Category Archive for: Fed Watch [Return to Main]

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

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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:

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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:

ISMb090114

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:

RateA083114

RateB083114

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

RateC083114

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.

Wednesday, August 13, 2014

Fed Watch: Heading Into Jackson Hole

Tim Duy:

Heading Into Jackson Hole, by Tim Duy: The Kansas City Federal Reserve's annual Jackson Hole conference is next week, and all eyes are looking for signs that Fed Chair Janet Yellen will continue to chart a dovish path for monetary policy well into next year. Indeed, the conference title itself - "Re-Evaluating Labor Market Dynamics" - points in that direction, as it emphasizes a topic that is near and dear to Yellen's heart. My expectation is that no hawkish surprises emerge next week. Despite continued improvement in labor markets, Yellen will push the Fed to hold back on aggressively tightening monetary policy. And with inflation still below target, wage growth constrained, and inflation expectations locked down, she holds all the leverage to make that happen.
Today we received the June JOLTS report, a lagging, previously second-tier report elevated to mythic status by Yellen's interest in the data. The report revealed another gain in job openings, leading to further speculation that labor slack is quickly diminishing:

JOLTS081214

Anecdotally, firms are squealing that they can't find qualified workers. Empirically, though, they aren't willing to raise wages. Neil Irwin of the New York Times reports on the trucking industry as a microcosm of the US economy:
Yet the idea that there is a huge shortage of truck drivers flies in the face of a jobless rate of more than 6 percent, not to mention Economics 101. The most basic of economic theories would suggest that when supply isn’t enough to meet demand, it’s because the price — in this case, truckers’ wages — is too low. Raise wages, and an ample supply of workers should follow.
But corporate America has become so parsimonious about paying workers outside the executive suite that meaningful wage increases may seem an unacceptable affront. In this environment, it may be easier to say “There is a shortage of skilled workers” than “We aren’t paying our workers enough,” even if, in economic terms, those come down to the same thing.
The numbers are revealing: Even as trucking companies and their trade association bemoan the driver shortage, truckers — or as the Bureau of Labor Statistics calls them, heavy and tractor-trailer truck drivers — were paid 6 percent less, on average, in 2013 than a decade earlier, adjusted for inflation. It takes a peculiar form of logic to cut pay steadily and then be shocked that fewer people want to do the job.
A "peculiar form of logic" indeed, but one that appears endemic to US employers nonetheless. Meanwhile, from Business Insider:
Profit margins are still getting wider.
"With earnings growth (6.7%) rising at a faster rate than revenue growth (3.1%) in Q2 and in future quarters, companies have continued to discuss cost-cutting initiatives to maintain earnings growth rates and profit margins," said FactSet's John Butters on Friday.
This comes at a time when profit margins are already at historic highs.
Ever since the financial crisis, sales growth has been weak. However, corporations have been able to deliver robust earnings growth by fattening profit margins. Much of this has been done by laying off workers and squeezing more productivity out of those on the payroll.
Margins serve as a line of defense against inflation. In fact, I would imagine that Yellen's ideal world is one in which margins are compressing because stable inflation expectations prevent firms from raising prices while tight labor markets force wage growth higher. A Goldilocks scenario from the Fed's perspective. This is also the scenario that is most likely to foster the tension in the FOMC as Fed's hawks argue for immaculate inflation while doves battle back about actual inflation. In any event, until wage growth actually accelerates, the likelihood of any meaningful, self-sustaining inflation dynamic remains very, very low.
Separately, a second justification for a moderate pace of tightening emerges. Via Reuters:
Approaching a historic turn in U.S. monetary policy, Janet Yellen has staked her tenure as chair of the Federal Reserve on a simple principle: she'd rather fight inflation than another economic downturn.
Interviews with current and former Fed officials indicate that Yellen and core decision-makers at the U.S. central bank are determined not to raise interest rates too early and risk hurting the fragile U.S. economy...
...The nightmare scenario she wants to avoid is hiking rates only to see financial markets and the economy take such a hit that she has to backtrack. Until the Fed has gotten rates up from the current level near zero to more normal levels, it would have little room to respond if the economy threatened to head into another recession.
Gasp! Is the reality of the zero bound finally sinking in at the Fed? The basic argument is that the Fed needs to at least risk overshooting to pull interest rates into a zone that allows for normalized monetary policy during the next recession. And given that the Fed knows how to effectively tame inflation while stimulating the economy at the zero bound in more challenging, the costs of overshooting are less than the costs of undershooting.
(Note that I suspect overshooting in this context is the 2.25-2.5% range, but that still provides more leeway than a 2.25% cap.)
In addition, Yellen can point out that since the disinflation of the early 90's, the Fed has not faced an inflation problem, but instead has struggled with three recessions. This on the surface suggests that monetary policy has erred in being too tight on average.
Bottom Line: Anything other than a dovish message coming from the Jackson Hole conference will be a surprise. Tight labor markets alone will not justify an aggressive pace of tightening. An aggressive pace requires that those tight labor markets manifest themselves into higher wage growth and higher inflation. Yellen seems content to normalize slowly until she sees the white in the eyes of inflation.

Wednesday, August 06, 2014

Fed Watch: Fed Hawks Squawk

Tim Duy:

Fed Hawks Squawk, by Tim Duy: How much leeway does Fed Chair Janet Yellen have in her campaign to hold interest rates low for a considerable period after asset purchases end later this year? If you listen to Fed hawks, you would believe that she is quickly running out of room. Dallas Federal Reserve President Richard Fisher argued that the liftoff date for interest rates is creeping forward. From Reuters:
"I think the committee, as I listen to them and I can only speak for myself around that table during two days of discussion, is coming in my direction, so I didn’t feel the need to dissent,” Dallas Federal Reserve Bank President Richard Fisher said on Fox Business Network.
"We are going to have to move the date of liftoff further forward than had been projected the last time we issued the 'dots'” he said, referring to the official Fed forecasts for short-term interest rates, last issued in June.
At the time of the June FOMC meeting, the most recent read on the unemployment rate was 6.3% (May), while the July rate was just a nudge lower at 6.2%. The inflation rate (core-PCE) at the time of the June FOMC meeting was 1.43% (April), compared to 1.49% in June. So the Fed is arguably just a little closer to its goals, but enough to dramatically move forward the dots just yet? Not sure about that, but a downward lurch of unemployment in the next report would likely elicit a reaction in the dots. If the dots don't move, Fisher promises a dissent at the next FOMC meeting.
The pace of the tightening, however, is in my opinion more important than the timing of the first rate hike. Richmond Federal Reserve President Jeffrey Lacker argues that the pace of rate hikes will be more aggressive than currently anticipated by market participants. Via Craig Torres at Bloomberg:
Investors may be underestimating the pace at which the Federal Reserve will raise interest rates over the next two years, said Jeffrey Lacker, president of the Federal Reserve Bank of Richmond.
Short-term interest-rate markets have for months priced in a slower tempo of increases than policy makers themselves forecast. That’s risky because the misalignment, a bet against a rate path that the central bank alone controls, could lead to volatility if traders have to adjust rapidly, Lacker said.
“When there is that kind of gap, it gets your attention,” Lacker, a consistent critic of the Fed’s record easing who votes on policy next year, said in an Aug. 1 interview at his Richmond office overlooking the James River. “It wouldn’t be good for it to be closed with great rapidity.”
How much should we listen to Lacker? Torres notes correctly that Lacker's track record on policy is not exactly the greatest:
Lacker’s forecasts haven’t always been on target, which he’s acknowledged in his speeches. In a March 2012 dissent, he indicated the federal funds rate would have to rise “considerably sooner” than late 2014 “to prevent the emergence of inflationary pressures,” according to minutes of the meeting. The benchmark rate is still close to zero, and inflation is below the Fed’s target.
ISI's Krishna Guha suggests that the market expects that Fed Chair Janet Yellen's forecast will win the day. Via Matthew Boes:
Where to begin? First, it is worth dispensing with the myth of "immaculate inflation." Fed hawks seem to believe that low unemployment is sufficient to send inflation screaming higher. They see the 1970s under ever carpet, behind every closet door. But the relationship between unemployment and inflation is simply very weak:

InfC080514

Generally, inflation has been within a range of 1.0% to 2.5% since the disinflation of the early 1990s. No immaculate inflation. What is missing to generate that immaculate inflation? Inflation expectations. After the decline in inflation expectations in the early 1980's:

InfD080514

inflation expectations have been remarkably stable:

InfE080514

As long as inflation expectations remain anchored, immaculate inflation remains unlikely. Stable inflation expectations thus clearly give Yellen room to pursue a less aggressive normalization strategy. Note that this does not mean waiting until inflation expectations begin to rise before tightening. Remember that the reason that inflation expectations remain anchored is because the Fed does in fact tighten policy in when conditions point toward above-target inflation. The Fed learned in the early 1980s that they do in fact have substantial control over inflation expectations, and they intend to retain that control. But without conditions that argue for a real threat to those expectations - including, notably, actual inflation above the 2.25% in the context of faster wage growth - Yellen will have justification to resist an aggressive pace of tightening.
Moreover, Yellen still has tepid wage growth on her side. And if unemployment dips below 6% as seem inevitable by the end of this year, I suspect we will move into a critical test of the Yellen hypothesis. Consider the relationship between wage growth and unemployment:

InfA080514

The downward slop looks obvious, but becomes even clearer if we isolate some of the movement associated with recessions:

Inf080514

At the moment, wage growth is on the soft side of where we might expect given the unemployment rate, consistent with Yellen's position. If that situation continues, then it follows that Yellen will have a strong hand to play with the FOMC. Lack of wage growth by itself would argue for a very gradual pace of rate hikes even in the face of higher inflation. Yellen - and the majority of the FOMC - will not see a threat to inflation expectations at the current pace of wage growth.
Bottom Line: At the moment, we are focused on wages as the missing part of the higher rate equation. But that is too narrow of an analysis. Also on Yellen's side is low actual inflation and anchored inflation expectations. To be sure, the Fed will be under increasing pressure to begin normalizing policy if unemployment drops below 6%. At that point the Fed will be sufficiently close to their objectives that they will believe the odds of falling behind the curve will rise in the absence of movement toward policy normalization. But without a more pressing threat to inflation expectations from a combination of actual inflation in excess of the Fed's target and wage growth to support that inflation, Yellen has room to normalize policy at a gradual pace. For now, the data is still on her side and the hawks will remain frustrated, much as they have for the past several years.

Friday, August 01, 2014

Fed Watch: July Employment Report

Tim Duy:

July Employment Report, by Tim Duy: The overall tenor of the July employment report was consistent with the song that Yellen and Co. are singing. Labor markets are generally improving at a moderate pace, yet despite relatively low unemployment, there is plenty of reason to believe considerable slack remains in the economy.
The headline nonfarm payroll number was a ho-hum gain of 209K with some small upward revisions for the previous two months. Steady above 200k gains this year are lifting the 12-month moving average of jobs higher:

NFPc080114

In the context of the range of indicators that Fed Chair Janet Yellen has drawn specific attention to:

NFPa080114

NFPb080114

Consistent with the consensus of the FOMC as revealed at the conclusion of this week's FOMC meeting, measures of underutilization of labor remain elevated. Notable is the flat wage growth - clearly a ball in Yellen's court. Moreover, these numbers should override any enthusiasm over yesterday's ECI report, which is obviously overtaken by events.
In other news, inflation remains below target:

PCEa080114

although pretty much right at target over the past three months:

PCEb080114

Numbers like these gave the Fed reason to upgrade its inflation outlook this week. If these numbers can hold up for the next several months, you will see the year-over-year number gradually converge to the Fed's target, clearing the way for the Fed's first rate hike in the middle of next year (my preference remains the second quarter over the third).
On the whole, these data continue to argue for a very gradual pace of tightening. The Fed will be in rush to normalize policy until labor underutilization approaches normal levels and wage growth accelerates. Since it's Friday and everyone is looking forward to the weekend, we can avoid re-inventing the wheel on this topic and just refer to Binyamin Appelbaum's report on the FOMC meeting, in which he quotes some random commentator:
The Fed’s chairwoman, Janet L. Yellen, and her allies have taken a more cautious view, arguing that the decline in the unemployment rate appears to overstate the improvement in the labor market, because it counts only people who are looking for work. Ms. Yellen has said she expects some people who dropped out of the labor force to return as the economy continues to improve, and she has pointed to tepid wage growth as evidence that it remains easy to find workers.
“The recovery is not yet complete,” she told Congress this month.
The statement suggested that the committee continued to back Ms. Yellen’s view, said Tim Duy, a professor of economics at the University of Oregon.
“The committee as a whole is still willing to give Yellen the benefit of the doubt,” Mr. Duy said. “And honestly they have good reason. Until you get upward pressure on wages, it is terribly difficult to say that she’s wrong.”
In recent conversations with Oregon businesses, Mr. Duy said, he heard repeatedly that it was becoming harder to hire workers, but also that businesses were unwilling to offer higher wages as an inducement, because they doubted their ability to recoup the cost through increased sales or higher prices.
Bottom Line: Nothing here to change the outlook for monetary policy.

Thursday, July 31, 2014

Fed Watch: On That ECI Number

Tim Duy (see Dean Baker too):

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

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

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

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

ECIa073114

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

ECIb073114

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

ECIc073114

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

Wednesday, July 30, 2014

Fed Watch: FOMC Statement

Tim Duy:

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

FOMCa073014

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

FOMCb073014

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

Tuesday, July 15, 2014

Fed Watch: Yellen Testimony

Tim Duy:

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

BULLARD071514

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

Thursday, July 10, 2014

Fed Watch: QEInfinity Not

Tim Duy:

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

BN-DP809_dwindl_G_20140709142508

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

INF070914

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

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

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

Wednesday, July 09, 2014

Fed Watch: When The Fed Starts Raising Rates

Tim Duy:

When The Fed Starts Raising Rates, by Tim Duy: Via Twitter, modest proposal summarizes my last post:
Shorter @TimDuy, short the front end not the 10 year because the Fed will tighten before inflation is a problem http://t.co/1a0xRNueEO
— modest proposal (@modestproposal1) July 7, 2014
This made me think about the last tightening cycle. For those that hope to use tighter monetary policy to bolster the case against equities, recall that patience may be required:

FedTight1

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

FedTight2

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

FedTight3

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

FedTight4

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

FedTight5

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

FedTight6

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

Monday, July 07, 2014

Fed Watch: Inflation Hysteria Redux

Tim Duy:

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

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

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

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

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

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

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

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

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

INFLATION2

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

INFLATION

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

Thursday, July 03, 2014

Fed Watch: June Employment Report

Tim Duy:

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

EMPDAYd070314

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

EMPDAYb070314

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

EMPDAYh070314

EMPDAYc070314

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

EMPDAYf070314

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

EMPDAYg070314

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

EMPDAYa070314

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

EMPDAYe070314

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

Monday, June 23, 2014

Fed Watch: Inflation Hysteria

Tim Duy:

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

INFf062314

Missed it?  Maybe we should zoom in:

INFb062314

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

INFe062314

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

INFa062314

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

INFd062314

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

Thursday, June 19, 2014

Fed Watch: Janet Yellen the Hawk

One more from Tim Duy:

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

Fed Watch: Still a Dove

Tim Duy:

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

  FED061814

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

  FED2061814

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

Monday, June 16, 2014

Fed Watch: FOMC Preview

Tim Duy:

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

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Neither does the path of aggregate weekly hours:

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Nor the growth of retail sales:

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Nor industrial indicators:

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

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

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and inflation potentially bottoming out and turning up:

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

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

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

WAGEFEDFUNDS

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

Wednesday, May 28, 2014

Fed Watch: Policy Induced Mediocrity?

Tim Duy:

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

REALPOT051114

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

NFP051114

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

Wednesday, May 21, 2014

Fed Watch: Dudley Revisits Exit Strategy

Tim Duy:

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

Monday, May 05, 2014

Fed Watch: Difficult Labor Report

Tim Duy:

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

EMPDAY4050414

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

EMPDAY5050414

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

EMPDAY050414

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

EMPDAY3050414

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

EMPDAY2050414

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

Thursday, April 10, 2014

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

Tim Duy:

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

Consider the Fed's take on labor markets:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The next line, however, is not particularly helpful:

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

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

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

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

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

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

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

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

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

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

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

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

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

Friday, April 04, 2014

Fed Watch: One For the Doves

Tim Duy:

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

NFPa040413

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

UNEMP040413

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

NFPb040413

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

WAGES040414

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

PCE033114

PCEa033114

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

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

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

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

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

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

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

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

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

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

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

Thursday, April 03, 2014

Fed Watch: Employment Report Ahead

Tim Duy:

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

ISM0400314

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

INITCLAIMS0400314

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

NFPFOR0400314

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

Monday, March 24, 2014

Fed Watch: Williams Acknowledges Forecast Change

Tim Duy:

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

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

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

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

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

Also, regarding financial stability, I said Friday:

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

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

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

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

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

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

Fed Watch: Post-FOMC Fedspeak

Tim Duy:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

That said, it is clear the dots moved:

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

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

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

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

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

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

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

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

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

Recall, however, Goldman's view from November:

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

Why? Because of extensions of the optimal control framework.

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

And more from Hatzius from Bill McBride at Calculated Risk:

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

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

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

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

Saturday, March 22, 2014

Fed Watch: Kocherlakota's Dissent

Tim Duy:

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

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

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

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

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

Now consider Kocherlakota's version of the Evans rule:

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

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

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

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

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

Thursday, March 20, 2014

Fed Watch: Unintentionally Hawkish

Tim Duy:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Wednesday, March 19, 2014

Fed Watch: That Train Left the Station

Tim Duy:

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

INFEXP031714

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

BREAK031714

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

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