities for the Fed of operating with a much larger balance sheet, although I see both of these issues as manageable.
The problem with this cost and efficacy approach is that new "costs" could pop up at anytime. Definitely a policy wild card, and one the Fed is increasingly considering using.
The desire to taper also drives the frantic search for alternative modes of accommodation:
In those circumstances, it might well be appropriate to offset the effects of reduced purchases by undertaking alternative actions to provide accommodation at the same time.
One such way would be enhanced forward guidance:
As part of the planning discussion, participants also examined several possibilities for clarifying or strengthening the forward guidance for the federal funds rate, including by providing additional information about the likely path of the rate either after one of the economic thresholds in the current guidance was reached or after the funds rate target was eventually raised from its current, exceptionally low level.
There was not, however, widespread support for changing the thresholds:
A couple of participants favored simply reducing the 6-1/2 percent unemployment rate threshold, but others noted that such a change might raise concerns about the durability of the Committee's commitment to the thresholds. Participants also weighed the merits of stating that, even after the unemployment rate dropped below 6-1/2 percent, the target for the federal funds rate would not be raised so long as the inflation rate was projected to run below a given level. In general, the benefits of adding this kind of quantitative floor for inflation were viewed as uncertain and likely to be rather modest, and communicating it could present challenges, but a few participants remained favorably inclined toward it.
Instead, the favored path seems to be incorporating what we have been hearing from policymakers more directly in the FOMC statement:
Several participants concluded that providing additional qualitative information on the Committee's intentions regarding the federal funds rate after the unemployment threshold was reached could be more helpful. Such guidance could indicate the range of information that the Committee would consider in evaluating when it would be appropriate to raise the federal funds rate. Alternatively, the policy statement could indicate that even after the first increase in the federal funds rate target, the Committee anticipated keeping the rate below its longer-run equilibrium value for some time, as economic headwinds were likely to diminish only slowly.
Essentially, a commitment to ignore the thresholds without changing the thresholds. Later, the Fed circled back to an oldy but a goody:
Participants also discussed a range of possible actions that could be considered if the Committee wished to signal its intention to keep short-term rates low or reinforce the forward guidance on the federal funds rate. For example, most participants thought that a reduction by the Board of Governors in the interest rate paid on excess reserves could be worth considering at some stage, although the benefits of such a step were generally seen as likely to be small except possibly as a signal of policy intentions.
Notice a theme above? Fed officials have little faith in any of their alternatives. They want to pull back from quantitative easing, fearing that the costs will turn against them soon, yet have little to offer in return. Not good - it is almost as if the Fed is beginning to believe that they are near the end of their rope.
Interestingly, one of the costs of quantitative easing seems to be the inability to exit quantitative easing. This was revealed in today's bond market sell-off after the minutes were released. Despite the Fed's repeated efforts to use forward guidance to hold down rates, despite repeated reassurances that tapering is not tightening, Treasury yields gain almost 10 basis points at the 10 year horizon on even a whisper of tapering - and this after Bernanke's dovish speech and Vice Chair Janet Yellen's (perceived) dovish Senate hearing last week. Fine tuning policy with a tool of uncertain force is something of a challenge. Sufficient faith in an alternative tool would help clear the way for tapering despite this uncertainty, but after reading these minutes, I am somewhat concerned such faith is lacking.
Bottom Line: Clear evidence of the space we have been in for months. The Fed wants to taper, and is becoming increasingly nervous they will need to pull the trigger on that option before the data allows. That means that tapering is not data dependent. That means the policy deck is stacked with at least one wild card. And that sounds like a recipe for the kind of volatility the Fed is looking to avoid.