Category Archive for: Monetary Policy [Return to Main]

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:

JOBSd020516

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

JOBSe020516

JOBSf020516

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

JOBSc020516

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

JOBSb020516

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

JOBSa020516

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:

JOBSg020516

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

'Dovish Actions Require Dovish Talk (To Be Effective)'

Narayana Kocherlakota:

Dovish Actions Require Dovish Talk (To Be Effective): The Federal Open Market Committee (FOMC) has bought a lot of assets and kept interest rates extraordinarily low for the past eight years.  Yet, all of this stimulus has accomplished surprisingly little (for example, inflation and inflation expectations remain below target and are expected to do so for years to come).   Does that experience mean that we should give up on monetary policy as a useful way to stimulate aggregate demand?  
My answer is no.  I argue that, over the past seven years, the FOMC's has consistently talked hawkish while acting dovish.  This communications approach has weakened the effectiveness of policy choices, probably in a significant way.  Future monetary policy stimulus can be considerably more effective if the FOMC is much more transparent about its willingness to support the economy - that is, about its true dovishness.
My starting point is that households and businesses don’t make their decisions about spending based on the current fed funds rate - which, is after all, a one-day interest rate.  Rather, spending decisions are based on longer-term yields.  Those longer-term yields depend on market participants’ beliefs about how monetary policy will evolve over the next few years.  Those beliefs are a product of both FOMC actions and FOMC communications. 
In December 2008, the FOMC lowered the fed funds rate target range to 0 to a quarter percent. It did not raise the target range until December 2015, when the unemployment rate had fallen back down to 5%.   But - with the benefit of hindsight - a shocking amount of this eight years’ worth of unprecedented stimulus was wasted, because it was largely unanticipated by financial markets. (Full disclosure: I took part in FOMC meetings from November 2009 through October 2015, and it could certainly be argued that I was part of the problem that I describe until September 2012.)  
I’ll illustrate my basic point in the most extreme way that I can.  In November 2009, the Committee’s statement said that the fed funds rate might be raised after “an extended period” - a term that was generally interpreted to mean “about six months”.  Accordingly, as footnote 25 of this speech notes, private forecasters in the Blue Chip survey projected that the unemployment rate would be near 10 percent at the time of the first interest rate increase.  
Now, suppose that the FOMC had communicated its true reaction function in November 2009 (or even as late as December 2012): as long as inflation was anticipated to be below 2% over the medium-term, the Committee would not raise the fed funds rate until the unemployment rate had fallen to 5% or below.  We can’t know the impact of such communication with certainty.   But most macroeconomic models would predict that this kind of statement would have put significant upward pressure on employment and prices.  In other words: the models predict that if the FOMC had been willing to communicate its true willingness to support the economy, the Committee would have been able to (safely) raise rates much sooner.  
I want to be clear: my point in this post is not to express regrets or recrimination over past “mistakes”.    (It would have been good in 2009 to know what we know now, but we didn’t.)  And my point is not that monetary policy is some kind of panacea.  In the presence of a lower bound on nominal interest rates, expansionist fiscal policy would have been helpful in the past (and could be now too). 
My point is this: we shouldn’t make judgements about the efficacy of future monetary policy stimulus based on the experience from the past seven years.   Unfortunately, much of the potential impact of that lengthy stimulus campaign was vitiated by the FOMC’s generally hawkish communications.   
In my view, the FOMC can deliver useful impetus to aggregate demand with its remaining tools.  But it needs to communicate ahead of time about its true willingness and ability to support the economy.   Without that prior communication, later attempts at stimulus are likely to prove in vain - and the Fed’s credibility may suffer further damage.

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:

NFPFORa020416

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:

NFPFOR020416

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:

FISHER

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.

Saturday, January 30, 2016

5 to 4

Narayana Kocherlakota:

5 to 4: On Friday, the Policy Board of the Bank of Japan decided to lower its deposit rate into negative territory for the first time.  The vote was five to four.  In this post, I argue that US monetary policy would be stronger if the Federal Open Market Committee (FOMC) were willing to issue statements and take actions that were supported by such narrow margins.
As is well-known, the FOMC operates by consensus.  No decision has had more than three No votes in at least twenty-five years.  There has not been a No vote by a governor in ten years, and there has not been more than one No vote by a governor at a meeting in over twenty years.  (See this great article by Thornton and Wheelock for a deeper review.)  
This decision framework is not statutory.  Rather, it is a Committee norm.  The norm is buttressed by Fed watchers and the media, who often refer approvingly to the absence of dissents at a meeting.  (Even today, this FT article refers to the lack of dissents at the December 2015 meeting as being a sign of a successful liftoff.)
This tradition of consensus has three main deficiencies. 
First, consensus creates a strong status quo bias that reduces the sensitivity of monetary policy to incoming data.   The current Committee norms imply that it requires a super-majority of the FOMC to implement a change in direction.  Without that super-majority, the Committee tends to stick to its prior course.   This automatically makes monetary policy relatively insensitive to incoming information.  
Second, the tradition of consensus opens up the possibility that relatively small minorities of FOMC voters can have a disproportionate influence  on monetary policy decisions.   For example, the above history suggests that the FOMC is following a practice under which all decisions need near-unanimous support from the governors.  If so, it becomes theoretically possible for a bloc of one or two governors to exercise veto rights over changes in the direction of monetary policy.
Finally, and perhaps most troublingly, the desire/need for consensus tends to strip collective Committee statements of their clarity.   (See a recent Wall Street Journal op-ed by Charles Plosser for a similar concern.)  For example, here’s how the current FOMC statement describes the conditionality of the path for the fed funds rate: 
“In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.”
This length of this list of conditioning variables helps create consensus, but it also serves to reduce the public’s understanding of the overall FOMC strategy.  This uncertainty can be a drag on the effectiveness of policy. 
Bold policy moves often engender significant disagreement.   Policy-making bodies must have cultures that can allow those decisions to get made, despite that disagreement.   Clearly, the Policy Board of the BOJ has that kind of culture.   I worry that the FOMC, with its emphasis on consensus, does not. 
I’ll write more about the potential economic importance of the BOJ’s move in a later post.  For now, I’ll simply say that, given the challenges facing the global economy, I applaud Governor Kuroda’s willingness to lead the BOJ in this new direction.

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:

FT

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:

RECESSIONb012516

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:

RECESSIONa012516

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.

Tuesday, January 26, 2016

'The Five Scenarios Now Facing the Federal Reserve'

Tim Duy:

The Five Scenarios Now Facing the Federal Reserve: Federal Reserve policymakers are likely enjoying this month about as much as market participants are.
Central bankers at the Fed don’t like fast-moving markets to begin with, and they especially won’t like the implication that their supposedly inconsequential 25-basis-point interest rate hike in December was a mistake. The only saving grace for the Fed is that January was off the table for a rate hike anyway, so the volatility on Wall Street will have little impact on this week’s policy outcome, due to be announced on Wednesday... Continue reading at Bloomberg ...

Sunday, January 24, 2016

Banks' Influence on Congressional ''Reform'' of the Fed

Narayana Kocherlakota:

Banks' Influence on Congressional “Reforms” of the Fed: Senator Sanders’ December 23 NYT op-ed expressed concern about what he perceived to be an undue influence of the financial sector on the Federal Reserve. In my last post, I explained how the Fed could allay these concerns through greater transparency about the role of the Board of Governors. In this post, I elaborate on what I see as a much bigger problem: the financial sector’s influence on Congress as it seeks to “reform” the Fed.
Here’s an example of what I mean. Last year, Congress amended Section 10.1 of the Federal Reserve Act. That section now requires a person who is experienced with community banks to be on the Board of Governors. There is no other explicit sectoral requirement of this kind in the Act.
How should one interpret this new statutory requirement? The issue is not whether it is often beneficial to have a Board member who has prior experience with community banks. I fully agree that it is. But that’s true of many other sectors in the US economy. So why is Congress picking this particular sector as being one that needs to be represented on the Board?
Unfortunately, the answer is clear to me (as I suspect that it will be to anyone who fills this new slot): Congress wants the Fed to tilt supervision, regulation, and monetary policy to be more favorable to community banks. This interpretation is consistent with the fact that the passage of this statutory change came after six years of lobbying from the Independent Community Bankers of America.
This statutory preference for community banks is disturbing. It’s true that community banks are often located on Main Street. But the interests of community banks are absolutely not the same as the interests of Main Street.
In terms of supervision and regulation: lax supervision and regulation increases the probability of bank failure. Bank failures impose a cost on the FDIC which is, ultimately, backstopped by the taxpayer. Community banks operating in the interests of their shareholders should not - and don’t - fully internalize these taxpayer costs. Accordingly, community banks systematically favor less supervision and regulation than would be in the public interest.
In terms of monetary policy, the profits that banks derive from many of their products are positively correlated with the overall level of interest rates in the economy. For this reason, community bankers typically favor higher interest rates than is in the general public interest. (Of course, this preference is shared by larger financial institutions for similar reasons.)
In writing the above, I’m not intending to be critical of community banks. They’re private businesses. No one should expect the interests of a given private business to coincide with the general public interest.
The problem is with Congress. Congress is supposed to act in the interest of the public. But this law is not in the public interest. Instead, it is a rather clear attempt to influence the Fed so that it acts more in the interest of (part of) the financial sector.
In his op-ed, Senator Sanders says that he wants to reform the Fed so that “the foxes would no longer guard the henhouse”. The first step in this agenda should be to repeal the recent amendment to section 10.1 of the Federal Reserve Act. This step will not be easy to accomplish. The amendment passed with overwhelming support from both parties in both Houses of Congress.

Friday, January 15, 2016

Are Long-Term Inflation Expectations Declining? Not So Fast, Says Atlanta Fed

From the Atlanta Fed's Macroblog:

Are Long-Term Inflation Expectations Declining? Not So Fast, Says Atlanta Fed:
"Convincing evidence that longer-term inflation expectations have moved lower would be a concern because declines in consumer and business expectations about inflation could put downward pressure on actual inflation, making the attainment of our 2 percent inflation goal more difficult."
—Fed Chair Janet Yellen, in a December 2, 2015, speech to the Economic Club of Washington
To be sure, Chair Yellen's claim is not controversial. Modern macroeconomics gives inflation expectations a central role in the evolution of actual inflation, and the stability of those expectations is crucial to the Fed's ability to achieve its price stability mandate.
The real question on everyone's mind is, of course, what might constitute "convincing evidence" of changes in inflation expectations. Recently, several economists, including former Treasury Secretary Larry Summers and St. Louis Fed President James Bullard, have weighed in on this issue. Yesterday, President Bullard cited downward movements in the five-year/five-year forward breakeven rates from the five- and 10-year nominal and inflation-protected Treasury bond yields. In November, Summers appealed to measures based on inflation swap contracts. The view that inflation expectations are declining has also been echoed by the New York Fed President William Dudley and former Minneapolis Fed President Narayana Kocherlakota.
Broadly speaking, there seems to be a growing view that market-based long-run inflation expectations are declining and drifting significantly away from the Fed's 2 percent target and that this decline is troublingly correlated with oil prices.
A problem with this line of argument is that the breakeven and swap rates are not necessarily clean measures of inflation expectations. They are really better referred to as measures of inflation compensation because, in addition to inflation expectations, these measures also include factors related to liquidity conditions in the markets for these securities, technical features of the inflation protection in each security, and inflation risk premia. Here at the Atlanta Fed, we've built a model to separate these different components and isolate a better measure of true inflation expectations (IE).
In technical terms, we estimate an affine term structure model—similar to that of D'Amico, Kim and Wei (2014)—that incorporates information from the markets for U.S. Treasuries, Treasury Inflation-Protected Securities (TIPS), inflation swaps, and inflation options (caps and floors). Details are provided in "Forecasts of Inflation and Interest Rates in No-Arbitrage Affine Models," a forthcoming Atlanta Fed working paper by Nikolay Gospodinov and Bin Wei. (You can also see Gospodinov and Wei (2015) for further analysis.) Essentially, we ask: what level of inflation expectations is consistent with this entire set of financial market data? And we then follow this measure over time.
As chart 1 illustrates, we draw a very different conclusion about the behavior of long-term inflation expectations. The chart plots the five-year/five-year forward TIPS breakeven inflation (BEI) and the model-implied inflation expectations (IE) for the period January 1999–November 2015 at a weekly frequency. Unlike the raw BEI, our measure is quite smooth, suggesting that long-term inflation expectations have been, and still are, well anchored.

160115a

After making an adjustment for the inflation risk premium, we term the difference between BEI and IEs a "liquidity premium," but it really includes a variety of other factors. Our more careful look at the liquidity premium reveals that it is partly made up of factors specific to the structure of inflation-indexed TIPS bonds. For example, since TIPS are based on the non-seasonally adjusted consumer price index (CPI) of all items, TIPS yields incorporate a large positive seasonal carry yield in the first half of the year and a large negative seasonal carry yield in the second half. Chart 2 illustrates this point by plotting CPI seasonality (computed as the accumulated difference between non-seasonally adjusted and seasonally adjusted CPI) and the five-year breakeven inflation.

160115b

Redemptions, reallocations, and hedging in the TIPS market after oil price drops and global financial market turbulence can further exacerbate this seasonal pattern. Taken together, these factors are the source of correlation between the BEI measures and oil prices. To confirm this, chart 3 plots (the negative of) our liquidity premium estimate and the log oil price (proxied by the nearest futures price).

160115c

Our measure of long-term inflation expectations is also consistent with long-term measures from surveys. Chart 4 presents the median along with the 10th and 90th percentiles of the five-year/five-year forward CPI inflation expectations from the Philadelphia Fed's Survey of Professional Forecasters (SPF) at quarterly frequency. This measure can be compared directly with our IE measure. Both the level and the dynamics of the median SPF inflation expectation are remarkably close to that for our market-based IE. It is also interesting to observe that the level of inflation "disagreement" (measured as the difference between the 10th and 90th percentiles) is at a level similar to the level seen before the financial crisis.

160115d

Finally, we note that TIPS and SPF are based on CPI rather than the Fed's preferred personal consumption expenditure (PCE) measure. CPI inflation has historically run above PCE inflation by about 30 basis points. Accounting for this difference brings our measure of the level of long-term inflation expectations close to the Fed's 2 percent target.
To summarize, our analysis suggests that (1) long-run inflation expectations remain stable and anchored, (2) the seemingly large correlation of market-implied inflation compensation with oil prices arises mainly from the dynamics of the TIPS liquidity premium, and (3) long-run market- and survey-based inflation expectations are remarkably close in terms of level and dynamics over time. Of course, further softness in the global economy and commodity markets may eventually drag down long-term expectations. We will continue to monitor the pure measure of inflation expectations for such developments.

Thursday, January 14, 2016

'Information in Inflation Breakevens about Fed Credibility'

More on the "risk" of inflation. This is from Narayana Kocherlakota:

Information in Inflation Breakevens about Fed Credibility: The Federal Open Market Committee has been gradually tightening monetary policy since mid-2013. Concurrent with the Fed’s actions, five year-five year forward inflation breakevens have declined by almost a full percentage point since mid-2014. I’ve been concerned about this decline for some time (as an FOMC member, I dissented from Committee actions in October and December 2014 exactly because of this concern). In this post, I explain why I see a decline in inflation breakevens as being a very worrisome signal about the FOMC”s credibility (which I define to be investor/public confidence in the Fed’s ability and/or willingness to achieve its mandated objectives over an extended period of time).
First, terminology. ...
Conceptually, the five-year five-year forward breakeven can be thought of as the sum of two components:
1. investors’ best forecast about what inflation will average 5 to 10 years from now
2. the inflation risk premium over a horizon five to ten years from now - that is, the extra yield over that horizon that investors demand for bearing the inflation risk embedded in standard Treasuries.
(There’s also a liquidity premium component, but movements in this component have not been all that important in the past two years.)
There is often a lot of discussion about how to divide a given change in breakevens in these two components. My own assessment is that both components have declined. But my main point will be a decline in either component is a troubling signal about FOMC credibility.
It is well-understood why a decline in the first component should be seen as problematic for FOMC credibility. The FOMC has pledged to deliver 2% inflation over the long run. If investors see this pledge as credible, their best forecast of inflation over five to ten year horizon should also be 2%. A decline in the first component of breakevens signals a decline in this form of credibility.
Let me turn then to the inflation risk premium (which is generally thought to move around a lot more than inflation forecasts). A decline in the inflation risk premium means that investors are demanding less compensation (in terms of yield) for bearing inflation risk. In other words, they increasingly see standard Treasuries as being a better hedge against macroeconomic risks than TIPs.
But Treasuries are only a better hedge than TIPs against macroeconomic risk if inflation turns out to be low when economic activity turns out to be low. This observation is why a decline in the inflation risk premium has information about FOMC credibility. The decline reflects investors’ assigning increasing probability to a scenario in which inflation is low over an extended period at the same time that employment is low - that is, increasing probability to a scenario in which both employment and prices are too low relative to the FOMC’s goals.
Should we see such a change in investor beliefs since mid-2014 as being “crazy” or “irrational”? The FOMC is continuing to tighten monetary policy in the face of marked disinflationary pressures, including those from commodity price declines. Through these actions, the Committee is communicating an aversion to the use of its primary monetary policy tools: extraordinarily low interest rates and large assetholdings. Isn’t it natural, given this communication, that investors would increasingly put weight on the possibility of an extended period in which prices and employment are too low relative to the FOMC’s goals?
To sum up: we’ve seen a marked decline in the five year-five year forward inflation breakevens since mid-2014. This decline is likely attributable to a simultaneous fall in investors’ forecasts of future inflation and to a fall in the inflation risk premium. My main point is that both of these changes suggest that there has been a decline in the FOMC’s credibility.
To be clear: as I well know, in the world of policymaking, no signal comes without noise. But the risks for monetary policymakers associated with a slippage in the inflation anchor are considerable. Given these risks, I do believe that it would be wise for the Committee to be responsive to the ongoing decline in inflation breakevens by reversing course on its current tightening path.

Wednesday, January 13, 2016

'The Validity of the Neo-Fisherian Hypothesis'

Narayana Kocherlakota:

Validity of the Neo-Fisherian Hypothesis: Warning: Super-Technical Material Follows

The neo-Fisherian hypothesis is as follows: If the central bank commits to peg the nominal interest rate at R, then the long-run level of inflation in the economy is increasing in R. Using finite horizon models, I show that the neo-Fisherian hypothesis is only valid if long-run inflation expectations rise at least one for one with the peg R. However, in an infinite horizon model, the neo-Fisherian hypothesis is always true. I argue that this result indicates why macroeconomists should use finite horizon models, not infinite horizon models. See this linked note and my recent NBER working paper for technical details.

In any finite horizon economy, the validity of the neo-Fisherian hypothesis depends on how sensitive long-run inflation expectations are to the specification of the interest rate peg.

  • If long-run inflation expectations rise less than one-for-one (or fall) with the interest rate peg, then the neo-Fisherian hypothesis is false.
  • If long-run inflation expectations rise at least one-for-one with the interest rate peg, then the neo-Fisherian hypothesis is true.

Intuitively, when the peg R is high, people anticipate tight future monetary policy. The future tightness of monetary policy pushes down on current inflation. The only way to offset this effect is for long-run inflation expectations to rise sufficiently in response to the peg.

In contrast, in an infinite horizon model, the neo-Fisherian hypothesis is valid - but only because of an odd discontinuity. As the horizon length converges to infinity, the level of inflation becomes infinitely sensitive to long-run inflation expectations. This means that, for almost all specifications of long-run inflation expectations, inflation converges to infinity or negative infinity as the horizon converges to infinity. Users of infinite horizon models typically discard all of these limiting “infinity” equilibria by setting the long-run expected inflation rate to be equal to the difference between R and r*. In this way, the use of an infinite horizon - as opposed to a long but finite horizon - creates a tight implicit restriction on the dependence of long-run inflation expectations on the interest rate peg

To summarize: The validity of the neo-Fisherian hypothesis depends on an empirical question: how do long-run inflation expectations depend on the central bank's peg? This empirical question is eliminated when we use infinite horizon models - but this is a reason not to use infinite horizon models.

In case you missed this from George Evans and Bruce McGough over the holidays (on learning models and the validity of the Neo-Fisherian Hyposthesis, also "super-technical"):

The Neo-Fisherian View and the Macro Learning Approach

I've been surprised that none of the Neo-Fisherians have responded.

Monday, January 11, 2016

'Overly Tight Macroeconomic Policy'

I missed this from Narayana Kocherlakota a little over a week ago:

Overly Tight Macroeconomic Policy: The level of public debt is high by historical standards in many countries.  Central banks have set their nominal interest rate targets to extraordinarily low - sometimes negative - levels.  Despite these historical comparisons, though, macroeconomic outcomes tell a clear story: Macroeconomic policy remains much too tight in the US and around the world.  
In terms of monetary policy, inflation remains low, and is expected to remain low for years.  Indeed, financial market participants are betting that most major central banks will fall short of their inflation targets over the next decade or two.  Nonetheless, those same central banks (including the Federal Reserve) continue to communicate a strong desire to "normalize" - that is, tighten - monetary policy over the medium term.   
In terms of fiscal policy, many governments are able to borrow long-term at unusually low real interest rates.  They could invest those funds in needed physical and human infrastructure. Or they could return the funds to their citizens through tax cuts - tax cuts that could be tailored to incentivize physical investment or R&D.   But the relevant governments instead continue to emphasize the need to further restrict the level of public debt.  
Economic policymakers can do better.   The key is to focus a lot more on the question of how to use available policy tools to achieve desirable macroeconomic outcomes, and a lot less on historical empirical regularities.   Just because debt is high by historical standards doesn't mean that governments cannot make their citizens better off by issuing more debt   Just because nominal interest rates are low by historical standards doesn't mean that central banks can't achieve their objectives more rapidly by lowering them still further.  
We are only beginning to see the impact of tight policy choices on our economies.  We all know what has been happening in Spanish and Greek labor markets.  But even in the US - which supposedly has a near-normal labor market - the fraction of men aged 25-34 who do not have a job is over 50%(!) higher than it was in 2007.   Given these kinds of macroeconomic outcomes, it should not be surprising that we see increasing signs of social fracturing and disengagement in many developed countries.
I've said that economic policymakers can do better.  Indeed, I increasingly believe that they must do better. 

See here for more of his thoughts on macroeconomic policy.

Friday, January 08, 2016

Bernanke's Mundell-Fleming Lecture (Video)

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:

ISM010616

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.

Tuesday, January 05, 2016

'What Did You Do in the Currency War, Daddy?'

I recently gave a talk in Honolulu hosted by the Korean Institute of Economic Policy, and this was a heated topic of discussion. Koreas was criticized in the Treasury's semi-annual report on currency manipulation (though not formally identified a a manipulator), and I had the impression their criticism of US monetary policy was an attempt to say "see, you do it too." My defense of the US was not popular:

Ben Bernanke:

What did you do in the currency war, Daddy?: The financial crisis and its immediate aftermath saw close cooperation among the world’s policymakers, especially central bankers. For example, in October 2008, the Federal Reserve coordinated simultaneous interest-rate cuts with five other major central banks. It also established currency swap arrangements—in which the Fed provided dollars in exchange for foreign currencies—with fourteen foreign central banks, including four from emerging markets. However, once the crisis had passed and recovery begun, national economic interests began to diverge. In particular, some foreign policymakers argued that the Fed’s aggressive monetary policies, undertaken to support the U.S. economic recovery, were damaging their own economies.
Two criticisms were prominent, and a third perennial issue also reared its head. First, several foreign policymakers accused the Fed of engaging in “currency wars”—deliberately weakening the dollar to gain an advantage in trade. (The phrase is most closely associated with Brazilian finance minister Guido Mantega, who leveled the charge when the Fed began a second round of quantitative easing in November 2010.) A second complaint, raised prominently by Reserve Bank of India governor Raghuram Rajan, among others, was that shifts in Fed policy (toward either greater tightness or greater ease) were creating spillovers—sharp swings in capital flows and increased market volatility—that destabilized financial markets in emerging-market countries. This concern has surfaced again recently, as the Fed has initiated what may prove to be a series of interest-rate increases. ...

Skipping to the bottom line (after a long, detailed discussion):

Overall, I find little support for the claims that the Fed has engaged in currency wars. Although the Fed’s monetary policies of recent years likely put downward pressure on the dollar, the effect of the weaker dollar on US net exports was largely offset by the effects of higher US incomes on Americans’ demand for imported goods and services. Indeed, recent years have seen neither an increase in US net exports nor any sustained depreciation of the dollar.

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:

2016f

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

2016l

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:

2016d

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:

2016e

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.

2016b

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:

2016c

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:

2016a

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:

2016g

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:

2016j

2016i

2016h

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:

2016k

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.

Tuesday, December 29, 2015

'The Fed and Financial Reform – Reflections on Sen. Sanders op-Ed'

This is the beginning of a long response from Larry Summers to an op-ed by Bernie Sanders:

The Fed and Financial Reform – Reflections on Sen. Sanders op-Ed: Bernie Sanders had an op Ed in the New York Times on Fed reform last week that provides an opportunity to reflect on the Fed and financial reform more generally. I think that Sanders is right in his central point that financial policy is overly influenced by financial interests to its detriment and that it is essential that this be repaired. At the same time, reform requires careful reflection if it is not to be counterproductive. And it is important in approaching issues of reform not to give ammunition to right wing critics of the Fed who would deny it the capacity to engage in the kind of crisis responses that have judged in their totality been successful in responding to the financial crisis.  The most important policy priority with respect to the Fed is protecting it from stone age monetary ideas like a return to the gold standard, or turning policymaking over to a formula, or removing the dual mandate commanding the Fed to worry about unemployment as well as inflation. ...

Tuesday, December 22, 2015

Summers: My Views and the Fed’s Views on Secular Stagnation

Larry Summers:

My views and the Fed’s views on secular stagnation: It has been two years since I resurrected Alvin Hansen’s secular stagnation idea and suggested its relevance to current conditions in the industrial world. Unfortunately experience since that time has tended to confirm the secular stagnation hypothesis. Secular stagnation is a possibility. It is not an inevitability and it can be avoided with strong policy. Unfortunately, the Fed and other policy setters remain committed to traditional paradigms and so are acting in ways that make secular stagnation more likely. ... Indeed I would judge that there is at least a two-thirds chance that we will experience zero or negative rates again in the next five years. ...

I believe its decision to raise rates last week reflected four consequential misjudgments.
First, the Fed assigns a much greater chance that we will reach 2 percent core inflation than is suggested by most available data. ...
Second, the Fed seems to mistakenly regard 2 percent inflation as a ceiling not a target. ...
Third... It is suggested that by raising rates the Fed gives itself room to lower them. ... I would say the argument that the Fed should raise rates so as to have room to lower them is in the category with the argument that I should starve myself in order to have the pleasure of relieving my hunger pangs.
Fourth, the Fed is likely underestimating secular stagnation. It is ... overestimating the neutral rate. ...
Why is the Fed making these mistakes if indeed they are mistakes? It is not because its leaders are not thoughtful or open minded or concerned with growth and employment. Rather I suspect it is because of an excessive commitment to existing models and modes of thought. Usually it takes disaster to shatter orthodoxy. We can all hope that either my worries prove misplaced or the Fed shows itself to be less in the thrall of orthodoxy than it has been of late.

The Fed's job would have been, and will be a lot easier if fiscal policy makers would help. I disagree with Charles Plosser's view on monetary policy, but I have some sympathy for the view that many people have come to expect too much from monetary policy:

... On the monetary policy side central banks have clearly pushed the envelope in an effort to stabilize and then promote real economic growth.  The pressure to do so has come from inside and outside the central banks.  These actions have raised expectations of what the central bank can do.  For the last three or four decades, it has been widely accepted among academics and central bankers that monetary policy is primarily responsible for anchoring inflation and inflation expectations at some low level.  In the United States, where the Fed operates under the so-called dual mandate to promote both price stability and maximum employment, monetary policy has also attempted to stabilize economic growth and employment.  Yet it has also been widely accepted that monetary policy’s impact on real variables was limited and temporary, thus in the long-run changes in money were neutral for real variables.

The behavior of central banks during the crisis and subsequent recession has turned much of this conventional wisdom on its head.  It is not clear that this is wise or prudent.  Many have come to fear that without substantial support from monetary policy our economies will slump into stagnation. This would seem to fly in the face of nearly two centuries of economic thinking. ...

If secular stagnation is real, the Fed cannot overcome it by itself. Fiscal policy will have to be part of the solution. (I do think one statement above is wrong, and it gets at the heart of Summer's recent work reviving hysteresis and his statement above about commitment to orthodoxy. When Plosser says "monetary policy’s impact on real variables was limited and temporary, thus in the long-run changes in money were neutral for real variables," he is ignoring recent work by Summers, Blanchard, and Fatas showing that recessions can permanently  lower our productive capacity, and it is worse when the recession lasts longer. This means that monetary policy -- and fiscal policy too -- can have a permanent impact on the natural rate of output by helping the economy to recover faster. The faster the recovery, the less the natural rate is lowered. So I agree with Summers that monetary policy needs to take the possibility of secular stagnation into account, I just wish he'd put more emphasis on the essential role of fiscal policy -- something he has certainly done in the past, e.g., "I believe that it is appropriate that we go back to an earlier tradition that has largely passed out of macroeconomics of thinking about fiscal policy as having a major role in economic stabilization.")

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:

Spreadfed

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:

Spread

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.

Sunday, December 20, 2015

'The FTPL Version of the Neo-Fisherian Proposition'

I've never paid much attention to the fiscal theory of the price level:

The FTPL version of the Neo-Fisherian proposition: The Neo-Fisherian doctrine is the idea that a permanent increase in a flat nominal interest rate path will (eventually) raise the inflation rate. It is then suggested that current below target inflation is a consequence of fixing rates at their lower bound, and rates should be raised to increase inflation. David Andolfatto says there are two versions of this doctrine. The first he associates with the work of Stephanie Schmitt-Grohe and Martin Uribe, which I discussed here. He like me is not sold on this interpretation, for I think much the same reason. ... But he favours a different interpretation, based on the Fiscal Theory of the Price Level (FTPL).

Let me first briefly outline my own interpretation of the FTPL. This looks at the possibility of a fiscal regime where there is no attempt to stabilize debt. Government spending and taxes are set independently of the level or sustainability of government debt. The conventional and quite natural response to the possibility of that regime is to say it is unstable. But there is another possibility, which is that monetary policy stabilizes debt. Again a natural response would be to say that such a monetary policy regime is bound to be inconsistent with hitting an inflation target in the long run, but that is incorrect. ...

A constant nominal interest rate policy is normally thought to be indeterminate because the price level is not pinned down, even though the expected level of inflation is. In the FTPL, the price level is pinned down by the need for the government budget to balance at arbitrary and constant levels for taxes and spending. ...

I have a ... serious problem with this FTPL interpretation in the current environment. The belief that people would need to have for the FTPL to be relevant - that the government would not react to higher deficits by reducing government spending or raising taxes - does not seem to be credible, given that austerity is all about them doing exactly this despite being in a recession. As a result, I still find the Neo-Fisherian proposition, with either interpretation, somewhat unrealistic.

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

Inffore

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.

Friday, December 11, 2015

'Why It's Tricky for Fed Officials to Talk Politically'

I think I disagree with Brad DeLong:

Why it's tricky for Fed officials to talk politically: Should speeches by Federal Reserve officials be limited to topics concerning monetary policy and financial stability, or should they be free to speak on any topic, no matter how politically charged it might be? It's an important question as the Fed prepares to announce next week what's looking like a significant change in its eight-year policy of zero-perecent interest rates.
Fed Chair Janet Yellen, for example, was sharply criticized for a speech last year highlighting what economists know about rising inequality and what might be done to overcome it.
This speech, which Yellen gave in October 2014, is still creating controversy. This week, it erupted again when UC Berkeley economist Brad DeLong defended Yellen against the charge that she's a "partisan hack," a description in the headline of a Washington Post story by Michael Strain after Yellen's speech. ...

Monday, December 07, 2015

Paul Krugman: The Not-So-Bad Economy

The cost of raising interest rates too soon is much higher than raising them too late. Remember the Fed's vow of patience?:

The Not-So-Bad Economy, by Paul Krugman, Commentary, NY Times: ...unemployment has been cut in half, and the Federal Reserve is getting ready to raise interest rate...
I believe that the Fed is making a mistake. But the fact that hiking rates is even halfway defensible is a sign that the U.S. economy isn’t doing too badly. So what did we do right?
The answer, basically, is that the Fed and the White House have mostly worried about the right things. (Congress, not so much.) Their actions fell far short of what should have been done; unemployment should have come down much faster... But at least they avoided taking destructive steps to fight phantoms. ...
Meanwhile, on the other side of the Atlantic, the European Central Bank gave in to inflation panic, raising interest rates twice in 2011 — and in so doing helped push the euro area into a double-dip recession.
What about the White House? Some of us warned ... that the 2009 stimulus was too small..., a warning vindicated by events. But it was much better than nothing, and was enacted over scorched-earth opposition from Republicans...
Unfortunately, the U.S. ended up doing a fair bit of austerity too, partly driven by conservative state governments, partly imposed by Republicans in Congress via blackmail over the federal debt ceiling. But the Obama administration at least tried to limit the damage.
The result of these not-so-bad policies is today’s not-so-bad economy. ... Still, things could be worse. And they may indeed get worse, which is why the Fed’s likely rate hike will be a mistake.
Fed officials believe that the solid job growth of the past couple of years ... will continue even if rates go up..., those officials could be right, in which case waiting to raise rates could mean some acceleration of inflation.
On the other hand, they could be wrong, in which case a rate hike could end the run of good economic news. And this would be much more serious than a modest uptick in inflation, because it’s not at all clear what the Fed could do to fix its mistake.
I’m not sure why this argument, which a number of economists are making, isn’t getting much traction at the Fed. I suspect, however, that officials have been worn down by incessant criticism of their policies, and want to throw the critics a bone.
But those critics have been wrong every step of the way. Why start taking them seriously now?

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:

NFPa120615

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:

NFPb120615

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:

PFPD120615

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.

Sunday, December 06, 2015

'Central Bankers Do Not Have as Many Tools as They Think'

Larry Summers:

Central bankers do not have as many tools as they think: ... While recession risks may seem remote.., no postwar recession has been predicted a year ahead... History suggests that when recession comes it is necessary to cut rates more than 300 basis points..., the chances are very high that recession will come before there is room to cut rates enough to offset it. ...
Central bankers bravely assert that they can always use unconventional tools. But there may be less in the cupboard than they suppose. The efficacy of further quantitative easing ... is highly questionable. There are severe limits on how negative rates can become. A central bank forced back to the zero lower bound is not likely to have great credibility if it engages in forward guidance.
The Fed will in all likelihood raise rates this month. ... But the unresolved question that will hang over the economy is how policy can delay and ultimately contain the next recession. It demands urgent attention from fiscal as well as monetary policymakers.

Friday, December 04, 2015

Toward a Better Monetary Policy Reaction Function

Narayana Kocherlakota:

Monetary Policy Renormalization:  ... Point 3: Toward a Better Reaction Function I’ve argued that, in November 2009, the FOMC was aiming for a slow recovery in both prices and employment. I’ve argued too that the Committee’s desire for a slow recovery was consistent with its pre-2008 reaction function, which sought to constrain the variability of short-term interest rates. I now turn to the question of how the FOMC could change its “normal” policy reaction function so as to engender a better response to severe adverse shocks.
To be clear, there have been many prior suggestions about how to arrive at a better framework. Some observers have suggested that the FOMC should increase the inflation target, so as to have more policy space to deal with adverse demand shocks. Some observers have suggested that the FOMC should target the price level rather than the inflation rate. Still others have suggested that the FOMC should target the level of nominal income.
I see merit in all of these suggestions, and I welcome explorations of their consequences. But they represent large changes in the FOMC’s long-run goals. I will instead recommend a more minimal change in terms of the FOMC’s strategy—that is, how it seeks to pursue its current long-run goals. My recommendation is that the FOMC should adopt a policy framework that puts considerably more emphasis on returning the economy to its dual mandate objectives over the medium term. Such a framework would immediately imply that the FOMC should use a monetary policy reaction function that is a lot more responsive to the Committee’s best medium-term projections of inflation and output gaps.
What would be the benefits of this change in the FOMC’s strategic framework? I see two clear benefits. First, the FOMC’s choices would systematically return both inflation and output to desired levels more rapidly. There would be less persistence and less volatility in both inflation and output gaps. Second, the credibility of the FOMC’s inflation target would be enhanced. As noted earlier, in November 2009, the staff projected that, if the FOMC used the Taylor Rule after liftoff, inflation would remain at 1.6 percent or below for the next five years. This kind of outcome creates large downside risk to the credibility of the inflation target.
Those are the benefits: less variance in macroeconomic variables and enhanced credibility of the FOMC’s long-run inflation target. What would be the costs? The key cost is that, of course, the fed funds rate would be more variable around its long-run level. I have two comments about this putative cost. First, I don’t know of models in which such a cost is grounded in traditional welfare economics.10 The real interest rate is a key intertemporal price, and it may need to vary a lot to effect a desirable allocation of resources. According to models that are currently available, it would be welfare-reducing to smooth the fluctuations of this important price.
Second, and perhaps relatedly, my reading of the Federal Reserve Act is that Congress has not mandated that the FOMC seek to constrain the variability of its policy instruments. Congress has mandated that the Committee adjust its policy instruments as needed so as to achieve its macroeconomic objectives.11
To summarize my third and final point: The FOMC should strongly consider lowering its implicit penalty on interest rate variability relative to what was being imposed before the crisis. Doing so would lead the Committee to use a monetary policy reaction function that puts more weight on its forecasts of inflation and output gaps. Such a reaction function would automatically engender a more appropriate monetary policy response to severe downturns in inflation and employment such as those experienced during the Great Recession.
Conclusions
The theme of this speech is that the FOMC’s thinking about appropriate monetary policy in extraordinary times like late 2009 is heavily influenced by its policy framework during normal times. It should choose its new “normal” policy framework with this in mind. I have argued that the pre-2008 framework led the Committee to aim for a relatively slow recovery in inflation and employment in the wake of the Great Recession. I’ve recommended that, going forward, the Committee should use a reaction function that would be considerably more responsive to its best available forecasts of inflation and output gaps.
The U.S. House recently passed a measure, the Fed Oversight Reform and Modernization Act, that would enshrine the Taylor Rule as a key benchmark for monetary policy. Federal Reserve Chair Janet Yellen recently wrote in a letter12 to House leaders that the bill “would severely impair the Federal Reserve's ability to carry out its congressional mandate to foster maximum employment and stable prices and would undermine ability to implement policies that are in the best interest of American businesses and consumers.”  
My argument today gives a concrete example of Chair Yellen’s criticism. The FOMC did treat the Taylor Rule as a key benchmark for monetary policy during the early part of the recovery from the Great Recession. By doing so, we were systematically led to make choices that were designed to keep both employment and prices needlessly low for years.
Ultimately, if this legislation were to become law, it would force the Federal Reserve into the same kinds of choices in the wake of future adverse shocks.

Thursday, December 03, 2015

'Fed Emergency Lending'

Ben Bernanke:

Fed emergency lending: Earlier this week, the Federal Reserve’s Board of Governors approved a rule implementing restrictions on its emergency lending powers that were mandated by Congress in the 2010 Dodd-Frank Act. On the whole, the rule is a sensible compromise which clarifies the procedures for Fed lending in a panic while responding to critics’ concerns. ... Going forward, however, we should be wary of any further changes that might have the effect of deterring financial firms from borrowing from the Fed during a financial panic. ...

In a financial panic, providers of short-term funding to financial institutions refuse to renew their lending, out of fear that an institution might fail. ... When banks or other financial firms cannot obtain funding, they ... stop extending credit to households and businesses, which can bring the economy to a halt.

The most important tool that central banks (like the Fed) have for fighting financial panics is their ability to serve as a lender of last resort... Crucially, the Fed retains the authority to lend freely in a panic. ...

My biggest concern about the collective impact of the reforms is related to what economists call the stigma of borrowing from the central bank. For lender-of-last resort policies to work, financial institutions have to be willing to avail themselves of the central bank’s loans. If they fear that by doing so that they will be identified by the marketplace as weak, and thus subject to even more pressure from creditors and counterparties, then they will see borrowing from the Fed as counterproductive and will stay away. This is the stigma problem... Deprived of access to funding, financial firms will instead hoard cash, dump assets, cut credit, and call in loans, with bad effects on the whole economy.

We faced a serious stigma problem during the recent crisis, and, collectively, the reforms to the Fed’s lending authorities have probably made the problem worse. An example is the effect of new reporting requirements. Dodd-Frank requires that the identities of all borrowers (including non-emergency borrowers through the discount window) be disclosed... These provisions serve the important purposes of advancing transparency, accountability, and democratic legitimacy, and I am not advocating that they be changed. But we should be aware that, by increasing the risk of early disclosure of borrowers’ identities, these requirements will probably reduce the willingness of firms to borrow from the Fed in a panic... 

I don’t see an easy remedy for this problem. As is often the case, policymakers must trade off competing goals. However, in contemplating possible future changes to the Fed’s authorities, we should be very careful to avoid anything that might worsen further the stigma problem...

Tuesday, December 01, 2015

The New Supply-Side Economics

New column:

The New Supply-Side Economics: Traditionally, macroeconomic policy has been divided into two distinct types. The first type, stabilization policy, attempts to keep output and employment as close to their full employment levels as possible. The idea behind these policies is to minimize, or even eliminate, short-term boom-bust cycles around the natural rates of output and employment caused by fluctuations in aggregate demand. 
The second type of policy, growth policy, works on the supply-side and attempts to keep the long-term natural rates of output and employment growing as fast as possible. Thus, if the long-term natural growth rate of output is, say, 2.5 percent, supply-side policy would try to increase this rate, while demand-side stabilization would try to keep us from deviating from it, whatever it might be. 
Importantly, these policies were believed to be independent. Monetary and fiscal policy used to stabilize the economy could change how fast the economy returns to the natural rate after a positive or negative shock, but the policy would have no impact at all on the natural rate itself. 
But what if this is wrong, as data from the Great Recession suggests? What if demand-side policies impact the natural rate after all? What does this mean for monetary and fiscal policy? It turns out to have important implications. ...

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:

PRICESa112915

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:

ISM112915

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:

WAGESe112915

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

WAGESa112915

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:

  WAGESc112915

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: 

WAGESb112915

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.

Sunday, November 29, 2015

Commodity Prices, Exchange Rates, and the Fed

Jim Hamilton's bottom line is worth noting:

Commodity prices and exchange rates: The dramatic decline in the prices of a number of commodities over the last 16 months must have a common factor. One variable that seems to be quite important is the exchange rate. ...
One would expect that when the dollar price of other countries’ currencies falls, so would the dollar price of internationally traded commodities. But it is a mistake to say that the exchange rate is the cause of the change in commodity prices. The reason is that exchange rates and commodity prices are jointly determined as the outcome of other forces. ...
For example,... the Great Recession in 2008-2009 ... meant falling demand for commodities. It was also associated with a flight to safety in capital markets, which showed up as a surge in the value of the dollar. It’s not the case that the strong dollar then was the cause of falling dollar prices of oil and copper. Instead, the Great Recession was itself the common cause behind movements in all three variables. ...
I had been giving a similar interpretation to the correlation since June 2014 ... – news about weakness in the world economy seemed to be a key reason for strength of the dollar..., and would also be a reason for declining commodity prices.
However, developments of the last three weeks call for a different explanation. The October 28 FOMC statement and subsequent statements by Fed officials have made clear that a hike in U.S. interest rates is coming December 16. An increase in U.S. interest rates relative to our trading partners is the primary reason that the dollar appreciated 4% (logarithmically) since October 16. Over that same period the dollar price of oil and copper each fell 16%. ...
I will offer the view, based on the market reaction so far, that if the Fed’s objective in raising rates is to lower U.S. inflation and GDP, it seems to have taken a significant step in that direction.

[There's quite a bit more analysis in the full post.]

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.

Wednesday, November 18, 2015

'A More Inflexible Fed Would Cause More Crises'

Adam Posen:

A More Inflexible Fed Would Cause More Crises: Having saved the US economy from a second Great Depression, the Federal Reserve has become a political scapegoat in the Congress for its own failures to secure the recovery. Rather than improving our tax code, investing in our future, or simply passing a budget that is little more than avoiding default, the House is prioritizing so-called “reform” of the Fed.  Just as throughout the global financial crisis and recovery, Congress is abdicating its economic responsibilities to the American people and attacking one of the few policy institutions that worked instead.
Both Republicans and Democrats have already curtailed the ability of the US central bank to respond proactively to any financial crisis... They have done this by restricting the Fed’s ability to lend to troubled institutions in a crisis—even though such lending is the very essence of why the central bank exists: ...
Now, there are new legislative efforts trying to force the Fed to follow strictly a narrow policy rule when setting monetary policy even in normal times—and report to Congress in a very literal-minded short-term way about any deviations from that rule. ...
More closely examined, any imposition of a simplistic rigid policy rule with mechanistic monitoring will only serve to politicize monetary policy to an unprecedented extent. And that, for good reason, is almost universally seen in the economics profession as something that would inevitably lead to ongoing higher inflation and bigger, more frequent boom-bust cycles. ...
Any effort to limit US monetary policy to an inflexible rule with politicized short-term oversight should be opposed..., doing so would bring severe harm to the workers, savers, and investors in the US economy.

Monday, November 16, 2015

'Inflation and Activity – Two Explorations and their Monetary Policy Implications'

Olivier Blanchard, Eugenio Cerutti, and Lawrence Summers (the results are preliminary):

Inflation and Activity – Two Explorations and their Monetary Policy Implications Olivier Blanchard, Eugenio Cerutti, and Lawrence Summers NBER Working Paper No. 21726 November 2015: Introduction: We explore two empirical issues triggered by the Great Financial Crisis. First, in most advanced countries, output remains far below the pre-recession trend, leading researchers to revisit the issue of hysteresis... Second, while inflation has decreased, it has decreased less than was anticipated (an outcome referred to as the “missing disinflation’’), leading researchers to revisit the relation between inflation and activity.
Clearly, if confirmed, either the presence of hysteresis or the deterioration of the relation between inflation and activity would have major implications for monetary policy and for stabilization policy more generally. ...
First, we revisit the hysteresis hypothesis, defined as the hypothesis that recessions may have permanent effects on the level of output relative to trend. ... We find that a high proportion of recessions, about two-thirds, are followed by lower output relative to the pre-recession trend even after the economy has recovered. Perhaps more surprisingly, in about one-half of those cases, the recession is followed not just by lower output, but by lower output growth relative to the pre-recession output trend. That is, as time passes following recessions, the gap between output and projected output on the basis of the pre-recession trend increases. ...
Turning to the Phillips curve relation, we ... find clear evidence that the effect of the unemployment gap on inflation has substantially decreased since the 1970s. Most of the decrease, however, took place before the early 1990s. Since then, the coefficient appears to have been stable, and, in most cases, significant...
Finally, in the last section, we explore the implications of our findings for monetary policy. The findings of the second section have opposite implications for monetary policy... To the extent that recessions are due to the perception or anticipation of lower underlying growth, this implies that estimates of potential output, based on the assumption of an unchanged underlying trend, may be too optimistic, and lead to too strong a policy response to movements in output. However, to the extent that recessions have hysteresis or super-hysteresis effects, then the cost of allowing downward movements in output in response to shifts in demand increases implies that a stronger response to output gaps is desirable.
The findings of the third section yield less dramatic conclusions. To the extent that the coefficient on the unemployment gap, while small, remains significant, the implication is that, within an inflation targeting framework, the interest rate rule should put more weight on the output gap relative to inflation. ...

Friday, November 13, 2015

'Where Fed's Critics Got it Wrong in GOP Debate'

Couldn't resist commenting on this:

Where Fed's critics got it wrong in GOP debate, by Mark Thoma: The Federal Reserve was instrumental in easing the impact of the Great Recession. As bad as the downturn was, it could have have been worse if central bankers hadn't aggressively used monetary policy to curb the severity of the crisis and help put the U.S. economy on the path to recovery.
So it has been disappointing to hear Republican presidential candidates bash the Fed in their debates and on the campaign trail. ...

Paul Krugman: Republicans’ Lust for Gold

Why have Republican candidates for president embraced hard money policies?:

Republicans’ Lust for Gold, by Paul Krugman, Commentary, NY Times: It’s not too hard to understand why everyone seeking the Republican presidential nomination is proposing huge tax cuts for the rich. Just follow the money...
But what we saw in Tuesday’s presidential debate was something relatively new on the policy front: an increasingly unified Republican demand for hard-money policies, even in a depressed economy. Ted Cruz demands a return to the gold standard. Jeb Bush ... is open to the idea. Marco Rubio wants the Fed to focus solely on price stability, and stop worrying about unemployment. Donald Trump and Ben Carson see a pro-Obama conspiracy behind the Federal Reserve’s low-interest rate policy.
And let’s not forget that Paul Ryan ... has spent years berating the Fed for policies that, he insisted, would “debase” the dollar and lead to high inflation. Oh, and he has flirted with Carson/Trump-style conspiracy theories, too...
As I said, this hard-money orthodoxy is relatively new. ... George W. Bush’s economists praised the “aggressive monetary policy”... And Mr. Bush appointed Ben Bernanke... But now it’s hard money all the way. ...
This turn wasn’t driven by experience. The new Republican monetary orthodoxy has already failed the reality test with flying colors... But years of predictive failure haven’t stopped the orthodoxy from tightening its grip on the party. What’s going on?
My main answer would be that the Friedman compromise — trash-talking government activism in general, but asserting that monetary policy is different — has proved politically unsustainable. You can’t, in the long run, keep telling your base that government bureaucrats are invariably incompetent, evil or both, then say that the Fed, which is ... basically a government agency run by bureaucrats, should be left free to print money as it sees fit. ...
The interesting question is what will happen to monetary policy if a Republican wins next year’s election. As best as I can tell, most economists believe that it’s all talk, that once in the White House someone like Mr. Rubio or even Mr. Cruz would return to Bush-style monetary pragmatism. Financial markets seem to believe the same. At any rate, there’s no sign in current asset prices that investors see a significant chance of the catastrophe that would follow a return to gold.
But I wouldn’t be so sure. True, a new president who looked at the evidence and listened to the experts wouldn’t go down that path. But evidence and expertise have a well-known liberal bias.

Thursday, November 12, 2015

'Being An Inflation Hawk Means Never Having To Say You’re Sorry'

I was considering saying a few words about the Binyamin Appelbaum interview with Richmond Fed president Jeff Lacker, but Paul Krugman beat me to it:

Being An Inflation Hawk Means Never Having To Say You’re Sorry: Jeffrey Lacker, president of the Richmond Fed, is worried about inflation unless the Fed tightens quickly, ignoring the worriers. Here’s what he just said:
If we hope to keep inflation in check, we cannot be paralyzed by patches of lingering weakness.
Oh, wait: That’s what he said six years ago. It is, however, pretty much indistinguishable from what he is saying now.
It seems to me that this is a bit of much-needed context.

I prefer the approach by Charles Evans, president of the Chicago Fed where the asymmetric risks of making a policy mistake (due to the asymmetric difficulties of recovering from a policy mistake) are at the forefront:

... So why do I lack confidence in our ability to achieve our 2 percent inflation target over the medium term? One reason is that there exist a number of important downside risks to the inflation outlook. Now I recognize that “medium term” is somewhat vague. To a central banker it can mean two to three years or three to four years. It is more a term of art than science.
So what are these inflation risks? With prospects of slower growth in China and other emerging market economies, low energy and import prices could exert downward pressure on inflation longer than most anticipate. That’s a risk. In addition, while many survey-based measures of long-term inflation expectations have been relatively stable in recent years, we shouldn’t take them as confirmation that our 2 percent target is assured. In fact, some survey measures of inflation expectations have ticked down in the past year and a half. Furthermore, measures of inflation compensation derived from financial markets have moved quite low in recent months. These could reflect either lower expectations of inflation or a heightened concern over the nature of the economic conditions that will be associated with low inflation. Adding to my unease is anecdotal evidence: I talk to a wide range of business contacts, and virtually none of them are mentioning rising inflationary or cost pressures. No one is planning for higher inflation. My contacts just don’t expect it.
How does this asymmetric assessment of risks to achieving the dual mandate goals influence my view of the most appropriate path for monetary policy over the next three years? It leads me to conclude that 1) a later liftoff and 2) a more gradual normalization of our monetary policy setting will best position the economy for the potential challenges ahead.
More specifically, before raising rates, I would like to have more confidence than I do today that inflation is indeed beginning to head higher. Given the current low level of core inflation, some evidence of true upward momentum in actual inflation is critical to this assessment. I believe that it could be well into next year...
Historically, central bankers have established their credibility by defending their inflation target from above — to fight off undesirably high inflation. Today, policy needs to defend our inflation target from below. This is necessary to validate our claim that we aim to achieve our 2 percent inflation target in a symmetric fashion. Failure to do so may weaken the credibility of this claim. The public could begin to mistakenly believe that 2 percent inflation is a ceiling — and not a symmetric target. As a result, expectations for average inflation could fall, lessening the upward pull on actual inflation and making it even more difficult for us to achieve our 2 percent target.
Another factor underlying my thinking about policy is a consideration of policy mistakes we could make. One possibility is that we begin to raise rates only to learn that we have misjudged the strength of the economy or the upward tilt in inflation. 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 large-scale asset purchases. I think our multiple rounds of asset purchases were effective, but they clearly are a second-best alternative to traditional policy. This scenario is not merely hypothetical. Just consider the recent challenges experienced in Europe and Japan. Policymakers tried to raise rates that were near or at their lower bounds; but faced with faltering demand, they were forced to reverse course and deploy nontraditional tools more aggressively than before. And we all know the subsequent difficulties Europe and Japan have had in rekindling growth and inflation. So I see substantial costs to premature policy normalization.
An alternative potential policy mistake would be that sometime during the gradual policy normalization process, inflation begins to rise too quickly. Well, we have the experience and the appropriate tools to deal with such an outcome. Given how slowly underlying inflation would likely move up from the current low levels, we probably could keep inflation in check with only moderate increases in interest rates relative to current forecasts. And given how gradual the projected rate increases are to start with, the concerns being voiced about the risks of rapid increases in policy rates if inflation were to pick up seem overblown to me. For example, we could raise the funds rate 100 basis points more than envisioned by the median participant’s projection in a year simply by increasing rates 25 basis points at every meeting instead of at every other meeting — that’s hardly a steep path of rate increases.
All told, I think the best policy is to take a very gradual approach to normalization. The outlook for economic growth and the health of the labor market continues to be good. But the outlook for inflation remains too low. A gradual path of normalization would balance both the various risks to my projections for the economy’s most likely path and the costs that would be involved in mitigating those risks. ...

Wednesday, November 11, 2015

'A Debate With Bernanke Over the Fed’s Easy Money Policies'

William Cohan ("a former senior mergers and acquisitions banker") argues with Ben Bernanke over the Fed's interest rate policy. These people (the one who isn't Bernanke in this case) are nuts:

A Debate With Bernanke Over the Fed’s Easy Money Policies: By the end of our recent conversation, Ben S. Bernanke ... and I had a gentleman’s bet. I believe the easy money policies he ... put in place while serving as Fed chairman starting in 2008 ... will lead inevitably to a near-term financial crisis; he thinks that idea is beyond ridiculous...
“The low rate of interest isn’t something that God gave us,” he explained. “It’s something that is a feature of the economy. There’s a lot of savings in the world looking for a relatively small number of good-return investments, and so the equilibrium real interest rate in the economy is very, very low.” ...
There is a target interest rate that is consistent with full employment. “And for most of the recovery,” he said, “that number was actually negative. Any economist can explain why ..., “policy did lower the interest rate ... but even after lowering them, they were still too high ... because of the zero lower bound. ...
He said the blame for the extended period of low interest rates belonged with Congress... “Go complain to Congress because the fiscal policy turned very contractionary, which meant the Fed had to bear the entire burden of creating a recovery,” he continued. “If fiscal policy had been more balanced, then we could’ve had the same recovery with higher interest rates. ...Congress said essentially, ‘The Fed will take care of it,’ then the Fed could use the only tool it had.” ...
But he will owe me a beer when the next financial crisis hits, sooner than anyone would like.

Related to the post before this one:

He said that it was “a red herring” that quantitative easing or the zero interest rate policy helped make the rich richer...
“It’s been going on for a long time,” he said. “It’s been increasing since the 1970s. ... The Fed’s effects on inequality are modest and temporary, and the fact that the Fed’s policies created jobs means that the absolute benefits for the working class are very substantial.”

Trickle Down, Starve the Beast, Supply-Side, and Sound Money Fantasies

From the WSJ editorial page:

...On the other hand, Mr. Cruz’s pitch for “sound money” that helps the middle class stands out in the GOP field and deserves more elaboration. It’s also notable that nearly all of the GOP candidates identify the Federal Reserve’s post-crisis monetary policy as a source of rising inequality that has favored the wealthy. This is a populist note that has the added benefit of being true. ...

Rising inequality for four decades can be blamed on the Fed's response to the financial crisis? Seriously? On taxes:

Then there’s tax policy, in which all of the candidates offered up reform plans that would be an improvement over the status quo.

But it has to be the right kind of tax policy (tax cuts or credits for the wealthy:

Marco Rubio was challenged on his child tax credit, which he would increase to $2,500 from $1,000. ... Mr. Rubio’s diagnosis of the changing economy has particular appeal to anxious voters. It’s too bad his tax credit is such an expensive political pander.

But of course cutting taxes on the wealthy is not an expensive pander, it will generate growth!!! Tax revenue will rise and the deficit will fall!!! The benefits will trickle down to the middle class (unless that evil Fed gets in the way decades later)!!! None of which has actually happened according to the empirical evidence. Republicans seem to have a talent for telling economic stories about how their policies will benefit the middle class all the while disguising the true intent of the legislation. So long as it can be true in theory (the confidence fairy comes to mind), the actual evidence doesn't matter.

James Pethokoukis says it's time to end the supply-side charade:

A last hurrah for Republican tax slashers: The Republican party’s raison d’être is cutting taxes. ... Republicans should pray for a new purpose. Their standing with middle-class voters is little improved from 2012. ... Their “supply-side” orthodoxy would merit much of the blame. Big tax cuts, particularly for the wealthiest, do not work in an age of high inequality and heavy debt. ...
Many of the party’s 2016 candidates seem to disagree that change is needed. ... Almost all have released economic plans built around “pro-growth” tax cuts costing trillions. ... But there are good reasons to view the next election as a last hurrah for Republican-style supply-side policy.
First, voters do not much care about taxes. ... Second, America’s fiscal situation makes deep tax cuts implausible. ... Third, tax cuts look like an answer desperately searching for a problem. Today’s top US marginal tax rate is 39.6 per cent...
There are signs candidates are starting to wriggle out of the supply-side straitjacket. At this week’s Republican presidential debate in Wisconsin, Marco Rubio said a larger tax credit for families was just as important as tax cuts for business. ... While 1980s-style supply-side doctrine still rules the Republican roost, it may not beyond November 2016.

There are also signs that these proposals, while perhaps helping candidates draw votes, have little chance of success in Congress. Republicans may need a new cover story -- a new "economic" argument or the middle class that obscures the true intent of the policy -- but it's not clear there's anything as magical as trickle down, starve the beast, supply-side, sound money fantasies that have served them so well.

Update: From Kevin Drum:

...Well, the Tax Foundation is a right-leaning outfit, so you have to figure they're going to give Republican plans a fair shake. And their distributional analysis of Rubio, Bush, Trump, and Cruz shows that their tax plans are all pretty similar: tiny gains for middle-income workers and huge gains for the top 1 percent. I've used the static analysis, since it's the most tethered to reality, but even if you use the magic dynamic estimates you get roughly the same result: the rich make out a whole lot better than the middle class.
That said, you really have to give Ted Cruz credit. When it comes to giving huge handouts to the rich, he's the true Republican leader.

Blog_gop_tax_plans_middle_class

Tuesday, November 10, 2015

Questions for Monetary Policy

James Bullard, president of the St. Louis Fed, says there are five questions for monetary policy:

The five questions

  • What are the chances of a hard landing in China?
  • Have U.S. financial market stress indicators worsened substantially?
  • Has the U.S. labor market returned to normal?
  • What will the headline inflation rate be once the effects of the oil price shock dissipate?
  •  Will the U.S. dollar continue to gain value against rival currencies?

I would add:

  • Will wage gains translate into inflation (or something along those lines)?

Anything else?

Monday, November 09, 2015

'Budgetary Sleight-of-Hand'

Congress enjoys a "political free lunch," budgetary illusions that make it appear that tax cuts, new spending -- whatever -- will not require cuts in other spending, an increase in taxes, or change the deficit. Ben Bernanke reveals the trickery behind the latest attempt at deception:

Budgetary sleight-of-hand: The House voted Thursday to pay for planned highway construction by drawing on the Federal Reserve’s capital. The idea of using Fed capital to pay for government spending, which comes up periodically, is a bad one, for several reasons. ... More substantively—and this is what I want to focus on in this post—“paying” for highway spending with Fed capital is not paying for it at all in any economically meaningful sense. Rather, this maneuver is a form of budgetary sleight-of-hand that would count funds that are already designated for the Treasury as “new” revenue.

To see why, first note that the Fed, as a side effect of its other activities, is already a major source of revenue for the federal government. The Fed earns interest on its portfolio of securities. This income, less the Fed’s operating expenses and interest paid on Fed liabilities, is sent to the Treasury on a pretty much continuous basis. These remittances are large: Over the past half dozen years the Fed has sent nearly half a trillion dollars to the Treasury, funds which directly reduce the government’s budget deficit. ... The Fed’s capital account provides a buffer that absorbs any losses on the Fed’s portfolio and allows the payments to the Treasury to be smoothed over time.

Unlike the Fed’s remittances, which are real resources whose availability reduces the burden on the taxpayer, drawing down the Fed’s capital provides no net new funding for the government. ...

Legislators who care about the integrity of the budgeting process should not support this budgetary sleight-of-hand.

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:

NFPb110815

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:

NFP110815

NFPa110815

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:

NFPc110815

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

NFPd110815

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:

GPDCONT110315

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

DOMPUR110315

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:

ISM110315

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):

NFP110315

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:

UNEMP110315

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:

PCE110315

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:

INFEXP1110315

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

INFEXP2110315

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.

'Yellen Signals a Fed Tilt Toward December Rate Increase'

Here we go again:

Yellen Signals a Fed Tilt Toward December Rate Increase, by Binyamin Appelbaum: Janet L. Yellen, the Federal Reserve chairwoman, told Congress on Wednesday that the Fed would consider raising its benchmark interest rate in December, citing an economy that she said was “performing well.”
“It could be appropriate” to act at the Fed’s final policy-making meeting of the year, Ms. Yellen told the House Financial Services Committee. She suggested that if growth continued apace, the Fed was inclined to start raising interest rates, although she added the cautionary note that “no decision has been made.” ...

Monday, November 02, 2015

'You Should Sit Down with Your Nobel Prize Winning Husband'

Ralph Nader thinks Janet Yellen needs to consult with her husband on monetary policy:

... But anyway, Nader's questionable and sometimes wholly inaccurate policy analysis—don’t get me started on his aside about student loans—isn't really the most remarkable part of the letter. Rather, it's when the man gets personal. He writes:

Chairwoman Yellen, I think you should sit down with your Nobel Prize winning husband, economist George Akerlof, who is known to be consumer-sensitive. Together, figure out what to do for tens of millions of Americans who, with more interest income, could stimulate the economy by spending toward the necessities of life.

Yes, Ralph Nader just told the most powerful woman in the world to take more tips from her husband. Akerlof is a brilliant man. I'm sure he has interesting thoughts on monetary policy that they discuss over dinner. But Yellen is Fed chair for a reason.

Anyway, just in case Yellen wants advice from another man in her life, Nader has a second suggestion...

Thursday, October 29, 2015

'The Tragedy of Ben Bernanke'

I would send you to Brad DeLong's piece on Ben Bernanke through a short excerpt if I could, but when I post just a few sentences from anything appearing at Project Syndicate they get mad at me. So I mostly just put their articles in links, if I link them at all. Not sure why they don't want me to send them traffic.

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. https://t.co/gN9Pcbhbua
— 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% pic.twitter.com/1NLZwHgivE
— 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.

Wednesday, October 28, 2015

''The 'Most Confused' Critique of the Fed This Year''

Larry Summers provides another "huh?" response to the WSJ editorial by Mike Spence and Kevin Warsh claiming "that overly easy monetary policy reduces business investment. Indeed, they blame the weakness of business investment during the current recovery on the Fed":

I just read the ‘most confused’ critique of the Fed this year: My friends Mike Spence and Kevin Warsh, writing in the Wall Street Journal on Wednesday, have produced what seems to me the single most confused analysis of U.S. monetary policy that I have read this year. Unless I am missing something -- which is certainly possible -- they make a variety of assertions that are usually exposed as fallacy in introductory economics classes. (Brad DeLong has expressed related views).
My problem is not with their policy conclusion, though I do not share their highly negative view of quantitative easing (QE). There are many harshly critical analyses of QE ... which are entirely coherent and consistent with the macroeconomics of the last 50 years. My differences are based on judgments about empirical magnitudes and relative risks -- not questions of basic logic. ...
Perhaps Spence and Warsh are on to something that I am missing. I'm curious whether they can point to any peer reviewed economic research, or indeed any statistical work, that backs up their views. I am certainly open to any new evidence or new argument after all that has happened in recent years that easy money reduces business investment. And there is plenty of room for debate over policy.
For now, though, I would put the Spence-Warsh doctrine that easy money reduces investment in a class of propositions backed by neither logic nor evidence.

No Rate Hike

No rate hike, but door still open for later this year, appears a bit less worried about international conditions, a bit more worried about conditions in the US:

Press Release, Release Date: October 28, 2015, For immediate release: Information received since the Federal Open Market Committee met in September suggests that economic activity has been expanding at a moderate pace. Household spending and business fixed investment have been increasing at solid rates in recent months, and the housing sector has improved further; however, net exports have been soft. The pace of job gains slowed and the unemployment rate held steady. Nonetheless, labor market indicators, on balance, show that underutilization of labor resources has diminished since early this year. Inflation has continued to run below the Committee's longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports. Market-based measures of inflation compensation moved slightly lower; survey-based measures of longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate. The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced but is monitoring global economic and financial developments. Inflation is anticipated to remain near its recent low level in the near term but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.

To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. 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. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee's holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.

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

Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams. Voting against the action was Jeffrey M. Lacker, who preferred to raise the target range for the federal funds rate by 25 basis points at this meeting.