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Friday, June 10, 2016

Five Questions for Janet Yellen

Tim Duy:

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

Monday, June 06, 2016

Fed Watch: Employment Report, Yellen, and More

Tim Duy:

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


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


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


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


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


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


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

Wednesday, June 01, 2016

Fed Watch: Waiting For The Employment Report

Tim Duy:

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


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


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


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

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

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

Another Bloomberg story to keep an eye on:

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


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

Thursday, May 26, 2016

Fed Watch: Powell, Data

Tim Duy:

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

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


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


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


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


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

Wednesday, May 25, 2016

Fed Watch: Should The Fed Tolerate 5% Unemployment?

Tim Duy:

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


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


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


(or even stalled):


and inflation remains below target:


We will soon see if the Fed agrees.

Tuesday, May 24, 2016

Fed Watch: Curious

Tim Duy:

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


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


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


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

Sunday, May 22, 2016

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

Tim Duy:

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

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

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

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

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

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

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

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

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

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

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

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

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

the view was not widely shared:

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

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

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

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

But others saw room for further improvement:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Thursday, May 19, 2016

Fed Watch: Minutes Say June Is On The Table

Tim Duy:

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

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

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

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

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

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

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

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

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

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

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

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

But it is clearly under consideration.

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

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

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

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

One final note. Consider this paragraph:

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

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

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

Tuesday, May 17, 2016

Fed Watch: Fed Officials Come Looking For A Fight

Tim Duy:

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


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


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


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


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

Monday, May 16, 2016

Fed Watch: Fed Not As Convinced About June As Markets

Tim Duy:

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


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


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


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


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

Thursday, May 12, 2016

Fed Watch: Fed Speak, Claims

Tim Duy:

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


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


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

Monday, May 09, 2016

Fed Watch: June Fades Away

Tim Duy:

June Fades Away, by Tim Duy: At the beginning of last week, monetary policymakers were trying to keep the dream of June alive. Via Bloomberg:
“I would put more probability on it being a real option,” Lockhart told reporters at the Atlanta Fed’s financial markets conference at Amelia Island, Florida, when asked about the low implied odds of a move next month. “The communication of committee participants and members between now and mid-June obviously should try to prepare the markets for at least a realistic range of possibilities” for the next policy meeting...
...Williams, a former head of research to Fed Chair Janet Yellen, said he would support raising rates at the next meeting, provided the economy stayed on track.
“In my view, yes, it would be appropriate, given all of the things that we’ve talked about, to go that next step,” Williams told Kathleen Hays in an interview on Bloomberg Radio. “But you know, a lot can happen between now and June.” Williams is also not an FOMC voter this year.
Later in the week, however, financial market participants took one look at the employment report and concluded the Fed was all bark and no bite. Markets see virtually no possibility of a Fed rate hike in June.
That - a desire to keep June in play coupled with insufficient data to actually make June happen - all happened faster than I anticipated. But don't think the Fed will go down without a fight. New York Federal Reserve President William Dudley played down the April employment numbers. Via his must-read interview with Binyamin Applebaum of the New York Times:
I wouldn’t make too much about the headline payroll number being a little softer, because there’s other things in the report that are more positive. For example, total hours worked were up quite a bit; average hourly earnings were up quite a bit. So there’s actually a lot of income being generated from the labor market. And the data on payrolls is quite volatile month to month — 160,000 sounds like a lot weaker than the 200,000 people were expecting, but it’s actually well within what you’d expect in terms of normal volatility. It’s a touch softer, maybe, than what people were expecting, but I wouldn’t put a lot of weight on it in terms of how it would affect my economic outlook.
I would agree that the report is within the bounds from normal volatility. From my tweet ahead of the report:


The pace of job growth has softened, though only modestly so:


But if we view the labor report through Janet Yellen's eyes, the picture becomes somewhat murkier:



Generally solid numbers, but I can't help but notice the unemployment rate is flattening out, and so too has progress on part-time employment and long-term unemployment. Indeed, I found this from Dudley somewhat odd:
The news from this latest payroll unemployment report was actually quite positive in terms of the long-term unemployed. I think what’s happening is, as we’ve run the labor market to a higher degree of utilization, the long-term unemployed are getting picked up and getting more employment opportunities.
He appears to be focusing on just the last month of data while ignoring the trend over the last year. But someone at the next FOMC meeting will surely draw that trend to his attention.
Note that unemployment is settling into a level slightly above the Fed's estimate of the natural rate of unemployment:


For Yellen, this should be something of a red flag. The plan was to let the economy run hot enough that unemployment sank somewhat below the natural rate, thereby more aggressively reducing underemployment. Now, you can argue that this plan has faltered for a good reason - the labor participation rate rose, placing upward pressure on the unemployment rate. That however gets you to the same place as a more negative story. It reveals that there is substantial excess capacity in the labor market, and consequently the Fed should not be in a rush to raise rates. Indeed, because they have underestimated the slack in the economy, they need to let the economy run hot for even longer if they wish to push inflation back up to target - of which it remains woefully below:


Bottom Line: The Fed breathed a sigh of relief after financial markets stabilized. That opened up the possibility that June would still be on the table, leaving them the option for three rate hikes this year. I don't think that policymakers will abandon June as easily as financial market participants. My sense is that they will remain coy, implying odds closer to 50-50. But the data are not in their favor. The employment report was by no means a disaster, but nor was it a blowout. Moreover, I think they will be wary to hike rates until unemployment resumes its decline or underemployment more broadly improves. And we won't have enough data to see such a trend until September.

Friday, April 29, 2016

Fed Watch: Warning: Hawkishness Ahead

Tim Duy:

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


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

Wednesday, April 06, 2016

Fed Watch: Dovish Minutes

Tim Duy:

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

Meeting participants were generally confident in the outlook:

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

But outside of the consumer, all is not rosy:

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

And global concerns loomed large:

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

Caveats abound, however:

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

Is the economy at full employment? Maybe:

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

Maybe not:

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

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

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

But concerns about too low inflation clear dominated:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Tuesday, April 05, 2016

Fed Watch: Fed Has Little Reason to Hike Rates

Tim Duy:

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


and nonmanufacturing:


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


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


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


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


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


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



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

Friday, April 01, 2016

Fed Watch: Yellen Pivots Toward Saving Her Legacy

Tim Duy:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Monday, March 28, 2016

Fed Watch: Oil, Inflation Expectations, and Credibility

Tim Duy:

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


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


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


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


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


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


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

Friday, March 25, 2016

Fed Watch: On Credibility

Tim Duy:

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

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

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

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

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

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

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

What I wrote:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

I hope Fed policymakers remain resistant to such taunts.

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

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

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

Monday, March 07, 2016

Fed Watch: State of Play

Tim Duy:

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


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


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


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


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


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

Wednesday, March 02, 2016

Fed Watch: Dudley the Dove

Tim Duy:

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

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

Monday, February 29, 2016

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

Tim Duy:

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


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

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

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

The persistent of this shock has significant implications for policy:

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

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

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

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

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

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

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

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

The implication for US policy:

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

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

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

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

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

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

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

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

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

Thursday, February 25, 2016

Fed Watch: Lacker, Kaplan, Fischer

Tim Duy:

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


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

Wednesday, February 24, 2016

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

Tim Duy:

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


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


Industrial production ticked up and weakness remains fairly concentrated:


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


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


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

Thursday, February 18, 2016

Fed Watch: FOMC Minutes and More

Tim Duy:

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

Thursday, February 11, 2016

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

Tim Duy:

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


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

Friday, February 05, 2016

Fed Watch: Solid Jobs Report Keeps Fed In Play

Tim Duy:

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


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



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


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


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


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


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

Thursday, February 04, 2016

Fed Watch: Jobs Day

Tim Duy:

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


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


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

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

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


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

Wednesday, February 03, 2016

Fed Watch: Resisting Change?

Tim Duy:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Wednesday, January 27, 2016

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

Tim Duy:

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


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


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


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

Thursday, January 14, 2016

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

Tim Duy:

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


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


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


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

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

Tim Duy:

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


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


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


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


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


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


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


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


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


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

Thursday, January 07, 2016

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

Tim Duy:

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


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

Monday, January 04, 2016

Fed Watch: A Look Ahead Into 2016

Tim Duy:

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


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


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


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


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


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


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


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


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




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


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

Monday, December 21, 2015

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

Tim Duy:

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


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


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

Wednesday, December 16, 2015

Fed Watch: As Expected

Tim Duy:

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

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

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

Importantly, the Fed does not believe policy is tight:

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

The Fed currently expect future hikes to occur only gradually:

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

But, this is a forecast not a promise:

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

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

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

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

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

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

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

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

Tuesday, December 15, 2015

FOMC Preview - Watch the Dollar and Oil

Tim Duy:

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

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

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

Continue reading on Bloomberg...

Monday, December 14, 2015

Fed Watch: Makes You Wonder What The Fed Is Thinking

Tim Duy:

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


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

Monday, December 07, 2015

Fed Watch: And That's A Wrap

Tim Duy:

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


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


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


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

Tuesday, December 01, 2015

Fed Watch: The Final Countdown

Tim Duy:

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


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


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


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


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


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


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

Monday, November 23, 2015

Fed Watch: Mission Accomplished

Tim Duy:

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

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

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

New York Federal Reserve President William Dudley, via Reuters:

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

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

Atlanta Federal Reserve President Dennis Lockhart, via CNBC:

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

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

San Francisco Federal Reserve President John Williams, via Reuters:

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

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

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

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

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

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

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

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

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

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

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

Williams, via Reuters:

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

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

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

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

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

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

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

Monday, November 09, 2015

Fed Watch: Onto The Next Question

Tim Duy:

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


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



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


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


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

Wednesday, November 04, 2015

Fed Watch: What 2016 Might Bring

Tim Duy:

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


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


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


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


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


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


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


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


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

Thursday, October 29, 2015

Fed Watch: December Still Very Much A Live Meeting

Tim Duy:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Tuesday, October 13, 2015

Fed Watch: Brainard Drops A Policy Bomb

Tim Duy:

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

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

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

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

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

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

and Fischer:

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

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

After assessing the quality of the recovery, Brainard asserts:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

But Stan Fischer's speech provides us with neither.

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

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

Monday, October 12, 2015

Fed Watch: Fed Struggles With The High Water Mark

Tim Duy:

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

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

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

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

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

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

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

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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

Thursday, September 17, 2015

Fed Watch: Final Thoughts On September

Tim Duy:

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

Tuesday, September 15, 2015

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

Tim Duy at Bloomberg:

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

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

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

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

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

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

Tuesday, September 08, 2015

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

Tim Duy:

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


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


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

Saturday, September 05, 2015

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

Tim Duy:

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


Another view from real median weekly earnings:


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

Monday, August 31, 2015

Fed Watch: Does 25bp Make A Difference?

Tim Duy:

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


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