Category Archive for: Fed Watch [Return to Main]

Friday, April 03, 2015

Fed Watch: Air Pocket

Fed Watch:

Air Pocket, by Tim Duy: The employment data hit an air pocket in March, in line with a variety of softer economic news in the first quarter. That said, it likely will have little near term impact on Fed policy; I anticipate they will tend to dismiss the number as expected volatility in the overall upward path of job growth.
Job growth was paltry 126k in March and, in what might be a greater indication that US labor markets are hitting an inflection point, the January and February numbers were revised downward. The three-month moving average dipped sharply, while the 12-month moving average is leveling out:

NFPa040315

A clear slowdown in the good producing sector is contributing to the weaker numbers as the impact of lower oil prices works through mining. That factor, the stronger dollar, and the West coast port slowdown are also likely taking a toll on manufacturing. Flat construction numbers also contributed.
The unemployment rate was unchanged at 5.5% and wage growth remains tepid compared to last year. Payrolls in the context of indicators previously cited by Federal Reserve Chair Janet Yellen:

NFPc040315

NFPb040315

Broad yet still slow general improvement in underemployment indicators.

How does this impact the Fed's outlook? First, some recent quotes from policymakers, beginning with Federal Reserve Chair Janet Yellen:

...I anticipate that real gross domestic product is likely to expand somewhat faster than its potential in coming quarters, thereby promoting further gains in employment and declines in the unemployment rate.

And:

...a significant pickup in incoming readings on core inflation will not be a precondition for me to judge that an initial increase in the federal funds rate would be warranted...

...That said, I would be uncomfortable raising the federal funds rate if readings on wage growth, core consumer prices, and other indicators of underlying inflation pressures were to weaken, if market-based measures of inflation compensation were to fall appreciably further, or if survey-based measures were to begin to decline noticeably...

San Francisco Federal Reserve President John Williams, via the Wall Street Journal:

“Things are looking better–in fact, they’re looking downright good,” the official said in a speech to be delivered to an audience in Sydney and Melbourne via video.

Given how much the economy has improved and is likely to continue to gain ground, “I think that by mid-year it will be the time to have a discussion about starting to raise rates,” Mr. Williams said.

The strength of the U.S. dollar against a “broad index” of currencies is not an impediment to the U.S. economy reaching real GDP growth of 2.5% this year, he said.

“The U.S. economy has good momentum…even with what is a rather large appreciation of the U.S. dollar,” Mr. Williams said.

Atlanta Federal Reserve President Dennis Lockhart, via the New York Times:

The slowness in the first quarter obviously raises concerns that we’re going to see a continuing or persistent slowdown, but that’s not my base case view. My base case view is that we’ll see a rebound in the second and third quarter and beyond and that we’ll stay on the basic track that has been our story, our narrative here, for the last year or more. And that is a 2.5 percent to 3 percent growth rate with continuing improvement on the employment front, and gradual rise in inflation toward the 2 percent target. So to some extent I’m taking on a Wilbur Mills position: That’s my story and I’m sticking to it.

St. Louis Federal Reserve President James Bullard, via the Wall Street Journal:

Mr. Bullard said he expects the economy to recover in the second quarter following a soft start to the year as low gasoline prices fuel consumer spending. He added the European Central Bank’s decision to begin buying government bonds is driving down bond yields in the U.S., too, keeping a lid on corporate and household borrowing costs.

“These facts put us in a position for normalization of us monetary policy in 2015,” Mr. Bullard told the City Week conference.

You get the picture. Federal Reserve officials are clearly looking past the first quarter. Hence, while the number was clearly disappointing, I will stick with my thoughts from earlier this week:

Yellen intends to look through any first quarter weakness in GDP data, seeing it as largely an aberration (like arguably the first quarter of last year), as long as the employment data continues to hold up. And even there, I doubt any one weak report would do much to undermine her confidence in the recovery; we should be focusing on the story told by the next three employment reports in aggregate.

That said, I would also add that this strengthens the case that the Federal Reserve will need to move further in the direction of financial markets toward a slower and lower path of normalization than currently anticipated by the Summary of Economic Projections. It may be that if the March number was an outlier to the downside, the strong job growth in November and December of last year where outliers to the upside. On net, then job growth is solid, but still less robust than anticipated at the end of last year. Combined with lower estimates of the natural rate of unemployment, this would naturally push back and down the policy path.

Bottom Line: One jobs report is just that - one report. It needs to be placed in context of subsequent reports to confirm or deny the underlying trend, at least as far as policymakers are concerned. At the moment they seem content to believe the first quarter will be an aberration overall. If it looks like less of an aberration come June, they will be forced to push normalization plans back into the fourth quarter. This would make them less than happy.

Wednesday, March 18, 2015

Fed Watch: Yellen Strikes a Dovish Tone

Tim Duy:

Yellen Strikes a Dovish Tone, by Tim Duy: The FOMC concluded its two-day meeting today, and the results were largely as I had anticipated. The Fed took note of the recent data, downgrading the pace of activity from "solid" to "moderated." They continue to expect inflation weakness to be transitory. The risks to the outlook are balanced. And "patient" was dropped; April is still off the table for a rate hike, but data dependence rules from that point on.
Growth, inflation and unemployment forecasts all came down. Especially important was the decrease in longer-run unemployment projections. The Fed's estimates of NAIRU are falling, something almost impossible to avoid given the stickiness of wage growth in the face of falling unemployment. The forecast changes yielded a downward revision to the Fed's interest rate projections. In addition, the strong dollar was clearly on the Fed's mind. Federal Reserve Chair Janet Yellen often referred to the dollar and its impact on growth in the press conference, much more than I expected. I think they are probably happy the dollar took a hit today. On net, I think this from last week stood up well:
...assuming the Federal Reserve takes sufficient note of the rising dollar, and its impact on inflation, by lowering the expected path of short term interest rates. And perhaps this is exactly what is revealed in next week's Summary of Economic Projections. Look for the possibility next week that the Fed is both hawkish - by opening the door for a June hike - and dovish - by lowering the median rate projections in the dot plot.
Note that the Fed is capitulating here. The distance between the bond market and the Fed rate expectations has been something of a conundrum for policymakers. But it is now clear the bond market is not moving toward the Fed; the Fed is moving toward the bond market. Going forward, they still believe that their rate forecast is accommodative. Based on the new estimate of NAIRU and New York Federal Reserve President William Dudley's recent estimate of the equilibrium rate, they are correct:

FOMCa

But if you assume a lower equilibrium interest rate, the Fed's rate forecast has more downside to it if they wish to remain accommodative:

FOMCb

For what it's worth, this is what San Fransisco Federal Reserve President John Williams' research suggests about the current equilibrium rate:

FOMCc

Is June really on the table? Regarding the timing of the first rate hike, the FOMC had this to say:
The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.
Yellen was pushed to quantify "reasonably confident" during the press conference, but she declined to give a mechanical answer. Actual inflation, the path of the labor market, wage growth, and measures of inflation expectations were all fair game in the assessment. She did say wage growth was not a precondition for rate hike. I tend to think that unemployment dropping to 5% or an acceleration in wage growth is sufficient to prompt the first rate hike, either of which could still happen by the time of the June meeting. That said, at this point, the inflation and growth data point to a later lift-off, and weighting the expectations for a rate hike at a later date seems appropriate at this juncture.
Bottom Line: Yellen does it again - she moves the Fed both closer to and further from the first rate hike of this cycle. By moving toward the markets on the path of rate hikes, the Fed acknowledges that they are eager to let this recovery run on. Moreover, they proved that they are in fact data dependent by moving policy in the direction of the data. Overall, Yellen has managed the transition away from what the Fed came to see as excessive forward guidance just about as well as could be expected.

Monday, March 16, 2015

Fed Watch: The End of "Patient" and Questions for Yellen

Tim Duy:

The End of "Patient" and Questions for Yellen, by Tim Duy: FOMC meeting with week, with a subsequent press conference with Fed Chair Janet Yellen. Remember to clear your calendar for this Wednesday. It is widely expected that the Fed will drop the word “patient” from its statement. Too many FOMC participants want the opportunity to debate a rate hike in June, and thus “patient” needs to go. The Fed will not want this to imply that a rate hike is guaranteed at the June meeting, so look for language emphasizing the data-dependent nature of future policy. This will also be stressed in the press conference.

Of interest too will be the Fed’s assessment of economic conditions since the last FOMC meeting. On net, the data has been lackluster – expect for the employment data, of course. The latter, however, is of the highest importance to the Fed. I anticipate that they will view the rest of the data as largely noise against the steadily improving pace of underlying activity as indicated by employment data. That said, I would expect some mention of recent softness in the opening paragraph of the statement.

I don’t think the Fed will alter its general conviction that low readings on inflation are largely temporary. They may even cite improvement in market-based measures of inflation compensation to suggest they were right not to panic at the last FOMC meeting. I am also watching for how they describe the international environment. I would not expect explicit mention of the dollar, but maybe we will see a coded reference. Note that in her recent testimony, Yellen said:

But core PCE inflation has also slowed since last summer, in part reflecting declines in the prices of many imported items and perhaps also some pass-through of lower energy costs into core consumer prices.

Stronger dollar means lower prices of imported items.

The press conference will be the highlight of the meeting. Presumably, Yellen will continue to build the case for a rate hike. Since the foundation of that case rests on the improvement in labor markets and the subsequent impact on inflationary pressures, it is reasonable to ask:

On a scale of zero to ten, with ten being most confident, how confident is the Committee that inflation will rise toward target on the basis on low – and expected lower - unemployment?

Considering that low wage growth suggests it is too early to abandon Yellen’s previous conviction that unemployment is not the best measure of labor market tightness, we should consider:

Is faster wage growth a precondition to raising interest rates?

I expect the answer would be “no, wages are a lagging indicator.” The Federal Reserve seems to believe that policy will still remain very accommodative even after the first rate hike. We should ask for a metric to quantify the level of accommodation:

What is the current equilibrium level of interest rates? Where do you see the equilibrium level of interest rates in one year?

A related question regards the interpretation of the yield curve:

Do you consider low interest long-term interest rates to be indicative of loose monetary conditions, or a signal that the Federal Reserve needs to temper its expectations of the likely path of interest rates as indicated in the “dot plot”?

Relatedly, differential monetary policy is supporting capital inflows, depressing US interest rates and strengthening the dollar. This dynamic ignited a debate of what it means for the economy and how the Fed should or should not respond. Thus:

The dollar is appreciating at the fastest rate in many years. Is the appreciating dollar a drag on the US economy, or is any negative impact offset by the positive demand impact of looser monetary policy abroad? How much will the dollar need to appreciate before it impacts the direction of monetary policy?

Given that the Fed seems determined to raise interest rates, we should probably be considering some form of the following as a standard question:

Consider the next six months. Which is greater - the risk of moving too quickly to normalize policy, or the risk of delay? Please explain, with specific reference to both risks.

Finally, a couple of communications questions. First, the Fed is signaling that they do not intend to raise rates on a preset, clearly communicated path like the last hike cycle. Hence, we should not expect “patient” to be replaced with “measured.” But it seems like the FOMC is too contentious to expect them to shift from no hike one meeting to 25bp the next, then back to none – or maybe 50bp. So, let’s ask Yellen to explain the plan:

There appears to be an effort on the part of the FOMC to convince financial markets that rate hikes, when they begin, will not be on a pre-set path. Given the need for consensus building on the FOMC, how can you credibly commit to renegotiate the direction of monetary policy at each FOMC meeting? How do you communicate the likely direction of monetary policy between meetings?

Finally, as we move closer to policy normalization, the Fed should be rethinking the “dot plot,” which was initially conceived to show the Fed was committed to a sustained period of low rates. Given that the dot-plot appears to be fairly hawkish relative to market expectations, it may not be an appropriate signal in a period of rising interest rates. Time for a change? But is the Fed considering a change, and when will we see it? This leads me to:

Cleveland Federal Reserve President Loretta Mester has suggested revising the Summary of Economic Projections to explicitly link the forecasts of individual participants with their “dots” in the interest rate projections. Do you agree that this would be helpful in describing participants’ reaction functions? When will this or any other revisions to the Summary of Economic Projections be considered?

Bottom Line: By dropping "patient" the Fed will be taking another step toward the first rate hike of this cycle. But how long do we need to wait until that first hike? That depends on the data, and we will be listening for signals as to how, or how not, the Fed is being impacted by recent data aside from the positive readings on the labor market.

Thursday, March 12, 2015

Fed Watch: Will the Dollar Impact US Growth?

Tim Duy:

Will the Dollar Impact US Growth?, by Tim Duy: A quick one while I wait for my flight at National. Scott Sumner argues that the strong dollar will not impact US growth. In response to a Washington Post story, he writes:

This is wrong, one should never reason from a price change. There are 4 primary reasons why the dollar might get stronger:

1. Tighter money in the US (falling NGDP growth expectations.)
2. Stronger economic growth in the US.
3. Weaker growth overseas.
4. Easier money overseas.

In my view the major factor at work today is easier money overseas. For instance, the ECB has recently raised its growth forecasts for 2015 and 2016, partly in response to the easier money policy adopted by the ECB (and perhaps partly due to lower oil prices—but again, that’s only bullish if the falling oil prices are due to more supply, not less demand–see below.) That sort of policy shift in Europe is probably expansionary for the US.

The initial point is correct - arguing from a price change is a risky proposition. Go to the underlying factors. But I think the next paragraph is a bit questionable. I think that the policy shift in Europe does reduce tail risk for the global economy, and is therefore a positive for the US economy (I suspect the Fed thinks so as well). But it reduces tail risk because ECB policy is supporting not one but two positive economic shocks - both falling oil and a rising falling Euro. And, all else equal, a rising falling euro means a stronger dollar, which means a negative for the US economy. Tail risk for Europe is reduced at a cost for the US economy (a cost that the Federal Reserve and US Treasury both seem willing to endure).

That said, all this means is that Sumner is right, you can't reason from a price change, but reasoning in a general equilibrium framework is very, very hard. Sumner gets closer here, but still I think falls short:

However NGDP growth forecasts in the Hypermind market have trended slightly lower in the past couple of months. Unfortunately, this market is still much too small and illiquid to draw any strong conclusions. Things will improve when the iPredict futures market is also up and running, and even more when the Fed creates and subsidizes a NGDP prediction market. But that’s still a few years away. Nonetheless, let’s assume Hypermind is correct. Then perhaps money in the US has gotten slightly tighter, and perhaps this will cause growth to slow a bit. But in that case the cause of the slower growth would be tighter money, not a stronger dollar.

So let's try to close the circle - not only can't you reason from a price change, but also you need to pay attention to the entire constellation of prices. If ECB policy - and, by extension, the falling euro - was a net positive for the US economy, shouldn't we expect higher long US interest rates? But long US rates continue to hover around 2%, which seems crazy given the Fed's stated intention to start raising rates. Consider, however, that the stronger dollar does in fact represent tighter monetary conditions, but long interest rates are falling, which acts as a counterbalance by loosening financial conditions. Essentially, markets are anticipating that the stronger dollar saps US growth, but the Fed will respond with a slower pace of policy normalization, which acts in the opposite direction. So the stronger dollar does negatively impact growth, but market participants expect a monetary offset.

Hence - and I think Sumner would agree with this - the ball is in the Federal Reserve's court. The stronger dollar is a negative for the US economy, while the expected impact on monetary policy is a positive. The net impact is neutral. You should anticipate a stronger domestic economy offset by a larger trade deficit.

That is, of course, assuming the Federal Reserve takes sufficient note of the rising dollar, and its impact on inflation, by lowering the expected path of short term interest rates. And perhaps this is exactly what is revealed in next week's Summary of Economic Projections. Look for the possibility next week that the Fed is both hawkish - by opening the door for a June hike - and dovish - by lowering the median rate projections in the dot plot.

Update: I see Paul Krugman is lamenting the possibility that some FOMC members interpret falling interest rates as reason to tighten policy more aggressively - a view primarily outlined by New York Federal Reserve President William Dudley. My read of the bond market implies that market participants expect the opposite - the Fed needs to accept additional financial accommodation. That said, Dudley's stance clearly opens the door to the possibility of the Fed running an excessively tight policy stance, which wouldn't happen if they took their inflation target seriously.

Friday, March 06, 2015

Fed Watch: 'Patient' is History

Tim Duy:

Patient' is History: The February employment report almost certainly means the Fed will no longer describe its policy intentions as "patient" at the conclusion of the March FOMC meeting. And it also keep a June rate hike in play. But for June to move from "in play" to "it's going to happen," I still feel the Fed needs a more on the inflation side. The key is the height of that inflation bar.

The headline NFP gain was a better-than-expected 295k with 18k upward adjustment for January. The 12-month moving average continues to trend higher:

NFPa030615

Unemployment fell to 5.5%, which is the top of the central range for the Fed's estimate of NAIRU. Still, wage growth remains elusive:

NFPb030615

Is wage growth sufficient to stay the Fed's hand?  I am not so sure. I recently wrote:

My take is this: To get a reasonably sized consensus to support a rate hike, two conditions need to be met. One is sufficient progress toward full-employment with the expectation of further progress. I think that condition has already been met. The second condition is confidence that inflation will indeed trend toward target. That condition has not been met. To meet that condition requires at least one of the following sub-conditions: Rising core-inflation, rising market-based measures of inflation compensation, or accelerating wage growth. If any were to occur before June, I suspect it would be the accelerating wage growth.

I am less confident that we will see accelerating wage growth by June, although I should keep in mind we still have three more employment reports before that meeting. Note, however, low wage growth does not preclude a rate hike. The Fed hiked rates in 1994 in a weak wage growth environment:

NFPg030615

And again in 2004 liftoff occurred on the (correct) forecast of accelerating wage growth:

NFPf030615

So wage growth might not be there in June to support a rate hike. And, as I noted earlier this weaker, I have my doubts on whether core-inflation would support a rate hike either. That leaves us with market-based measures of inflation compensation. And at this point, that just might be the key:

NFPe030615

If bond markets continue to reverse the oil-driven inflation compensation decline, the Fed may see a way clear to hiking rates in June. But the pace and timing of subsequent rate hikes would still be data dependent. I would anticipate a fairly slow, halting path of rate hikes in the absence of faster wage growth.

Bottom Line:  "Patient" is out. Tough to justify with unemployment at the top of the Fed's central estimates of NAIRU. Pressure to begin hiking rates will intensify as unemployment heads lower. The inflation bar will fall, and Fed officials will increasingly look for reasons to hike rates rather than reasons to delay. They may not want to admit it, but I suspect one of those reasons will be fear of financial instability in the absence of tighter policy. June is in play.

Tuesday, March 03, 2015

Fed Watch: Does The Fed Have a Currency Problem?

Tim Duy:

Does The Fed Have a Currency Problem?, by Tim Duy: The PCE inflation data was released today, and I have been seeing commentary on the relative strength of the core-inflation numbers. This, for example, from the Wall Street Journal:
A key gauge of U.S. consumer prices sank in January due partly to cheaper oil, undershooting the Federal Reserve’s goal of 2% annual inflation for the 33rd consecutive month. But a gauge of underlying price pressures remained resilient headed into 2015.
The picture:

PCEa030215

Core-PCE is hovering around 1.3%, and the stability relative to last month is supposedly supportive of Federal Reserve plans to hike interest rates later this year.  
I would caution against that interpretation just yet. While it is true that the year-over-year change is how the Fed measures its progress toward price stability, you should also be watching the near term changes to see the likely direction of the year-over-year message. And in recent months, near-term core inflation has been falling at a rapid pace:

PCEb030215

On a 3-month basis, core inflation is at its lowest since the plunge in 2008. Year-over-year inflation has been held up by a basis effect from a jump in early 2014, but unless we get another jump in the monthly data, you can guess where the year-over-year number will be heading in the next few months:

PCEc030215

Which means that unless the numbers turn soon, there is a fairly good chance the Fed's preferred inflation guide (I say guide because headline inflation is truly the target) drifts lower as the year progresses. Hence I am less eager to embrace that today's release is supportive of the Fed's plans.  
Why is core-inflation drifting lower?  Federal Reserve Chair Janet Yellen offered this in her testimony last week:
But core PCE inflation has also slowed since last summer, in part reflecting declines in the prices of many imported items and perhaps also some pass-through of lower energy costs into core consumer prices.
 While oil prices have stabilized, the dollar continues to gain ground, hitting an 11-year high today:

DOLLAR030215

If the dollar continues its upward gains - as might be expected given divergent monetary policy across the globe - further downward pressure on core-inflation is likely. This clearly throws a wrench into the Fed's plans. It would be hard to justify confidence in the inflation outlook if core-inflation trends lower in the months ahead.
The Fed could be headed for a very uncomfortable place. The dollar is rising, tightening financial conditions and placing downward pressure on inflation. At the same time, interest rates remain low while equities push higher, loosening financial conditions, arguably an equilibrating response to the rising dollar.  On net, then, the US economy keeps grinding upward, the labor market keeps improving, and the unemployment rate sinks lower. Yellen & Co. would want to resist tightening in the face of low inflation, but they would be increasingly tempted to react to low unemployment. Moreover, concerns of financial instability would mount if longer-term rates remained low and equities pushed higher. All in all, sounds like an increasingly hawkish FOMC coupled with a sluggish global economy and dovish central bankers elsewhere is raising the odds of a US policy error. 
Bottom Line: The rising dollar may be causing the Fed more headaches than they like to admit. To the extent that it is pushing inflation lower, the dollar should be delaying the time to the first rate hike as well as lowering the subsequent path of rates. The Fed may have to respond to the so-called "currency wars" whether they like it or not. That said, I can't rule out that they ignore the inflation numbers given the tightening labor market and what they perceive to be loose financial conditions. The Fed could fail to see the precarious nature of the current environment and move forward with plans to normalize policy. Increasingly likely to be a very interesting summer for monetary policy.

Monday, March 02, 2015

Fed Watch: Game On

Tim Duy:

Game On, by Tim Duy: Almost too much Fed news last week to cover in one post.

The highlight of the week was Federal Reserve Chair Janet Yellen's testimony to the Senate and House. On net, I think her assessment of the US economy was more optimistic relative to the last FOMC statement, which gives a preview of the outcome of the March 17-18 FOMC meeting. Labor markets are improving, output and production are growing at a solid pace, oil is likely to be a net positive, both upside and downside risks from the rest of the world, and, after the impact of oil prices washes out, inflation will trend toward the Fed's 2% target. To be sure, some challenges remain, such as still high underemployment and low levels of housing activity, but the overall picture is clearly brighter. No wonder then that the Fed continues to set the stage for rate hikes this year. Importantly, Yellen gave the green light for pulling "patient" at the next FOMC meeting:

If economic conditions continue to improve, as the Committee anticipates, the Committee will at some point begin considering an increase in the target range for the federal funds rate on a meeting-by-meeting basis. Before then, the Committee will change its forward guidance. However, it is important to emphasize that a modification of the forward guidance should not be read as indicating that the Committee will necessarily increase the target range in a couple of meetings. Instead the modification should be understood as reflecting the Committee's judgment that conditions have improved to the point where it will soon be the case that a change in the target range could be warranted at any meeting.

She is under pressure from both hawks and moderates to leave June open for a rate hike, which requires pulling "patient" from the statement. But at the same time, they don't want the end of "patient" to be a guarantee of a rate hike in June. And that is the message Yellen sends here.

More broadly, though, Yellen is signaling the end of extensive forward guidance. They don't know how the data will unfold at this point, so they are no longer willing to guarantee one particular monetary policy path or another. This was also the message sent by Federal Reserve Vice Chair Stanley Fischer. Via the Wall Street Journal:

Mr. Fischer said that while many believe the Fed will move rates steadily higher, meeting by meeting, in modest increments, it is unlikely the world will allow that to happen. “I know of no plans to follow one of those deterministic paths,” he said, adding, “I hope that doesn’t happen, I don’t believe that will happen.”

Instead, Mr. Fischer affirmed that whatever the Fed does with short-term rates will be determined by the performance of the economy, which will almost certainly offer the unexpected.

Mr. Fischer said there is value in making sure you don’t take markets “by surprise on a regular basis.” But at the same time, offering too much guidance can shackle monetary policy makers, and “there’s no good reason to telegraph every action.”

It's "game on" for Fed watchers! Figure it out, because the Fed will no longer be holding our hands.

Separately, San Francisco Federal Reserve President John Williams echoes Yellen's assessment of the US economy. Via the Wall Street Journal:

In an interview with The Wall Street Journal, Mr. Williams expressed a good deal of confidence in the U.S. outlook, especially on hiring. He said the jobless rate could fall to 5% by the end of the year, which means the central bank is getting closer to boosting its benchmark short-term interest rate from near zero, where it has been since the end of 2008.

“We are coming at this from a position of strength,” Mr. Williams said. “As we collect more data through this spring, as we get to June or later, I think in my own view we’ll be coming closer to saying there are a constellation of factors in place” to make a call on rate increases, he said.

He also gives guidance on why the Fed will soon be confident that inflation will trend back toward target. It's all about the labor market:

Mr. Williams said it is likely that the Fed will see a hot labor market that should in turn produce the wage pressures that will drive inflation back up to desired levels. He said much of the weakness seen now in price pressures is due to the sharp drop in oil prices, which he said isn’t likely to last.

“The cosmological constant is that if you heat up the labor market, get the unemployment rate down to 5% or below, that’s going to create pressures in the labor market” causing wages to rise, he said.

Williams also bemoans the failure of financial market participants to, as he sees it, catch a clue:

Mr. Williams said there is a “disconnect” between Fed officials’ and markets’ expectations for the path of short-term rates. He said he hopes that can be bridged by effective communication explaining central bank policy choices.

St. Louis Federal Reserve President James Bullard has often stated the same concern, and does so again in yet another interview with the Wall Street Journal:

Mr. Bullard said he is worried financial markets aren’t fully taking on board the likely path of monetary policy, and are underpricing what the Fed will do with interest rates.

“The market is pricing in a later and slower and shallower pace of increases” compared to what central bankers think, the official said. “The mismatch has to get resolved at some point, and I think there’s some risk it could be resolved in a violent way,” which he suspects no one would like to see.

Similarly, New York Federal Reserve President William Dudley warns that the Fed will need to choose a more aggressive rate path if financial market participants don't figure it out after the Fed starts raising rates:

As an example, one significant conundrum in financial markets currently is the recent decline of forward short-term rates at long time horizons to extremely low levels—for example, the 1-year nominal rate, 9 years forward is about 3 percent currently. My staff’s analysis attributes this decline almost entirely to lower term premia. In this case, the fact that market participants have set forward rates so low has presumably led to a more accommodative set of financial market conditions, such as the level of bond yields and the equity market’s valuation, that are more supportive to economic growth. If such compression in expected forward short-term rates were to persist even after the FOMC begins to raise short-term interest rates, then, all else equal, it would be appropriate to choose a more aggressive path of monetary policy normalization as compared to a scenario in which forward short-term rates rose significantly, pushing bond yields significantly higher.

All of which sounds to me like the Fed wants to see the term premium start drifting higher - in other words, the situation is now the opposite of the unintended climb in term premiums during the 2013 "Taper Tantrum" incident.

When will that first hike occur? Far too much attention is placed on that question says Fischer:

He said there has been “excessive attention” paid to the issue of when rates will be lifted, and not enough to attention to what happens with short-term rates once they’ve been boosted off of their current near-zero levels.

That I suspect is correct; I am more interested in how the Fed proceeds after the first rate hike (June still on the table, but I don't know if they will have sufficient data to be confident in the inflation outlook) than the timing of the rate hike itself. Is the Fed really as eager to challenge financial markets as Dudley suggests? I am a little nervous this is shaping up to be a repeat of the Riksbank incident.

Bottom Line: The Fed's confidence in the US economy is driving them closer to policy normalization. The labor market improvements are key - as long as unemployment is falling, confidence in the inflation outlook is rising. The more important message, however, is as the timing of the first rate hike draws closer, the level of uncertainty is rising. And it is not just about the timing of that rate hike. The Fed is sending a clear message that the subsequent path of rates is also very uncertain, and they don't think that uncertainty is being taken seriously by market participants. In their view, financial markets are too complacent about the likely path of interest rates.

Monday, February 23, 2015

Fed Watch: Yellen Heading to the Senate

Tim Duy:

Yellen Heading to the Senate, by Tim Duy: All eyes will be focused on Federal Reserve Chair Janet Yellen as she presents the semi-annual monetary policy testimony to the Senate Banking Committee. I anticipate that she will stick to an economic outlook very similar to that detailed in the last FOMC statement and related minutes. Expect her to indicate that the Fed is closing in on the time of the first rate hike - after all, this was clearly the topic of conversation at the January FOMC meeting. I anticipate the "Audit the Fed" movement will be on display in the Q&A, which will provide Senators the opportunity to display their ignorance of monetary policy. And with any luck, we will learn how "patient" the Fed really is.
That said, I am wary of expecting much in the way of insight on "patient." The Fed has trapped itself with that language, and I am thinking that it will take the collective power of the FOMC to devise a way out. And they have little choice but to deal with that issue at the March FOMC meeting. The basic problem is this: The hawks would be happy with pulling the trigger on 25bp at the March meeting. The center isn't ready to go along with that, but they want the option of being able to pull the trigger in June. But Yellen, in trying to signal in December that a rate hike was not imminent, linked the term "patient" to two meetings. So if they keep "patient" in the statement, it seems to imply that June is off the table, but that message will brings squeals of unhappiness from the hawks and even leave the center uncomfortable. But just pulling "patient" risks leaving the impression that a June hike is a certainty, which is a message the center doesn't want to send.
If you think this is a dumb way to manage monetary policy, you are correct. Now that the Fed is closer to meeting their employment mandate, they simply cannot credibly signal intentions six months in advance. They need to let the data start doing the work for them, but don't know how to make that transition.  
It something of a shame that Yellen couldn't leave well enough alone in December and let financial market participants believe that "patient" would be used as it had been in 2004. In that case, "patient" would have no time horizon other than that dropping the word "patient" meant that a rate hike was likely just one meeting away. They could credibly manage such a signal. Anything more than one meeting ahead is problematic.
On the economic outlook, I would say that if Yellen were to deviate from the January FOMC meeting, it would be in a generally positive direction. I think they will take the subsequently released upbeat employment report as strong evidence that underlying trends remain solid. The news that Wal-Mart is raising salaries will likely be viewed as just the tip of the iceberg. I doubt anyone on the FOMC believes Wal-Mart leadership acted out of the kindness of their hearts. Yellen herself will probably think something to the effect that "I told you that the quits rate was important."  

RETAILQUITS

Assuming the Greece situation holds together for another 24 hours, that coupled with easing by global central banks in recent weeks will lead FOMC members to believe that global risks have dissipated. And to top it off, US equities pushed back to record highs. What's not to like? Maybe the GDP numbers, but Cleveland Federal Reserve President Loretta Mester gave what I think is the consensus view on the topic:
WSJ: Putting aside the tailwinds that you’re seeing. The growth data look a little soft at the moment.
MESTER: Not really. The fourth quarter came in after two quarters of really robust growth. The employment report actually was revised up for those last couple of months. There is this tendency to look at the last data point. I’m just not that concerned. I think we’ve seen growth pickup. I think there is more momentum in the economy.
Hence why I also don't agonize about what a snowstorm means for monetary policy. It means nothing.
There is plenty on the docket beyond Yellen this week. Existing and new home sales, consumer confidence, regional Fed manufacturing indexes, durables goods orders, CPI, Case-Shiller, GDP revisions, and, if that weren't enough, speeches by Fed Presidents of Atlanta (Lockhart), Cleveland (Mester), and New York (Dudley), and Federal Reserve Governor Stanley Fischer. The fun just won't stop!
Bottom Line:  I expect the Fed will continue to walk the fine line between keeping June in play while signaling that the data will soon justify a rate hike though not necessarily in June. And watch for signs of an effort to shift the focus to the expected gradual pace of rate hikes in an effort to minimize adverse market reaction to the possibility of June. Expect generally positive views of recent data; the Fed thinks the economy is finally on the right path.

Wednesday, February 18, 2015

Fed Watch: January FOMC Minutes

Tim Duy:

January FOMC Minutes, by Tim Duy: Minutes from the January FOMC meeting were released today. It is fairly clear that the Fed is gearing up for rates hikes:

Participants discussed considerations related to the choice of the appropriate timing of the initial firming in monetary policy and pace of subsequent rate increases. Ahead of this discussion, the staff gave a presentation that outlined some of the key issues likely to be involved...

The debate sounds familiar. On one side are those concerned that the Fed's zero rate policy will overstay its welcome:

Several participants noted that a late departure could result in the stance of monetary policy becoming excessively accommodative, leading to undesirably high inflation. It was also suggested that maintaining the federal funds rate at its effective lower bound for an extended period or raising it rapidly, if that proved necessary, could adversely affect financial stability...

while on the other side doesn't want to pull the trigger too early:

In connection with the risks associated with an early start to policy normalization, many participants observed that a premature increase in rates might damp the apparent solid recovery in real activity and labor market conditions, undermining progress toward the Committee's objectives of maximum employment and 2 percent inflation. In addition, an earlier tightening would increase the likelihood that the Committee might be forced by adverse economic outcomes to return the federal funds rate to its effective lower bound.

I would say that "many" is greater than "several," which means that as of January, the consensus leaned toward later than sooner. Indeed:

Many participants indicated that their assessment of the balance of risks associated with the timing of the beginning of policy normalization had inclined them toward keeping the federal funds rate at its effective lower bound for a longer time...

Here it would be helpful to know the expected time horizons. How long is a "longer" time? My sense is that the possibility of a March hike was on the table at the request of the hawks, and "longer" meant sometime after March. But when after March? That is data dependent, but the Fed is challenged to describe exactly what conditions need to be met before justifying a rate hike:

Participants discussed the economic conditions that they anticipate will prevail at the time they expect it will be appropriate to begin normalizing policy. There was wide agreement that it would be difficult to specify in advance an exhaustive list of economic indicators and the values that these indicators would need to take.

Still, they have some broad guidelines:

Nonetheless, a number of participants suggested that they would need to see further improvement in labor market conditions and data pointing to continued growth in real activity at a pace sufficient to support additional labor market gains before beginning policy normalization. Many participants indicated that such economic conditions would help bolster their confidence in the likelihood of inflation moving toward the Committee's 2 percent objective after the transitory effects of lower energy prices and other factors dissipate.

It seems then that "many" participants are focused primarily on the labor market. It would be interesting to see how "many" of those "many" saw their confidence increase after the positive January numbers. Others pointed to inflation measures and wages as important indicators:

Some participants noted that their confidence in inflation returning to 2 percent would also be bolstered by stable or rising levels of core PCE inflation, or of alternative series, such as trimmed mean or median measures of inflation. A number of participants emphasized that they would need to see either an increase in market-based measures of inflation compensation or evidence that continued low readings on these measures did not constitute grounds for concern. Several participants indicated that signs of improvements in labor compensation would be an important signal, while a few others deemphasized the value of labor compensation data for judging incipient inflation pressures in light of the loose short-run empirical connection between wage and price inflation.

My take is this: To get a reasonably sized consensus to support a rate hike, two conditions need to be met. One is sufficient progress toward full-employment with the expectation of further progress. I think that condition has already been met. The second condition is confidence that inflation will indeed trend toward target. That condition has not been met. To meet that condition requires at least one of the following sub-conditions: Rising core-inflation, rising market-based measures of inflation compensation, or accelerating wage growth. If any were to occur before June, I suspect it would be the accelerating wage growth.

On communication, the Fed sees that is has trapped itself:

Participants discussed the communications challenges associated with signaling, when it becomes appropriate to do so, that policy normalization is likely to begin relatively soon while remaining clear that the Committee's actions would depend on incoming data. Many participants regarded dropping the "patient" language in the statement, whenever that might occur, as risking a shift in market expectations for the beginning of policy firming toward an unduly narrow range of dates. As a result, some expressed the concern that financial markets might overreact, resulting in undesirably tight financial conditions.

If "patient" means exactly two meetings as is widely believed, then why would dropping patient imply higher rates in an "unduly narrow range of dates"? Isn't "two" two? If "two" is two, why the need for the adjective "unduly"? The definition of "unduly" according to the dictionary is:

to an extreme, unreasonable, or unnecessary degree

So "two" is thus extreme or unreasonable? Either "two" isn't two or patient wasn't meant to imply always two meetings. Indeed, Cleveland Federal Reserve President Loretta Mester suggests that "two" is only one interpretation. Via the Wall Street Journal:

WSJ: When you say that, do you have April in mind or do you have June in mind?

MESTER: Given what we’ve communicated, June is a viable date. We have the patient language which has been interpreted as two meetings.

The language "has been interpreted" not "means" two meetings. If "two" is plainly two, how can it have any other interpretation? And "has been interpreted" by whom, for that matter?

You get the point. The Fed can't keep itself from making calendar dependent statements, and thus undermines it's own communications. Yellen should have said "patient" means "until the data says otherwise." But she couldn't help herself by not including some kind of calendar dependent qualifier. As a consequence, now the Fed is stuck with modifying the language to keep a June rate hike on the table.

Wait, is a June rate hike still on the table? Although the minutes were interpreted dovishly by financial market participants, I doubt the Fed will want to pull the plug on June just yet. Incoming Fed speak continues to signal a rate hike is coming (including Mester describing June as a "viable option" this week), the January labor report was solid, via the minutes the Fed sees external risks as dissipating, we have four more employment reports before the June meeting, and I doubt the Fed really wants to start signaling policy two periods in advance. Too early to pull June off the table, but they can't move in June without something solid on the inflation front. So the March statement, or subsequent press conference, will be about dealing with the "patient" language, and the April meeting will be about whether they really expect to move in June or not.

One more consideration. It has been noted that the length of the minutes ballooned in January. Less noted is that the FOMC has a new secretary, Thomas Laubach, who succeeds William English. The additional detail may reflect that change, and the additional detail may swing our interpretation of the minutes relative to past minutes.

Bottom Line: The Fed is plainly focused on raising rates. As a group, they sense the time is coming to begin policy normalization. But they don't yet know when exactly that time will be. They don't yet have everything they need to begin, and they don't know when they will have everything (which is why they need to end calendar-dependent language). We know not yet. June? Maybe, maybe not.

Tuesday, February 10, 2015

Fed Watch: Fedspeak Points To June

Tim Duy:

Fedspeak Points To June, by Tim Duy: Federal Reserve speakers were out and about today. First off, Richmond Federal Reserve President Jeffrey Lacker set a fairly high bar for NOT hiking in June. Via the Wall Street Journal:
“At this point, raising rates in June looks like the attractive option for me,” Mr. Lacker told reporters following a speech Tuesday in Raleigh, N.C. “Data between now and then may change my mind, but it would have to be surprising data.”...
...“The economy’s clearly growing at a more rapid, sustained pace than it was a year ago,” he said. “Economies that are growing faster need higher real interest rates, and a variety of indicators point to the need for higher real rates.”
What about inflation? It is all about oil:
Mr. Lacker said the effects of lower gasoline prices on inflation should be transitory, and he expects inflation will move back toward the Fed’s 2% annual target over the next year or two. “The inflation rate was clearly moving towards 2% before oil prices began falling last summer,” he said.
Here I worry, because Lacker is clearly ignoring the data, or least weighing the year-over-year changes far too heavily. Inflation actually accelerated in the second half of 2013, but was clearly decelerating by the beginning of 2014 (right idea, wrong dates) first half of 2014, but was clearly decelerating by June, prior to the oil shock. By July, the 3-month annualized change in core was just 0.97% while oil was still above $100 and gas above $3.50:

PCEb020215

But the Fed is close to achieving the employment mandate, so inflation data be damned! Still think the employment part of the dual mandate is really a good idea?
San Francisco Federal Reserve President John Williams digs in his heals and assures us a rate hike is coming. Via the Financial Times:
John Williams, president of the Federal Reserve Bank of San Francisco, said the time for the US central bank to start raising rates is getting “closer and closer” amid faster-than-expected wage rises in January and “really strong” hiring. Some investors may be caught out by a rate increase, but that should not stop the Fed from tightening policy if necessary, he said.
What about inflation? No problem, it is all about the lags:
...Economists including Lawrence Summers, a former US Treasury secretary, have urged the Fed to leave rates unchanged until there is clear evidence that inflation, and inflation expectations, are set to breach its 2 per cent target.
However Mr Williams dismissed such calls, warning of the risk that the Fed gets behind the curve on inflation and that it could end up being forced to hike rates “much more dramatically” to rein in inflation, provoking market turmoil. Given the trails with which monetary policy operates it was better to start raising interest rates “gradually, thoughtfully”, he said.
Note that he pulled out the "if we don't hike now we will need to hike more later" argument. That, along with the financial stability argument, is how they will justify a rate increase in the absence of inflation. Williams, however, hedges on June:
A key question obsessing financial markets is whether the Fed pulls the trigger in the middle of the year or waits longer. Mr Williams did not commit himself to voting for a move in June, saying instead that the decision of whether to hike or delay a bit longer would be “in play” at that point.
Time is growing short for the wage gains necessary to begin hiking in June.
Importantly, Williams also rejects the idea that bond markets are signaling secular stagnation:
He dismissed arguments that low long-term bond yields in the US reflect fears of a gloomy outlook for the American economy, saying they more likely were a result of global financial conditions, amid slowdowns and policy easing in large parts of the rest of the world.
US policy would still be very accommodative even after the Fed raised rates, he stressed. “That first step of raising interest rates is just removing a sliver of that accommodation,” he said.
The last paragraph is key. Williams, like the rest of the FOMC argues that conditions will remain very accommodative after even a small rate hike. As I noted last night, this is not true under the secular stagnation hypothesis:

TAYLORb020815

It would be interesting if we had William's estimate of the equilibrium rate for comparison. Wait, we do - from his January 2014 Brookings paper:

WILLIAMS021015

Oh my, that brownish-greenish line appears to be a fairly pessimistic estimate of the natural rate, certainly one inconsistent the assertion that conditions remain accommodative after even just a small rate hike. Perhaps some journalists should start pressing Williams on the policy implications of his research. And, for that matter, I think the Fed's view on the equilibrium real rate should be a front-and-center topic for the next FOMC press conference.
Meanwhile, soon-to-retire Dallas Federal Reserve President Richard Fisher is pegging his rate outlook to wage gains:
“If we were to see employment continue to increase, we’re getting much, much better on that front and you begin to see the wage price pressures, that should govern what we do with interest rates.”
The Fed simply has no justification to raise rates in June absent acceleration in wage growth. Even Fisher agrees. Fisher also pushes back against the renewed "Audit the Fed" movement:
“We are — I’ll be blunt — we are audited out the wazoo. Every Federal Reserve Bank has a private auditor. We have our auditor of the system. We have our own inspector general. We are audited. That’s not what he’s talking about. What he’s talking about is politicizing monetary policy.”
That's the plain truth. It has nothing to do with economics, and everything to do with politics.
Bottom Line: The Fed wants to hike in June. They continue to dismiss the inflation data, but they still need wage growth to hike. They dismiss the secular stagnation hypothesis. I hope they are right on that, or this is going to get ugly. Quickly.

Friday, February 06, 2015

Fed Watch: Upbeat Jobs Report

Tim Duy:

Upbeat Jobs Report, by Tim Duy: The January jobs report came in above expectations, with nonfarm payrolls growing by 257k and, more importantly, there were large upward revisions to the previous two months. Simply put rumors of the demise of the US economy continue to be premature.
The pace of job gains accelerated further on average:

NFPa020615

Oil and gas extraction jobs declined by 1.9k, but we all know more are coming. But outside of that sector, the economy added 255k jobs. The oil and gas extraction sector itself is only 200k jobs. In short, the fears that this sector is going to topple the US economy are just simply not going to come to pass.
In the context of data Federal Reserve Chair Janet Yellen has previously signaled as important:

NFPc020615

NFPd020615

Ongoing general improvement with measures of underemployment still elevated. There was some excitement about the 12 cent gain in average hourly earnings. I myself am less impressed as to me this largely represents a correction from December's anomalous drop. Wage growth remains fairly anemic year-over-year:

NFPb020615

I would also like to see what happens after the impact of minimum wage hikes dissipates. The Fed, however, my take more comfort in the uptick than me. It goes without saying that a June rate hike remains on the table, although I think it is difficult to justify without faster wage growth. Still four jobs reports till then, so plenty of time to pull that number upward.
Jon Hilsenrath reiterates the view that if the Fed wants to keep the June option open they need to pull the word "patient" in March:
Second, Fed officials will decide at their March meeting whether to change or drop the language in their policy statement pledging to “be patient” in deciding when to raise their benchmark short-term interest rate from zero. That phrase means they won’t move for at least two more meetings.
After the March gathering, the Fed has meetings scheduled for April and June. If the policy makers keep the “patient” language in the statement, that would indicate they don’t think they’ll raise rates at those meetings. If they scrap the phrase, that would give them the option to move as early as June if the economic data hold up.
I doubt this is as black and white as Hilsenrath argues. I don't think Yellen intended to imply that "patient" always means two meetings. Perhaps I just have too many memories about "considerable time" first meaning six months and then not. Plus, the Fed is aware of its past history, and in 2004 "patient" turned to "moderate" just one meeting before the hike. But it was technically the second meeting after "patient" was dropped, so is that two meetings? Also, as we saw with the "considerable" to "patient" transition, the Fed has its own unique way of wordsmithing that can deliver something for everyone. And finally, Yellen has the press conference to redefine her interpretation of "patient." But maybe I am wrong. In any event, I am not taking a fixed stand on what "patient" means until the press conference.
Bottom Line: The US economy has very real momentum on its side at the moment. It is more resilient to shocks than commonly assumed. This isn't 2011. June is still on the table.

Thursday, February 05, 2015

Fed Watch: Fed Updates

Tim Duy:

Fed Updates, by Tim Duy: Some quick notes on monetary policy this afternoon:

1.) Another policymaker in favor of a first half rate hike.  Cleveland Federal Reserve President Loretta Mester supports a rate hike by June.  Via Michael Derby at the Wall Street Journal:

Expressing confidence weak inflation will eventually rise again, Federal Reserve Bank of Cleveland President Loretta Mester said Wednesday the U.S. central bank remains on track for raising rates in the next few months.

Noting that Fed policy isn’t on a “pre-set path,” Ms. Mester said “if incoming economic information supports my forecast, I would be comfortable with liftoff in the first half of this year.” Because Fed policy actions affect the economy over a long period of time, the central banker said the Fed will need to act before it has fully achieved its job and price mandates.

She is, however, watching the survey data:

The official told reporters after her speech that if inflation expectations began to weaken, especially ones derived from surveys, “that would give me pause” when it comes to advocating for rate increases.

While the timing of any policy move remains in flux, Mester's basic story is close to consensus: The Fed is looking at putting the economy on a glide path to achieving its mandates, which means moving ahead of those mandates.

2.) But another is pointing out the danger of low inflation. Boston Federal Reserve President Eric Rosengren doesn't speak to the timing of rate hikes, but low inflation is clearly on his mind:

Of course today, after significant labor market improvement, and with the horizon over which inflation will return to its target being uncertain, inflation has taken on a more prominent role in our deliberations.

Currently, an obvious caveat in interpreting the low inflation rate in the U.S. is the supporting role played by the recent decline in energy prices. Oil shocks have been associated with major changes in monetary policy before. The failure to control inflation in the United States during the 1970s, in the presence of an adverse oil supply shock, highlighted a serious dilemma facing monetary policy at that time. Importantly in that case, what might have been a temporary pass-through of oil to non-oil prices turned into a more lasting problem with overall inflation, as wage and price dynamics at that time helped turn increases in oil prices into fairly protracted increases in overall inflation. Former Federal Reserve Board Chairman Volcker is rightfully recognized for taking forceful action to address the situation and ultimately tame inflation in the United States.

Currently, a concern is that central banks are facing the mirror image of the problem in the 1970s. The problem of significantly undershooting inflation – a dynamic which could well keep interest rates at the zero lower bound – is likely to be a key challenge to central bankers in the first two decades of the 21st century. And I would say that as with the oil shock in the 1970s, the current shock has served to accentuate a potential monetary policy pitfall – in this case, the failure to quickly and vigorously address a significant undershooting of inflation targets, potentially leaving economies stagnant at the zero lower bound. 

He would support later rather than sooner with regards to the first rate hike.  

3.) Fed ready to lower NAIRU?  I have argued in the past that if the Fed is faced with ongoing slow wage growth, they would need to reassess their estimates of NAIRU.  Cardiff Garcia reminded me:

@TheStalwart @TimDuy Whether/extent to which Fed reverts nat-rate estimates to pre-2010 range is one of 2015's big Qs pic.twitter.com/CKieHx2zRC

— Cardiff Garcia (@CardiffGarcia) February 4, 2015

While David Wessel adds today:

JPMorgan run the Fed's statistical model of the economy and says the NAIRU (which was 5.6%+ through 2013 data) is now down to 5%.

— David Wessel (@davidmwessel) February 5, 2015

Jim O'Sullivan from High Frequency Economics says not yet:

"Hard-to-fill" @NFIB jobs series up to 26 in Jan (+1). Corroborates unempl decline, with no sign of lower #NAIRU pic.twitter.com/DVYGyGV4e6

— Jim O'Sullivan (@osullivanEcon) February 5, 2015

A reduction in the Fed's estimate of the natural rate of unemployment would likely mean a delayed and more gradual path of policy tightening, should of course the Fed ever get the chance to pull off the zero bound.  Keep an eye on this issue!

4.) Will the Fed remain "patient" in March?  Jon Hilsenrath at the Wall Street Journal says the Fed needs to remove "patient" from the FOMC statement in March if they want to move in June:

The “patient” assurance, Fed chairwoman Janet Yellen has said, means no rate increases for at least two more policy meetings. The next two policy meetings after March are in April and June. If officials think they might raise rates in June, they need to remove “patient” in March to give themselves the option to proceed if economic data justify a move by June.

Interesting - this is a stricter interpretation of "patient" than I had from Yellen's comments. I did not think that "patient" would always mean just two more meetings, only that in December "patient" meant two more meetings. During the last rate hike cycle, the Fed maintained "patient" until March, switched to "measured" in May, and hiked in June. So they hiked the second meeting after the last "patient." Does that meet the definition that Yellen gave in December? I don't know, but I an not sure she meant to imply that "patient" always and forever means no hike for the next two meetings. So I guess we have our first question for the next press conference. At the moment, following the last cycle, I don't think that keeping "patient" means they are taking June off the table.

5.) Employment report watch.  Calculated Risk notes that Goldman Sachs cut their forecast for tomorrow's employment report to a 210k gain in nonfarm payrolls and a 5.5% unemployment rate, at the low end of consensus and similar to my forecast. But the January number might be an even bigger crapshoot than usual anyway. Via Bloomberg:

 A significant risk to the January payroll print is that the seasonal adjustment may not be properly calibrated. If employers added more seasonal workers than usual based on a firmer assessment of economic conditions, then there may be more layoffs in January. If the seasonal factors do not properly account for this, then a weaker-than-expected payroll gain could result.

And note that one number doesn't make a trend:

Underlying labor market momentum is largely being sustained, as economic growth remains decent, albeit slower than the mid-year hot streak between Q2 and Q3 of 2014. As such, if January employment disappoints, it is probably an anomaly related to seasonal adjustment issues, not a meaningful downshift in the pace of hiring.

The ongoing improvement in consumer attitudes is an encouraging sign that households continue to sense a healthy labor market.

6.) Falling interest rates worldwide. The global push for easier monetary policy continues. China's central bank is now officially in easing mode, while the Danish Central Bank moves deeper into negative territory. The Fed wants to be able to move in the opposite direction, but financial markets are telling them this isn't the time to move off of zero. The Fed will resist - this isn't 2011 when the US economy was much further from reaching its employment mandate than it is today. That said, they eventually had to relent and ease in 1998, so holding steady would be familiar territory (they are not bringing QE back to life yet). But will they worry that easing then helped sustain an asset bubble, a situation they do not want to repeat? Increasingly, the Fed looks to be back in a place they hoped they had left behind - between a rock and a hard place.

And with that we await tomorrow's employment report. Sorry I don't have time to give each of these topics the time they deserve.

Tuesday, February 03, 2015

Fed Watch: Brief Comment

Tim Duy:

Brief Comment, by Tim Duy: It is always interesting to see how others perceive you. For instance, I wasn't sure what to make of this from Paul Krugman:

The monetary-policy gap between insiders and outsiders — between economists at the Fed and other policy institutions, who still seem eager to raise rates, and those of us on the outside, who think this is a really, really bad idea — continues to widen. This morning Tim Duy — one of the outsiders who, commenting from his perch at Mark Thoma’s invaluable blog, has seemed most sympathetic to the urge to hike rates — joins the what-are-they-thinking chorus.

When I read that I realized that perhaps I wasn't defining my space quite right. Primarily, I attempt - albeit, admittedly, not always successfully - to understand the world as Federal Reserve policymakers see it. Failing to put your personal opinion in the background is one of the biggest mistakes a Fed Watcher can make. Right now, for example, policymakers are somewhat hawkish relative to market expectations, so my writing has a hawkish tilt, which is what I think Krugman interprets as "sympathetic." 

Occasionally, however, my opinions become more evident, which is what Krugman interprets as joining the "what-are-they-thinking chorus."  In truth I am not particularly sympathetic with the Federal Reserve's campaign to normalize policy. That campaign is predicated on the belief that the economy is close to full employment. Krugman sees the natural rate of unemployment as mostly likely below 5%. I concur. The Fed's Summary of Economic Projections, however, places the natural rate in the 5.2-5.5% range. My thinking is that is as much as 0.5 percentage points or even more too high. That is a big, big error, somewhere around 800,000 real lives impacted. A lot of jobs to risk when inflation is trending downward, in my opinion.

I also believe that the fact that we have experienced two recessions since 1991 yet no outbreak of inflation is prima facie evidence that the Fed, on average, maintains too tight a monetary policy.  Seems likely a little bit looser policy would yield significant welfare gains.

Anyway, I think readers probably get the idea at this point. My expectations of a particular Fed policy does not necessarily indicate support for that policy. In future writing I will endeavor to more clearly delineate between the two.

Monday, February 02, 2015

Fed Watch: Fed's Preferred Inflation Measure Dives

Tim Duy:

Fed's Preferred Inflation Measure Dives, by Tim Duy: Not only is core-PCE inflation on a year-over-year basis trending away from the Fed's target:

PCEa020215

but the deceleration in recent months is truly shocking:

PCEb020215

It is hard to see how the Fed can be confident that inflation with trend back to target when looking at these numbers. They need some acceleration in wage growth to justify their intentions to begin normalizing policy, and even with such acceleration, I think their case is fairly weak in the context of the current inflation environment. If they make a case, they will base it on these three pillars:

1.) With unemployment nearing 5%, they have reached their employment mandate.
2.) Monetary policy is exceptionally accommodative even if they raise interest rates.
3.) Failure to raise rates invites asset bubbles.

On point three, refer to New York Federal Reserve President William Dudley:

Quickly, let me give two examples that illustrate how variable this linkage can be.  First, during the 2004-07 period, the FOMC tightened monetary policy nearly continuously, raising the federal funds rate from 1 percent to 5.25 percent in 17 steps.  However, during this period, 10-year Treasury note yields did not rise much, credit spreads generally narrowed and U.S. equity price indices moved higher.  Moreover, the availability of mortgage credit eased, rather than tightened.  As a result, financial market conditions did not tighten.  

As a result, financial conditions remained quite loose, despite the large increase in the federal funds rate.  With the benefit of hindsight, it seems that either monetary policy should have been tightened more aggressively or macroprudential measures should have been implemented in order to tighten credit conditions in the overheated housing sector.

It may be that the Fed looks at the tech and housing bubble episodes and concludes that zero interest rates are not desirable even if inflation is below trend. Yes, I know, macroprudential before interest rates when addressing asset bubbles. But at a point when the economy is at the Fed's idea of full-employment, and given the events of recent decades? Easy to see the Fed seeing danger in putting all of their eggs in the macroprudential basket. 

Bottom Line: Below trend inflation as the economy nears full-employment is a very uncomfortable position for the Federal Reserve. It will be interesting to see how Federal Reserve Chair Janet Yellen navigates these waters at the upcoming Congressional testimony.

Fed Watch: As of Yet, Fed Not Changing Tune

Tim Duy:

As of Yet, Fed Not Changing Tune, by Tim Duy: Early salvos by Federal Reserve policymakers in the wake of last week's FOMC non-event suggest that recent developments have had little impact on Fed thinking with regards to the appropriate timing of rate hikes. The middle of this year remains the internal forecast. Whether data or events cooperate is of course another question.

I think it is worth viewing Friday's two interviews with St. Louis Federal Reserve President James Bullard at Bloomberg and San Francisco Federal Reserve President John Williams at CNBC. Bullard is fairly clear in his view that financial markets are doing it wrong:

“The market has a more dovish view of what the Fed is going to do than the Fed itself,” Bullard said in an interview Friday in New York. “Markets should take it at face value” from the Fed’s rate projections, and it’s “reasonable” to expect an increase in June or July.

In contrast, I would say that Williams is a bit more cautious:

Given this projection, Williams said he thought "around the middle of this year is the time that I think, in my view, that we'll be getting closer to 'Should we raise rates now, or should we wait a little longer, collect some more data, get more confidence in the forecast?'"

The baseline story, however, is generally the same. They believe the US economy has sufficient momentum to weather any external shocks. They both view the first quarter GDP report as consistent with their underlying forecast. So did I, for that matter. You need to be able to tease out the underlying trend when parsing the data. Calculated Risk gets it right. R-E-L-A-X:

There are legitimate concerns about a strong dollar, and weak economic activity overseas, impacting U.S. exports and GDP growth. However, overall, the Q4 GDP report was solid.

In short, neither Williams nor Bullard is seeing anything in the recent data to worry them significantly. Regarding the timing of a rate hike, I think that if you view the videos, you will see a line of logic fairly similar to what I described last week. They see unemployment falling to 5% or less this year. They do not think that such a situation as consistent with zero rates. They think they need to move ahead of actual inflation. They think that even after hiking rates, monetary policy will remain accommodative.

A couple of clarifications and extensions:

First, my take is that the Fed wants to pull the focus off of the first rate increase to the subsequent path of policy. What comes first is not as important as what comes after. The "comes after" is one reason they want to move sooner than later given the current economic environment. Bullard views it important to narrow the gap between zero and normal rates because he fears that falling behind the curve will necessitate a steeper subsequent policy path. This thinking is probably endemic within the Federal Reserve.

Second, notice that again Bullard dismisses market-based measures of inflation expectations as distorted by the massive drop in the price of oil. And his opinion is not illogical: There is no reason to think 5y5y forward exceptions to be impacted in lock step with the collapse in oil prices. He wants to see how that situation plays itself out.

Third, Bullard says that we are 400bp below normal policy and that his view of normal policy has not changed much. There is no new normal. This too I think is endemic in Fed thinking and where I think lies the greatest potential for a policy error. They should not be holding a dogmatic view of what is normal. The bond markets are telling me that would be a mistake.

Fourth, Bullard was not disturbed by the rise of the dollar as he sees it as a natural consequence of a stronger US economy and weaker economies abroad. This contrasts with the general view that the Fed is panicking over the dollar.

So what does Fed Chair Janet Yellen think? Well, both Bullard and Williams are coming right out of the gates of an FOMC meeting, and I doubt either would take a position that was strongly in contrast to Yellen. That said, expectations seem to be growing for Yellen to head a different direction. Via the Wall Street Journal:

“If the markets stay how they are today three months from now, the Fed would have a hard time raising interest rates,” Alan Rechtschaffen, a financial adviser at UBS, said this week. That would make Ms. Yellen’s twice-yearly testimony before the House and Senate, expected in the third week of next month, a potential opportunity for beginning to show increased concern about low inflation—particularly if measures of prices excluding energy and food costs keep moving lower.

“As early as the Humphrey-Hawkins testimony the Fed could begin to lay the groundwork for a transition in monetary policy” toward a later date for interest-rate increases, Mr. Rechtschaffen said.

Like I thought that there would be little change in the FOMC statement, I am cautious about expecting a change in Yellen's tone. It might be good to consider this anecdote from former Federal Reserve Governor Larry Meyer:

The final question is whether Janet is really a dove. Let me tell you a story. Janet and I held very similar views when we were colleagues on the Committee, despite the fact that I was immediately viewed as a hawk and she was already viewed as a dove. (I thought of myself at the time as being a “hawkish dove.”) In any case, when it comes to ensuring price stability and maintaining well-anchored inflation expectations, there are no doves on the Committee. Before the September 1996 FOMC meeting, Janet and I went to see the Chairman to talk about the policy decision at that meeting and at following meetings. This was the only time I ever visited the Chairman (at my initiative) to talk about monetary policy, before or after a meeting. Janet and I were both worried about inflation, even though it was very well contained at the time. We told the Chairman that we loved him but could not remain at his side much longer if he continued, as he had been doing for some time, to push the next tightening action into the next meeting, and then not follow through. He listened, more or less patiently. I recall, though this may have not been the case, that he just smiled and didn’t say a word. After an awkward silence, we said our good-byes. Needless to say, we didn’t win this argument. Yet, we never dissented. That is another matter of etiquette for the entire Board, at least since when I was there: The Board is a team, always votes as a block, and, therefore, always supports the Chairman.

The reason I bring this up is that if my analysis of the Fed's baseline thinking is generally correct, then Yellen will have a hard time staying a dove if her underlying framework is unchanged from 1996. And I think we are seeing that as the economy heads into more normal territory, that underlying framework is indeed unchanged. This is especially the case when she could view former Federal Reserve's Chair Alan Greenspan's 1996 bet as being a special case attributable to higher productivity, and she does not have productivity in her corner this time around. Just something to think about.

Bottom Line: I am not convinced the Fed is changing its thinking as quickly as markets think the Fed is changing its thinking. That means that Fedspeak might continue to be hawkish relative to expectations.

Wednesday, January 28, 2015

Fed Watch: FOMC Decision

Tim Duy:

FOMC Decision, by Tim Duy: If you were looking for fireworks from today's FOMC statement, you were disappointed. Indeed, you need to work pretty hard to pull a story out of this statement. It provided little reason to believe that the Fed has shifted its view since December. A June rate hike remains the base case.

The Fed's assessment of the current statement is arguably the best in years:

Information received since the Federal Open Market Committee met in December suggests that economic activity has been expanding at a solid pace. Labor market conditions have improved further, with strong job gains and a lower unemployment rate. On balance, a range of labor market indicators suggests that underutilization of labor resources continues to diminish. Household spending is rising moderately; recent declines in energy prices have boosted household purchasing power. Business fixed investment is advancing, while the recovery in the housing sector remains slow.

The Fed is simply not seeing any warning signs in recent data. Regarding inflation:

Inflation has declined further below the Committee’s longer-run objective, largely reflecting declines in energy prices. Market-based measures of inflation compensation have declined substantially in recent months; survey-based measures of longer-term inflation expectations have remained stable.

They continue to dismiss headline inflation, and I think they will continue to do so. And if you continue to insist that the Fed is paralyzed with fear over market based measures of inflation expectations, note that they do not refer to these as "expectations" measures. It is inflation "compensation." From Fed Chair Janet Yellen's most recent press conference:

There are a number of different factors that are bearing on the path of market interest rates, I think, including global economic developments. It is often the case that when oil prices move down and the dollar appreciates, that that tends to put downward pressure on inflation compensation and on longer-term rates. We also have safe-haven flows that may be affecting longer-term Treasury yields. So I can’t tell you exactly what is driving market developments. But what I can say is that we are trying to communicate our thoughts as clearly as we can.

And:

Oh, and longer-dated expectations. Well, what I would say, we refer to this in the statement as “inflation compensation” rather than “inflation expectations.” The gap between the nominal yields on 10-year Treasuries, for example, and TIPS have declined—that’s inflation compensation. And five-year, five-year-forwards, as you’ve said, have also declined. That could reflect a change in inflation expectations, but it could also reflect changes in assessment of inflation risks. The risk premium that’s necessary to compensate for inflation, that might especially have fallen if the probabilities attached to very high inflation have come down. And it can also reflect liquidity effects in markets. And, for example, it’s sometimes the case that— when there is a flight to safety, that flight tends to be concentrated in nominal Treasuries and could also serve to compress that spread. So I think the jury is out about exactly how to interpret that downward move in inflation compensation. And we indicated that we are monitoring inflation developments carefully.

They are trying to tell us very clearly that TIPS are not giving a measure of pure inflation expectations. They do not want those measures by themselves to affect market expectations of the path of monetary policy.

Growth risks are balances and low inflation is transitory:

The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to decline further in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate. The Committee continues to monitor inflation developments closely.

They make a small nod to international concerns when considering future policy actions:

This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.

The Fed remains patient and policy is data dependent:

Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy. However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.

June remains on the table. Within the context of the current forecast, I think that June will be difficult to justify in the absence of wage acceleration. A sharp decline in the forecast, or the balance of risks to the forecast, would also prompt a delay. Importantly, at this point they see the current forecast as still the most likely outcome.

Bottom Line: At this point, the Fed does not see market turbulence as an impediment to raising rates. They are willing to hike rates even if stocks are moving sideways (which they probably think is reasonable in the context of expectations for less monetary accommodation). They do not see any data that threatens their baseline forecast. Maybe market participants have written off June, but for the Fed, June remains very much on the table.

Fed watch: While We Wait For Yet Another FOMC Statement...

Tim Duy:

While We Wait For Yet Another FOMC Statement...: The FOMC will reveal the outcome of this week's meeting later today. I think Calculated Risk hits the high points - "patient" is in, "considerable time" is completely out. Beyond this, we will be looking for clues on how the Fed is interpreting the current economic environment. I suspect little change in the overall tenor of the statement as they will want to leave June open as an option. I reiterate my position: The Fed needs to see an acceleration in wage growth to be confident that inflation will return to trend if they intend to raise rates in June. 

Why is the Fed focused on normalizing policy? This is one explanation I see tossed around, from Jeffrey Gunlock via Reuters:

"The Fed seems to want to raise interest rates simply because they don't want to be at zero when the next recession occurs," he said.

A similar statement from the Economic Cycle Research Institute:

In this context, ECRI explains the reasons for the declines in both measures, but also why they may ultimately not be that important to the timing of rates hikes. Above all, the Fed wants to remain relevant in case the economy is hit by recessionary shocks that require interest rates to return to the zero-lower-bound (ZLB). By definition, once on the ZLB, they need to rise before they can fall again.

I don't think these are accurate representations of Fed thinking. The Fed recognizes that hiking rates prematurely to "give them room" in the next recession is of course self-defeating. They are not going to invite a recession simply to prove they have the tools to deal with another recession.  

The reasons the Fed wants to normalize policy are, I fear, a bit more mundane:

  1. They believe the economy is approaching a more normal environment with solid GDP growth and near-NAIRU unemployment. They do not believe such an environment is consistent with zero rates.
  2. They believe that monetary policy operates with long and variable lags. Consequently, they need to act before inflation hits 2% if they do not want to overshoot their target. And they in fact have no intention of overshooting their target.
  3. They do not believe in the secular stagnation story. They do not believe that the estimate of the neutral Fed Funds rate should be revised sharply downward. Hence 25bp, or 50bp, or even 100bp still represents loose monetary policy by their definition.

I am currently of the opinion that there is a reasonable chance the Fed is wrong on the third point, and that they have less room to maneuver than they believe. If so, they will find themselves back at the zero bound in the next recession, very quickly I might add. This is not their expectation. They expect to remain relevant in the next recession and do not believe they need to quickly raise rates to achieve relevance. Again, they know this is self-defeating.

Whether or not they can maintain their mid-year target is of course the topic du jour. But the logic of those who believe the Fed will not have what it needs in June and thus expect the first hike much later is more convincing than those who argue that they will raise rates due to some pressing need to prepare for the next recession.

Thursday, January 22, 2015

Fed Watch: Policy Divergence

Tim Duy:

Policy Divergence, by Tim Duy: Increasingly, the Federal Reserve stands in stark contrast with its global counterparts. While the ECB readys its own foray into quantitative easing, the Bank of England shifted to a more dovish internal position, the central bank of Denmark joined the Swiss in cutting rates, and the Bank of Canada unexpectedly cut rates 25bp this morning. The latter move I found somewhat unsurprising given the likely impact of oil prices on the Canadian economy. The rest of the world is diverging from US monetary policy. How long can the Fed continue to stand against this tide?

Late last week, Reuters reported that the Fed's resolve was stiffening. This week, the Wall Street Journal reported the Fed was staying the course. This morning, Bloomberg says the Fed is getting weak in the knees:

Federal Reserve officials are starting to reassess their outlook for the economy as global weakness and disappointing data on American consumer spending test their resolve to raise interest rates this year.

San Francisco Fed President John Williams last week said he will trim his U.S. estimate because of slower growth abroad. Atlanta’s Dennis Lockhart said Jan. 12 that he advocates a “cautious” approach to rate increases and inflation readings “may be pivotal.” Both are voters on the Federal Open Market Committee in 2015 and repeated that rates could be raised in the middle of the year.

I doubt the Fed will place too much weight on the December retail sales report. It is fairly noisy data and there is no indication that the fundamental upward trend has been broken:

RETAIL012115

Moreover, I think they would be wary of reading too much into one data point given the upswing in consumer confidence in recent months. That, of course, only builds upon the upswing in employment data. And housing starts finished the year on a strong note - see Calculated Risk for more on that topic.

All that said, the Fed should of course be cautious about the impact of global weakness. But how does the Fed communicate such caution? The challenge I see for the Fed is that they will want to hold the statement fairly steady, with falling oil prices and global weakness as offsetting risks while holding the line on the "low inflation is transitory" story. They want to keep June alive. After all, it's still five months out - a lifetime at the speed of today's financial world. They don't want expectations to fall too far to the back of the year while they are still looking at a June hike.

Such a steady hand, however, may be viewed as hawkish, which is also a message the Fed does not want to send. My expectation is that they highlight the improving US economy, particularly the acceleration in job growth, while offering concerns about the global economy. Remember that the condition of the US job market is very different than during previous bouts of financial instability; the momentum looks more self-sustaining than it has in a long time. They may even point to policy action on the part of foreign central banks to help assuage some global weakness concerns.

Separately, St. Louis Federal Reserve President James Bullard gives no quarter in his argument for rate hike in the first quarter of this year in this Wall Street Journal interview:

I still think we should get off zero (interest rates). The kinds of things we’re observing now, it is not the constellation of data that would be consistent with a zero policy rate. I think it is important to get started and to start normalizing policy. Even once we start to normalize, interest rates would still be extremely low. We’re talking about levels of 50 basis points or 75 basis points. That is still extremely low and that would still be putting upward pressure on inflation even if we did that. So I’d like to get going. I don’t think we can any longer rationalize a zero interest rate policy.

Bullard thinks the data is not consistent with a zero rate policy, while I fear that the data is where it is at because of the zero rate policy. Moreover, I would tend to proceed more cautiously then Bullard given the current flattening of the yield curve. But Bullard is an outlier; the FOMC consensus is in favor of caution, which is why there is no rate hike on the table next week or in March. And it is why June is in no way guaranteed; they need something from wage growth that they just aren't getting. If they want to set up for a June rate hike without wage growth, they need to start telling a compelling alternative story soon.

Somewhat disappointing is that Bullard is flip-flopping. To date he has been a fairly reliable inflation-hawk - his opinions shift consistently with the inflation outlook. Not this week:

I do worry about TIPS-based inflation compensation and it has been down a lot recently and it does concern me. What I want to do with that is wait and see what happens in global oil markets, wait and see what equilibrium turns out to be and then see what happens with breakeven inflation at that point. I want to let the dust settle on the oil market and then go back and check breakeven inflation rates and see what’s happened.

Basically, Bullard wants to ignore the market-based inflation metrics that would have in the past told him to hold off on any tightening. He really, really wants to liftoff from the zero bound, the sooner the better. I don't think this level of immediacy is felt by other FOMC members, but I do think they are hoping and praying the data gives them enough to move by mid-year.

Bottom Line: The Fed finds itself in a familiar place - wanting to change policy but not quite getting the data they need while at the same time global stress in on the rise. Luckily for them, they weren't going to move off the zero-bound next week anyways; they still have months of data to sift through between now and then. And unlike past times of turbulence, the US is coming from a position of strength, eliminating the need for any panicky moves. Next week is mostly then just about communicating how and how not they are responding to overseas developments.

Monday, January 19, 2015

Fed Watch: Seconded

Tim Duy:

Seconded, by Tim Duy: I see Jon Hilsenrath at the Wall Street Journal seconds my take from this morning:

Federal Reserve officials are on track to start raising short-term interest rates later this year, even though long-term rates are going in the other direction amid new investor worries about weak global growth, falling oil prices and slowing consumer price inflation.

This is generally consistent with my view. The Fed is likely reacting more slowly than market participants. Hilsenrath adds something I forgot to mention:

Central to their internal deliberations ahead of the March meeting is a debate about how low the jobless rate can fall before it stirs wage and inflation pressure. Fed officials estimate the “natural rate” of unemployment—meaning the rate below which wage pressures increase—is between 5.2% and 5.5%.

Mr. Rosengren said he was considering revising this estimate down because the jobless rate has fallen to near the 5.2%-5.5% range without triggering any sign of wage pressure. He said he suspected some of his Fed colleagues also were considering moving this estimate down. The lower the estimate goes, the more patient they might be before raising rates.

Just as I think it will be hard for the Fed to raise rates if the unemployment rate continues to fall while wage growth remains subdued, it will also be difficult to justify current estimates of the natural rate of unemployment under those circumstances. Still, I would caution that lowering the estimate of the natural rate would be, I think, an implicit rejection of the "underemployment hypothesis." It would be easier to adjust estimates of the natural rate downward if measures of underemployment were more consistent with their traditional relationships with unemployment. In other words, the natural rate may be consistent with subdued wage growth due to the existence of high levels of underemployment.

My opinion is that the global disinflationary environment would support low inflation at levels of unemployment below the Fed's current estimate of the natural rate, similar to the situation of the late 1990s.

Fed Watch: Will The Fed Take a Dovish Turn Next Week?

Tim Duy:

Will The Fed Take a Dovish Turn Next Week?, by Tim Duy: As it stands now, we are heading into the next FOMC meeting with the growing expectation that the Fed will take a dovish turn. Is it not obvious that global economic turmoil, collapsing oil prices, weak inflation, and a stronger dollar are clearly pointing to rapidly rising downside risks to the US economy? For financial market participants, they answer is a clear "yes." Expectations of the first rate hike have been pushed out to the end of this year, seemingly in complete defiance of Fed plans for policy normalization. The Fed may get there as well and abandon their carefully crafted mid-year plan, but I suspect they will not move quite as rapidly as financial market participants desire.
As a general rule, the Fed tends to act in a more deliberate fashion. To be sure, this was not evident during the crisis. Indeed, "panicky" might be a better adjective during that period. But note that in comparison to past bouts of tumolt on global markets, the US economy is in a much better place, with accelerating job growth when unemployment is already near traditional mandate-levels. From their point of view, this is a whole different world compared to that of the last round of Euro-induced crisis.
This take from Jonathan Spicer and Ann Saphir at Reuters probably saw less play than it deserved:
Tumbling oil prices have strengthened rather than weakened the Federal Reserve's resolve to start raising interest rates around midyear even as volatile markets and a softening U.S. inflation outlook made investors push back the timing of the "liftoff."
Kind of a "Fed is from Mars, markets are from Venus" situation. It is important to recognize that the Fed sees falling oil prices as a significant, unexpected development that represents the realization of an upside risk to their forecast. They are thinking of an outcome not unlike that revealed in the most recent Bloomberg/UMich read on consumer sentiment:

CONSEN011815

Through the roof, one might say. So at this point the Fed will view the external threats to the economy as just risks, but the very real move in oil is at a minimum adding upside risk to their forecasts or already pushing their forecasts to the upside. With regards to external threats, they probably think that more aggressive ECB action is in the wings to put their immediate fears to rest. And the downward push on inflation is, from their perspective, a transitory issue and therefore a non-issue.
Consider this also from the Reuters article:
Interviews with senior Fed officials and advisors suggest they remain confident the U.S. economy will be ready for a modest policy tightening in the June-September period, while any subsequent rate hikes will probably be slow and depend on how markets will behave.
in light of this from St. Louis Federal Reserve President James Bullard:
“The level of inflation is not so low that it can alone justify a policy rate of zero,” Mr. Bullard said in material prepared for a speech in Chicago.
and this from San Fransisco Federal Reserve President John Williams:
Placing heavy emphasis on the date of liftoff “suggests that you don’t have any other decisions to make,” Williams said. “We want to be very confident that we’re on the right path, that the data support that first move, but that first move on tightening is only one of many, many policy actions we’ll need to do during the normalization. It’s not the critical component.”
and this from Federal Reserve Chair Janet Yellen:
So, I think you raise a very important point because, although there is a great deal of market focus on the timing of liftoff, what to matter in thinking about the stance of policy is what the entire path of interest rates will look like. And I really don’t have much for you other than to say that they will be data dependent—that, over time, the stance of policy will be adjusted to try to keep the economy on a track where we see continuing progress toward achieving our goals of maximum employment and price stability.
My takeway is that the Fed sees the timing of the first rate hike as less important than everything that comes after that hike. This will leave them less eager to delay the hike. Given where the economy currently stands, I suspect they see little chance of damage from that first hike alone.
This is also interesting:
Some of those interviewed stressed that in the light of last year's strong jobs gains waiting until mid-year represented a cautious approach rather than an aggressive one, allowing the Fed to delay the rate liftoff if needed, particularly if inflation expectations turned sharply down.
The suggestion here is that at least some Fed officials view signaling a mid-year rate hike as the cautious approach because the data increasingly suggests to them that they should be moving sooner than later.
Bottom Line: I reiterate my view that despite the generally positive data flow, and the upward boost from oil, I don't see how they can justify raising rates without some reasonable acceleration in wage growth. That said, perhaps by my own argument above they can justify it on the basis of 25bp won't hurt anyone anyways. But my broader point is this: During normal times the Fed moves methodically if not ponderously. The current state of the economy gives them room to move as such. So I would not be surpised to see a fairly steady hand revealed in the next FOMC statement.

Friday, January 09, 2015

Fed Watch: Wage Growth - or Lack of - Continues to Surprise

Tim Duy:

Wage Growth - or Lack of - Continues to Surprise, by Tim Duy: The December employment report, with its surprising combination of solid job gains and decelerating wage growth, leaves Fed policy up the air.
Headline nonfarm payrolls gained by 252k, while previous months were revised up a net 50k. Job growth continues to accelerate:

NFPa010915

Note the acceleration in aggregate hours worked:

NFPd010915

Such gains suggest the recent acceleration in GDP growth is real and likely to be sustained. From the household survey, we see that the unemployment rate continues to decline. Fed forecasts will once again soon be in jeopardy:

NFPc010915

In the context of indicators previously identified by Federal Reserve Chair Janet Yellen:

YELLENa010915

YELLENb010915

Overall, the story is one of ongoing improvement in labor markets, including metrics of underemployment. Wage growth, however, nosedived during the month:

NFPb010915

I would be wary of this read on wages - strikes me as an aberration that is likely to be violently reversed, but I also stick to what I wrote yesterday:
I believe that an acceleration of wage growth would do the trick, which is why this remains the data to watch in the employment report. If June rolls around with no inflation and no greater wage growth, the Fed will find it challenging to begin normalization. In that case, they would need to focus on the employment mandate or pivot to some financial stability story to justify a rate hike.
Bottom Line: Generally a very solid report. But the wage numbers present a dilemma for the Fed. Simply put, no wage growth means the Fed can't be particularly confident that inflation will trend toward target. Not that a rate hike was imminent in any event; Fed is still looking at June, but they need some more help from the data. Of course, June is still a long way off - we have five more employment reports before that meeting. Time enough for these numbers to turn around. Note that if the wage trend does reverse quickly, policy expectations would shift just as quickly.

Thursday, January 08, 2015

Fed Watch: Volatile Week Ahead of Employment Report

Tim Duy:

Volatile Week Ahead of Employment Report, by Tim Duy: At the moment, there are many different competing threads in the tapestry of monetary policy, with another thread entering the pattern with tomorrow's employment report. In short, the Fed is balancing clear evidence of accelerating US activity in the back half of 2014 against the implications of declining oil prices and a host of international weaknesses that are roiling financial markets. The reality of volatility in asset prices was on full display this week. The Fed desire to begin normalizing policy with a rate hike in the middle of this year certainly appears in jeopardy. They very much need continued solid data on the US side of the equation to push forward with their plans.
Early 2015 US data in the form of ISM reports provides little new guidance. While the measures slipped from recent high, I would be hard-pressed to say that the underlying trend has changed after considering the volatility of this data:

NAPMa010814

NAPMb010814

Likewise, initial unemployment claims continue to hover below pre-recession lows, signaling solid labor demand:

CLAIMS010815

Plunging gasoline prices will almost certainly bolster consumer confidence:

GAS010814

The Fed anticipates that declining energy prices will have a net positive impact on the economy. Via the minutes of the most recent FOMC meeting:
In their discussion of the foreign economic outlook, participants noted that the implications of the drop in crude oil prices would differ across regions, especially if the price declines affected inflation expectations and financial markets; a few participants said that the effect on overseas employment and output as a whole was likely to be positive. While some participants had lowered their assessments of the prospects for global economic growth, several noted that the likelihood of further responses by policymakers abroad had increased. Several participants indicated that they expected slower economic growth abroad to negatively affect the U.S. economy, principally through lower net exports, but the net effect of lower oil prices on U.S. economic activity was anticipated to be positive.
I tend agree that the net impact will be positive, but note that the negative impacts will be fairly concentrated and easy for the media to sensationalize, while the positive impacts will be fairly dispersed. We all know what is going to happen to rig counts, high-yield energy debt, and the economies of North Dakota and at least parts of Texas. "Kablooey," I think, is the technical term. Easy media fodder. Much more difficult to see the positive impact spread across the real incomes of millions of households, with particularly solid gains at the lower ends of the income distribution. This will be most likely revealed in the aggregate data and be much less newsworthy.
The decline in energy prices, combined with the stronger dollar, confounds the Fed's inflation outlook, but for now they seem content to assume the impacts are transitory:
Participants generally anticipated that inflation was likely to decline further in the near term, reflecting the reduction in oil prices and the effects of the rise in the foreign exchange value of the dollar on import prices.Most participants saw these influences as temporary and thus continued to expect inflation to move back gradually to the Committee's 2 percent longer-run objective as the labor market improved further in an environment of well-anchored inflation expectations.
The Fed also, at least for now, is choosing to heavily discount market-based measures of inflation expectations:
Survey-based measures of longer-term inflation expectations remained stable, although market-based measures of inflation compensation over the next five years, as well as over the five-year period beginning five years ahead, moved down further over the intermeeting period.Participants discussed various explanations for the decline in market-based measures, including a fall in expected future inflation, reductions in inflation risk premiums, and higher liquidity and other premiums that might be influencing the prices of Treasury Inflation-Protected Securities and inflation derivatives.Model-based decompositions of inflation compensation seemed to support the message from surveys that longer-term inflation expectations had remained stable, although it was observed that these results were sensitive to the assumptions underlying the particular models used. It was noted that even if the declines in inflation compensation reflected lower inflation risk premiums rather than a reduction in expected inflation, policymakers might still want to take them into account because such changes could reflect increased concerns on the part of investors about adverse outcomes in which low inflation was accompanied by weak economic activity. In the end, participants generally agreed that it would take more time and analysis to draw definitive conclusions regarding the recent behavior of inflation compensation.
For example, the Cleveland Federal Reserve measure of inflation expectations over the next ten years was 1.83% in December, within spitting distance of the Fed's target. This kind of analysis, combined with survey-based measures, provides the Fed with a great deal of comfort regarding the inflation situation.
That said, inflation remains below target and, importantly, was decelerating before the impact of lower energy prices worked its way through the economy:

PCE33122314

Shouldn't this alone keep any talk of rate hikes at bay? You might think so, but the Fed already believed there was a good chance that they would raise interest rates while core-inflation was below target:
With lower energy prices and the stronger dollar likely to keep inflation below target for some time, it was noted that the Committee might begin normalization at a time when core inflation was near current levels, although in that circumstance participants would want to be reasonably confident that inflation will move back toward 2 percent over time.
So what is the bar for "reasonably confident"? I believe that an acceleration of wage growth would do the trick, which is why this remains the data to watch in the employment report. If June rolls around with no inflation and no greater wage growth, the Fed will find it challenging to begin normalization. In that case, they would need to focus on the employment mandate or pivot to some financial stability story to justify a rate hike.
Jon Hilsenrath offers a potential interpretation of the implications of the rally at the long end of the Treasury yield curve:
If falling yields are a reflection of diminishing inflation prospects, as is typically the case, it ought to prompt the Fed to hold off on raising short-term interest rates in the months ahead. If, on the other hand, lower long-term rates are a reflection of investors pouring money into U.S. dollar assets, flows that could spark a U.S. asset price boom, it might prompt the Fed to push rates higher sooner or more aggressively than planned.
The latter interpretation is less conventional, but it is one that New York Fed President William Dudley made at length in a speech in December. He argued the Fed had the wrong reaction to lower long rates in the 2000s, a mistake that might have contributed to the housing boom that ended disastrously.
I wrote about this last month, coming to the conclusion:
A second point is that Dudley is not taking seriously the possibility that the flattening yields curve suggests the Fed has less room to move than policymakers think they do. This is something I worry about - if the Fed leans on the short end too much, they risk taking an expansion that should last another fours years to one that has just two more years left. But that might be a story for next December.
I think the late-90's is a better comparator to the current envrionment, but that will take another post to deal with. For the moment, I will add that San Francisco Federal Reserve President John Williams hinted that current action in the bond market is in fact telling a less hawkish story. Via Greg Robb at MarketWatch:
Williams said he thinks a rate hike this year will be appropriate, but added he is in "no rush" to tighten. He said that mid-2015 is a reasonable guess of when the Fed will first ask "should we do it now or wait a little longer."
I have interpreted Williams remarks in the past as pointing at a June rate hike. Arguably, here he hedges and says June is when they should start considering the rate hike. Perhaps falling Treasury yields are having the traditional impact on Fed thinking after all.
Bottom Line: Fed wants to begin normalizing policy, but sees a murkier path compared to even just last month. They need hard US data to overwhelm the oil/international driven fears. An acceleration of wage growth would help put some light on the path they want to follow.

Monday, December 22, 2014

Fed Watch: Looking Backward to See the Future

Tim Duy:

Looking Backward to See the Future, by Tim Duy: Is this our future, brought back from the past? A contact referenced the last hike cycle via the FOMC statements from 2003-04 (emphasis added):

October 28, 2003:

The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. In contrast, the probability, though minor, of an unwelcome fall in inflation exceeds that of a rise in inflation from its already low level. The Committee judges that, on balance, the risk of inflation becoming undesirably low remains the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.

December 9, 2003:

The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. The probability of an unwelcome fall in inflation has diminished in recent months and now appears almost equal to that of a rise in inflation. However, with inflation quite low and resource use slack, the Committee believes that policy accommodation can be maintained for a considerable period.

January 28, 2004:

The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. The probability of an unwelcome fall in inflation has diminished in recent months and now appears almost equal to that of a rise in inflation. With inflation quite low and resource use slack, the Committee believes that it can be patient in removing its policy accommodation.

March 16, 2004:

The Committee perceives the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. The probability of an unwelcome fall in inflation has diminished in recent months and now appears almost equal to that of a rise in inflation. With inflation quite low and resource use slack, the Committee believes that it can be patient in removing its policy accommodation.

May 4, 2004:

The Committee perceives the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. Similarly, the risks to the goal of price stability have moved into balance. At this juncture, with inflation low and resource use slack, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured.

June 30, 2004:

The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 1-1/4 percent.

"Patient" lasted for two meetings before being replaced by "measured." This is fairly consistent with my expectations. My baseline scenario is that the Fed drops "considerable" entirely in January, retains "patient" in March, drops "patient" in April, and raise rates in June. In her press conference, Federal Reserve Chair Janet Yellen said:

There certainly has been no decision, you know, decision on the part of the Committee to move at a measured pace or to use language like that. I think quite a few people looking back on the use of that language in the--I can't remember if it was 12 or 16 meetings, where there were 25 basis point moves. We'd probably not like to repeat a sequence in which there was a measured pace and 25 basis point moves at every meeting. So I certainly don't want to encourage you to think that there will be a repeat of that.

If she really believes this, Yellen will not push to replace "patient" with "measured," but instead some more vague data-dependent type language.

Bottom Line: Assuming the data holds, maybe history will repeat itself. If it really is this easy, I have no idea what I will be writing about for the next six months.

Fed Watch: Asked and Answered. Mostly.

Tim Duy:

Asked and Answered. Mostly, by Tim Duy: Last week I had six questions for Federal Reserve Chair Janet Yellen. Here is my attempt to piece together the answers from her post-FOMC press conference:

Question 1: If you want to know what the Fed is thinking at this point, a journalist needs to push Yellen on the secular stagnation issue at next week's press conference. Does she or the committee agree with Fischer? And does she see any inconsistency with the SEP implied equilibrium Federal Funds rates and the current level of long bonds?

Yellen, in answer to Peter Coke of Bloomberg Television: "(The Committee) are optimistic that those conditions will lift. They see the longer-run normal level of interest rates as around 3-3/4 percent. So there's no view in the Committee that there is secular stagnation in the sense we won't eventually get back to pretty historically normal levels of interest rates."

Yellen, in answer to Robin Harding of the Financial Times: "There are a number of different factors that are bearing on the path of market interest rates. I think including global economic developments. It is often the case that when oil prices move down, and the dollar appreciates, that tends to put downward pressure on inflation compensation and on longer-term rates. We also have safe haven flows that may be affecting longer-term Treasury yields. So I can't tell you exactly what is driving market developments. But what I can say is that we are trying to communicate our thoughts as clearly as we can."

The Federal Reserve believes that the current level of long rates is an artifact of safe-haven flows, not an indication of secular stagnation. They must anticipate that the yield curve will not flatten further or invert when they begin raising rates.

Question 2: I would like a journalist to press Yellen on her interpretation of the 5-year, 5-year forward breakeven measure of inflation expectations. Does she see this measure as important or too noisy to be used as a policy metric? What is her preferred metric?

Yellen, in answer to Greg Ip of the Economist: "Oh, and longer-dated expectations. Well I would say we refer to this in the statement as inflation compensation, rather than inflation expectations. The gap between the nominal yields on 10-year Treasuries for example. And TIPS have declined -- that's inflation compensation, and five-year, five-year forwards, as you've said, have also declined. That could reflect a change in inflation expectations. But it could also reflect changes in assessment of inflation risks. The risk premium that's necessary to compensate for inflation. That might especially have fallen if the probabilities attached to very high inflation have come down. And it can also reflect liquidity effects in markets and for example, it's sometimes the case that -- when there is a flight to safety, that flight tends to be concentrated in nominal Treasuries, and can also serve to compress that spread. So I think the jury is out about exactly how to interpret that downward move in inflation compensation. And we indicated that we are monitoring inflation developments carefully."

The Federal Reserve does not believe market-based measures of inflation expectations as indicative of actual inflation expectations. Watch surveys, Cleveland Fed-type measures, and actual inflation instead.

Question 3: Considering that recent updates of your optimal control framework now suggest that the normalization process should already be underway, how useful do you believe such a framework is for the conduct of monetary policy? What specific framework are you now using to dismiss the results of your previously preferred framework?

Yellen, in answer to Greg Ip of the Economist: "So you -- your first question is why is it that the committee sees unemployment as declining slightly below its estimate of the longer-run, natural rate? And I think in part, the reason for that is that inflation is running below our objective, and the committee wants to see inflation move back toward our objective over time. And a short period of a very slight under shoot of unemployment below the natural rate will facilitate slightly faster return of inflation to our objective. It is, I should say, a very small undershoot in a situation where there is great uncertainty about exactly what constitutes maximum employment, or a longer-run, normal rate of unemployment."

This is the general story of optimal control - hold unemployment below the natural rate to accelerate return to target inflation. Ignore any overshooting of inflation in such an analysis; Yellen was never really serious about that. Only thing preventing Fed from raising rates now is tweeking the optimal control results to account for still-high unemployment.

Question 4: St. Louis Federal Reserve President James Bullard has defined a specific metric to assess the Fed's current distance from its goals. What is your specific metric and by that metric how far is the Fed from it's goals? What does this metric tell you about the likely timing of the first rate hike of this cycle?

Yellen, in answer to Binyamin Appelbaum of the New York Times: "And with respect to inflation -- and our forecast for inflation, and inflation expectations, let me start by saying I think it's important that monetary policy be forward-looking. The lags in monetary policy are long. And therefore the committee has to base its decisions on how to set the federal funds rate looking into the future. Theory is important, and theories that are consistent with historical evidence will be something that governs the thinking of many people around the table. Typically we have seen that as long as inflation expectations are well-anchored, that as the labor market recovers, we'll gradually see upward pressure on both wages and prices. And that inflation will tend to move back toward 2 percent. I think historically we have seen, as the economy strengthens and slack diminishes, that inflation does tend to gradually rise over time. And as long -- you know, I just -- speaking for myself, that I will be looking for evidence that I think strengthens my confidence in that view, and you know, looking at the full range of data that bears on, whether or not that's a reasonable view of how events will unfold. But it's likely to be a decision that's based on forecasts and confidence in the forecast."

No firm metrics. Raising rates is like pornography - we know it is time when we see it.

Question 5: Why is the Fed setting the stage for raising interest rates next year while inflation measures remain below target? What is the risk, exactly, of explicitly committing to a zero interest rate policy until inflation reaches at least your target?

Yellen, in answer to Greg Ip of the Economist: "But it's important to point out that the committee is not anticipating an over-shoot of its 2 percent inflation objective."

From the Fed's perspective, not an interesting question. Theory says monetary policymakers need to move ahead of seeing inflation at target. If inflation was actually at target, they would be behind the curve in this economic environment. Also refer to San Francisco Federal Reserve President John Williams, via the Wall Street Journal:

“There’s no question that core inflation will likely be below 2% when liftoff is appropriate,” Mr. Williams said.

You have to love that statement - only an economist could piece together a sentence with "no question" and "likely" in this context. In short, they have no intention of allowing inflation to drift above 2%. The 2% goal is a ceiling, not a target. They are perfectly happy tolerating modestly below-target inflation as long as unemployment is below 6%. If you thought that any mention of above-target inflation was anything more than an acknowledgement of potential forecast errors, you were wrong. As far as the Fed is concerned, 2% inflation was handed down by God. It's in the Bible. Look it up.

Question 6: High yield debt markets are currently under pressure from the decline in oil prices. Are you confident that macroprudential tools are sufficient to contain the damage to energy-related debt? If the damage cannot be contained and contagion to other markets spreads, what does this tell you about the ability to use low interest rate policy without engendering dangerous financial instabilities?

Yellen, in answer to Greg Robb of MarketWatch: "So I mean there is some--you're talking about in the United States exposure? I mean we have seen some impacts of lower oil prices on the spreads for high-yield bonds, where there's exposure to oil companies that may see distress or a decline in their earnings, and we have seen some increase in spreads on high-yield bonds more generally. I think for the banking system as a whole the exposure to oil, I'm not aware of significant issues there. This is the kind of thing that is part of risk management for banking organizations and the kind of thing they look at in stress tests. But the movements in oil prices have been very large, and undoubtedly unexpected.

We--in terms of leverage, and whether or not levered entities could be badly effected by movements in oil prices, leverage in the financial system in general is way down from the levels before the crisis. So it's not a major concern that there are levered entities that would be badly affected by this, but we'll have to watch carefully. There have been large and unexpected movements in oil prices."

I honestly think that Yellen was surprised the rest of us were worried about this. Don't worry, be happy -high yield energy debt problems are contained.

Bottom Line: Final result is data dependent, but nothing at the moment is dissuading the Fed from their intention to hike rates in the middle of 2015.

Wednesday, December 17, 2014

Fed Watch: Quick FOMC Recap

Tim Duy:

Quick FOMC Recap, by Tim Duy: Running short on time today....

Today's FOMC statement was a reminder that in normal times the Federal Reserve moves slowly and methodically. Policymakers were apparently concerned that removal of "considerable time" by itself would prove to be disruptive. Instead, they opted to both remove it and retain it:

Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy. The Committee sees this guidance as consistent with its previous statement that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program in October, 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.

If you thought they would drop "considerable time," they did. If you thought they would retain "considerable time," they did. Everyone's a winner with this statement.

Federal Reserve Chair Janet Yellen explained the change in language as necessary to shift away from the increasingly dated reference to the end of quantitative easing. In addition to the lower inflation and interest rate expectations in the Summary of Economic Projections, the statement was initially regarded as dovish. The press conference, however, was in my opinion anything but dovish.

During the presser, Yellen explained that "patience" was only likely guaranteed through the next "couple" of meetings, later clarified to be two. Hence, the April meeting is still on the table, although I still suspect that is too early. Yellen also said that a press conference was not required to raise rates; if necessary, they could always opt to have a presser even if one not scheduled. She dismissed falling market-based inflation expectations as reflecting inflation "compensation" rather than expectations. She dismissed the disinflationary impulse from oil, calling it transitory and drawing attention to the expected positive implications for US growth (much as she corrected described "noisy" inflation indicators earlier this year). She indicated that inflation did not need to return to target prior to raising rates, only that the Fed needed to be confident it would continue to trend toward target. She was very obviously unconcerned about the risk of contagion either via Russia or high yield energy debt - I think she almost seemed surprised anyone was worried about the latter.

In short, Yellen dismissed virtually all of the reasons to expect the Federal Reserve to delay rate hikes past its expectation of mid-2015. They have their eyes set firmly on June. My sense is that they see the accelerating economy and combine that with, as Yellen mentioned, the long lags of monetary policy, and worry that it will not be long before they are behind the curve.

To be sure, it is easy to outline a scenario that derails the Fed's plans. The impact of the oil shock on core inflation may be more than expected. Or rising labor force participation stabilizes the unemployment rate and wage growth continues to move sideways. My guess is that if they see an acceleration in wage growth between now and June, a June hike is pretty much in the bag.

Bottom Line: Like it or not, believe it or not, the Fed is seriously looking at mid-2015 to begin the normalization process. And there is no guarantee that it will be a predictable series of modest rate hikes. As much as you think of the possibility that the hike is delayed, think also of the possibility of 1994.

Tuesday, December 16, 2014

Fed Watch: IP, Russia

Tim Duy:

IP, Russia, by Tim Duy: The string of solid US economic news continued with industrial production advancing 1.3% in November. Year-over-year growth (5.2%) is now comparable to the late-90's:

IP121514

Meanwhile, the international fallout from the oil price drop continues. Russia is a classic emerging market crisis story. The decline in energy prices reveals a currency mismatch between assets and liabilities. The decline in oil dries up the dollars needed to support those liabilities, so the value of the ruble is bid down as market participants scramble for dollars. One suspects that capital flight from Russia only aggravates the problem; those oligarchs are seeing their fortunes whither. Currency plummets, aggravating the cycle. The sanctions were the beginning of this crisis, the oil price shock the culmination.
The Central Bank of Russia is forced into defending its currency via either depleting reserves or hiking interest rates. Both are losing games in a full blown crisis. The Central Bank of Russia has tried both, upping the ante by jacking up rates to 17% this afternoon, a hike of 650bp. That, however, is no guarantee of stability. Tight policy will crush the financial sector and the economy with it, triggering further net capital outflows that my guess will swamp the net inflows the rate hike was intended to create. Everything heads into free-fall until a new, lower equilibrium is established.
It is all appears really quite textbook. At this point, an IMF program would be on the horizon. But that's where the textbook changes. Hard to see the IMF just handing out a lifeline to an economy probably viewed by most as currently invading its neighbor (that's the point of the sanctions after all). And I am guessing that Russian Premier Vladimir Putin is not going to easily acquiesce to an IMF program in any event. At the moment, looks like Russia is toast. (Update: Arguably I am being a little pessimistic here. Joseph Cotterill points out that the rate hike falls well short of 1998.)
Venezuela is heading down the tubes as well, but that was always a given. Just a matter of time on that one.
Back at the Federal Reserve ranch, a fascinating experiment is underway. Have policymakers been successful in insulating the financial sector from these kinds of shocks? There will be losses, but will those losses cascade throughout the financial sector and into the real economy, or will they be contained? If the answer is containment, then interestingly Russia will lose a bargaining chip and the Fed's willingness to counter the potential risks of low interest rates with macroprudential policy will look like a sustainable policy mix.
If, however, contagion takes hold, we will once again be revisiting regulatory policy. And if the proximate cause of the contagion is deemed high-yield energy sector debt, and the excessively low rates in high-yield in general is deemed a consequence of ZIRP, then the Fed will be pushed to rethink its faith in macroprudential policy. The Austrians would have plenty of grist to chew on.
Bottom Line: All of this will be on the table at tomorrow's two-day FOMC meeting. The Fed will be forced to balance the US picture against the global shock. The primary argument to pull "considerable time" is the current US economic momentum. Furthermore, changing the language is not a policy change in any event; arguably, the language itself is already meaningless if the Fed is truly data dependent. In addition, policymakers may be wary to appear overly sensitive to financial markets. They may also be concerned that not eliminating the language will make the Fed appear less hawkish and more pessimistic than it is, thus risking disrupting financial markets at a later time if data suggests a rate hike is appropriate. The issue of "considerable time" however, is in my opinion, no longer of much interest. The macroprudential/regulatory experiment is far more important now.

Monday, December 15, 2014

Fed Watch: More Questions for Yellen

Tim Duy:

More Questions for Yellen, by Tim Duy: FOMC meeting this week. We all pretty much know the lay of the land. "Considerable time" is on the table, and whether it stays or goes is a close call. The existence of the press conference this week argues for the change over just waiting until January. Stupid reason, I know, but we are just playing the Fed's game here. No real reason not to wait until January other than to keep a March rate hike in play, but only a few policymakers are seriously looking at March anyway. Uncertainty regarding the financial market impact of the oil price drop and its subsequent impact on credit markets seems sufficient to stay the Fed's hand - but they may be hesitant to appear reactive to every dip in financial markets. If the statement is changed, they will probably replace "considerable time" with the intention to be "patient" when considering the timing of the first rate hike.
They will be navigating some tricky currents when constructing the rest of the statement. The opening paragraph will need to acknowledge the improved data - the US economy clearly has some momentum. They will also acknowledge again the expected impact of energy prices on headline inflation, but emphasize the temporary nature of the impact and fairly stable survey-based expectations. This suggest another dismissal of market-based measures.
The Fed could argue that improving domestic indicators at a time of softening in the global economy leaves the risks to the outlook as nearly balanced. They can't both suggest that risks are weighted to the downside and pull the "considerable time" language. That would, I think, be just silly. If they want to suggest there is a preponderance of downside risks, then they will leave in "considerable time." It will be interesting to see if they mention the external environment at all - we know from the minutes of the previous meeting that they were concerned about appearing overly pessimistic.
I have previously suggested two questions for Federal Reserve Chair Janet Yellen at the post-FOMC press conference:
If you want to know what the Fed is thinking at this point, a journalist needs to push Yellen on the secular stagnation issue at next week's press conference. Does she or the committee agree with Fischer? And does she see any inconsistency with the SEP implied equilibrium Federal Funds rates and the current level of long bonds?
and
I would like a journalist to press Yellen on her interpretation of the 5-year, 5-year forward breakeven measure of inflation expectations. Does she see this measure as important or too noisy to be used as a policy metric? What is her preferred metric?
Now I have four additional questions. The first refers to Yellen's previous endorsement of optimal control theory, which as stated in 2012 suggests the extension of zero rate policy well into 2015. Recent research from the Federal Reserve indicates that the same framework is now signaling that liftoff should occur in late 2014, suggesting that the Federal Reserve is now behind the curve. Did Yellen embrace this methodology only until it began to give results she did not like? The obvious question is thus:
Considering that recent updates of your optimal control framework now suggest that the normalization process should already be underway, how useful do you believe such a framework is for the conduct of monetary policy? What specific framework are you now using to dismiss the results of your previously preferred framework?
The second, arguably related, question refers to St. Louis Federal Reserve President James Bullard's argument that the Fed is very close to reaching its monetary policy goals:

Bullard121214

Thus another question is:
St. Louis Federal Reserve President James Bullard has defined a specific metric to assess the Fed's current distance from its goals. What is your specific metric and by that metric how far is the Fed from it's goals? What does this metric tell you about the likely timing of the first rate hike of this cycle?
A third question is obvious. Given current readings on inflation:
Why is the Fed setting the stage for raising interest rates next year while inflation measures remain below target? What is the risk, exactly, of explicitly committing to a zero interest rate policy until inflation reaches at least your target?
The fourth question addresses the potential financial instability related to oil price shock. Note that critics of Fed policy have posited that the low interest rate policy would encourage excessive risk taking in the reach for yield. High yield debt markets have come under particular scrutiny. The Fed has responded that they need to address any financial market instabilities first with macroprudential policy rather than tighter monetary policy. That approach is going to come under sharp criticism if the oil-related debt defaults cascade destructively throughout US financial markets. A natural question is thus:
High yield debt markets are currently under pressure from the decline in oil prices. Are you confident that macroprudential tools are sufficient to contain the damage to energy-related debt? If the damage cannot be contained and contagion to other markets spreads, what does this tell you about the ability to use low interest rate policy without engendering dangerous financial instabilities?
If anyone uses these questions or variations thereof, feel free to give me some credit. Or at least when you speak of me, speak well.
Bottom Line: Odds are high that the Fed alters the statement to increase their policy flexibility next year. But even if they drop "considerable time," Yellen will emphasize via the press conference that this change does not mean a rate hike is imminent. She will emphasize that the timing and pace of rate hikes remains firmly data dependent. The current oil-related disruptions in financial markets loom like a dark cloud over a both the FOMC meeting and the generally improving US outlook.

Friday, December 12, 2014

Fed Watch: Data Supportive of Fed Plans

Tim Duy:

Data Supportive of Fed Plans, by Tim Duy: Incoming data in the second half of this week continues to support the Federal Reserve's plans to begin normalizing policy in the middle of next year, with the removal of "considerable time" language next week a likely first step.
Retail sales for November were unquestionably strong and reveal an acceleration in the pace of core sales:

CORERETAIL121214

You were right if you dismissed the early earnings on the holiday shopping season as useless noise. Similarly, consumer confidence is pushing to pre-recession levels:

MICHSENT121214

And note this from Reuters:
"Expected wage gains rose to their highest level since 2008, and consumers voiced the most favorable buying attitudes in several decades," survey director Richard Curtin said in a statement.
As I have said before, nothing interesting happens until we get unemployment below 6%. Be prepared for a better equilibrium.
Even as the economic data improve, however, Wall Street remains on edge. Lower oil prices and the resulting impact on high yield bonds are resonating throughout credits markets while equity prices struggle. Despite warnings from Fed officials about the likely path of policy, long-dated US Treasury yields continue to remain under pressure. It is difficult to assess the impact on policy-making at this point. Fed officials will be torn between the market turmoil and expectations that lower energy prices will boost an already accelerating economy. And note that New York Federal Reserve President William Dudley was very dismissive of the idea that the Fed would respond to every financial market disruption as policy moved toward normalization:
Because financial market conditions affect economic activity only slowly over time, this suggests that we should look through short-term volatility and movements in financial markets. We should not respond until we become convinced that the movements will likely, without action on our part, prove sufficiently persistent to conflict with achievement of our objectives. Often, financial markets can be quite volatile and move a lot without disturbing underlying economic performance.
Similarly, he has been dismissive of market-based measures of inflation expectations.
In assessing inflation expectations, I currently put more weight on survey-based measures of inflation expectations as opposed to market-based measures. Survey-based measures have been generally stable, consistent with inflation expectations remaining well-anchored. However, market-based measures, such as those based on breakeven inflation derived from the difference between yields on nominal versus Treasury Inflation-Protected Securities (TIPS), have registered declines over the past few months, even on a 5-years forward basis. Research done by my staff suggests that much of this decline in market-based measures of inflation compensation reflects a fall in the inflation risk premium—that is, what investors are willing to pay to protect themselves against inflation risk. Adjusting for the fall in the inflation risk premium, inflation expectations appear to have declined much less than implied by TIPS inflation breakeven measures.
Market participants believe the Fed leans heavily on the 5-year, 5-year forward inflation metric. That measure is heading toward lows last seen on the eve of operation twist:

5Y5Y121214

The Fed dares not defy this chart. Or do they? Jim O'Sullivan at HFE accurately notes that the 5-year, 5-year forward breakeven has been inordinately driven by oil prices:
Why Fed prefers "survey based:" 5y5yf TIPS swing with oil even tho current infl irrelevant for pic.twitter.com/StxfsvubNh
— Jim O'Sullivan (@osullivanEcon) December 12, 2014
The Fed may be losing faith in these measures. As Dudley suggests, they may feel that such metrics are too simplistic, and find themselves favoring metrics like that offered by the Cleveland Fed that shows a firming of inflation expectations in recent months:

Image1

Note also that the resilience of survey-based metrics of inflation expectations. Back to Reuters and the confidence report:
The survey's one-year inflation expectation rose to 2.9 percent from 2.8 percent, while its five-year inflation outlook also rose to 2.9 percent from 2.6 percent last month.
And that leads me to my bottom line - another question for Federal Reserve Chair Janet Yellen at next week's post-FOMC press conference.
Bottom Line: I would like a journalist to press Yellen on her interpretation of the 5-year, 5-year forward breakeven measure of inflation expectations. Does she see this measure as important or too noisy to be used as a policy metric? What is her preferred metric?

Thursday, December 11, 2014

Fed Watch: Challenging the Fed

Tim Duy:

Challenging the Fed, by Tim Duy: Both Paul Krugman and Ryan Avent are pushing back on the Federal Reserve's apparent intent to raise rates in the middle of next year. Why is the Fed heading in this direction? Krugman offers this explanation:

My guess — and it’s only that — is that they have, maybe without knowing it, been bludgeoned into submission by the constant attacks on easy money. Every day the financial press, many of the blogs, cable financial news, etc, are full of people warning that the Fed’s low-rate policy is distorting markets, building up inflationary pressure, endangering financials stability. Hard-money arguments, no matter how ludicrous, get respectful attention; condemnations of the Fed are constant. If I were a Fed official, I suspect that I would often find myself wishing that the bludgeoning would just stop, at least for a while — and perhaps begin looking for an opportunity to prove that I’m not an inflationary money-printer, that I can take away punchbowls too.

I don't think that the Fed is reacting to external criticism. What I think is that there are two basic views of the world. In one view, the post-2007 malaise is simply the hangover from a severe financial crisis. Time heals all wounds, including this one, and the recent data suggests such healing is underway. The alternative view is that the economy is suffering from secular secular stagnation similar although not to the same extreme as Japan. The latter view suggests the need for a very low or negative real interest rates to maintain full employment, the former view suggests a fairly significant normalization of monetary policy.

I believe that the consensus view on the Fed is the former, that the malaise is simply temporary ("a temporary inconvenience") and now ending. I think this is evident from the Summary of Economic Projections - the implied equilibrium Federal Funds rate is around 3.75%. Perhaps this is below what might have been perceived as normal ten years ago, but the difference could be attributed to slower potential growth rather than secluar stagnation.

If you don't like that argument, then take the more explicit route. Gavin Davies did the intellectual legwork here so we don't have to, and catches Vice Chair Stanley Fischer saying that he doesn't believe the situation calls for protracted negative interest rates. In other words, he rejects the main monetary policy implication of the secular stagnation hypothesis.

And, I don't know if Krugman agrees, but I find it hard to believe that Fischer carries anything but extreme intellectual weight within the Fed. So I would hardly be surprised that the Fed would be moving in a direction he defined. One wonders where Fed Chair Janet Yellen's leadership is on this point? That was always a risk of adding Fischer to the Board - that what might have seemed to be a dream team turned into a power struggle.

This is not to say that I do not share Krugman's and Avent's concerns. I most certainly do. Fischer claims that markets do not believe the secular stagnation story either, but in my mind the flattening of the yield curve is a red flag that the Fed has less room to maneuver than implied by the SEP. But maybe once the Fed actually starts hiking rates, market participants get the clue and the yield curve shifts up. I am not sure I am interested in taking that risk at this point, but no one is asking me to serve on the Federal Reserve Board.

One quibble with Krugman regarding his interpretation of the Phillips Curve:

Suppose the Fed waits too long. Well, inflation ticks up — probably not much, since the short-run Phillips curve looks very flat. And the Fed has the tools to rein the economy in. It would be annoying, unpleasant, and no doubt there would be Congressional hearings berating the Fed for debasing the dollar etc.. But not a really big problem.

Maybe two quibbles. First is that if you asked policymakers why the Phillips Curve was flat, I think they would say that nominal wages rigidities hold up the back end, while tighter policy holds down the front. In other words, the reason inflation does not accelerate at low unemployment rates is that the Fed tightens policy accordingly. Second, I think they equate "reigning the economy in" as triggering a recession. I think they find this more than unpleasant.

Bottom Line: If you want to know what the Fed is thinking at this point, a journalist needs to push Yellen on the secular stagnation issue at next week's press conference. Does she or the committee agree with Fischer? And does she see any inconsistency with the SEP implied equilibrium Federal Funds rates and the current level of long bonds?

Tuesday, December 09, 2014

Fed Watch: Fed Updates Ahead of FOMC Meeting

Tim Duy:

Fed Updates Ahead of FOMC Meeting: I have tended to think that there is a tendency to underestimate the potential for a more hawkish Fed. From last week:

Dudley appears to be increasingly concerned that the evolution of financial conditions this year suggests the Fed needs to pursue a more aggressive policy stance or else risk a repeat of 04-07. If this concern is being felt more generally within the Fed, it clearly puts a more hawkish bias to the Fed's reaction function. And, in my opinion, I think the risk of a more hawkish Federal Reserve is under-appreciated. Few are expecting a hawkish Federal Reserve, reasonably so given the path of policy since 2008. But I don't think the data are that far from a tipping point for the Federal Reserve. Of course, take that in the context of my general optimism.

I think policymakers have been falling in line with the idea of a mid-2015 rate hike, somewhat earlier than market expectations. In a great piece, Gavyn Davies concurs:

One of the most successful rules for investors in the past few years has been never to underestimate the innate dovishness of the Federal Reserve. Whenever there has been a scare that the Fed might move in a hawkish direction, this has quickly proven to be a mistake. Forward curves for short term interest rates have consistently moved “lower for longer”, and incoming economic data have always ensured that the Federal Open Market Committee (FOMC) has remained comfortable with this tendency.

In recent months, however, the markets may have become over confident about the Fed’s dovishness in the face of a large and persistent decline in the US unemployment rate...

...The controlling group may be shifting towards the median dot, rather than the dovish end of the spectrum. This may even include Ms Yellen herself, if the Stanley Fischer interview is any guide. Mr Fischer is universally regarded as an intellectual heavyweight, but he has said very little about his personal views on monetary policy since taking office last May. He is unlikely to have broken this silence without the knowledge and support of the Chair.

Davies summarizes Federal Reserve Vice Chair Stanley Fischer's recent interview and concludes that "Mr Fischer is building a high hurdle to any delay in lift-off beyond mid 2015." Many policymakers are ready and eager to normalize policy, and they see economic improvements as consistent with normalization. Just like they wanted out of the asset purchase business, they want out of the zero rate business, and they see fewer and fewer reasons why this isn't possible.

A small step to that rate hike is the removal of the "considerable time" language in the FOMC policy statement on the basis that too much improvement in labor markets has occurred to justify a certain position on zero interest rates. If the Fed is looking for flexibility and does not want to surprise market participants with an unexpectedly hawkish position next year, they will soon need to loosen up the language. Hence sometime soon "considerable time" will be replaced, perhaps with the term "patience."

Jon Hilsenrath at the Wall Street Journal puts us on alert that next week may be just that time:

Federal Reserve officials are seriously considering an important shift in tone at their policy meeting next week: dropping an assurance that short-term interest rates will stay near zero for a “considerable time” as they look more confidently toward rate increases around the middle of next year.

Senior officials have hinted lately that they’re looking at dropping this closely watched interest-rate signal, which many market participants take as a sign rates won’t go up for at least six months.

“It’s clearer that we’re closer to getting rid of that than we were a few months ago,” FedVice Chairman Stanley Fischer said in an interview with The Wall Street Journal last week. New York Fed President William Dudleyhas avoided using the “considerable time” phrase in recent speeches and instead said the Fed should be “patient” before raising rates.

I find this piece of logic, however, to be irritating:

Fed officials have several tactical issues to consider that could prompt them to shift their rate assurance now, while they’re still taking measure of the economy’s strength. Ms. Yellen has a news conference after the policy meeting ends Dec. 17 to explain the central bank’s decision. The Fed doesn’t have another news conference scheduled until March. If officials wait to change the words until then, the market could take it as a signal officials are pushing off planned rate increases until the second half of next year.

It is not Hilsenrath I am irritated with, it is the Fed. It is fairly clear that the Fed has set expectations such that major policy moves can only be made in meetings with press conferences. It's the reason that June 2015 comes into focus for a rate hike - given the repeated warnings about the "middle of next year," March seems too early, and September too late. April and July are deemed not real policy meetings because they don't have press conferences. This really needs to end. The Fed needs to move to a press conference with every meeting.

If they feel they need a press conference to announce the end of the "considerable time" language, supporters of such a change will argue strongly for next week and probably win. It also opens up the possibility of a March hike, something the hawks would be keen on. Delaying the removal of "considerable time" to March would likely close off a June hike, but the moderates want to retain that option. I think both moderates and doves would be willing to wait until the January meeting, but that meeting has no press conference. So at this point I would be expecting that a change in the language next week is likely, and by the end of January is certain.

But make no mistake that I think that having to set policy by the timing of press conferences rather than the meetings is just stupid.

Finally, another line from Hilsenrath leaves me cautious:

At the same time, a stronger dollar and falling commodities prices—including the sharp decline in oil prices—are putting downward pressure on inflation.

I can certainly imagine that the stronger dollar is a consequence of stronger economic growth, which supports consumer prices. On the declining oil prices, I tend to view those as primarily supply side related and almost certainly a net positive for the US economy. Over the weekend Matt Busigin reminded us of this:

In April of 2011, Ben Bernanke was universally lambasted and lampooned for claiming that inflation, which was accelerating and running above 3%, was “transitory”. He used this view to justify loosening monetary policy. The next few months of CPI were not favourable to the Fed chairman’s views: it peaked at 3.8% (nearly double the implicit target at that point) in September of 2011, sparking a feverishly pitched cacophony of criticism that the Fed chair was out of touch, and tone-deaf in his theoretical ivory tower to the practical realities on the ground.

This, however, proved to be Bernanke’s finest hour. Yes, even more so than the extraordinary measures taken during the height of the credit crisis. His detractors then, of which there were still many, included people and institutions on the brink that needed the Fed to extend them a hand. In September of 2011, the chairman stood very much alone in his call for moderated inflation now that the acute disaster removed influential institutions and people from needing the Fed to act in order to survive....

...This is why Ben Bernanke’s 2011 triumph is relevant today. The same framework for understanding inflation through commodity prices and wages that successfully predicted the deceleration of inflation against the tidal wave of popular belief now finds itself in the inverse position: the expectations of inflation are very low, and despite low commodity prices, it expects inflation will accelerate...

You can read this for my similar take back in 2011. Rather than preventing inflation from returning to target, the oil price decline is likely to have the opposite impact and push inflation back to target. Hence the low-inflation argument for holding rates near zero will look weaker by June if not March.

Bottom Line: Fed is still positioning to begin normalizing rates in the middle of 2015. The data is less of an impediment with each passing day. The time to eliminate the "considerable period" language is fast approach. The press conference calendar argues for next week. Honestly, I hope they will skip this meeting in favor of the January meeting just to prove that every FOMC meeting is a live meeting. Alas, I think they believe they need the press conference to temper any adverse reactions from market participants. Finally, I am wary with the consensus view that the oil price decline in disinflationary. Open up to the possibility of the opposite. Look back to what you believed in 2011.

Friday, December 05, 2014

Fed Watch: Economy Clearly Gaining Momentum

Tim Duy:

Economy Clearly Gaining Momentum, by Tim Duy: The November employment report came in ahead of expectations, with a monthly nfp gain of 321k and 44k of upward revisions to previous months. Job gains were spread throughout the major sectors of the economy. The 2014 acceleration in job growth is clearly evident:

NFPa120514

The employment report in the context of indicators previously identified by Federal Reserve Chair Janet Yellen as important to watch:

NFPb120514

NFPc120514

Measures of underemployment are generally moving in the right direction. To be sure, the labor force participation rate remains in a general downward trend, but on this point I think you have to accept that demographic forces are driving the train. Year-over-year wage growth remains anemic although average wages gained 0.37% on the month. While this indicates that wage gains are not dead and gone forever, I would find it more impressive if these kinds of gains repeated themselves in the next few months. As I have said before, I think that will happen as unemployment rates fall further. I read nothing of importance into the unchanged unemployment rate for the month.
The tenor of this report harmonizes well with the song sung by recent data. Of course, data are inherently variable, and not every report will be as bright (or as dark) as the last. Nor would we expect a string of 300k+ gains in employment just yet. But I think any reasonable single extraction effort tells you that activity is on a firmer footing than it has been in years, and there is little reason to expect the improvements will reverse quickly. The US economy has momentum. Do not discount the value of that momentum.
Fixed income markets quickly discerned what this report means for the Fed - the risk is that rate hikes will come sooner than expected. At time of writing, the yield on the two-year bond gained 11bp, while the ten-year yield rose 9bp. The Fed will be pleased by the upward though controlled gains at the longer end of the yield curve as they will associate those gains with modestly less financial accommodation. They may be less pleased that stocks keeps hitting record highs as it suggests that financial conditions are easing somewhat, thus perhaps necessitating a faster pace of rate hikes. Over the longer run, I remain wary of the flattening yield curve.
My guess is that the Fed will soon begin to believe that they stayed pessimistic on the recovery the year the recovery began to show significant signs of life. More on the Fed next week.
Bottom Line: A solid employment report. The risk that the first rate hike comes sooner than June continues to rise.

Thursday, December 04, 2014

Fed Watch: Ahead of the November Employment Report

Tim Duy:

Ahead of the November Employment Report, by Tim Duy: Data in the first week of December has told a generally bullish story for the US economy. The week began with an upbeat number from the ISM manufacturing index with solid underlying data:

ISM1120214

While this was seemingly at odds with the Markit manufacturing index, I would say that both of these series (like consumer confidence) exhibit far too much variability to place too much weight on any one month of data. If I look at the ISM measure in context with other US manufacturing data, the overall view is one of steadily improving activity in the sector (note the estimated 17.1 million auto sales rate for November):

IND120214

This also seems consistent with the anecdotal story told by the Beige Book:
Manufacturing activity generally advanced during the reporting period. The automotive and aerospace industries continued to be sources of strength. Steel production increased in Cleveland, Chicago, and San Francisco. Fabricated metal manufacturers in the Chicago and Dallas Districts noted widespread growth in orders. Dallas reported that domestic sales for plastics were strong, while demand for plastics was steady in Richmond and declined in Kansas City. Chemical manufacturers in the Boston District indicated that the falling price of oil relative to natural gas had made U.S. producers less competitive, because foreign chemical producers rely more heavily on oil for feedstock and production. St. Louis, Minneapolis, and Dallas reported that food production was little changed on balance, but production in Kansas City continued to decline. Chicago and Dallas indicated that shipments of construction materials increased. Manufacturers of heavy machinery in the Chicago District cited improvements in sales of construction machinery, but reported ongoing weak demand for agricultural and mining equipment. High-tech manufacturers in Boston, Dallas, and San Francisco noted steady growth in demand. Biotech revenue increased in the San Francisco District.
I would also add that the Beige Book had a decidedly optimistic tenor:
Reports from the twelve Federal Reserve Districts suggest that national economic activity continued to expand in October and November. A number of Districts also noted that contacts remained optimistic about the outlook for future economic activity.
The ISM's service sector report was equally upbeat:

ISM2120214

The ADP report fell somewhat short of expectations, but again this number is far too volatile to place much if any weight on a small miss. Or even a large miss, for that matter. Calculated Risk places the ADP number in context of other labor market indicators, concluding that:
There is always some randomness to the employment report. The consensus forecast is pretty strong, but I'll take the over again (above 230,000).
I don't have much to add here. As I have said before, predicting the monthly nonfarm payroll change is a fool's errand, yet an errand we all undertake. I would pick 235k with an upside risk. More important is what happens to wage growth. I expect that to pick up over the next six months, but would be surprised to see any large gain this month.
Jon Hilsenrath at the Wall Street Journal reports that top Federal Reserve policymakers are not deterred in their plans for policy normalization:
In public appearances this week, Janet Yellen’s two top lieutenants sounded like individuals who want to start raising short-term interest rates in the months ahead, despite mounting uncertainties about growth abroad and associated downward pressure on commodities prices...
...“It is clear we are getting closer” to dropping an assurance that rates will stay low for a considerable time, he said. Mr. Fischer repeatedly emphasized his desire to get back to normal. “We almost got used to thinking that zero is the natural place for the interest rate. It is far from it,” he said.
In case there is any doubt about where top Fed officials are going with this, New York Fed president Bill Dudley said bluntly: “Market expectations that lift-off will occur around mid-2015 seem reasonable to me.” Like Mr. Fischer, Mr. Dudley sees the recent decline in oil prices as a net positive for the U.S., a net importer of energy which benefits from a lower cost of imported oil.
I think the speech my New York Federal Reserve President William Dudley is a must read. I have been repeatedly drawn to this paragraph (emphasis added):
First, when lift-off occurs, the pace of monetary policy normalization will depend, in part, on how financial market conditions react to the initial and subsequent tightening moves. If the reaction is relatively large—think of the response of financial market conditions during the so-called “taper tantrum” during the spring and summer of 2013—then this would likely prompt a slower and more cautious approach. In contrast, if the reaction were relatively small or even in the wrong direction, with financial market conditions easing—think of the response of long-term bond yields and the equity market as the asset purchase program was gradually phased out over the past year—then this would imply a more aggressive approach. The key point is this: We will pursue the monetary policy stance that best generates the set of financial market conditions most consistent with achievement of the FOMC’s dual mandate objectives. This depends both on how financial market conditions respond to the Fed’s policy actions and on how the real economy responds to the changes in financial conditions.
Long term yields have been drifting down since the "taper tantrum," flattening the yield curve significantly:

RATESA120214

RATESB120214

Dudley seems to be saying that he does not think that financial conditions should be easing, especially since he thinks he has been clear that the time to begin policy normalization is fast approaching. Robin Harding at the Financial Times sees the implications:
Although Mr Dudley does not say it, this argument could apply to the timing of rate rises as well as their pace. Markets have not reacted much to the prospect of Fed rate rises: the ten-year yield at 2.22 per cent is no higher than it was before the taper tantrum in summer 2013; the S&P 500 is up by 15 per cent on a year ago. Mr Dudley explicitly cites the low level of 10-year Treasury yields, saying they are presumably due, “in part, to the fact that long-term interest rates in Europe and Japan are much lower”.
If markets are not reacting to potential Fed rate rises then, by Mr Dudley’s logic, rate rises could need to come earlier as well as faster. The initial rate rise, in particular, could help the Fed to learn about the financial market response. That may help to explain why Mr Dudley is still in June 2015 for rate lift-off despite his dovish views.
Take this all in context of an earlier passage from the Dudley speech:
...during the 2004-07 period, the FOMC tightened monetary policy nearly continuously, raising the federal funds rate from 1 percent to 5.25 percent in 17 steps. However, during this period, 10-year Treasury note yields did not rise much, credit spreads generally narrowed and U.S. equity price indices moved higher. Moreover, the availability of mortgage credit eased, rather than tightened. As a result, financial market conditions did not tighten.
As a result, financial conditions remained quite loose, despite the large increase in the federal funds rate. With the benefit of hindsight, it seems that either monetary policy should have been tightened more aggressively or macroprudential measures should have been implemented in order to tighten credit conditions in the overheated housing sector...
Dudley appears to be increasingly concerned that the evolution of financial conditions this year suggests the Fed needs to pursue a more aggressive policy stance or else risk a repeat of 04-07. If this concern is being felt more generally within the Fed, it clearly puts a more hawkish bias to the Fed's reaction function. And, in my opinion, I think the risk of a more hawkish Federal Reserve is under-appreciated. Few are expecting a hawkish Federal Reserve, reasonably so given the path of policy since 2008. But I don't think the data are that far from a tipping point for the Federal Reserve. Of course, take that in the context of my general optimism.
A second point is that Dudley is not taking seriously the possibility that the flattening yields curve suggests the Fed has less room to move than policymakers think they do. This is something I worry about - if the Fed leans on the short end too much, they risk taking an expansion that should last another fours years to one that has just two more years left. But that might be a story for next December.
Bottom Line: Generally positive US data leave the Fed on track for a rate hike in the middle of next year. I am inclined to believe that the risk is that rate hikes come sooner and faster than anticipated outweigh the risk of later and slower.

Monday, December 01, 2014

Fed Watch: Sometimes I Wonder

Tim Duy:

Sometimes I Wonder, by Tim Duy: Sometimes I wonder if the Fed every actually looks at the data. This, from Ann Saphir and Jonathon Spicer at Reuters:
With the U.S. economy humming along at its fastest clip in more than a decade, the Federal Reserve should be confident about its ability to weather a global slowdown and start lifting interest rates around the middle of next year.
But then there is inflation.
Interviews with Fed officials and those familiar with its thinking show the mood inside is more somber than the central bank's reassuring statements and evidence of robust economic health would suggest. The reason is the central bank's failure to nudge price growth up to its 2 percent target and, more importantly, signs that investors and consumers are losing faith it can get there any time soon...
..."The primary concern at the moment is whether you can get back to 2 percent in a way that keeps expectations anchored, and maintains the credibility of the Fed as an institution that can achieve its goal," said Jeffrey Fuhrer, the Boston Fed's senior policy advisor...
...One Fed official, who declined to be named, told Reuters policymakers must resist the urge to lift rates at the first opportunity because they might be forced to backtrack if inflation failed to pick up...
One would think that central bank officials would recognize that low inflation is not a new phenomenon. It has been a persistent phenomenon for the past twenty years:

PCE120114

Note the long periods of below trend core inflation. Has this trend really gone unnoticed on Constitution Avenue? Moreover, the periods of elevated inflation have been more persistent when unemployment is below 5%, compared to the current 5.8%. At current rates, I would say you are more likely to be below than about 2% inflation:

PHIL1

And even focusing on 5% you have to ignore the low inflation of the late 1990's as an outlier. It seems clear that the economy is only now moving into a range where upward pressure on inflation is more likely to occur. So why should the Fed be surprised at the inflation numbers?
Bottom Line: Sometimes I think the Fed's underlying pessimism stems from some belief that inflation and wage pressures were about to occur when there was absolutely no reason to hold such a belief. The economy is only just beginning to move into a zone where more interesting things could happen. Honestly, it would be much more interesting if the economy moved to 4% unemployment with no wage or price pressures.

Fed Watch: Yes, I am Optimistic

Tim Duy:

Yes, I am Optimistic, by Tim Duy: I stood relieved when Federal Reserve policymakers recognized the tendency toward pessimism during this recovery when no such pessimism was warranted:
Finally, a couple of members suggested including language in the statement indicating that recent foreign economic developments had increased uncertainty or had boosted downside risks to the U.S. economic outlook, but participants generally judged that such wording would suggest greater pessimism about the economic outlook than they thought appropriate.
This stands in contrast to fairly consistent efforts to find the dark cloud in every silver lining. This, from the Wall Street Journal:
Economic prospects are flagging across Europe, Japan and big emerging markets such as India, a turn that presents fresh challenges to the relatively robust U.S. economy at a time when the world needs a dependable growth engine.
At least they mentioned the "robust" part. And the perennial activity of agonizing over holiday sales is in full swing, despite the reality that holiday sales tell you little if anything about the overall economy.
The lesson no one wants to draw from this recovery is that the US economy is both stronger and more resilient than commonly believed. Everyone, it would seem, is in the pessimism business - and such pessimism seems endemic throughout the US public. Perhaps only pessimism scores political points. Or perhaps that is only human nature. As Deirdre McCloskey recently remarked in her review of Piketty:
…pessimism sells. For reasons I have never understood, people like to hear that the world is going to hell, and become huffy and scornful when some idiotic optimist intrudes on their pleasure. Yet pessimism has consistently been a poor guide to the modern economic world. We are gigantically richer in body and spirit than we were two centuries ago…
Overall, I find the pessimism (from the right and the left) inconsistent with the fact that despite the ups and downs of the quarterly data, throughout the recovery, GDP has grown at a fairly consistent rate:

GPD112914

And even that might hide the strength of the recovery this year. GDP growth has exceeded 3% in four of the last five quarters. In two of those quarters, growth was in excess of 4%. It is simply reasonable to believe that the first quarter GDP report was largely an aberration. Do not dismiss the real improvement in the economy since 2009. It is not unimportant that 2014 is likely to be the biggest year for private sector employment since 1999 and that auto sales will reach a level not seen since 2001. It is not unimportant, in contrast to the conventional wisdom, that "in the post-Great Recession era, the growth in full-employment is, without a doubt, way out ahead." These are just three of many genuine signals of economic strength. It seems to me that in the effort to find what is wrong with the economy, everyone misses what is right.
The US economy is far more resilient than it is given credit for. None of the downside risks of recent years have been sufficient to derail the recovery, nor will the supposed downside risks of next year. They are mostly external, while the primary engine of US growth is internal and flexible. The decline in energy prices (another purported reason to fear the new year) will prove to be no exception. I believe we are witnessing a supply driven dynamic, not collapsing global demand. The US economy will adjust as the balance shifts from energy producers to energy consumers. While this will have some concentrated, negative implications for a handful of sectors and geographies (I would hope but find it unlikely that state and municipal leaders in North Dakota recognized the boom-bust nature of the commodity cycle well in advance of the bust part), I expect that the net impact will be modestly positive.
Indeed, the resiliency of the economy was almost certainly on display in the years preceding the Great Recession. Brad DeLong likes to note that the economy was adjusting to the housing collapse (a much deeper and widespread sector of the economy than energy production) fairly well until the financial crisis:
…you also have a strong argument that it was the financial crisis and not the collapse of the housing bubble that was the lead violin in this catastrophe. Construction reached its housing-bubble peak in the third quarter of 2005. From then until the third quarter of 2008, through the business cycle peak and out the other side, the market economy adjusted as smoothly to the recognition of a sectoral disequilibrium as the most optimistic of macroeconomists could have hoped: interest rates fell as demand for loans to finance construction eased off, and exports and business investment took up the slack resources released by the shrinking construction sector. The NBER's Business-Cycle Dating Committee did not conclude that the U.S. economy was in a full-blown recession until more than halfway through the fourth quarter of 2008.
As long as people have babies, capital depreciates, technology evolves, and tastes and preferences change, there is a powerful underlying (and under-appreciated) impetus for growth that is almost certain to reveal itself in any reasonably well-managed economy. This ultimately is the reason that despite the seemingly persistent belief that the recessionary bogeyman is just around the corner, recessions are remarkably rare events.
Since 1983, the US economy has been in expansion for 350 months. Recessions account for just 34 months, less than 10% of the time. In any given month, the probability of recession is certainly less than 10%. Recessions are concentrated in a handful of periods. If you are not in a recession this month, it is almost certain that you will not be in a recession next month. Consider that only three times since 1983 has a recession occurred in a month preceded by an expansion.
But this makes it seem as if recessions simply spring out of thin air, which they do not. Even if you thought the conditions for a recession were currently brewing, it is highly unlikely that the momentum of the US economy will turn in twelve months or less. Even if you thought, for example that the financial sector could not absorb any losses that stem from a decline in energy prices and thus be faced once again with crisis (unlikely, in my opinion, especially in the wake of regulatory enhancements since the last crisis), it would still take months for that shock to propagate throughout the economy.
Moreover, this ignores the other relevant feature of US recessions – they are preceded by long periods of sustained monetary tightening. And the Fed has not yet initiated even its first rate hike. Even if you accept that tapering is tightening, we are still on the front end of the cycle rather than the back end.
Hence my probability of recession in the next twelve months: 0%. I would place similar odds on the following twelve months as well.
To be sure, improvements were not as quick as many had hoped, but the shortfalls can largely be traced to two sectors – housing, in which the financing mechanism was damaged, and the failure of the fiscal authorities to adequately plug the hole. But the resilient economy continued to march higher nonetheless. And now fiscal policy is no longer a drag; the bottom in government jobs has likely been reached. Moreover, there is one silver lining in the relatively low pace of new housing activity – such activity has room to run. I expect that over the next two years housing will become an increasingly strong force in the US economy. Nor will the economy likely be impeded by monetary policy, which even if tighter than expected is likely to remain more accommodative than traditional metrics of appropriate monetary conditions would suggest.
Bottom Line: Perhaps, just perhaps, the US economic expansion has been consistently undersold, and continues to be undersold. It is worth considering that maybe it is time to just accept the good news without the desperate search for every dark cloud.

Thursday, November 13, 2014

Fed Watch: Dudley, Plosser, JOLTS, Potential Output

Tim Duy:

Dudley, Plosser, JOLTS, Potential Output, by Tim Duy: Not enough time to do any of these topics justice, but some quick takeaways for the last two days.
First, read today's speech by Federal Reserve President William Dudley in which he discusses the global implications of US monetary policy. Some keys points:
1. Still dismissing the recent drop in inflation expectations. Dudley says:
In assessing inflation expectations, I currently put more weight on survey-based measures of inflation expectations as opposed to market-based measures. Survey-based measures have been generally stable, consistent with inflation expectations remaining well-anchored. However, market-based measures, such as those based on breakeven inflation derived from the difference between yields on nominal versus Treasury Inflation-Protected Securities (TIPS), have registered declines over the past few months, even on a 5-years forward basis. Research done by my staff suggests that much of this decline in market-based measures of inflation compensation reflects a fall in the inflation risk premium—that is, what investors are willing to pay to protect themselves against inflation risk. Adjusting for the fall in the inflation risk premium, inflation expectations appear to have declined much less than implied by TIPS inflation breakeven measures.
The Fed is not taking the market-based measured of inflation expectations at face value, especially now that the Fed is closer to its employment objectives and they are increasingly confident that the recovery is more likely than not to strengthen further.
2. Cautious about prematurely raising rates. Dudley on the implications of his outlook for monetary policy:
In considering the appropriate timing of lift-off, there are three important reasons to be patient. First, the Committee is still undershooting both its employment and inflation objectives...Second, when interest rates are at the zero lower bound, the risks of tightening a bit too early seem considerably greater than the risks of tightening a bit too late. A premature tightening might lead to financial conditions that are too tight, resulting in a weaker economy and an aborted lift-off...Finally, given the still high level of long-term unemployment, there could be a significant benefit to allowing the economy to run “slightly hot” for a while in order to get these people employed again. If they are not employed relatively soon, their job skills will erode further, reducing their long-term prospects for employment and, therefore, the productive capacity of the U.S. economy.
Hence, no need for a rate hike now. But...
3. Rate hikes are coming. Dudley continues:
All that said, I hope the economic outlook evolves so that it will be appropriate to begin to raise interest rates sometime next year. While raising interest rates is often portrayed as a difficult task for central bankers, in fact, given the events since the onset of the financial crisis, it would be a development to be truly excited about. Raising interest rates would signal that the U.S. economy is finally getting healthier, and that the Fed is getting closer to achieving its dual mandate objectives of maximum employment and price stability. That would be very good news, even if it were to cause a bump or two in financial markets.
The economy is improving, hence normalization is coming. And note he does not specify any time frame other than next year. Based on previous comments we might reasonably conclude that he thinks mid-year, but it is a data-dependent decision. I think his is "patient" in the sense that it is not going to happen this year (which really isn't a question to begin with). But I doubt he has ruled out the end of the first quarter of next year. And again, don't expect the Fed to change course on the basis of some market turbulence. They expect it as part of the policy transition.
Outgoing Philadelphia Federal Reserve President Charles Plosser, in contrast, is looking for action sooner than later. While Dudley sees the risks of premature tightening, Plosser thinks the risk of wanting too long before normalization are higher:
First, we do not know how to confidently determine whether the labor market is fully healed or when we have reached full employment...Second, if we wait until we are certain that the labor market has fully recovered before beginning to raise rates, policy will be far behind the curve. One risk of waiting is that the Committee may be forced to raise rates very quickly to prevent an increase in inflation...This would represent a return of the so-called "go-stop" policies of the past...A third risk to waiting is that the zero interest rate policy has generated a very aggressive reach for yield as investors take on either credit or duration risk to earn higher returns...For these reasons, I would prefer that we start to raise rates sooner rather than later. This may allow us to increase rates more gradually as the data improve rather than face the prospect of a more abrupt increase in rates to catch up with market forces, which could be the outcome of a prolonged delay in our willingness to act. Of course, financial markets are not always patient, so some volatility will be unavoidable.
Still a minority position on the FOMC, but eventually hawks (or those that remain, see below) and doves will converge. I still think that convergence will happen in the middle of next year with the risks weighted more on the second than the third quarter. Indeed, the JOLTS report for September suggests the labor market improvement is accelerating as we head into the final months of the year. Notably, the quits rates spiked:

JOLTS111314

I suspect that a faster quit rate will force employers to step up the pace of higher out of necessity. Moreover, unemployment below 6% and heading south and quit rates heading north to pre-recession levels suggests that wage growth is coming. And that wage growth will push FOMC moderates toward the "hike sooner than later" side of the debate. Call me an optimist on the near-term outlook.
Finally, via Mark Thoma, researchers at the Federal Reserve are questioning the ability of the economy to regain anything like what we thought was potential output prior to the recession:
The economic collapse in the wake of the global financial crises (GFC) and the weaker-than-expected recovery in many countries have led to questions about the impact of severe downturns on economic potential. Indeed, for several major economies, the level of output is nowhere near returning to pre-crisis trend (figure 1). Such developments have resulted in repeated downward revisions to estimates of potential output by private- and public-sector forecasters. In addition, this disappointment in post-recession growth has contributed to concerns that the U.S. economy, among others, is entering an era of secular stagnation. However, the historical experience of advanced economies around recessions indicates that the current experience is less unusual than one might think. First, output typically does not return to pre-crisis trend following recessions, especially deep ones. Second, in response, forecasters repeatedly revise down measures of trend...
...Although these calculations are simple, they raise deeper questions about the impact of recessions on trend output. The finding that recessions tend to depress the long-run level of output may imply that demand shocks have permanent effects. The sustained deviation of the level of output from pre-crisis trend points to flaws in the way the economics profession models the recovery of output to economic shocks and raises further doubts about the reliance on measures of output gaps to determine economic slack. For policymakers, the results also point to the cost of recessions, especially deep and long ones, and provide a rationale for strong and rapid policy responses to economic downturns.
Those of us concerned by the risk that the lengthy cyclical downturn would yield structural damage would not be surprised by this conclusion. Note that the more the Fed believes output is close to potential, the less patient they will be in holding rates low. And note that the have already pretty much given up on the CBO potential output numbers:

POT111314

If he don't get back to that estimate of potential output by 2017, that estimate just isn't going to hold. Call me a pessimist on this point. I think it more likely than not that the CBO estimate of potential is revised downward again. I suspect the Fed has already done so.
And in a late-breaking development, Dallas Federal Reserve President Richard Fisher announced his retirement today, effective March 19, 2015. Another hawk down.
Bottom Line: Watch the data. In my opinion, the pessimistic focus from both the left and the right risks underestimating the degree of economic improvement. The Fed's patience will wane in the face of further improvement in the pace of activity.

Friday, November 07, 2014

Fed Watch: Employment Report, Yellen Speech

Tim Duy:

Employment Report, Yellen Speech, by Tim Duy: The October employment report was another solid albeit not spectacular read on the labor market. Job growth remained above the 200k mark, extending the ever-so-slight acceleration over the past year:

NFPa110714

Upward revisions to the previous two months added another 31k jobs. The acceleration is a bit more evident in the year-over-year picture, albeit still modest:

NFPc110714

The unemployment rate fell to 5.8% while the labor force participation rate ticked up. The labor market picture in the context of indicators previously cited by Federal Reserve Chair Janet Yellen looks like this:

YELLENa110714

YELLENb110714

Looks like steady, ongoing progress to meeting the Federal Reserve's goals that remains fairly consistent with expectations for a mid-year rate hike. Wage growth remains anemic, but as regular readers know I believe we are just entering the zone where we might expect upward pressure on wage growth:

NFPb110714

I am wondering what the Fed will do if the unemployment rate touches 5% and wage growth and inflation remain anemic? Not my baseline scenario, but I am wondering how patient they will be before moving further along the normalization process. I suppose this is what Chicago Federal Reserve President Charles Evans wonders about as well. Via Reuters:
The Federal Reserve should be "extraordinarily patient" when it comes to raising interest rates, because doing so too soon could choke off recovery and force the U.S. central bank to cut rates back to zero again, a top Fed official said on Friday...
...But the biggest risk, he said, is raising rates prematurely, which could consign the United States to the kind of stagnation that affected it in the 1930s and that dogs Japan today.
Speaking of policy normalization, Yellen made some interesting remarks this morning:
As employment, economic activity, and inflation rates return to normal, monetary policy will eventually need to normalize too, although the speed and timing of this normalization will likely differ across countries based on differences in the pace of recovery in domestic conditions. This normalization could lead to some heightened financial volatility. But as I have noted on other occasions, for our part, the Federal Reserve will strive to clearly and transparently communicate its monetary policy strategy in order to minimize the likelihood of surprises that could disrupt financial markets, both at home and around the world. More importantly, the normalization of monetary policy will be an important sign that economic conditions more generally are finally emerging from the shadow of the Great Recession.
Take note of the specific emphasis on financial volatility. The message is that market participants should not expect the Fed to react to every twist and turn in equity markets. More to the point, they expect volatility as they progress toward policy normalization. Consequently, while they will keep an eye on the financial markets, they are primarily concerned with watching overall economic indicators as they consider the timing and pace of their next steps. In short, they are signalling that market participants misread the likely path of the Federal Reserve when 2 year yields collapsed last month:

RATES110714

That said, I am fairly concerned that the Fed is not taking the flattening of the yield curve seriously enough. I see that as a signal that they have less room for normalization than they might think they have.
Bottom Line: Steady as she goes.

Fed Watch: Nonsense

Tim Duy:

Nonsense, by Tim Duy: I stumbled across this piece in The America Spectator in which the authors argue against the prospect of the Federal Reserve pursuing a "triple mandate" by adding inequality to the current mandate of price stability and maximum employment. They claim the current mandate itself is unworkable:
...Replace the Fed’s current dual mandate with a single mandate—keep the price system as honest and stable as possible.
The dual mandate creates a contradictory tension that makes it practically impossible for the Fed to function effectively...
...The Fed currently finds itself unable to pursue that kind of price stability, because its unemployment mandate gets in the way. The Fed can induce a temporary boom by unexpectedly boosting inflation...
...If the Fed tinkers with interest rates and the money supply in an effort to reduce inequality, it puts further obstacles in the path of entrepreneurs, and hurts the very people it intends to help...If the Fed’s seeks to maintain a stable, predictable, and honest price system as its sole monetary policy objective, it will do more to lift people out of poverty than any double or triple mandate.
The implication is that the Fed is currently creating unexpected inflation to lower unemployment. The implication is that the Fed is not meeting its price stability mandate. The first thing that makes this such nonsense is the absolute absence of inflationary pressures for going on 30 years now:

PCE110714

There have been NO episodes of "unexpectedly boosting inflation." In fact, for all intents and purposes, the Phillips Curve has become nonexistent:

PHILLIPS110714

There is no "contradictory tension." The Fed can obviously meet both mandates concurrently. See Minneapolis Federal Reserve President Narayana Kocherlakota. It is pretty straightforward. And even if the Fed wanted to boost inflation beyond its current target, they would not want unexpected inflation. They would only do so because they needed more room to cushion against the zero bound. They would want higher expected inflation. It would be anything but unexpected. They would scream it from sea to sea.
Of course, inflation truthers will argue that the Fed's chosen price measure does not measure "real" inflation. Only "real" people, not economists, know what "real" inflation is. Well, if you ask "real" people, once again you get a flat Phillips Curve:

PHILLIPS2110714

Sure, the public tends to overreact to gas prices (both up and down), but I have always thought the overall consistency of median inflation expectations among the public is pretty remarkable and under-appreciated. To be sure that is arguably because the Fed has generally made reality consistent with expectations. But perhaps not so much lately. Consider inflation expectations and acutal year ahead inflation:

EXPECT110714

Note that I used headline CPI inflation as it is arguably the best known price index. Interestingly, since 1983, average expected inflation was 3.1%, compared to an actual 2.9%. Remarkably close. And note that since 2007, actual inflation over the next twelve months has remained well below expectations. In other words, the US economy is experiencing unexpected disinflation. By the author's argument, shouldn't that mean that unemployment is now artificially high? (Note too that concerns about the Fed's credibility may be premature.)
The second thing that makes this such nonsense is that the authors seem to believe that if the Fed dumped its dual mandate in favor of a single price mandate, monetary policy would be tighter (because the current need to maintain low unemployment requires unexpected inflation, or loose policy). This is exactly opposite of reality. The reality is that if the Fed focused only on its price mandate, it would not be so eager to normalize policy. The Federal Reserve currently can neither hit its target nor anticipates hitting its target over the next two years. So what is driving the push for normalizing policy? They fear that falling unemployment falling toward their estimate of the natural rate (5.2-5.5%) will trigger an inflationary outbreak if not caught early with tighter policy! They want to arrest the decline in unemployment before it slides much below 5.2%.
Truth be told, oftentimes I would prefer the Fed abandon its dual mandate as well. I wish they would focus more on prices than unemployment at this point. But that's because I understand the implications for monetary policy. It would be looser, not tighter. Monetary policymakers would have one less excuse to justify normalizing policy when they still can't hit their inflation targets.
I would also add that the Fed isn't doing itself any favors when they argue that they need to keep policy loose to meet their employment mandate or give the impression that they intend to keep policy loose to address inequality. They could just point out they need to keep policy loose to meet their inflation target and by meeting their inflation target they foster conditions amenable to sustained maximum employment and by extension reducing inequality. Do themselves a favor and keep the price stability mandate front and center. Read Minneapolis Federal Reserve President Narayana Kocherlakota's statement on his dissent:
I felt that the FOMC needed to reduce possible downside risk to the credibility of its 2 percent inflation target by taking more purposeful steps to move inflation back up to 2 percent.
The arch-dove on the FOMC is a dove because his colleagues can't meet or are unwilling to meet their inflation target.
Bottom Line: The Fed is not using unexpected inflation to lower unemployment. Just isn't happening now. Not tomorrow. Or the day after that either. And if the Fed wants to reduce inequality, they don't need unexpected inflation in any event. What they need is to actually generate the inflation they promised.

Thursday, November 06, 2014

'Blog You Need to Read: Tim Duy's Fed Watch'

I can't claim to be unbiased, but fully agree with Brad DeLong:

Blog You Need to Read: Tim Duy's Fed Watch: Over at Equitable Growth As all of you surely know by now, I am a big fan of Tim Duy of the University of Oregon and his Fed Watch.

Here is a sample--ten very useful and informative takes from the past half-year or so:

Always judicious, always giving a fair shake to all the currents of thought in the Federal Reserve, to the data, and to the live and serious models of how the economy works.

Read Tim Duy, and you have a sophisticated, broad, and truly balanced understanding of what the Federal Reserve is thinking, what it is doing, why it is doing it, and what the likely outcomes of its actions are. That is a package that is very hard to find anyplace else.

It still surprises me that Tim Duy does not get significantly more airplay in the general conversational mix than he does...

Friday, October 31, 2014

Fed Watch: Another Kocherlakota Dissent

Tim Duy:

Another Kocherlakota Dissent, by Tim Duy: Minneapolis Federal Reserve President Narayana Kocherlakota released a statement regarding his dissenting vote at this week's FOMC meeting. He does not share his colleagues faith that inflation will return to target anytime soon:
...In my assessment, the medium-term outlook for inflation has shown no overall improvement since last December and, indeed, is arguably worse. Failing to act in response to this subdued inflation outlook increases the downside risk to the credibility of our 2 percent inflation target. Market-based measures of longer-term inflation expectations have fallen recently to unusually low levels, a decline that I believe reflects that kind of increased downside risk...
Today's reading on inflation is supportive of Kocherlakota's concerns:

PCE103114b
PCE103114a

He reiterated his preferred policy outcomes:
There are a number of possible actions that I would have seen as responsive to the evolution of the data. Let me describe two in particular. First, the Committee could have continued to buy $15 billion of longer-term assets per month. Second, it could have committed to keeping the target range for the federal funds rate at its current level at least until the one- to two-year-ahead inflation outlook has risen back to 2 percent, as long as risks to financial stability remain well-contained.
I find this interesting compared to his preferred language after his dissent in March:
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.”
Notice that earlier this year the best he thought he could get from his colleagues was an allowance for 2.25% inflation. Now the best he could hope for has been downgraded to a 2%, suggesting - you guessed it - that the rest of the FOMC considers 2% a ceiling.
I think the inflation downgrade in Kocherlakota's suggested policy language suggests that low inflation is less of a concern for FOMC members now that unemployment is below 6% and measures of underemployment are improving. I believe that Kocherlakota is hearing from his colleagues that 1.) inflation will almost certainly move toward target as the unemployment rate falls further and that 2.) even if inflation remains below 2%, declining slack in the labor market suggests that less financial accommodation is necessary and failure to reduce accommodation will result in undesirable financial instability.
Bottom Line: Kocherlakota's dissent raises the possibility that labor data will trump inflation data in policy considerations. It also suggests that given the pace of labor market improvement, they are not writing off the possibility of a March rate hike (although that is not my baseline).

Thursday, October 30, 2014

Fed Watch: FOMC Recap

Tim Duy:

FOMC Recap, by Tim Duy: In broad terms, the FOMC meeting concluded as I had expected. To the extent there were any surprises, they were on the hawkish side. Or, I would say, hawkish mostly if you believed the events of the last few weeks justified a radical revision of the Fed's anticipated policy path. I didn't, but was too busy those same past few weeks to scream into the wind.

As I anticipated, the Fed dismissed the decline in market-based inflation expectations. They clearly believe financial markets over-reacted to the decline in oil prices, and that that decline would ultimately prove to be a one-time price shock rather than the beginning of a sustained disinflationary process.

This is why we watch core-inflation.

And note that the Fed sent a pretty big signal along the way. In contrast to conventional wisdom, they do not hold market-based measures of inflation expectations as the Holy Grail. Especially with unemployment below 6%, pay more attention to survey-based measures. And recognize they will discount even those if they feel they are unduly affected by energy prices in either direction.

Somewhat more hawkish than I anticipated, they did not explicitly hold out the hope of future asset purchases. The statement shifts directly to the issue of rate hikes. On that point, they did as I had expected, emphasize the data-dependent nature of future policy:

However, if incoming information indicates faster progress toward the Committee's employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.

In my opinion, this suggests that they want to retain the baseline expectation of a mid-2014 rate hike with the option for an earlier hike. I don't think they see recent data or market action as by itself justifying the shift to the latter part of 2015. If anything, remember that recent data is pointing to accelerating growth and a rapid decline in unemployment.

And that rapid decline in unemployment is important, as I have trouble imagining a scenario in which the Fed is content to watch unemployment fall below 5.5% without at least beginning the rate hike cycle. Remember that they think that even as they increase rates, they believe that policy will continue to be accommodative. In other words, they do not fear raising rates as necessarily a tightening of policy. They will view it as a necessary adjustment in financial accommodation in response to a decline in labor market slack. Hence the line:

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.

I anticipated at least one dissent. In all honesty, this would have been a more impressive call if I had also indicated the direction of the dissent. I expected a hawk to reject the retention of the considerable time language. No such luck - quite the opposite, with noted-dove Minneapolis Federal Reserve President Narayana Kocherlakota protesting both the considerable time language (wanting a more firm commitment to ZIRP) and the decision to end QE. The hawks, in contrast, were generally comfortable with the direction of the discussion. Expect Dallas Federal Reserve President Richard Fisher to say as much soon.

The acceptance of the hawks with the general tone of the meeting is also important. Clearly hawkish in contrast with the shift in market expectations. Time will tell.

Bottom Line: Despite the market turbulence of recent weeks, the general outlook of monetary policymakers remain generally unchanged. In general, they continue to see the direction of activity pointing to a mid-year rate hike. The actual date is of course data dependent, but they have not seen sufficient data in either direction to change that baseline outlook.

Tuesday, October 28, 2014

Fed Watch: FOMC Meeting

Tim Duy:

Fed Watch: FOMC Meeting, by Tim Duy: I have been buried the past few weeks. So blogging has been, and will be, at least for a little longer, light. That said, I have trouble letting an FOMC meeting pass without at least few words before and after - even if there already exist broad agreement on the outcome.

The general expectation is that the Fed ends its bond buying program at the conclusion of the meeting tomorrow. That alone promises to knock down the FOMC statement to a more manageable size. While St. Louis Federal Reserve President James Bullard offered up the possibility of retaining the program for another meeting, there is little indication that other FOMC members are similarly inclined. They have long wanted to get out of asset purchase business, and see no shift in activity sufficient to delay that objective. Moreover, as Boston Federal Reserve President Eric Rosengren has noted, the remaining $15 billion is effectively a rounding error. If the Fed really wants to do something, they need to go bigger. But that is not on the table.

Regarding the statement, here is what I anticipate:

1. The general description of the economy will remain essentially unchanged, expanding at a "moderate pace." This would be consistent with expectations that the economy is currently on track to post 3%+ growth in the third quarter.

2. That said, they will mention they remain watchful of foreign growth.

3. They will acknowledge the further decline in unemployment rates yet retain the view that labor market indicators still suggest underutilization of resources. I would not be surprised by specific mention of low wage growth as evidence of underutilization.

4. I expect the Fed will acknowledge the decline in market-based measures of inflation expectations, but ultimately dismiss those measures for now in favor of stable of survey based measures. In general, I think they will take the approach of Rosengren in this Washington Post interview:

"Inflation breakevens," Rosengren explained, "are based on the pricing of Treasury securities and Treasury Inflation-Protected Securities (TIPS). So if you think about what the implication of significant financial market turbulence is, particularly about Europe, it's for foreign investors to buy Treasury securities. They disproportionately buy regular Treasury securities, so the flight to safety is going to start changing the relative prices of Treasury securities" and make it look like markets expect less inflation. But "if you look at inflation expectations based more on surveys, there's been a little bit of softening, but certainly nothing consistent with the kind of movements we've seen in the [Treasury] breakevens. So I wouldn't overreact to one or two weeks of sharp movements, because I think there are plenty of other reasons to explain" them.

5. I expect the risks to growth and employment will remain balanced, and the risk of persistently low inflation will continue to be "somewhat diminished."

6. They will announce the end of the asset purchase program, but emphasize continued reinvestment of principle and that the sizable asset holdings will continue to provide support for the recovery.

7. They will note that despite the end of asset purchases, such purchases remain in the monetary toolbox and could be revived if conditions warranted.

8. The "considerable time" language will remain. I don't anticipate any tweaks to the interest rate guidance, but I would expect if there are any such tweaks, they would be to emphasize the data-dependent nature of future policy decisions.

9. I expect at least one dissent.

Bottom Line: I am anticipating a pretty straightforward result from this FOMC meeting.

Monday, October 13, 2014

Fed Watch: The Methodical Fed

Tim Duy:

The Methodical Fed, by Tim Duy: Just a few months ago the specter of inflation dominated Wall Street. Now the tables have turned and low inflation is again the worry du jour as a deflationary wave propagates from the rest of the world - think Europe, China, oil prices. How quickly sentiment changes.

And given how quickly sentiment changes, I am loath to make any predictions on the implications for Fed policy. The very earliest one could even imagine a possible rate hike would be March of next year, still five months away. But since that month is the preference of Fed hawks, better to think that the earliest is the June meeting, still eight months away.

Eight months is a long time. We could pass through two more of these sentiment cycles between now and then. Or maybe the story breaks decisively one direction or the other. Given the uncertainty of economy activity, it is clearly dangerous to become too wedded to a particular date for liftoff. At best we can describe probabilities.

But what I think is often missing is a recognition that through all of the ups and downs of last year, the Fed has sent a very consistent signal: The ongoing improvement in the US economy justifies the steady removal of monetary accommodation. To be sure, we can quibble over the timing of the first move, but consider the path since last May:

  1. In May of 2013, then-Federal Reserve Chair Ben Bernanke opens the door for tapering of asset purchases.
  2. The actual tapering begins in December of that year, two meetings later than expected. I think it is heroic to believe those 12 weeks were materially important. By that point, the underlying expectation was well established.
  3. Although they claimed that the pace of tapering was data dependent, they proceeded on a very methodical path of $10 billion cuts at each meeting. They proceeded on this path despite persistent below target inflation.
  4. They clearly established that this month's meeting is very, very likely to be the end of the asset purchase program. Again, they stated this expectation despite low inflation.
  5. Despite the current turmoil, I still expect the asset purchase program to end. I think hawks and doves alike want out of that program. They want to return to interest rate-based policy.
  6. Even as inflation bounces along below target, they formulated and announced the path of policy normalization. That normalization includes the expectation that the expansion of the balance sheet was temporary and thus will be reversed.
  7. Even as inflation has bounced along below trend, they have repeatedly warned via the Summary of Economic Projections that rate hikes are just around the corner, and that market participants should plan accordingly.
  8. And while New York Federal Reserve President William Dudley foreshadowed the minutes and a week of Fedspeak that was generally interpreted dovishly, the key takeaway was although the US economy was not expected to accelerate further, the current path was sufficient to believe in the "consensus view is that lift-off will take place around the middle of next year. That seems like a reasonable view to me" even "if it were to cause a bump or two in financial markets." Those remarks were seconded by San Francisco Federal Reserve President John Williams. So the moderates and hawks both continue to send signal rates hikes by the middle of next year, leaving the voices of doves Minneapolis Federal Reserve President Narayana Kocherlakota and Chicago Federal Reserve President Charles Evans sounding very lonely. Fed Chair Janet Yellen has been somewhat absent from the current debate, although we suppose she sympathizes more with the dovish position.

Given the consistent, methodological approach to policy normalization witnessed over the past year, is it wonder that inflation signals all look soft? For example:

PCE101214

INFXa101214

INFXb101214

Fed signaling resulted in consistent, downward pressure on inflation expectations. Hence what they view as a dovish policy stance, I view as a hawkish policy stance. And most remarkable to me is that they never realized what I always thought was obvious - that they were setting the stage for a return trip to the zero bound in the next recession. Matthew C Klein at the Financial Times points us to this from the Fed minutes:
For example, respondents to the recent Survey of Primary Dealers placed considerable odds on the federal funds rate returning to the zero lower bound during the two years following the initial increase in that rate. The probability that investors attach to such low interest rate scenarios could pull the expected path of the federal funds rate computed from market quotes below most Committee participants’ assessments of appropriate policy.
The most hawkish projection for the long-term Federal Funds rate is 4.25%. During the downside, cutting cycles are generally in excess of 500bp. The math here is not that complicated. I struggle to find the scenario by which policy does not revert to the zero lower bound. That would imply that the Fed allows conditions to evolve such that the appropriate Fed Funds rate is well in excess of 6%. But given the Fed thinks that the equilibrium real rate has fallen, this implies a willingness to support higher inflation expectations, which is something I just don't see at this point.
And I don't think it is just me. I don't think Wall Street sees the path out. Hence the high probability assigned to a return to the zero bound. Hence also the flattening of the yield curve since tapering began:

SPREAD101214

I think the Fed should very much change its messaging if policymakers want to lift us from the zero bound for more than a couple of years. I think they should drop the calendar-based guidance they are all now giving. I think they should drop the SEP dot plot, because that clearly sends a hawkish message. I think they should drop reference to the labor market outcomes in terms of quantities in favor of price signals (wages, a direction they seem to be moving). I think they should define their policy strategy to make clear they intend to lift the economy off the zero bound permanently, but that I believe requires them to abandon their 2% inflation fetish (and note that on this I believe their behavior is clearly more consistent with a 2% ceiling then a symmetrical target). They also need to adandon their claim that the balance sheet will be reversed. The size of the balance sheet should not be a policy objective, only the economic outcomes yielded by the size of the balance sheet.
That said, I am also beginning to expect that a return to the zero bound is almost guaranteed. I fear the time has passed for the appropriate mix of fiscal and monetary policy that leaps the economy to a higher equilibrium. But that is a topic for another post.
Bottom Line: Fed policy might sound dovish this week, but take note the the underlying tone has been methodically hawkish for a long, long time. And markets have responded accordingly, including anticipating a return to the zero bound when the next recession hits. Nor should this be unexpected. Monetary policymakers have yet to set clear objectives that includes a high probability that the zero bound is left behind for good.

Tuesday, October 07, 2014

Fed Watch: The Labor Market Conditions Index: Use With Care

Tim Duy:

The Labor Market Conditions Index: Use With Care, by Tim Duy: I was curious to see how the press would report on the Federal Reserve Board's new Labor Market Conditions Index. My prior was that the reporting should be confusing at best. My favorite so far is from Reuters, via the WSJ:
Fed Chairwoman Janet Yellen has cited the new index as a broader gauge of employment conditions than the unemployment rate, which has fallen faster than expected in recent months. The index’s slowdown over the summer could bolster the argument that the Fed should be patient in watching the economy improve before raising rates.
But its pickup last month could strengthen the case that the labor market is tightening fast and officials should consider raising rates sooner than widely expected. Many investors anticipate the Fed will make its first move in the middle of next year, a perception some top officials have encouraged.
Translation: We don't know what it means.
Now, this is not exactly the fault of the press. The Fed appears to want you to believe the LCMI is important, but they really don't give you reason to believe it should be important. They don't even release the LCMI - the charts on Business Week and US News and World Report are titled erroneously. The Fed releases the monthly change of the LCMI, as noted by Business Insider. But wait, no that's not right either. They actually release the six-month moving average of the LCMI, which means we really don't know the monthly change.1 What the Fed releases might actually be more impacted by what left the average six months ago than the reading from the most recent month. And you should recognize the danger of the six-month moving average - the longer the smoothing process, the more likely to miss turning points in the data. Unless of course the Fed released the raw data to follow as well. Which they don't.
The LCMI becomes even more confusing because it has been impressed upon the financial markets that it must have a dovish interpretation. From Business Insider:
The index was first "made famous" by Fed Chair Janet Yellen in her speech at Jackson Hole, when she said, "This broadly based metric supports the conclusion that the labor market has improved significantly over the past year, but it also suggests that the decline in the unemployment rate over this period somewhat overstates the improvement in overall labor market conditions."
Recall that at Jackson Hole, Yellen spoke about the labor market puzzle of a steadily declining unemployment rate and strong payroll gains against the backdrop of declining labor force participation and flat wages.
Consider this in light of this from the Fed:

LMCI2

The first part of the associated commentary:
Table 2 reports the cumulative and average monthly change in the LMCI during each of the NBER-defined contractions and expansions since 1980. Over that time period, the LMCI has fallen about an average of 20 points per month during a recession and risen about 4 points per month during an expansion. In terms of the average monthly changes, then, the labor market improvement seen in the current expansion has been roughly in line with its typical pace...
If you look closely, the average monthly change during this expansion is faster than every recovery since the 1980-81 expansion. How does this fit with the conventional wisdom that we are experiencing a slow labor market recovery? Indeed, look at the chart:

LMCI1

According to this measure, the pace of improvement in this recovery exceeds than much of the 1990's. Think about that.
Moreover, consider the next sentence of the commentary:
...That said, the cumulative increase in the index since July 2009 (290 index points) is still smaller in magnitude than the extraordinarily large decline during the Great Recession (over 350 points from January 2008 to June 2009).
OK - so the Fed thinks the cumulative change is important. They think it is relevant that the LCMI has not retraced all of its losses. Let's take this idea further. Rather than using the recession dating, consider the even larger move from peak to trough. Between May 2007 to June 2009, the cumulative decrease in the LCMI was 398.4. Since then, the cumulative increase is 300.7, so the LCMI has retraced 75% of its losses.
Now consider the unemployment rate. The unemployment rate increased 5.6 percentage points from a low of 4.4% to a high of 10%. SInce then it has retraced 4.1 percentage points of that gain to last month's 5.9% rate. 4.1 is 73% of 5.6. In other words, the unemployment rate has retraced 73% of it losses.
The LCMI has retraced 75% of its losses. The unemployment rate has retraced 73% of it losses. So the LCMI shows the exact same amount of improvement in labor market conditions peak to trough as implied by the retracement of the unemployment rate.
You see the problem. The LCMI (or the data made available to the public) suggests the same amount of improvement in labor market conditions as implied by the unemployment rate. The LCMI suggests a faster pace of improvement than that seen in the previous three recoveries. So how exactly does Yellen reach the conclusion that "the decline in the unemployment rate over this period somewhat overstates the improvement in overall labor market conditions"? I am not seeing it on the basis of the data provided. Indeed, where exactly is the research showing the LCMI has some policy relevance?
Then again, this could be exactly why Yellen uses the modifier "somewhat" in the above quote. Perhaps she has no conviction that the LCMI provides information not already in the unemployment rate. If that's the case, then expect the LCMI to die on the vine, eventually relegated to be computed by whoever still has the p-star model on their list of assignments.
Bottom Line: Use the Fed's new labor market index with caution. Extreme caution. They are not releasing the raw data. They don't appear to have research explaining its policy relevance. Yellen's halfhearted claim that it provides information above and beyond the unemployment rate is questionable with a simple look at the cumulative change of the index compared to that of unemployment. And her halfhearted claims are even more telling given that she was the impetus for the research. If it was policy relevant, you would think she would be a little more enthusiastic (think optimal control). Moreover, the faster pace of recovery of the index compared to previous recessions - as clearly indicated by the Fed - seems completely at odds with the story it is supposed to support. Simply put, the press and financial market participants should be pushing the Fed much harder to explain exactly why this measure is important.
1. The LCMI data provided by the Fed is described as the "average monthly change." I am not sure why they don't explicitly provide the span of the averaging, but the website describes it as "Chart 1 plots the average monthly change in the LMCI since 1977. Except for the final bar, which covers the first quarter of 2014, each of the bars represents the average over a six-month period."

Sunday, October 05, 2014

Fed Watch: Is There a Wage Growth Puzzle?

Tim Duy:

Is There a Wage Growth Puzzle?, by Tim Duy: Is there a wage growth puzzle? Justin Wolfers says there is, and uses this picture:

WOLFERS

to claim:
This puzzle isn’t entirely new, as the usual link between unemployment and the rate of wage growth has totally broken down over recent years.
​ The recent data have made a sharp departure from the usual textbook analysis in which a tighter labor market leads to faster wage growth, and subsequent cost pressures feed through to higher inflation.
But has the link between wage growth and unemployment "totally broken down"? Eyeball econometrics alone suggests reason to be cautious with this claim as the only deviation from the typical unemployment/wage growth relationship is the "swirlogram" of fairly high wage growth relative to unemployment through the end of 2011 or so. But is this a breakdown or a typical pattern of a fairly severe recession? While, it might seem unusual if you begin the sample at 1985 as Wolfers did, so let's see what the 1980-85 episode looks like:

PHILa100314

Same swirlogram. Compare the two recessions:

PHILd100314

Fairly similar patterns, although in the 80-85 episode there was more room to push down the inflation expectations component of wage growth. It would appear that in the face of severe contractions, wage adjustment is slow. Now consider the 1985-1990 period:

PHILb100314

Notice that wage growth is stagnant until unemployment moves below 6% - past experience thus suggests that we should not expect significant wage growth until we move well below 6% (you could argue the response actually began at 6.5%). Thus, it is premature to believe that there has been a breakdown in this relationship. So far, the response of wages is exactly what you should have expected in light of the 1980's dynamics. Which leads to two points:
  1. I am no fan of Dallas Federal Reserve President Richard Fisher. That said, he did not pick 6.1% out of a hat when he said that was the point at which wage growth has tended to accelerate in the past. That number fell out of his staff's research for a reason and surprises me not one bit.
  2. There is a reason the Fed picked 6.5% unemployment for the Evan's rule. There was absolutely no chance that that would be a meaningful number as far as labor market healing is concerned.
Consider now the sample since 1990:

PHILc100314

Note four points:
  1. Notice the minor "swirlogram" associated with the early-90's recession. Again, not a breakdown.
  2. After 1992, wage growth tends to move sideways until unemployment sinks below 6%.
  3. Since 2012, the relationship is as traditional theory would suggest, a point that is actually evident on Wolfer's chart as well. The R-squared on the regression line is 0.75. Although notice that again, as wage growth moves into that 2.5% range, it appears to once again move mostly sideways. No mystery - nothing we haven't seen before.
  4. Clearly, there is some noise in the relationship. You should be able to extract away from the noise and recognize that there is no sudden acceleration in wage growth.
Now let's take another step and consider the relationship between unemployment and real wages (note that the series ends in 2014:8 - we don't have the September PCE price data yet):

PHILf100314

The period of the Great Disinflation was generally associated with negative real wage growth. The period of the mid-90s to the Great Recession was generally associated with positive real wage growth. The swirlogram of the Great Recession is again evident, but notice that as unemployment approached the bottom end of the black regression line (R-squared = 0.65), real wage growth actually accelerated before returning to trend. I now have additional sympathy for firms that have complained in the past two years that they could not push wage growth through to higher prices. It does appear that real wage growth was faster than might be expected given the pace of economic activity and, by extension, the level of unemployment.
Oh - and real wage growth has reverted to the pre-Great Recession trend - pretty much exactly where you would expect it to be given the level of unemployment. Honestly, this one surprised me.
Which suggests that labor market healing has progressed much further than many progressives would like to admit. Many conservatives as well.
Which also means a lot of people are not going to like this chart.
And before you complain that the all-employee average wage data holds some great secret that is not in the production and nonsupervisory wage series (I have trouble taking seriously any sweeping generalizations of the business cycle dynamics of a series we only have through one business cycle), here is that version:

PHILg100314

Same swirlogram. Pretty much the same idea with wage growth heading right back to where you would expect prior to the great recession.
Bottom Line: Be cautious in assuming that this time is different. The unemployment and wage growth dynamics to date are actually very similar to what we have seen in the past. Low wage growth to date is not the "smoking gun" of proof of the importance of underemployment measures. There very well may have been much more labor market healing that many are willing to accept, even many FOMC members. The implications for monetary policy are straightforward - it suggests the risk leans toward tighter than anticipated policy.

Tuesday, September 23, 2014

Fed Watch: Fisher on Wages

Tim Duy:

Fisher on Wages, by Tim Duy: Dallas Federal Reserve President Richard Fisher said Friday the US economy was threatend by higher wages. Via Reuters:
Fisher said on Friday he worries that further declines in unemployment nationally could lead to broader wage inflation. To head that off, and also to address what he called rising excesses in financial markets, Fisher said he prefers to raise rates by springtime, sooner than many investors currently anticipate.
After a snarky tweet, I wondered if he was not misquoted or misinterpreted. But he definitely warns that wage growth is set to accelerate in his Fox News interview (begin at the 3:50 mark). The crux of his argument is that wage growth accelerates when unemployment hits 6.1% and he uses strong wage growth in Texas as an example. He seems genuinely concerned that wage growth is negative outcome - that wage growth in Texas is a precursor to a terrible outcome for the US economy as a whole.
His entire tone is odd, and I feel compelled to clean up his argument, at least as much as is possible.
Fisher says that he presented evidence at the last FOMC meeting that 6.1% was the tipping point for wage acceleration. I can't disagree - I said as much this past March. The updated chart:

FISHER092214

Another version:

FISHERa092214

It is reasonable to expect that wage growth will accelerate as unemployment moves below 6%. I believe this is something of a test of the hypothesis that alternative measures of under-utilization more accurately convey information about the degree of slack. If that hypothesis is correct, then wage growth should not accelerate.
That said, why should Fisher fear wage growth? I don't see how one can expect real wages to rise in the absence of nominal wage growth in excess of inflation. And once you accept the possibility of real wage growth, you recognize the link between wage growth and inflation could be very weak. And so it is:

FISHERb092214

Note the period of disinflation that pulls inflation down to it's range since the mid-90s across a wide-variety of wage growth rates. The past 20 years give no reason to believe that 4% wage inflation cannot happily coexist with 2% price inflation.
So if wage inflation does not necessarily translate into price inflation, why worry at all? Why is Fisher even worried about wages? The key is really just this quote:
This is like duck hunting, you shot ahead of the mallard rather than try to get it from behind, otherwise you can't hit it.
It is all about the timing. I think his argument might be more effective is he said this:
  • The reason low unemployment does not cause inflation - or, essentially, why the Phillips curve is now flat - is that policymakers remove financial accommodation ahead of actual inflation. This is implicit in the Summary of Economic Projections. The reason inflation stabilizes near target is because unemployment settles near its natural rate, guided there by higher interest rates.
  • To judge the appropriate timing and magnitude of financial market accommodation, the Federal Reserve traditionally used the unemployment rate as a key indicator of slack in the economy. Accommodation would be reduced as the unemployment rate moved close to its natural rate, and conditions tightened has unemployment moved below the natural rate.
  • The Texas experience suggests that these traditional measures remain relevant - this should be his key point. Low unemployment rates stoke wage inflation as firms compete for workers, just as it has in the past.
  • Rather than act disgusted by higher wage growth, he should say that the Fed needs to ensure that such growth translates into real wage growth, and the Fed accomplishes this by adjusting accommodation to maintain its price inflation target. The Fed wants to hold unemployment in a zone consistent with both real wage growth and low and stable inflation. This requires nominal wage growth in excess of 2%.
  • It follows then that given the unemployment rate is already near 6%, it is not reasonable for the Fed to suggest that the first rate hike is a "considerable period" off in the future. The Fed traditionally moves ahead of inflation, and higher wage growth, which will soon be at hand, will be evidence that the first rate hike needs to be pulled forward.
Stated like this, I suspect a large portion of the FOMC would be sympathetic. For example, recall San Francisco Federal Reserve President John Williams from this past March:
“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.”
That said, most members lack Fisher's certainty that wages gains are set to accelerate and indicate that labor market slack has dwindled to the point that it is appropriate to remove financial accommodation. There remains the concern that the unemployment rate is not the best measure of labor market slack. They would prefer to wait until they have firm evidence of the absence of labor market slack and risk a small overshoot of inflation.
Moreover, as we now know, showing their anti-inflationary resolve did not do the Fed any favors in 2006 and 2007. As a whole, the Fed is acutely aware of this result. It has not gone unnoticed that the while the economy has suffered from repeated recessions since the great Moderation began, it has not suffered from a bout of inflation. It is reasonable to thus conclude that on average, the Fed has been too tight, not too loose. Hence again why the FOMC is willing to be patient in the normalization process.
Bottom Line: Fisher suggests that wage inflation by itself is a concern and needs to be brought to a halt. This is of course incorrect. Fisher sees an inflation threat in any and all data. Indeed, there could really be no other reason to be concerned about wage inflation. I suspect that Fisher has pivoted to concerns about wage inflation because his much feared price inflation has never emerged. That said, there is an element of truth here as well. Unemployment is nearing a range that is typically associated with faster wage growth. The Fed will respond to reduced slack in labor markets with less accommodation, and they will see accelerating wage growth as a signal that slack has largely been eliminated. But they are in no rush to do so any faster than necessary. Hence the slow taper and the subsequent delay in hiking rates. The balance of risks may be in the direction of tighter than expected policy, but the Fed needs to see more convincing data before they actually move in that direction.

Monday, September 22, 2014

Fed Watch: Hawkish Undertone

Tim Duy:

Hawkish Undertone, by Tim Duy: The Fed co«ntinuous to moves toward policy normalization.
Slowly. Very slowly.
They believe they are making every effort to avoid a premature withdrawal of accommodation. Every step is sequenced. And that sequencing did not allow for the removal of the considerable period language just yet.
That said, Federal Reserve Chair Janet Yellen noted in the associated press conference that, considerable period or not, the statement does not represent a promise to maintain a particular policy path. Moreover, the ambiguous definition of "considerable time" gives the Fed sufficient flexibility without breaking a promise in any event. Assuming asset prices end in October as the Fed expects, even a rate hike as early as March could still be considered a "considerable period." So too arguably would be a hike as early as January. It seems then that the considerable period language could survive longer than I anticipated.
Of course, if the statement is not a promise and "considerable period" has no fixed meaning, then the path of policy is strictly data dependent. And that is the idea now emphasized repeatedly by Yellen and Co. If the economy performs better than expected, rates hikes will come sooner and faster currently anticipated. If worse, the withdrawal of monetary accommodation will be delayed.
This is where the dot-plot comes into play. If we combine the midpoint of the economic estimates with the median of the rate expectations, you see the central tendency of the FOMC is to still expect a considerable period of time until rate normalization:

TAYLOR091714

Normalization is coming. But slowly. Very slowly. They have yet to see sufficient evidence to believe that policy will need to be considerably more aggressive than expected.
But where must the FOMC believe the balance of risks lies? Given the progress toward goals already achieved, and the wide spread between traditional metrics of appropriate policy and expected actual policy, it is reasonable to believe the FOMC is cautious that the risks are balanced toward tighter than expected policy. Indeed, the slow but steady increases in federal funds rate projections suggests that the data are indeed moving in such a direction. Hence, the Fed wants to disabuse market participants of the notion that the statement represents a promise. It is an only a policy expectation dependent on a particular set of assumptions. When those assumptions change, so too will the expectation.
Simply put, the Fed believes the statement accurately conveys their expectations given the current state of knowledge. It must then be somewhat disconcerting to the FOMC that while the possibility of a tighter than anticipating policy path is very real, financial market participants appear to believe the risks are weighted in the opposite direction. That, at least, is the message delivered by the San Francisco Federal Reserve in a well-publicized research note. The note also suggested much less uncertainty about the rate outlook than that of the FOMC. See also the Financial Times:
The FOMC’s median rate for the fed funds rate by the end of 2015 was raised to 1.375 per cent from 1.125 per cent, with the key overnight borrowing rate seen reaching 2.875 per cent, rather than 2.50 per cent by the end of 2016.
In contrast, the bond market expects a funds rate of 0.76 per cent by the end of 2015 and 1.82 per cent a year later.
When asked about these divergent expectations, Yellen suggested that other research found more aligned expectations. And even if the expectations did differ, they can be explained by different forecasts:
They are taking into account the possibility that there can be different economic outcomes, including--even if they're not very likely--ones in which outcomes will be characterized by low inflation or low growth and the appropriate path of rates will be low. So, differences in probabilities of different outcomes can explain part of that.
I would suggest another explanation. Financial market participants are attempting to find Yellen's dots as an indicator of the median policy expectation (note that Jon Hilsenrath of the Wall Street Journal asked her to reveal her dots during the press conference). The focus has fallen on the lower sets of dots in recognition of her reputation as a policy doves and, I think, the view that she repeatedly made an explicit policy promise with her optimal control framework. Specifically:

Yellen20121113a

No policy liftoff until 2016 - a rate path that is more consistent with the lower or lowest set of dots in the Fed's SEP than the median policy expectation. The assumption is that Yellen's dots are bigger in practice than the other dots, hence an emphasis on expecting a more prolonged period of low rates than the median FOMC participant.
It would be helpful if Yellen revisited her optimal control theory now that unemployment is hovering near 6%. But it is reasonable to believe that she is less certain of her previously suggested path of monetary policy now that the Fed is closer to meeting its stated goals. Hence the ambiguity in her message beginning with Jackson Hole. She is telling us that the time of commitment to low interest rates is drawing to an end. The data now take precedence. As long as the data cut in the direction of what are believed to be Yellen's dots, then those dots will yield a fairly accurate forecast. But if the data cut in a more positive direction, then more hawkish dots will have been the better forecast.
And, importantly, the Federal Reserve wants market participants to figure this out on there own. Policymakers believe they have sent sufficient signals regarding their likely reaction function. Now they want to see participants adjust pricing according to that reaction function, not on the basis of some promise that was never really a promise in the first place. Or, in Yellen's own words:
What can I say is that it is important for market participants to understand what our likely response or reaction function is to the data and our job is to try to communicate as clearly as we can the way in which our policy stance will depend on the data, and I promise to try to do that.
Bottom Line: The outcome of last week's meeting had little impact on my policy outlook. I continue to expect a rate hike in the middle of next year, with my distribution of risks weighted toward second over third quarter outcomes. And note that the second quarter would include a June meeting - still nine months away. I anticipate a generally positive pace of activity that will push the unemployment rate well below 6% by that time. As the unemployment rate moves below 6%, the FOMC will simply worry that accommodation is straying too far past traditional metrics to be consistent with stable inflation. They would not want this to come as a surprise, hence the emphasis on the ambiguity of the forecast. An ultra-low rate future is not guaranteed. The Fed is emphasizing the uncertainty of the forecast to ensure that market participants recognize another future is possible - and even perhaps more likely - than the lowest set of dots, as suggested by the upward drift in median rate projections. If that upward drift is prescient, don't say the Fed didn't warn you. Follow the data, just as the Fed is telling you.

Monday, September 08, 2014

Fed Watch: Forward Guidance Heading for a Change

Tim Duy:

Forward Guidance Heading for a Change, by Tim Duy: The lackluster August employment report clearly defied expectations (including my own) for a strong number to round out the generally positive pattern of recent data. That said, one number does not make a trend, and the monthly change in nonfarm payrolls is notoriously volatile. The underlying pattern of improvement remains in tact, and thus the employment report did not alleviate the need to adjust the Fed's forward guidance, allow there is a less pressing need to do so at the next meeting. In any event, the days of the "considerable time" language are numbered.
Nonfarm payrolls gained just 142k in August while the unemployment rate ticked back down to 6.1%. In general, the employment report is consistent with steady progress in the context of data that Fed Chair Janet Yellen has identified in the past:

NFPa090814

NFPb090814

Arguably the only trend that is markedly different is the more rapid decline in long-term unemployment, a positive cyclical indicator. Labor force participation remains subdued, although the Fed increasing views that as a structural issue. Average wage growth remained flat while wages for production workers accelerated slightly to 2.53% over the past year. A postive development to be sure, but too early to declare a sustained trend.
The notable absence of any bad news in the labor report leaves the door open to changing the forward guidance at the next FOMC meeting. As Robin Harding at the Financial Times notes, many Fed officials, including both doves and hawks, have taken issue with the current language, particularly the seemingly calendar dependent "considerable time" phrase. Officials would like to move toward guidance that is more clearly data dependent.
Is a shift in the language likely at the next meeting? Harding is mixed:
Their remarks could mean a move at the September FOMC meeting in 10 days, although there is little consensus yet on new wording, so a shift might have to wait until next month.
The trick is to change the language without suggesting the timing of the first rate hike is necessarily moving forward. The benefit of the next meeting is that it includes updated projections and a press conference. Stable policy expectations in those projections would create a nice opportunity to change the language. Moreover, Yellen would be able to to further explain any changes at that time. This also helps set the stage for the end of asset purchases in October. A shift in the guidance next week has a lot to offer.
A change in the language would also throw some additional light on Yellen's comments at Jackson Hole. Her typically unabashed defense of labor market slack was missing from her speech, replaced by a much more even-handed evaluation of the data. Was she simply setting the stage for an academic conference, or was she signalling a shift in her convictions? A change in the language at the next meeting would suggest the latter.
Bottom Line: The US economy is moving to a point in the cycle in which monetary policymakers have less certainty about the path of rates. Perhaps they need to be pulled forward, perhaps pushed back. Policymakers will need to be increasingly pragmatic, to use Yellen's term, when assessing the data. The "considerable time" language is inconsistent with such a pragmatic approach. It is hard to see that such language survives more than another FOMC statement. Seems to be data and policy objections are not the impediments preventing a change in the guidance, but instead the roadblock is the ability to reach agreement on new language in the next ten days.

Thursday, September 04, 2014

Fed Watch: August Employment Report Tomorrow

Tim Duy:

August Employment Report Tomorrow, by Tim Duy: Tomorrow morning we will be obsessing over the details of the August employment report with an eye toward the implications for monetary policy. Time for a quick review of some key indicators. First, initial unemployment claims continue to track at pre-recession levels:

CLAIMS083114

The employment components of both ISM reports where solid:

EMPb090414

The ADP report, however, was arguably lackluster with a gain of just 204k private sector jobs:

EMPa090414

The consensus forecast is for nonfarm payroll growth of 230k with a range of 195k to 279k. I am in general agreement with that forecast:

EMPc090414

I am somewhat concerned that I should be downgrading the importance of the ADP number and upgrading the strong claims and ISM data, leading me to conclude that the balance of risks lies to the upside of this forecast.
Of course, the headline nonfarm payrolls report is not necessarily the most important. Per usual, we will be scouring the data for indications that underemployment is lessening and slack being driven out of the labor market. And although Fed Chair Yellen has diverted our attention to those numbers, we should also keep a close eye on the unemployment rate, still the best single indicator of the state of the labor market. Consensus is a slight drop in the rate to 6.1%. I would hazard that a sub-6% rate is not out of the question as we have seen our share of 0.3 percentage point declines or greater in recent years.
A 5 handle on the unemployment rate would increase tensions in the FOMC between those who believe we are straying dangerously far from traditional indicators of appropriate monetary policy:

EMPd090414

and those who are willing to risk falling behind the curve by waiting until at least sustained target inflation is reached:

EMPe090414

Either way, I suspect any meaningful decline in unemployment will add fire to the communications debate at the Federal Reserve. Newly minted Cleveland Federal Reserve President Loretta Mester said today:
In addition to taking another step to taper asset purchases, in July, the FOMC maintained its forward guidance on interest rates. This guidance indicated that given our assessment of realized and expected progress toward our dual-mandate objectives, it will likely be appropriate to maintain the current 0-to-¼ percentage point range for the federal funds rate for a considerable period after the asset purchase program ends. With the end of the program nearing, I believe it is again time for the Committee to reformulate its forward guidance.
Bottom Line: Any further good news in labor markets will make it increasingly difficult for the Fed to maintain its "considerable period" guidance.

Tuesday, September 02, 2014

Fed Watch: Solid Start to September

Tim Duy:

Solid Start to September, by Tim Duy: The ISM manufacturing report came in ahead of expectations with the strongest number since 2011:

ISMa090114

Moreover, strength was evident throughout the internal components:

ISM090114

Note too that the report is consistent with other manufacturing numbers:

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If this is a taste of the data to expect this fall, it is tough to see how the Fed will be able to maintain their "considerable period" language much longer.

Fed Watch: Fed Positioning to Normalize Policy

Tim Duy:

Fed Positioning to Normalize Policy, by Tim Duy: With the leaves turning to gold signaling the end of summer, so too will the Fed be facing its own change of seasons as quantitative easing comes to an end. With asset purchases likely ending in October, time is growing short for the Fed to communicate a plan for the normalization of policy. To be sure, the outline of the plan is already in place, with interest on reserves playing a primary role backed by overnight repurchase operations. The timing of any action to raise rates, however, is likely to become a more contentious issue during the fall. Hawks will be pitted against doves as the former focus on improving labor markets while the latter point to underemployment and low inflation as reason for patience. The baseline scenario is that Fed Chair Janet Yellen guides the Fed to a delayed and gradual rate hike scenario. Given that this is just about the most dovish scenario imaginable at this juncture, the balance of risks is weighted toward a more aggressive approach to normalization.
The FOMC next meets Sept. 16 and 17. The almost certain outcome of that meeting will be another $10 billion cut from the Fed's asset purchase program. The subsequent press conference provides the opportunity to communicate more clearly the technical elements of the normalization process if the Fed feels sufficiently confident in the broad outlines of their plan. Less certain is a change in the forward guidance to reflect the the dissent of Philadelphia Federal Reserve Charles Plosser:
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.
The ability to maintain the considerable period language will likely be dependent on the next employment report. The pattern of initial unemployment claims data points toward fairly strong momentum in labor markets:

CLAIMS083114

Further improvements in labor markets will be make it difficult to promise a "considerable" period of time before the FOMC decides conditions are ripe for the first rate hike. Moreover, I found Yellen's language regarding the summary of labor market conditions in her Jackson Hole speech to be intriguing:
One convenient way to summarize the information contained in a large number of indicators is through the use of so-called factor models. Following this methodology, Federal Reserve Board staff developed a labor market conditions index from 19 labor market indicators, including four I just discussed. This broadly based metric supports the conclusion that the labor market has improved significantly over the past year, but it also suggests that the decline in the unemployment rate over this period somewhat overstates the improvement in overall labor market conditions.
Notice that the unemployment rate only "somewhat" overstates improvement in labor market conditions. "Somewhat" is not a word that suggests much conviction. Quite the contrary. And Yellen would have good reason to have little conviction on this point. I would caution against reading too much of significance into the Fed's new labor market indicators. I think the insightful Carola Binder absolutely nailed this one:
The main reason I'm not too excited about the LMCI is that its correlation coefficient with the unemployment rate is -0.96. They are almost perfectly negatively correlated--and when you consider measurement error you can't even reject that they are perfectly negatively correlated-- so the LMCI doesn't tell you anything that the unemployment rate wouldn't already tell you. Given the choice, I'd rather just use the unemployment rate since it is simpler, intuitive, and already widely-used.
Yellen sent her staff to prove that the unemployment rate does not accurately represent labor market improvement, and they created a measure that is almost perfectly negatively correlated with unemployment. In effect, the staff proved what Yellen has said repeatedly. For example, back in April:
I will refer to the shortfall in employment relative to its mandate-consistent level as labor market slack, and there are a number of different indicators of this slack. Probably the best single indicator is the unemployment rate.
If the unemployment rate remains the single-best indicator, it is no wonder then that Yellen's Jackson Hole speech was pragmatic not dogmatic. And pragmatic relative to the current baseline suggests the risk is toward tighter than expected monetary policy.
All that said, the actual inflation data still argues for patience. The higher inflation we witnessed this spring proved to be temporary:

InfA083114

InfB083114

Moreover, the flattening yield curve is suggestive of global deflationary forces:

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And financial markets are not sending a warning that inflation expectations are shifting upward:

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How do I put this all together? I tend to think the risk is that the employment data pulls the timing of the first rate hike forward. I have been focused on mid-year with a preference for the second quarter over the third. That said, I find it difficult to entirely discount the March meeting, especially if we see a string of solid employment reports. The March meeting also has the benefit of having a press conference. The inflation data, however, still argue for a gradual pace of interest rate hikes, thus Yellen should be able to argue that as long as inflation remains contained, there is no need to normalize policy aggressively even if such a policy begins a little earlier.
Indeed, I think the hawks will argue that Yellen is most likely to be able to maintain a dovish trajectory if she pulls forward the timing of the first rate hike to reflect that the Fed is close to meeting its targets. This is also the easiest way to alleviate any tension in FOMC if incoming labor reports suggest to FOMC members that the zero interest rate stance is excessively accommodative. It would also be arguably a pragmatic approach to policy making as Yellen outlined at Jackson Hole:
My colleagues on the Federal Open Market Committee (FOMC) and I look to the presentations and discussions over the next two days for insights into possible changes that are affecting the labor market. I expect, however, that our understanding of labor market developments and their potential implications for inflation will remain far from perfect. As a consequence, monetary policy ultimately must be conducted in a pragmatic manner that relies not on any particular indicator or model, but instead reflects an ongoing assessment of a wide range of information in the context of our ever-evolving understanding of the economy.
Bottom Line: The baseline path for interest rates is a delayed and gradual rate hike scenario beginning mid-2015. It seems reasonable, however, to believe that the risk is that this baseline is too dovish given the general progress toward the Fed's goals, a point made repeatedly by Fed hawks. Internal dissension to the baseline would only intensify in the face of another six months of generally solid economic news, especially on the labor front. Yellen would not want to risk the recovery, however, on an overly aggressive approach, especially in the face of low inflation. Considering the path of the data relative to the various policy factions with the Fed, I believe the risk is that the Fed pulls forward the date of the first rate hike as early as March - still seven months away! - while maintaining expectations for a gradual subsequent rate path.