Category Archive for: Monetary Policy [Return to Main]

Tuesday, April 18, 2017

Fed Watch: Autos Drag Down Industrial Production, Housing Solid

Tim Duy:

Autos Drag Down Industrial Production, Housing Solid, by Tim Duy: The Federal Reserve released March industrial production data today. Overall production was up 0.5% supported by a big jump in utilities. Despite the headline gains, it was something of a mixed message. First, the dispersion of weakness was the lowest since 2014:


It looks like with the rebound in energy prices and related production activity, the industrial side of the economy has turned a corner. On a softer note, manufacturing activity tumbled:


This was fairly disappointing considering the long run of solid growth beginning in the second half of last year. Slowing motor vehicle production took a bite out of the numbers. Specifically, autos, not trucks:


That chart makes it fairly clear that Americans prefer big vehicles to small ones. Overall motor vehicle sales are probably past their peak, and we can expect this source of weakness in industrial production to persist until sales settle into a new level. Note that motor vehicle output contributed 0.14 and 0.06 percentage points to overall growth in 2015 and 2016 respectively. That gives some sense of the magnitude of the opposite effect on growth this year - noticeable, but small.
Housing starts were below expectations, but February was revised upwards. Overall, a solid start to the year:


I don't see any reason to believe the uptrend in single family has broken, but multifamily is likely near cycle highs. For more on housing see Calculated Risk here and here.
Yesterday Federal Reserve Governor Stanley Fisher gave remarks on central bank communication. Of more immediate relevancy were his comments on balance sheet adjustment. Specifically, he doesn't see it as having a disruptive impact:
My tentative conclusion from market responses to the limited amount of discussion of the process of reducing the size of our balance sheet that has taken place so far is that we appear less likely to face major market disturbances now than we did in the case of the taper tantrum. But, of course, as we continue to discuss and eventually implement policies to reduce our balance sheet, we will have to continue to monitor market developments and expectations carefully.
Separately, Kansas City Federal Reserve President Esther George argued for continued rate hikes despite choppy data:
Overall, I am encouraged by the start of the normalization process and want to see it continue. Resisting the temptation to react to near-term fluctuations in the data will be necessary. Looking ahead, we should expect inflation to move up and down around 2 percent. A modest decline in inflation or an overshoot may not necessarily warrant the monetary policy normalization process to slow or accelerate. Such attempts at monetary fine-tuning can easily backfire, so a more forward looking view of inflation is needed.
And as part of that process she would like to see balance sheet reduction placed on auto pilot mode:
Balance sheet adjustments will need to be gradual and smooth, which is an approach that carries the least risk in terms of a strategy to normalize its size. Importantly, once the process begins, it should continue without reconsideration at each subsequent FOMC meeting. In other words, the process should be on autopilot and not necessarily vary with moderate movements in the economic data. To do otherwise would amount to using the balance sheet as an active tool of policy outside of periods of severe financial or economic stress, and would increase uncertainty rather than reduce it.
She also argues against deliberately overshooting the inflation rate. Her key reason is an often forgotten point. Not all goods and services have the same inflation rate, and a higher overall inflation rate may exacerbate inflation differences across the economy. Those differences would be expected to force a restructuring of the economy that could be costly. Her example is that housing costs may accelerate even faster if the Fed were to push for above target inflation:
Such concentration and persistently rising prices in one area suggests the economy is struggling to reallocate resources. For housing, it could reflect several factors such as tight lending standards faced by home builders and scarcity of skilled craftsmen needed to construct homes. I expect the market to eventually solve for, or at least adapt to, such factors. Using monetary policy however to compensate for them could easily end up hurting the population the policy is intended to help.
So count George as a "no" when it comes to any discussion of raising the Fed's inflation target.
Meanwhile, the Trump trade in bonds is reversing course; ten year yields are below 2.2 percent as I write. Also, odds of a Fed rate hike in June have fallen below 50 percent. Market participants are reasonably starting to think that the normalization process may take a bit longer than the Fed anticipates. It will be interesting to see if the Fed agrees. I expect that on average Fedspeak will stick with a fairly hawkish story as policymakers largely dismiss the choppy data of late. We will see if any of George's colleagues share her conviction that policy should not react to recent noise. I tend to think it is a small group, but I argued that Federal Reserve Chair Yellen sounded fairly complacent about the economy last week. Given that the Fed doesn't like to surprise, expect policymakers to speak out forcefully if they feel market participants just don't get it.

Monetary Policy Medicine: Large Effects from Small Doses?

An FRBSF Economic Letter from  ÒscarJordà, Moritz Schularick, and Alan M. Taylor:

Monetary Policy Medicine: Large Effects from Small Doses?: Making sure the economy operates at full employment without triggering inflation is tricky. Price stability can conflict with supporting a thriving economy. Choosing the right dose of monetary policy thus requires understanding how interest rates affect general economic activity and prices separately. Not surprisingly, few questions in economics have received as much attention.
Medical researchers consider randomized trials the gold standard in testing alternative treatments. In this Economic Letter, we adapt this approach to measure the efficacy of interest rates in achieving economic goals. Using historical economic data, we extend a traditional economic approach of controlling for domestic factors with a novel strategy that compares data from different external institutional arrangements, our randomized trials. Our findings suggest that interest rate effects may have been previously undermeasured. This has important implications now that some central banks are preparing for a sustained tightening of monetary policy after years of near-zero interest rates.
Randomized trials in practice
When the central bank raises interest rates, inflation and economic activity usually slow down—aggregate demand is being reined in. While researchers have come up with numerous theories to explain why this might happen, precisely measuring this tradeoff is considerably more difficult. Unlike the natural sciences, economics must rely on observational rather than experimental data.
Sinclair Lewis explained experimental data eloquently:
When a physician boasted of his success with this drug or that electric cabinet, Gottlieb always snorted, “Where was your control? How many cases did you have under identical conditions, and how many of them did not get the treatment?” – Arrowsmith, 1925
Central banks do not have the luxury of running such randomized experiments—they do not roll the dice when conducting monetary policy. Inflation and output reflect monetary policy as well as the factors that determined that policy to begin with. Just as umbrellas do not make it rain, if central banks cut interest rates when the economy slows it does not mean that accommodative monetary policy causes recessions.
Economists typically measure the effects of monetary policy with a variety of statistical methods that share a common thread: They control as much as possible for the information that the central bank might have used in choosing interest rates. Any remaining variation in interest rates is considered random. That is, interest rate adjustments that differ from predictions based on available information are like quasi-random experiments. We call this leftover variation in interest rates controlled variation.
The correlation of inflation and output over time with this quasi-random controlled variation in interest rates can provide a measure of the causal effect of monetary policy. For this empirical strategy to succeed, however, one has to make sure that no relevant information is left out, which is a tall order. Unobserved factors can make this type of measurement fraught, justifying the popularity of the randomized controlled trial in the sciences.
In experimental settings, random assignment into treated and control groups forms the basis of randomized controlled trials such as those described by Sinclair Lewis. While advanced economies have not randomly entered into various monetary and trade arrangements, some of these arrangements, like the euro zone, can provide a setting for an alternative type of monetary experiment. Economies that fix their exchange rate but allow capital to move freely across borders effectively relinquish control of domestic monetary policy. In such situations, monetary policy may not respond to domestic conditions and hence may produce quasi-random variation in interest rates that is less sensitive to unobserved factors.
We take advantage of this observation, extending the traditional approach of controlling for domestic factors with a novel strategy that explores what happens to economies that have historically pegged exchange rates while allowing unfettered capital movement. While the United States does not have a pegged exchange rate, we discuss direct implications for U.S. monetary policy later.
Quasi-random monetary experiments
Over the history of modern finance, advanced economies have managed exchange rate policies in a variety of ways. Sometimes they have allowed market forces to determine the exchange rate, generally called floating exchange rate regimes—or “floats” for brevity. At other times, countries we will call “pegs” have pegged the exchange rate to another currency. Examples of peg arrangements include the classical gold standard era that ended with World War I; the Bretton Woods era that began after World War II and ended around 1973; and, the European Monetary System in the 1970s up to when the euro was rolled out in 1999.
Two countries that peg the exchange rate and allow capital to move freely must have the same short-term safe interest rate. Otherwise an investor could borrow funds in one country for less than the return offered by the other without bearing any risk—a sure way to make unlimited profit. The absence of such risk-free arbitrage essentially robs local central banks of their autonomy by forcing interest rates to equalize across borders with those set by the center country’s central bank. The mechanism just described is often referred to as the trilemma in international finance (see, for example, Obstfeld, Shambaugh, and Taylor 2005).
In a recent paper (Jordà, Schularick, and Taylor 2017), we take advantage of this phenomenon to single out episodes in which interest rates fluctuated for reasons unrelated to the domestic outlook and direct decisions by the home-country central bank. We use such episodes to calculate how interest rates affect output and inflation. These episodes are our quasi-random monetary trials. We call variation in interest rates due to these episodes peg variation.
In particular, we rely on annual data for 17 advanced economies including the United States since 1870. In our sample, countries have moved in and out of exchange rate arrangements over time. We start by focusing on the sample for country-year pairs for pegs. We find that there is a difference between controls that use only observable information and those that add information on the variation in interest rates caused by the peg. This finding can improve our understanding of the effects of monetary policy.
Interest rates are a powerful lever
If using observables for the control is sufficient, the measured response of output and inflation to interest rates using either controlled variation or peg variation should be equivalent. If there are omitted factors, any differences will arise when using controlled variation. And in that case, variation due to the peg offers a more reliable guide. Just to be sure, we also include as controls information on GDP, inflation, and several other macroeconomic conditions.
Figures 1 and 2 suggest there is cause for concern when focusing on measures based on controlled-variation. Using post-World War II data, Figure 1 shows the response of inflation-adjusted GDP per capita in response to a 1 percentage point increase in short-term interest rates in year 0 calculated two different ways. The green line uses the traditional controlled variation approach, while the red line uses the peg variation approach surrounded by a gray 90% confidence band. There is a stark difference between the two approaches. In the first case, interest rates barely cause a ripple, whereas in the second, real GDP per capita is about 2% lower in year 4 than it was at the start.

Figure 1
Cumulative response of real GDP per capita


Note: Response to 1 percentage point increase in interest rates in year 0; gray shading shows 90% confidence band.

A similar picture emerges in Figure 2. The measured response of prices using controlled variation in interest rates is muted—prices are about 0.5% lower by year 4 relative to year 0. The same response calculated with peg variation is estimated to be nearly 2%. In other words, assuming a constant rate of price decline, inflation is about 0.4 percentage point per year lower.

Figure 2
Cumulative response of consumer price index level


Note: Response to 1 percentage point increase in interest rates in year 0; gray shading shows 90% confidence band.
The different paths in the figures suggest that the traditional controlled variation approach undermeasures the macroeconomic impact of changes in interest rates. One possible explanation is that interest rates follow different paths after year 0 under each type of measurement approach.
Figure 3 shows that interest rate paths clearly differ somewhat between the two approaches. Measures based on peg variation indicate that interest rates go up further in year 1 but then come down very quickly. The path using controlled variation is more persistent and would tend to have a longer-lasting effect on output and prices, which clearly contradicts the actual pattern seen in Figures 1 and 2.

Figure 3
Cumulative response of short-term interest rates


Note: Response to 1 percentage point increase in interest rates in year 0; gray shading shows 90% confidence band.
Checking the reliability of the results
What else could explain the stark differences in the figures? The first thing to check is whether there are differences between peg and float economies that would make their responses to interest rates fundamentally different. Although measures of peg variation are unavailable for floats, Jordà, Schularick, and Taylor (2017) find that controlled variation measures for both pegs and floats are, in fact, very similar, so the explanation must lie elsewhere.
Peg variation may reflect spillover effects from trade channels or other mechanisms that distort measures of the response to interest rates. Jordà, Schularick, and Taylor (2017) find that, if anything, spillover effects would tend to increase the differences.
Finally, our estimates are very similar to those reported in other research, including Romer and Romer (2004) and Cloyne and Hürtgen (2016). This line of research tries to avoid the pitfalls of the controlled variation approach using staff forecast errors from the Federal Reserve and the Bank of England, respectively, to identify exogenous changes in policy rates.
We do not have a definitive measure of how interest rates affect economic activity and inflation. However, along with other recent research, we find that interest rates have stronger effects on the macroeconomy than previously understood. Although the monetary experiments we use to calculate the response to interest rate changes rely on countries that peg—by contrast, the United States allows its exchange rate to freely float—there are good reasons to think that the U.S. economy responds to interest rate changes no differently. Our sample is made up of advanced economies that have institutional characteristics similar to the United States and whose economies respond much the same way as ours when using controlled variation. Without delving into the timing or path of monetary strategy more deeply, our research suggests that even a modest tightening cycle can have a substantial restraining effect on both inflation and economic activity.
Cloyne, James S., and Patrick Hürtgen. 2016. “The Macroeconomic Effects of Monetary Policy: A New Measure for the United Kingdom.” American Economic Journal: Macroeconomics 8(4), pp. 75–102.
Jordà, Òscar, Moritz Schularick, and Alan M. Taylor. 2017. “Large and State-Dependent Effects of Quasi-Random Monetary Experiments.” FRB San Francisco Working Paper 2017-02.
Lewis, Sinclair. 1925. Arrowsmith. New York: Harcourt, Brace & Company.
Obstfeld, Maurice, Jay C. Shambaugh, and Alan M. Taylor. 2005. “The Trilemma in History: Tradeoffs Among Exchange Rates, Monetary Policies, and Capital Mobility.” Review of Economics and Statistics 87(3), pp. 423–438.
Romer, Christina D., and David H. Romer. 2004. “A New Measure of Monetary Shocks: Derivation and Implications.” American Economic Review 94(4), pp. 1,055–1,084.
Opinions expressed in FRBSF Economic Letter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System.

Monday, April 17, 2017

Fed Watch: Fed Looking Forward to the Second Quarter

Tim Duy:

Fed Looking Forward to the Second Quarter, by Tim Duy: First quarter growth is likely to fall flat - at least that is the signal from numerous forecasters and the Atlanta Fed. But what does it mean for Fed policy? Probably not much for now. It will leave policymakers a little cautious as we head toward the June FOMC meeting (May seems most likely a off the table for policy action). But mostly the Fed will be watching incoming data from the end of the first quarter and the beginning of the second. If the data flow picks up over the next couple of months, they will likely move forward with a June hike. They seem to be in a "what, me worry?" frame of mind.
Retail sales stumbled in March, following up on a revised decline in February as well. Motor vehicle sales are partly to blame; we have likely seen the peak in car sales for this cycle and are settling into a lower pace of activity going forward. Lower gas prices and sluggish sales at building supply stores contributed to the fall as well. Stripping out the more volatile components, however, suggests a bit more stability in sales than suggested by the headline numbers:


March inflation came in lower than expected, with a surprise hit to core:


Ocular econometrics suggests the March print is something of an outlier - the first monthly decrease since 2010. A big 7 percent decline in cellular service prices played a roll, as did falling used car and apparel prices. While I anticipate a rebound in April, this kind of print will help keep the Fed's inflation forecast intact thus preventing them from stepping up the pace of tightening. Watch how this plays through to core-PCE inflation. As a reminder, that was running hot in the first two months of the year:


In another sign that the Fed's inflation metrics will remain contained, the PPI for health services remained subdued in March:


The New York Federal Reserve issued its survey of inflation expectations for February. Interesting split between the high and low numeracy groups:


The low numeracy group tends to be more volatile, so I anticipate it will revert back in the next month.
How will any of this matter for the Fed? First, remember that the Fed started dismissing first quarter data at the March FOMC meeting. From the minutes:
Participants generally saw the incoming economic information as consistent, overall, with their expectations and indicated that their views about the economic outlook had changed little since the January-February FOMC meeting. Al­though GDP appeared to be expanding relatively slowly in the current quarter, that development seemed primarily to reflect temporary factors, possibly including residual seasonality.
Hence I don't think they will be surprised by a weak GDP number; they will be surprised if that weakness looks to be carrying forward into the second quarter.
Second, I think the same goes for inflation. For the moment, I think that the decline in unemployment to 4.5% will weigh more heavily on their decisions than a weak inflation number. Still, I believe that if inflation looks to be tracking below their forecasts, they will eventually reduce their estimate of the natural rate. Just not right away.
Third, I think this take on Federal Reserve Chair Janet Yellen's talk last week from Marc Chandler is accurate:
We had detected a shift in the Fed’s stance that we characterized as looking for data to confirm the recovery to now looking for opportunities to normalize conditions. Yellen sees similarly. She said the Fed has shifted from “a post-crisis exercise of healing” to now trying to sustain the economic progress.
The Fed is not living in the crisis anymore. Policymakers no longer worry about trying to boost the pace of activity. The economy is, by their estimates, near full employment with growth is near potential growth. In this framework, a normal economy demands a more normal monetary policy. Policymakers are thinking that the expansion will be eight years old this summer with a good chance that this could turn into the longest running US economic expansion on record. They generally believe that preemptive but gradual rate hikes offer the best chance of expanding the expansion to ten years and beyond. Hence I tend to think their bias is to continue along the current policy path, which suggests they will continue to sound hawkish relative to what recent data would suggest.
Bottom Line: Fed likely to dismiss recent data as unrepresentative of underlying economic trends.

Thursday, April 13, 2017

The Zero Lower Bound on Interest Rates: How Should the Fed Respond?

Ben Bernanke:

...the Fed and other central banks cannot ignore the risks created by a low level of “normal” interest rates, which in turn limit the scope for interest-rate cuts. A wide-ranging discussion of alternative policy approaches would thus be welcome. Although raising the inflation target is one of the options that should be considered, that approach has significant drawbacks. Fortunately, there are promising policy options that may be able to mitigate the effects of the zero lower bound on interest rates without forcing the public to accept a permanently higher rate of inflation. Two such options (which are related, and could be combined) are price-level targeting and a “make-up” approach, under which the central bank commits to compensating for “missing” monetary ease after the economy leaves the zero lower bound.

Much more here: The zero lower bound on interest rates: How should the Fed respond? (link fixed).

Wednesday, April 12, 2017

How Big a Problem is the Zero Lower Bound on Interest Rates?

Ben Bernanke:

How big a problem is the zero lower bound on interest rates?: If inflation is too low or unemployment too high, the Fed normally responds by pushing down short-term interest rates to boost spending. However, the scope for rate cuts is  limited by the fact that interest rates cannot fall (much) below zero, as people always have the option of holding cash, which pays zero interest, rather than negative-yielding assets.[1] When short-term interest rates reach zero, further monetary easing becomes difficult and may require unconventional monetary policy, such as large-scale asset purchases (quantitative easing).
Before 2008, most economists viewed this zero lower bound (ZLB) on short-term interest rates as unlikely to be relevant very often and thus not a serious constraint on monetary policy. (Japan had been dealing with the ZLB for several decades but was seen as a special case.) However, in 2008 the Fed responded to the worsening economic crisis by cutting its policy rate nearly to zero, where it remained until late 2015. Although the Fed was able to further ease monetary policy after 2008 through unconventional methods, the ZLB constraint greatly complicated the Fed’s task.
How big a problem is the ZLB likely to be in the future? ...

Tuesday, April 11, 2017

Fed Watch: Solid Employment Report

Tim Duy:

Solid Employment Report, by Tim Duy: Labor markets were generally solid in March, with nothing by itself to dissuade the Fed from its current path. We should be watching for the Fed reaction to the decline in the unemployment rate, assuming it persists in the coming months. Could be dovish if the Fed lowers its estimate of the natural rate. Could be hawkish if they see a higher risk of undershooting the natural rate.
Nonfarm payroll growth slowed to 98k:


While this was below expectations, it wasn't a surprise. My interpretation is that most analysts expected downside risk to the estimates based on cold weather in March. No reason to think the basic underlying trend of solid but slowing declining job growth.
The unemployment rate dipped to a cycle low of 4.5% and stands below the Federal Reserve's longer run unemployment projection:


This will raise some eyebrows at the Federal Reserve. The median FOMC participant forecast 4.5% for December. So we are a little ahead of schedule on that. Does this mean the economy is poised to overheat? The wage numbers do not support that hypothesis:


Wage growth flattened out in recent months, suggesting the economy is not yet in danger of overheating. Policymakers will be closely watching this dynamic and, more importantly, the path of inflation, between now and the next meeting. If inflation looks to be overshooting the forecast, the Fed may conclude that weak wage growth reflects low productivity rather than slack in the economy. That would be hawkish. Keep an eye on this space.
While the headline jobs growth numbers disappointed, note that the forward looking indicator temporary help payrolls remains on an uptrend:


In some ways this feels like 1995-96, with a temporary slowdown followed by a sustained period of solid growth.
The back-to-back declines in retail trade reflected the ongoing stress in that sector:


Note too slowing wage growth in retail trade:


As of the last JOLTS report, the dynamics in retail trade employment are not driven by layoffs, but by a hiring slowdown:


Looks like both quits and hirings rolled over in recent months. What is interesting is that the due to the labor churn in the sector, a slowdown in hiring alone can have significant impact on the net job growth without relying on mass layoffs - at least not yet. Notice that discharges and layoffs in the sector are down from 2015. Still, the decline in the level of quits reflects employee worries about the state of the industry - they don't see it quite as easy to find a new job as they did in 2015.
One data point that doesn't seem to fit with the story of an industry in decline is the level of job openings:


If the sector is experiencing a truly apocalyptic event, we would expect job openings to roll over. How will the Fed view this story? Most likely as industry specific and not indicative of the broader economy but they will attempting to gauge the resulting slack, if any, in labor markets.
Bottom Line: Employment report was in line with (diminished) expectations. Most important for monetary policy was the decline in the unemployment rate. But absent more data, the exact implication could be either dovish or hawkish. Until the fog on that issues clears, expect the Fed to stick to its story: More tightening is coming, but at a gradual pace.

Monday, April 10, 2017

The Fed, the Reality of Tax Cuts Reality, and Donald Trump

I have a new column:

The Fed, the Reality of Tax Cuts Reality, and Donald Trump: For many years, Republicans argued that tax cuts for the wealthy pay for themselves. Cutting taxes on the wealthy, according to Republicans, allows them to keep a larger share of anything new they create and this leads to new economic activity and new innovation – so much that the resulting increase in economic growth and tax revenue fully offsets the budgetary effects of the tax cuts. Everyone is better off as income “trickled down” from the top.
What actually happened is that the tax cuts had very little, if any, impact on economic growth. Deficits went up, and somehow income never trickled down – if anything, it trickled up. Today, Republicans are less likely to argue that tax cuts pay for themselves, though you still hear it, but they still insist tax cuts for the wealthy magically increase economic growth and offset much of the revenue loss.
But even in the very unlikely case that Trump’s proposed tax cuts are successful (beyond increasing the income of the wealthy which many argue is the true goal), the economic growth rates Trump has promised are unlikely to be attained. ...

Friday, April 07, 2017

Fed Watch: Fed Likely To Discount Weakness in March Employment Report

Tim Duy:

Fed Likely To Discount Weakness in March Employment Report, Tim Duy: It seems that we are conditioned for a disappointing jobs report tomorrow. Although the ADP report came in strong, we have mixed signals from the employment components of the ISM reports, with the employment index up in manufacturing but down in the much bigger service sector. In addition, weather may be a factor - did warm weather goose the January and February numbers and now we will see payback due to a cold March? I expect that the Fed will be expecting the latter. The minutes suggest they are already primed for weaker first quarter numbers to begin with:
Participants generally saw the incoming economic information as consistent, overall, with their expectations and indicated that their views about the economic outlook had changed little since the January-February FOMC meeting. Al­though GDP appeared to be expanding relatively slowly in the current quarter, that development seemed primarily to reflect temporary factors, possibly including residual seasonality.
They would probably write off a weak headline payrolls numbers as a reflection of just another temporary factor. Of course, that also means they will embrace a solid number. It's kind of a heads they win, tails you lose situation for the Fed.
Consensus is looking for 175k on the payrolls in a range of 125k to 202k. This sounds reasonable; my estimate is 190k within a wider range of 106k to 275k:


Variance on these estimates, however, is notoriously high. My inclination is to expect the actual print to be more likely below and above 190k.
Assuming a weak read of payrolls that is written off to weather, the rest of the report is more important. The Fed maintains a laser sharp focus on signs unemployment is significantly undershooting the natural rate. Consensus expects the rate to hold at 4.7%. A drop would raise eyebrows at the Fed. An increase in the participation rate, however, would be welcome news that they can maintain a gradual pace of tightening. And wages of course will help guide them as they assess their distance from the natural rate.
Bottom Line: Unless the report is a complete disaster, I would expect the Fed is poised to look though any weakness. But that means a strong report will grab their attention.

Thursday, April 06, 2017

Fed Watch: Lots To Chew On In The FOMC Minutes

Tim Duy:

Lots To Chew On In The FOMC Minutes, by Tim Duy: The minutes of the March FOMC meeting confirmed that the Fed remains poised to tighten policy further, first via raising the federal funds rate followed by action to reduce the balance sheet later in the year. It appears most likely that the Fed will see the latter as a substitute for the former. That means rate hikes would perhaps be on hold during the start of 2018 as the Fed assesses the efficacy of its actions. To be sure, however, the pace and mix of tightening remain data dependent. With the Fed in general agreement that the economy is near full employment, an uptick in either the pace of growth or inflation concerns will prompt the Fed begin murmuring about an accelerated the pace of tightening.
The Fed tackled balance sheet strategy early in the meeting. On timing, the policymakers thought thought it soon be upon us:
Provided that the economy continued to perform about as expected, most participants anticipated that gradual increases in the federal funds rate would continue and judged that a change to the Committee's reinvestment policy would likely be appropriate later this year.
Now place that prediction in the context of this discussion from the committee action portion of the minutes:
Members generally noted that the increase in the target range did not reflect changes in their assessments of the economic outlook or the appropriate path of the federal funds rate, adding that the increase was consistent with the gradual pace of removal of accommodation that was anticipated in December, when the Committee last raised the target range.
The median rate projection in March held at a total of three hikes for 2017. The Fed believes that the March rate hike was consistent with the gradual pace of policy removal as anticipated in December. Assume then that the economy continues to stay the course, holding generally in line with the Fed's forecasts. Suppose that means the current pace of tightening holds as well.
A continuation of the current pace of tightening - one action per quarter - would put rate hikes in June and September. At that point, the target range in 1.25-1.5%. That is roughly halfway to the currently anticipated neutral rate. Then the normalization of rate policy would be well underway, and then, in December, the Fed switches gears to balance sheet reduction. Later this year, as stated in the minutes.
That suggests that "gradual" means policy action once a quarter. (Remember the Fed began 2016 thinking four hikes? I think once a quarter seems about right to them.) If so, and they still intend a total of three rates hikes and balance sheet action for 2018, it implies they think, reasonably, that action on balance sheet reduction is a substitute for rate hikes. And, furthermore, that the balance sheet forecast is implicitly built into the median rate forecast. If not for having to deal with the balance sheet, I suspect the median forecast for 2017 would be 4 rate hikes.
That gets you through 2017. What about 2018? They probably have in mind that the phasing out of reinvestments could take six months, though this has not yet been decided. Back to the minutes:
An approach that phased out reinvestments was seen as reducing the risks of triggering financial market volatility or of potentially sending misleading signals about the Committee's policy intentions while only modestly slowing reductions in the Committee's securities holdings. An approach that ended reinvestments all at once, however, was generally viewed as easier to communicate while allowing for somewhat swifter normalization of the size of the balance sheet.
The Fed could go cold turkey on reinvestments, option 2, but I suspect will choose to ease into balance sheet reduction, option 1. Less chance of disrupting financial markets. That would mean policy action at the second meeting of 2018 to get reinvestment strategy on its final path, followed up quarterly rate hikes after that.
Assuming this is the schedule they have in mind, policymakers expect to tighten policy once per quarter for the next two years, trading off between rate hikes and balance sheet policy. The risk, however is that balance sheet reduction takes longer than expected, or it more disruptive than expected, thus reducing the scope for rate hikes in 2018. Time will tell on that one.
The Fed, however, could step up the pace of action. On the mandates:
Nearly all participants judged that the U.S. economy was operating at or near maximum employment. In contrast, participants held different views regarding prospects for the attainment of the Committee's inflation goal.
Inflation continues to be the sticking point. If inflationary pressures were more visible, the Fed would be acting more aggressively. Watch this space, and core-PCE inflation in particular. It picked up in January and February. If that continues into March and April, the Fed will worry that they have pushed "gradual" as far as it will go. Watching employment, however, is a bit more tricky. For now, I expect the Fed to get nervous of a significant undershoot if the unemployment rate dips much further. Persistent low inflation, however, could yield a decrease in the Fed's estimate of the natural rate of unemployment.
Finally, note this:
In their discussion of recent developments in financial markets, participants noted that financial conditions remained accommodative despite the rise in longer-term interest rates in recent months and continued to support the expansion of economic activity. Many participants discussed the implications of the rise in equity prices over the past few months, with several of them citing it as contributing to an easing of financial conditions. A few participants attributed the recent equity price appreciation to expectations for corporate tax cuts or to increased risk tolerance among investors rather than to expectations of stronger economic growth. Some participants viewed equity prices as quite high relative to standard valuation measures. It was observed that prices of other risk assets, such as emerging market stocks, high-yield corporate bonds, and commercial real estate, had also risen significantly in recent months. In contrast, prices of farmland reportedly had edged lower, in part because low commodity prices continued to weigh on farm income. Still, farmland valuations were said to remain quite high as gauged by standard benchmarks such as rent-to-price ratios.
Fed officials aren't growing nervous about just equities. They are seeing high prices across a wide range of risky assets. If it was just one asset class, they might conclude that it doesn't pose systemic risk for the US economy. Or they might conclude that macro prudential policies were sufficient to maintain financial stability. But a wide range of assets might require a more blunt tool - like higher rates. Another space to watch. Where this space gets messy is the tendency of equity prices to remain high even as the Fed tightens - a pattern which may induce the Fed to tighten much more aggressively than they should.
Bottom Line: The Fed clearly anticipates more tightening, likely at a pace of one action per quarter between interest rates and balance sheet. My interpretation of the minutes is that with the economy near full employment and assuming asset prices stay high, it wouldn't take much movement on the labor market or inflation expectations to make Fed officials sufficiently nervous that you begin to hear more about stepping up the pace of tightening.

Wednesday, April 05, 2017

How Do People Find Jobs?

R. Jason Faberman, Andreas I. Mueller, Ayşegül Şahin, Rachel Schuh, and Giorgio Topa at the NY Fed's Liberty Street Economics:

How Do People Find Jobs?: Most people find themselves looking for work at some point in their adult lives. But what brings employers and job seekers together? And does searching for a new job while unemployed lead to different outcomes
 than searching while employed? Little is known about the job search process for unemployed workers. Even less is known about the search process and outcomes for currently employed workers—so‑called “on‑the‑job” search. This Liberty Street Economics post aims to shed light on these questions and to draw some conclusions for our understanding of labor market dynamics more generally.
The New York Fed has been fielding a labor market supplement to its Survey of Consumer Expectations every October since 2013. The supplement focuses on the job search process for all individuals, regardless of their employment status. The questions cover search behavior (for instance, what methods respondents used to look for jobs, the time spent searching for work, the number and type of contacts with employers, and job interviews), as well as the nature, number, and characteristics of any job offers received. Pooling together three successive waves of the survey supplement yields data on about 2,300 employed workers, 165 unemployed workers, and 430 respondents who are classified as being out of the labor force, all between eighteen and sixty-four years of age. Labor force status is defined using the Bureau of Labor Statistics definition: Specifically, individuals are classified as unemployed if they are not currently employed, actively looked for work in the last four weeks, and are available to start work within the next seven days. Workers on temporary layoff are also classified as unemployed.
How Do People Look for Jobs?
The table below describes the “extensive margin” of job search, by labor force status: That is, how many people actively searched for work in the last four weeks, regardless of how much effort they put into it. We employ various definitions to measure active search. The first definition is based on whether respondents report having used at least one job search method out of a comprehensive list of possible methods, which includes applying for jobs, looking at job postings online or elsewhere, sending out resumes, and contacting employers, employment agencies, former coworkers, or other professional contacts. The second definition focuses on those who applied to at least one job posting. The final definition is a measure based on whether respondents spent any time searching for jobs in the last seven days.

How Do People Find Jobs?

 The most surprising finding is that search is common among employed workers. Depending on the specific measure used, roughly one in five or one in four employed
 workers actively looked for work during the four weeks preceding the survey. Almost all of the unemployed actively searched—a predictable finding, given the definition of unemployment. (The only exceptions come from those on temporary layoff.) A small fraction of respondents who were not in the labor force also searched. These are respondents who searched but were not available to start work in the next seven days and were therefore classified as out of the labor force.
Let us now turn to the “intensive margin” of job search: Conditional on having actively searched, how intensively did people in our survey look for jobs? Here we employ two measures: one is a measure of hours spent searching in the last seven days; the other is the number of job applications sent out (either online or through other means) in the last four weeks. We also further distinguish the employed by their “extensive margin”—that is, by whether or not they are actively looking for work. The table below reports the results. The main finding is that unemployed job seekers search harder than the employed. On average, the unemployed spend 8.4 hours per week searching, compared with 1.2 hours for the employed, and send out 8.1 applications per month, compared with 1.2 for the employed. If we focus on employed workers actively looking for work, we find that their search effort is still only about half that of the unemployed.

How Do People Find Jobs?

 What Works?
So far, we have focused on what people do to look for work. But how effective is their search? To answer this question, we have to look at the outcomes of their efforts. Here we consider two measures, both computed over the preceding four weeks: the number of employers who contacted our respondents about a job opening, and the number of actual job offers received. We can summarize the results as follows (see the table below): First, even though unemployed workers search about seven times as hard as the employed (as illustrated in the table just above), they only generate about twice the number of offers. Thus, searching while unemployed is much less effective in generating offers than searching while on the job. Second, employed workers actively looking for work receive the greatest number of employer contacts and job offers. So, again, searching while employed seems to have the highest return in terms of generating new offers. Third, even those employed workers who are not looking for new work receive a substantial number of employer contacts and offers. This finding illustrates the importance of informal contacts and recruiting. Informal contacts can include networking at industry events; conversations with friends, present or former coworkers, or business associates; and unsolicited contacts by employers, recruiters, or headhunters.

How Do People Find Jobs?

 These results are summarized in a slightly different way in the table below. Unemployed workers make up about 7 percent of our sample. They send out 40 percent of the total applications in the sample, but receive only about 16 percent of the total offers. By comparison, those employed and actively looking for work make up about 20 percent of the sample but receive almost half of all offers. Further, the employed not looking for work receive about one‑fourth of all the offers in our sample—more than the unemployed! They also receive more than half of all the unsolicited offers in our sample. These findings again point to the importance of informal contacts and recruiting in labor market churning.

How Do People Find Jobs?

We have found that “on‑the‑job” search is common among employed workers, and that the job search process is more effective for currently employed workers than for the unemployed. In the paper cited as the source of our table estimates, we also show that offers received by employed workers are better than those received by the unemployed, both in terms of the wage associated with them and in terms of their nonwage benefits. This is true even after controlling for detailed worker characteristics and prior work history.
What are the broader implications of these findings for our understanding of labor market dynamics? We know that job-to-job transitions are an important component of new hires, and an important driver of wage growth in the economy. Voluntary quits (typically followed by a transition to a new job) have been described by Chair Janet Yellen as an important marker of the health of the labor market. By highlighting the importance and pervasiveness of on‑the‑job search, we have provided some evidence on the search mechanisms that underlie voluntary quits and job‑to‑job transitions. By tracking these search processes over time we can gain further insights into the likely evolution of these important labor market markers going forward.
Disclaimer The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

Tuesday, April 04, 2017

Departing Thoughts

Federal Reserve Governor Daniel K. Tarullo: 

Departing Thoughts: Tomorrow is my last day at the Federal Reserve. So in this, my final official speech, it seems appropriate to offer a broad perspective on how financial regulation changed after the crisis. In a moment, I shall offer a few thoughts along these lines. Then I am going to address in some detail the capital requirements we have put in place, including our stress testing program. Eight years at the Federal Reserve has only reinforced my belief that strong capital requirements are central to a safe and stable financial system. It is important for the public to understand why this is so, especially at a moment when there is so much talk of changes to financial regulation. ...

Monday, March 27, 2017

Markets Are Witnessing a Yellen Fed at Its Humblest

Tim Duy at Bloomberg:

Markets Are Witnessing a Yellen Fed at Its Humblest: It finally looks like when Federal Reserve officials say markets can expect multiple interest-rate increases this year, they really mean it. Even noted dove Chicago Federal Reserve President Charles Evans believes that another two hikes in 2017 is possible following last week's boost. Going one further, Philadelphia Federal Reserve President Patrick Harker left open the possibility of more than three total this year.
And yet the Fed has set the stage to be deep into the policy normalization process by the end of the year despite an inflation forecast that not only never cracks 2 percent but has repeatedly fallen short of its mark for years. The threat of inflation, not inflation itself, is what motivates the Fed after deciding long ago in favor of preemptive policy action to stay ahead of the curve. ...

Thursday, March 23, 2017

The Natural Rate of Interest: Estimates for the Euro Area

From Adrian Penalver at the Bank of France's Eco Notepad:

Billet_11_-_figure_2_-_eng[More at The natural rate of interest: estimates for the euro area.]

Wednesday, March 22, 2017

Fed Watch: Is Bank Lending A Concern?

Tim Duy:

Is Bank Lending A Concern?, by Tim Duy: I have seen some angst recently over declining growth in commercial bank lending. See, for example, the Wall Street Journal:
Bank loans across all categories are increasing 4.6% annually, the slowest pace since 2014, according to weekly Fed lending data from March 1. The trend is particularly marked in business loans, which are increasing 3.9% annually, a rate that is a nearly six-year low.
A number of factors are at play, including rising interest rates; bankers also said some business clients put borrowing on hold before the U.S. election and aren't confident enough to jump back in.
The slowdown is noteworthy because it is occurring when many metrics show the U.S. economy strengthening.
Looking at the weekly data, there does on the surface look to be some reason for concern:


These low rates of growth are rarely seen outside of recessions. Still, optical econometrics suggests this is more of a lagging than leading indicator. Moreover, we have another indicator that also exhibited behavior only seen in recessions. Spot the odd man out:


Recall a year ago when weak industrial production numbers raised recession concerns that proved unfounded. We could be seeing something similar in bank lending. Consider that industrial production might be a leading indicator for bank loans:


Here I focus on the post-1984 period (the Great Moderation). Optical econometrics again suggests to me that lending lags industrial production. To quantify that a bit more, I converted the data to log differences (multiplied by 100), and ran it through a 13 lag vector autoregression. Granger causality tests (the f-tests here) indicate that loans (DLOANS) do not cause (or are predictive of) industrial production (DIND):


Impulse response functions (in this case, the responses are converted to impacts on the levels of the variables) illustrate the dynamics of the system:


The impact of a shock to industrial production on commercial lending (lower left chart) is delayed six months and then builds gradually over the next 18 months. The impact of a shock to lending on industrial production (upper right chart) is negligible. Ordering of the variables does not affect these results. If I use the full sample (data begin 1947:1), both variables Granger cause each other, but the impact of loans on industrial production in the short-run is minimal and dies out in the long-run:


Bottom Line: The fall in commercial lending growth looks more consistent with a lagged impact from the industrial slowdown that weighed on the US economy last year than with a warning about future activity. Something to keep an eye on, to be sure, but if past history is a guide, it is more likely than not that lending will pick up over the next year.

Friday, March 17, 2017

FRBSF: The Current Economy and the Outlook

From the FRBSF:

FRBSF FedViews: Fernanda Nechio, research advisor at the Federal Reserve Bank of San Francisco, stated her views on the current economy and the outlook as of March 9, 2017.
Real GDP grew at an annual pace of 1.9% in the fourth quarter of 2016, consistent with an ongoing moderate expansion. Going forward, we expect GDP growth to continue at a similar rate, between 1½% and 2% over the next couple of years.

Continued moderate economic growth

Recent employment gains remain solid. Nonfarm payroll employment in January rose by 227,000 jobs, partly due to a mild winter which boosted construction. Over the past six months, payroll gains have averaged around 190,000 jobs per month.

Recent employment growth is robust

The labor market remains near its sustainable, full employment level. January’s unemployment rate of 4.8% is close to 5%, our estimate of the natural rate of unemployment. If economic growth continues at its projected pace and monetary policy continues to normalize over the next 2 to 3 years, we expect unemployment to move gradually toward 5% over this period.

Economy is near full employment

Inflation has remained below the Federal Reserve’s 2% objective for several years, but has been gradually increasing towards the target rate since early 2016. Overall inflation in the twelve months through January, as measured by the price index for personal consumption expenditures was 1.9%, up from 1.6% in December, as energy prices accelerated. Core inflation, which excludes changes in food and energy prices, rose more gradually. The price index of core personal consumption expenditures was 1.7% higher than a year ago. Given the robust labor market conditions, we expect overall and core consumer price inflation to rise gradually to 2% over the next couple of years.

Inflation is rising toward target

Interest rates rose sharply in the weeks after the November 2016 election, but have stabilized in recent months. The Federal Reserve raised its Federal funds target rate by ¼ percentage point in December. Based on futures markets, financial market participants expect two or three more quarter-point increases in the target rate in 2017.

Interest rates are up since the election

U.S. trade policy is an important factor for our near-term outlook. New policies under consideration include the introduction of border adjustment taxes, changes to import tariffs, and renegotiations of existing trade agreements. These measures are intended to boost both U.S. exports and employment.
Exports of goods and services help support jobs in the United States. According to the Department of Commerce’s International Trade Administration, exports accounted for an estimated 11.5 million jobs in 2015. The relative importance of the export sector, however, varies substantially across states, with jobs related to exports of goods ranging from about 10% of total employment in Washington and Texas to near 0% in Colorado and New Mexico.

Export-related jobs vary across states...

The share of jobs related to exports also varies across industries. As of 2014, jobs related to exports accounted for 26% of jobs in the manufacturing sector, but only about 8% in the service sector.

...and across industries

Few goods or services can be classified as purely export- or import-related because of the role of global supply chains. For example, many domestically manufactured goods, such as airplanes, may be exported or sold domestically but also have an import content through their use of foreign-made materials and intermediate goods.
Imports are also important for supporting jobs. For example, the apparel and computer equipment sectors rely heavily on imported goods, but generate domestic jobs in transportation, retail, advertising, and financial and insurance services. To add further complexity, many U.S. imports start their product lives as American intellectual property, which are then modified and produced abroad, before being imported back into the United States. As these goods move through their different stages of production, they add U.S. jobs all along the product cycle.
The variation in the relative importance of imports and exports across states and industries poses a challenge in assessing the effects of trade policy changes on the overall U.S. economy. Possible changes in the value of the dollar and trade prices associated with these policy changes also complicate the outlook.

Policy effects vary within sectors as well

Some sectors, such as manufacturing, have increasingly relied on technology to increase production, at the cost of reducing the number of employed workers. Trade policy changes are unlikely to affect the long-run trend of a declining number of jobs in this sector.

        Manufacturing jobs affected by technology

The views expressed are those of the author, with input from the forecasting staff of the Federal Reserve Bank of San Francisco. They are not intended to represent the views of others within the Bank or within the Federal Reserve System.

Thursday, March 16, 2017

The Fed's Bank Bailout

New research on the Fed's bank bailout during the financial crisis:

The fed's bank bailout, EurekAlert!:...While many Americans know the Fed for its role in making monetary policy, it serves another lesser-known but hugely important purpose: providing temporary, short-term funds to banks as a "lender of last resort."
During the financial crisis from 2007-09, the Fed took drastic steps to ensure that banks had access to liquidity so they could continue lending. ...
For the first time, new research from Washington University in St. Louis examines data from the crisis to show how the Fed can effectively assist banks in times of financial uncertainty. No matter the program or the bank size, this infusion of liquidity spurred lending that ultimately reached homes and businesses, thereby benefiting the economy, the researchers found in their analysis.
"Perhaps contrary to popular beliefs, our research shows that the Fed's actions were effective in encouraging banks to lend. This suggests that the credit crunch we witnessed could have been a lot worse in the absence of these facilities," said Jennifer Dlugosz, assistant professor of finance at Olin Business School, and a former economist at the Board of Governors of the Federal Reserve System. ...
During the course of their research, Dlugosz and her co-authors [Allen Berger, professor of banking and finance at the University of South Carolina, Lamont Black, assistant professor of finance at DePaul University, and Christa Bouwman, associate professor of finance at Texas A&M University] found a total of 20 percent of small U.S. banks and 62 percent of bigger U.S. banks -- more than 2,000 in all -- used the Discount Window or the Term Auction Facility at some point during the crisis. The access to liquidity increased bank lending of almost all types. Meanwhile, they found no evidence that banks were making riskier loans.
"We examined whether or not the Discount Window and the Term Auction Facility helped encourage banks to lend during the crisis," Dlugosz said. "We find that it did. It looks like one extra dollar in liquidity support from the Fed to a bank results in somewhere between 30 to 60 cents in additional lending by the bank, depending on its size.
"It wasn't obvious at the time whether this was going to work. ..."

Wednesday, March 15, 2017

FOMC Press Conference March 15, 2017 (Video)

FOMC Raises the Target Range for the Federal Funds Rate

No surprises, except perhaps the dissent by Neel Kashkari -- the Fed "decided to raise the target range for the federal funds rate to 3/4 to 1 percent," with indications of more rate increases to come:

Press Release, Release Date: March 15, 2017: Information received since the Federal Open Market Committee met in February indicates that the labor market has continued to strengthen and that economic activity has continued to expand at a moderate pace. Job gains remained solid and the unemployment rate was little changed in recent months. Household spending has continued to rise moderately while business fixed investment appears to have firmed somewhat. Inflation has increased in recent quarters, moving close to the Committee's 2 percent longer-run objective; excluding energy and food prices, inflation was little changed and continued to run somewhat below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, labor market conditions will strengthen somewhat further, and inflation will stabilize around 2 percent over the medium term. Near-term risks to the economic outlook appear roughly balanced. The Committee continues to closely monitor inflation indicators and global economic and financial developments.
In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 3/4 to 1 percent. The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.
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. The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant 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. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.
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, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee's holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Patrick Harker; Robert S. Kaplan; Jerome H. Powell; and Daniel K. Tarullo. Voting against the action was Neel Kashkari, who preferred at this meeting to maintain the existing target range for the federal funds rate.

Tuesday, March 14, 2017

Fed Watch: Shifting Dots

Tim Duy:

Shifting Dots, bt Tim Duy: The Federal Reserve begins its two-day meeting today. The outcome of the meeting is no longer in debate. A 25bp rate hike is widely expected after a round of Fedspeak in the week prior to the blackout period and the February employment report. More important now is what signal the Fed sends with the statement, the press conference, and the dots. I anticipate the overall message to signal general confidence in the economic outlook while reinforcing the idea that the Fed is neither behind the curve nor intends to fall behind the curve. The combination will give the Fed room to tighten policy at a gradual pace. I think that four hikes this year would still be considered gradual from the Fed's perspective. After all, the expectation of four hikes a year was considered gradual at the beginning of 2016. Not sure why it shouldn't be considered gradual now. 
At the end of last year, the Fed's median interest rate projection anticipated 75bp of rate hikes in each of 2017 and 2018. That translated into my 2017 baseline of two rate hikes with an option on a third, basically including a bias to account for the fact that the Fed's forecast has fallen short in recent years. If economic conditions were such, however, that the Fed pulled forward the first hike to March, I said that my expectation would shift to a baseline of three with an option on four. What that means, in effect, that I expect the dots to shift upward to reflect an anticipation of four rate hikes in 2017.
With March likely, will the dots move as I expect? Not everyone thinks so. Morgan Stanley, for instance, expects the dots will show higher rates in 2018 and 2019 instead. Via Business Insider:


 So why do I think it is more likely than not that the Fed raise the dots for 2017? Consider first the projections for output growth, unemployment, and inflation. Those should play directly into the rate hike forecast in a systematic fashion. So it you think the odds favor some combination of a higher expect growth gap (the difference between actual and longer run output growth), a lower than anticipated unemployment gap (the difference between actual and longer run unemployment), and a higher inflation forecast, then you should anticipate the dots will shift upward. 
In practice, of course, these estimates depend in part on the Fed's estimate of potential growth and the natural rate of unemployment. I don't think either has likely change, so the relevant factors should be the forecasts of the actual variables. Overall, I think it reasonable to believe that at least one, and likely two factors will point to higher rates.
Second, the Fed clearly believes that the balance of risks has tilted at least to completely balanced if not toward the upside. External risks have waned, incoming data both soft and now, with the employment report, hard have been solid, and Fed officials are captured by the allure of fiscal stimulus. FOMC participants whose rate forecasts incorporated a heavy downside risk (reasonable given what happened in 2016) will likely pull their rate forecasts up in a sigh of relief. In essence, these members will believe that without pulling forward rate hikes, they will be in danger of overshooting their targets.
Third, the financial markets were particularly buoyant in recent months even as expectations of tighter policy intensified. I think some FOMC members - yes, New York Federal Reserve President William Dudley, I am looking at you - will want to push back on those easier conditions in the name of financial stability. So that argues for pulling rate hikes forward.
Fourth,  estimates of the longer-run natural rate could rise. I don't anticipate this, as I don't see they have evidence to suggest this is the case, but I did not anticipate the small bump upward in the neutral rate estimates in the December Summary of Economic Projections. 
Altogether then I see more reasons likely to raise the 2017 rate projections than to hold them steady. Hence my expectations for the dots to nudge upward. Basically, it just puts the Fed back to where they started in 2016, expect with more cause to believe it will actually work out this time.
Of course, the rate projection is not a promise, and given recent history I tend to shade down my expectation from what the Fed projects. Hence my three with an option on four. I also am not entirely sure how they will integrate balance sheet reduction with rate hikes? Do they announce a balance sheet reduction at the same meeting they raise rates? Or do they pass on a rate hike to announce a balance sheet reduction? It seems like they would what to avoid the latter because it would equate the balance sheet tool with a rate hike a little too directly. Instead, I expect they would want everyone to think the balance sheet reduction is no big deal. So that argues for both at say the September meeting and that then places an option on the December meeting. If would be nice to have better guidance on this issue.
I tend to think the balance sheet issue is another reason to front load hikes in 2017 if possible. Then they have room to pause in 2018 if balance sheet reduction is a bit sloppier than anticipated.
Bottom Line: I see more reasons that not that the Fed will push up its 2017 rate hike projections. Lots of different factors - external, data flow, fiscal stimulus, and financial conditions - to say that with the economy hovering near potential output, the time is right to make a slightly faster move toward the neutral rate. Indeed, I have a hard time seeing why they would pull forward a rate hike if they weren't trying to create room for an additional hike this year. Note that this would really be just moving the ball down the field a bit quicker, not changing the goal posts - the estimate of the neutral rate. A higher estimate of the neutral rate would be much more hawkish than just quickening the pace slightly to that rate. 

Monday, March 13, 2017

Fed Watch: Green Light


Green Light, by Tim Duy: If there was truly any potential impediment to a rate hike from the Fed this week, it would have come from a weak employment report. The employment report was decidedly not weak. Instead, it finished paving the way to a Fed rate hike. Not enough yet, however, to justify a dramatic acceleration in the pace of future rate hikes, implying only a 25bp upward nudge in the Fed's rate projections for 2017.
Nonfarm payroll growth came in above expected at 235k:


The number may have been boosted by mild weather in February. Still, the underlying pace of growth in recent months is around 200k/month. This is faster than the Fed expects necessary to hold unemployment steady after the cyclical boost to labor force participation plays out. So far, however, labor supply continues to respond. Labor force participation edged up during the month, leaving the decline in the unemployment rate a modest 0.1 percentage points to 4.7 percent. This is just a touch below the Fed's estimate of NAIRU.
Underemployment numbers to continue to improve, as the Fed expects:


The economy is at something of a sweet spot, with job growth strong enough to prod along continued healing of the labor market but slow enough that the Fed can continue to remove accommodation at a gradual pace.
Wage growth rebounded in February, continuing to hover in the 2.5-3 percent range:


Should we be expecting much faster wage growth? Probably not. It strikes me that we are closing in on pre-recession rates:


If inflation rises to two percent (and here I am thinking core inflation), and wages rise with it, that adds about 30bp which pushes wage growth a bit above three percent. Note also, real wage growth was likely a touch higher prior to the recession, but not much:


And this needs to be taken in context of falling productivity growth over the past two decades:


So in order to expect substantially faster wage growth, we need to expect substantially higher productivity growth or substantially higher inflation. The Fed is betting against the former and actively tries to contain the latter. Indeed, on the latter they are only looking to get another 30bp or so. Which suggests to me that a meaningful acceleration of wages at this point would be interpreted by the Fed as evidence they had overshot the full employment mandate and needed to tighten policy more aggressively to contain inflationary pressures. But we are not there yet.
Bottom Line: Looks like the Fed knew what it was doing by signaling a rate hike in recent weeks. The earlier than expected rate hike should correspond to a bump up in this week's "dots." Some participants with two dots will switch to three, some with three to four. I expect the median rate hike projection of Fed participants will be four, which I translate into a baseline case this year of three with an option on four. The Fed will want to front load these hikes to stay ahead of the curve, which means March, June, and September if the data allows. Then December if needed. Data as of yet does not suggest a need by itself to step up the pace of hikes even more quickly. Watch the longer-run rate forecast. A rise in the end game dots would have much more hawkish implications than just a small acceleration in the near-term pace of hikes.

Saturday, March 11, 2017

Long-Run Money Demand Redux

Luca Benati, Robert Lucas, Juan Pablo Nicolini, and Warren E. Weber:

Long-run money demand redux: Most economists and central bankers no longer consider money supply measures to be useful for conducting monetary policy. One reason is the alleged instability of the relationship between monetary aggregates. This column uses data from 32 countries and spanning up to 100 years to argue that the long-run demand for money is alive and well. Results show a remarkable stability in long run money demand, both within and across countries. Nonetheless, short-run departures can be large and persistent, and further research is needed.
Over the last three decades, most economists and central bankers have come to doubt the usefulness of money supply measures for conducting monetary policy, and have turned to macroeconomic models in which monetary aggregates have no role.
What was the main reason behind this move away from monetary aggregates? In our view, it was the alleged disappearance, starting from the early 1980s, of any previously identified stable relationship between monetary aggregates, GDP, and interest rates. For the US, for example, researchers such as Friedman and Kuttner (1992) have documented the breakdown during those years of any stable long-run demand for several alternative monetary aggregates. By the same token, in the Eurozone, the ECB’s so-called monetary pillar (a reference value for the annual growth rate of M3 derived from a money demand equation) has come to be seen as too unreliable to be of any use at all.
There is a clear sense in which this move away from monetary aggregates has left monetary policy untroubled. Over the same decades, there was a surge in the number of central banks that were explicitly or implicitly following inflation-targeting policies in which the monetary policy instrument was the short-term interest rate. And the result has clearly been remarkable – inflation has been defeated. This has been the case for developed economies that saw their inflation rates climb to two digits for a few years in the late 1970s and early 1980s, for emerging economies that experienced hyperinflation during the same years, and for everything in between. In 2015, with a yearly inflation rate of around 30%, Argentina had one of the highest inflation rates in the world – a rate that, ironically, would have been one of the lowest in Latin America in the 1980s.
In this column, we first review recent work on the long-run demand for money, and argue that it is alive and well. We then explain why we believe that this finding may contribute to the monetary policy debate. ...

Wednesday, March 08, 2017

Fed Watch: Employment Report Ahead

Tim Duy:

Employment Report Ahead, by Tim Duy: Arguably, the Fed took the mystery out of this next FOMC meeting by fairly clearly signaling a rate hike is coming. What could hold them back at this point? Only a complete disaster of an employment report. And today's ADP number suggests that's very, very unlikely. Indeed, if the ADP number translates into a blowout employment report, the Fed probably didn't need to signal as aggressively as they did about this next meeting. The data would have brought market expectations to the same place. 

Calculated Risk provides a preview of the February employment report, concluding that he will take the "over" on the current forecast of a 195k gain in nonfarm payrolls within a range of 162k to 220k. I concur. Feeding recent data into my quick and dirty forecasting model suggests a gain of 273k for the month:


That said, I would not put too much emphasis on the point forecast itself. The change in payrolls is notoriously difficult to forecast. Almost a fool's game. That said, I do read this as a signal that there is substantial upside risk to the consensus forecast.

As important, if not more, is the unemployment rate and wage growth. A large gain in payrolls suggests a drop in the unemployment rate unless labor force responds positively. The Fed expects that as the recovery progresses, growth in the labor force will slow as demographic effects dominate cyclical effects. If this happens before job growth slows, the unemployment rate will decrease sharply and the Fed will undershoot the natural rate of unemployment. Faster wage growth would help confirm such an undershoot.

Bottom Line: A surge in hiring coupled with a decline in unemployment would be a red flag for the Fed. If that happens, expect the Fed to be more aggressive this year. It will give them more reason to front load rate hikes, and, if repeated in the next employment report, would open up the possibility of a May hike. Monetary policy is not on a preset course, and gradualism is not a promise, only an expectation.

Wednesday, March 01, 2017

Fed Watch: More on Dudley

Tim Duy:

More on Dudley, by Tim Duy: Following up on my piece this morning at Bloomberg, it is worth going into a little deeper detail on New York Federal Reserve President William Dudley’s comments. I think in this interview Dudley is doing a good job explaining policy in terms of the forecast. That is something the Fed needs to keep pushing. It doesn’t sound like the forecast or the risks have moved sufficiently to change the number of rate hikes expected this year. But he sure seems to be leaning toward pulling forward those hikes.

The CNN interview starts hawkish. What does “fairly soon” mean? According to Dudley:

President Dudley: I think it means what it says. It doesn't say it's a week, a month, a couple months. Fairly soon means in the relatively near future…

Quest: And that's obviously fairly soon, which implies sooner rather than later?

Dudley: I think that's fair.

March is sooner than June. May is sooner than June. March is sooner than May. June is sooner than December. Compared to last year, the next rate hike will certainly come sooner in the year. But given the context Dudley must be aware of how his comments would be received.

On the forecast Dudley says:

We've basically been saying that if the economy continues on the trajectory that it's on, slightly above-trend growth, gradually rising inflation, we're going to continue to remove monetary policy accommodation. So let's look at what we've actually gotten. It seems to me that most of the data we've seen over the last couple months is very much consistent with the economy continuing to grow at an above-trend pace, job gains remain pretty sturdy, inflation has actually drifted up a little bit as energy prices have increased. So we're very much on the trajectory that we said -- that we thought we'd be on and we said if we were on that trajectory we're going to gradually remove accommodation.

This is how I how been viewing the situation. The forecast seems pretty much intact, so there seems to be little reason to pull policy hikes forward. But then he adds:

What else have we seen? We've also seen things that should make us even more confident that this is going to continue in the future. After the election we've seen very large increases in household and business confidence, we've seen very buoyant financial markets -- the stock market is up, credit spreads are narrow. And we have the expectation that fiscal policy will probably move in a more stimulative direction. So, put it all together, I think the case for monetary policy tightening has become a lot more compelling.

Three issues are on the top of his mind – confidence measures, easier financial conditions, and fiscal policy. Arguable, these all distill down to expectations of stimultive fiscal policy. While none of these have yet translated into hard data, they have raised the probability of upside risk to the forecast. Indeed, he says this explicitly:

But we do know that fiscal policy is going to move in a more stimulative direction. So what that says to me is that the risks to the outlook are now starting to tilt to the upside. So while I haven't really built it into my GDP forecast, when I think about the balance of risks -- up or down in terms of economic activity -- I think the fiscal side tends to push things -- the risks to the upside.

And raising that upside risk thus makes the case for a preemptive rate hike more compelling.

All of this sounds like a strong push for March. As the interview continues on, however, he seems to walk back his own outlook:

Quest: But you can't wait for it to happen, can you? I mean the whole question of monetary lag. I know you've got to think about many of these policies not coming into force until 2018, but you have to plan now.

Dudley: Well, look, I think monetary policy is pursued on the basis on the economic outlook. Fiscal policy outlook obviously affects that -- the trajectory of GDP, unemployment and inflation. So that's a factor weighing on us but the fact that we have so little specifics yet about what's going to happen -- it's got to wind its way through Congress -- means I don't put a lot of weight on it in terms of my modal forecast. I just think it makes the risks to the outlook a little bit tilted to the upside at this point.

But Dudley said earlier that the case for policy tightening was “a lot more compelling.” So how does a “little bit tilted to the upside” translate to “a lot more compelling?”

What about financial conditions? Surely that demands an immediate response.

Quest: Into this difficult area we have the financial markets. They're on a tear. I mean today could be the 13th record high, we could be in record territory, you know the numbers better than myself. You can't wait for the fiscal plans completely until next year, but you have to take into account what's happening in the markets at the moment, don't you?

Dudley: Well, financial conditions are very important in terms of how they influence economic activity. So if the stock market is up, credit spreads are narrow, financial conditions are more buoyant, that's going to tend to make the economy stronger. The important thing for us, though, is not to overreact to every little movement in the stock market. It's got to be something that lasts for a period of time for it to actually affect household and business behavior. So if the stock market goes up, and then goes right back down, it's not going to have much consequence for the economic outlook. But if it goes up and stays up, then that's going to support, presumably, consumption through higher household wealth.

It important not to “overreact” because there is a lag between the stock market and the real economy. Stocks could head back down. Maybe the Trump rally will fade (but maybe it is less about Trump and more about cyclical improvement). In that case, it would not affect the outlook and thus shouldn’t influence the Fed’s policy decision.

But those confidence surveys, that’s the ticket, right? Well, maybe not:

Quest: What do you believe you're seeing at the moment?

Dudley: Well, there's no question that animal spirits have been unleashed a bit post the election. Stock market is up a lot. Household and business confidence have increased significantly. There's a survey of small businesses that showed a very large increase in December and sustained that increase in January. So, there's no question that sentiment has improved quite markedly post the election.

Quest: That -- animal spirits or whatever you want to call it -- that market influence. It transmits itself around to the entire economy, doesn't it?

Dudley: Well, we would expect to have some consequence for economic activity. But we'll have to see if that actually -- one if the confidence is sustained, and whether it actually materializes in terms of increases in spending. I would say so far we haven't seen much effect of the improvement in confidence actually leading into greater spending. I think the economy is still on about a 2% GDP track, which about what it's been over the last year or so.

So sentiment is a lot better, but it might not hold and even if it does it needs to be felt in the real economy to change the forecast.

Notice that in all three case he emphasizes that those factors have yet to change his forecast. And he downplays the likelihood of those points even translating into something that might change his forecast. So why then does he lead with the case for rate hikes is “a lot more compelling?” It doesn’t sound like it about the number of hikes for him, at least not yet. It is about the timing of the hikes. It seems to have less to do with the forecast itself and more to do with his desire to take preemptive action.

Bottom Line: When I read the interview, it is hard for me to see that he has a strong conviction for drawing forward the rate hike to March. It seems odd to do so if he sees no change in the forecast and downplays the impact of the upside risks. If he does want to move in March, it tells me then it has little to do with either factor and is entirely about staying ahead of the curve. It is about the need for a preemptive rate hike. If his forecast is for three hikes and he wants to hike in March, then his patience has ended and he wants those hikes frontloaded. If for FOMC participants as a whole the forecast has yet to change much, then it is possible that the even if they raise in March, the median projection of three rate hikes this year remains steady.

Thursday, February 23, 2017

Whom to Listen to in the Fed Minutes

Tim Duy:

Whom to Listen to in the Fed Minutes: When it comes to the meetings of the Federal Open Market Committee, not all central bank policy makers are created equally. There are “participants” -- all the policy makers in the room -- and there are “members,” those who have a vote. It is important to keep this distinction in mind when reading the minutes of the FOMC meetings -- especially because many of the more hawkish members of the Fed are participants, not members.
Continued at Bloomberg Prophets...

Wednesday, February 22, 2017

How the Fed's Rate Hikes Might Play Out

Tim Duy:

How the Fed's Rate Hikes Might Play Out: The U.S. economy is poised to deliver on the Federal Reserve’s economic forecast for this year. That means a baseline outlook for three interest-rate increases remains in play -- though not the way market may be anticipating. Think of it as two rate hikes, one each in June and December, with an option for a third in September.
Continued at Bloomberg Prophets....


Monday, February 13, 2017

Fed Watch: Takeaways From Fischer Speech

Tim Duy:

Takeaways From Fischer Speech, by Tim Duy: Federal Reserve Governor Stanley Fischer gave a very nice speech this weekend that shed light on the current monetary policymaking process. I found three points particularly notable. First:
One important but underappreciated aspect of the SEP is that its projections are based on each individual's assessment of appropriate monetary policy. Each FOMC participant writes down what he or she regards as the appropriate path for policy. They do not write down what they expect the Committee to do. Yet the public often misinterprets the interest rate paths we write down as a projection of the Committee's policy path or a commitment to a particular path.
The interest rate projections in the SEP do not represent the Committee’s forecast because there is no such forecast. And they certainly do not represent a policy commitment. It is often easy, however, to use the shorthand of referring to the median of the SEP projections as the Fed’s forecast, which is why we fall in the habit of doing so. It is important to realize, however, that this is not an official forecast, and even if it were, it can change over the year so it is not a promise.
My preference is to view the median SEP projection as a baseline to assess policy shifts throughout the year. For instance, I do not believe that incoming data suggests that the Fed will raise its projection relative to the baseline at the upcoming March FOMC meeting. In other words, the median projection is not likely to shift from three to four hikes. This further suggests that given the Fed’s predilection to delay rate hikes in favor of further labor market gains, there is no pressing reason for the Fed to hike in March. They still have plenty of time to raise rates three times this year if necessary and the data do not suggest they need to move early to act on the possibility of needing four rate hikes this year. So no rate hike is likely in March.
A second point from Fischer:
Figure 2 reproduces panels from the April 2011 Tealbook that show the staff's baseline forecast--the solid black line--as well as prescriptions from three simple policy rules that were generated using the FRB/US model. The panel on the left shows the paths for the federal funds rate, while the panels on the right show the implications of those policy prescriptions for the unemployment rate and core PCE (personal consumption expenditures) price inflation, respectively…
… How does the FOMC choose its interest rate decision? Fundamentally, it uses charts like those shown in figure 2 as an important input into the discussion. And in their discussion, members of the FOMC explain their policy choices, and try to persuade other members of the FOMC of their viewpoints.
The chart:


An important takeaway here is that the Fed makes monetary policy decisions on the basis of a medium term forecast. In other words, they tailor policy to meet their objectives over the medium term. This stands in contrast with criticism that the Fed either only sees the short-term outcomes of their actions or that they base policy only on the last piece of data. In reality, they are incorporating that most recent data into the medium term forecast and adjusting policy appropriately.
This process, however, is challenging for the public to understand. Moreover, I do not think the Fed has spent sufficient time explaining their actions in terms of the forecast. I suspect that the Fed may not be doing itself any favors with the opening paragraph of the FOMC statement, which is backwards-looking in nature and portrays the impression that the most recent data is the basis of policymaking. I thus appreciate that Fischer is using charts like these to explain policy choices and hope to see more of it in the future.
A final point from Fischer:
As the August 2011 meeting illustrates, the eureka moment I thought I had 50-plus years ago was a chimera. Why is that? First, the economy is very complex, and models that attempt to approximate that complexity can sometimes let us down. A particular difficulty is that expectations of the future play a critical role in determining how the economy reacts to a policy change. Moreover, the economy changes over time--this means that policymakers need to be able to adapt their models promptly and accurately in real time. And, finally, no one model or policy rule can capture the varied experiences and views brought to policymaking by a committee. All of these factors and more recommend against accepting the prescriptions of any one model or policy rule at face value.
The Fed relies on models, but not only models. Moreover, those models, or the underlying components of those models, such as the natural rate of interest, change over time. This is not a weakness of policymaking, it is a strength. The Fed responds to a ;changing economy. It is not possible to place the Fed in the straightjacket of a simplistic Taylor Rule and expect good outcomes for the economy. Clearly this is intended to push back at ongoing efforts to limit the Fed’s independence.
Bottom Line: Read Fischer’s speech for a greater understanding of the interplay between models, forecasts, data and judgment that governs the Fed’s policy choices.

Will Trump Bankrupt the Fed as an Institution?

I have a new column:

If Trump Stacks Its Board, He Politicizes the Fed and Demeans Its Independence: Daniel Tarullo announced on Friday that he is resigning from the Federal Reserve Board of Governors in early April, nearly five years before his term expires on January 31, 2022. Governor Tarullo, who was appointed by President Obama in 2009, led the effort to plug the holes in financial regulation that allowed the housing bubble and financial panic to occur. So his resignation comes at an inopportune time for those of us worried about Trump’s plans for wholesale deregulation of the financial sector and the vulnerability to another financial crisis that comes with it. 
Trump could also have a large impact on how the Fed conducts monetary policy..., the Fed could be permanently damaged...

Friday, February 10, 2017

Fed's Bullard Knows His Treasury Yield Curve

Tim Duy:

Fed's Bullard Knows His Treasury Yield Curve: Having tipped their toes in the water with two interest-rate hikes -- and more expected to come -- the Federal Reserve officials have begun the discussion about reducing the size of the central bank’s $4.45 trillion balance sheet. To date, they have tended to look at interest rate-policy as separate from balance-sheet policy. Once the former is heading toward normalization, then they can begin the latter... Continued at Bloomberg Prophets ...

Tuesday, February 07, 2017

Do Consumers Respond in the Same Way to Good and Bad Income Surprises?

Philip Bunn, Jeanne Le Roux, Kate Reinold and Paolo Surico at Bank Underground:

Do consumers respond in the same way to good and bad income surprises?: If you unexpectedly received £1000 of extra income this year, how much of it would you spend? All? Half? None? Now, by how much would you cut your spending if it had been an unexpected fall in income? Standard economic theory (for example the ‘permanent income hypothesis’) suggests that your answers should be symmetric. But there are good reasons to think that they might not be, for example in the face of limits on borrowing or uncertainty about future income. That is backed up by new survey evidence, which finds that an unanticipated fall in income leads to consumption changes which are significantly larger than the consumption changes associated with an income rise of the same size ...
The asymmetry that we document could have important implications for the way that households respond to changes in their income that are brought about by monetary and fiscal policies. For example, changes in monetary policy redistribute income between borrowers and savers (Cloyne, Ferreira & Surico (2016)). Borrowers reported higher MPCs than savers out of both positive and negative income shocks, as is typically assumed, but the asymmetry in MPCs was clearly present for both groups. Such an asymmetry in MPCs implies that, at least in the short term, a given interest rate rise would have a larger contractionary effect on spending than the expansionary effect from an equivalent fall in rates, although households may respond differently to small changes in rates than they do to large changes in income.

Thursday, February 02, 2017

Fed Watch: FOMC, Employment Report, Warsh

Tim Duy:

FOMC, Employment Report, Warsh, by Tim Duy: The FOMC meeting came and went with little fanfare this week. As expected, there was no policy change, with only small modifications to post-meeting statement. With only small changes, it is a struggle to read much into the statement. Some thoughts:
1. Business investment. The Fed drew attention to weak business investment. The recent gains in core capital goods orders and improving ISM manufacturing numbers could be pointing to an upturn in the months ahead, possibly enough to boost growth estimates. Keep an eye on this space.
2. Business/Consumer Confidence. The Fed cited the post-Trump improvement in confidence. These gains, however, could easily prove to be ephemeral. The Fed will see them as a risk to their outlook, but will need actual data before changing their outlook.
3. Inflation expectations. The Fed noted that market-based inflation compensation estimates remain low. I think this means that they are not panicking about the recent rise in such expectations; they remains well below pre-recession levels:


If they aren't panicking, neither should you. For what it's worth, I suspect that they will only address market-based inflation numbers when convenient and ignore them when inconvenient.
4. Inflation confidence. The Fed deleted the factors (energy, import prices) restraining inflation. This could be viewed as confidence in their inflation outlook (my initial response). Alternatively, it could be interpreted as saying they don't have any more excuses if inflation remains below target. Or, it could mean the former to some at the table, the latter to others at the table.  
All that said, the changes were relatively minor and provide no concrete clues about the Fed's next move. My thoughts on March remains unchanged - without more supportive data, the odds of a March rate hike remains low.
Could the January employment report start building the case for a March hike? It sure can - if, in particular, the ADP report is a reliable predictor. But regardless of ADP, the case was building for a solid number - see Calculated Risk. The consensus expectation is 175k within a range of 155k to 190k. Taking the ADP number at face value suggests the report will prove to be better than expected: 


I think there is upside risk to the consensus forecast this month. (Note the error bands. Forecasting the monthly NFP change is risky business). If that is indeed the reality, the Fed will take notice. They will certainly take notice if unemployment dips lower or wages spike higher.
This week I wrote a detailed response to former Federal Reserve Governor Kevin Warsh's recent WSJ op-ed. One interpretation of this puzzling op-ed is that auditions for the Fed Chair require you to find fault with the Fed regardless of whether or not you actually find fault. Hence he lists supposed reforms that more than anything already reflect current policy, knowing that if chosen to be Chair he would be able to maintain much of that policy. This, however, is something of a dangerous game because it undermines the credibility of the Fed - how much can we trust the Fed if one of their own is so critical of their policies? That credibility is especially vulnerable now given the extent of the current threats to Fed independence. In effect, he is giving the Fed's critics ammunition to weaken the institution he reportedly is in the race to lead. One would think this is then a counterproductive approach. Moreover, he is doing the public and market participants no favors  by misrepresenting the Fed and its policies.
Bottom Line: And now we await the employment report...

Wednesday, February 01, 2017

"The Committee decided to maintain the target range for the federal funds rate at 1/2 to 3/4 percent"

No change:

Press Release, Release Date: February 1, 2017, For release at 2:00 p.m. EST: Information received since the Federal Open Market Committee met in December indicates that the labor market has continued to strengthen and that economic activity has continued to expand at a moderate pace. Job gains remained solid and the unemployment rate stayed near its recent low. Household spending has continued to rise moderately while business fixed investment has remained soft. Measures of consumer and business sentiment have improved of late. Inflation increased in recent quarters but is still below the Committee's 2 percent longer-run objective. Market-based measures of inflation compensation remain low; most survey-based measures of longer-term inflation expectations are little changed, on balance.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, labor market conditions will strengthen somewhat further, and inflation will rise to 2 percent over the medium term. Near-term risks to the economic outlook appear roughly balanced. The Committee continues to closely monitor inflation indicators and global economic and financial developments.
In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1/2 to 3/4 percent. The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a return to 2 percent inflation.
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. 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 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. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.
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, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee's holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Patrick Harker; Robert S. Kaplan; Neel Kashkari; Jerome H. Powell; and Daniel K. Tarullo.
Implementation Note issued February 1, 2017

Fed Watch: Was Kevin Warsh Really A Fed Governor?

Tim Duy:

Was Kevin Warsh Really A Fed Governor?, by Tim Duy: Former Federal Reserve Governor Kevin Warsh’s column in Tuesday’s Wall Street Journal was so riddled with errors and misperceptions that it is hard to believe he was actually a governor.
Warsh wants the Fed to announce a “practicable long-term strategy and stick to it,” claiming they have offered many such plans but never stuck to them. I don’t agree. The Fed has a plan, but Warsh just refuses to see it.
The former governor’s first critique:
A year ago around this time, the U.S. stock market fell about 10%. The Fed reacted precipitously, reversing its announced plan for 2016 of four quarter-point rate increases. But when prices rallied near the end of the year, the Fed decided it wouldn’t look good to let the moment pass without raising rates. It raised its key interest rate by a quarter point in December.
The Fed did not reverse its announced plan. The rate forecast contained within the Fed’s Summary of Economic Projections is just that, a forecast, not a plan. Incoming data triggered a revision of that forecast. And, contrary to the narcissistic belief of many market participants, it wasn’t all about them. Falling equity prices were just one of many data points that changed the course of policy. The Fed faced a very real slowdown in activity. Andrew Levin, former Fed economist, for instance, described the economy as operating at stall speed. Note that output growth slowed markedly during 2015 and into 2016:


The unemployment rate stalled out:


And inflation remained tepid:


If the Fed updated their forecast, it was for good reason.
Warsh follows with another instance of the Fed supposedly reversing course:
In late October, Fed Chair Janet Yellen expressed willingness to run a “high-pressure economy” to push the unemployment rate lower and inflation higher. Yet in a speech two weeks ago, she said that allowing the economy to run “persistently ‘hot’ would be risky and unwise.”
Yellen never expressed a willingness to run a high-pressure economy. That was always a complete misrepresentation of her comments. In that speech, she was simply proposing a research agenda for macroeconomists, including the topic of the influence of aggregate demand on supply. Had anyone actually read the speech (and I have to assume Warsh did not), they would see that she did not provide any policy proposals. Her subsequent comments were nothing more than an effort to set the record straight, not a shift in position.
Warsh uses the above episodes to claim that the Fed lacks a strategy:
Changes in judgment should be encouraged, but they ought to indicate something other than day trading or academic fashion. They must be rooted in strategy. Otherwise, the real economy winds up worse off…
…The Fed’s technocratic expertise is no substitute for a durable strategy. This make-it-up-as-you-go-along approach causes many Fed members to race to their ideological corners, covering themselves as hawks and doves…
The problem here is that the Fed does have a strategy, but Warsh refuses to see it. Specifically, incoming information alters the Fed’s economic forecast and, in accordance with a basic Taylor Rule, the Fed’s rate forecast with the goal of meeting the dual mandates over the medium term. Indeed, San Francisco Federal Reserve economists Fernanda Nechio and Glenn Rudebusch show that the Fed altered its rate forecast systematically in response to incoming data in this manner. That data brought the Fed’s original forecast for four rate hikes down to the actual one rate hike.
There is indeed a strategy. It is not the Fed that is too focused on the near-term. It is Warsh that is too focused on the near-term.
Warsh proposes five reforms for the Federal Reserve, beginning with:
First, the Fed should establish an inflation objective of around 1% to 2%, with a band of acceptable outcomes. The current 2.0% inflation target offers false precision. According to the Fed’s preferred measure, inflation is running at 1.7%, only a few tenths below target. The difference to the right of the decimal point is too thin a reed alone to justify the current policy stance. It also undermines credibility to claim more knowledge than the data support.
This one reveals Warsh’s true intentions – the current inflation target does not support his desire for higher rates, so he wants to move the target! Moreover, the current target does not offer false precision. No one at the Fed believes they can consistently hit two percent. And being below two percent has not stopped them from raising rates. In practice, the Fed will tolerate misses within a reasonable (25bp) range around two percent as long as forecasted inflation is trending toward target. That’s the medium-term strategy Warsh claims to be so concerned about.
Second, the Fed should adjust monetary policy only when deviations from its employment and inflation objectives are readily observable and significant. The Fed should stop indulging in a policy of trying to fine-tune the economy. When the central bank acts in response to a monthly payroll report, it confuses the immediate with the important. Seeking in the short run to exploit a Phillips curve trade-off between inflation and employment is bound to end badly.
It is a misperception that the Fed acts impetuously on the most recent data. They use that data to update their forecast in a systematic fashion (see above). I generally excuse most people from not understanding this distinction. It is a difficult concept and, quite frankly, one that the Fed does a poor job communicating. Warsh, however, has no such excuse.
For his third reform:
…the Fed should elevate the importance of nonwage prices, including commodity prices, as a forward-looking measure of inflation. It should stop treating labor-market data as the ultimate arbiter of price stability…A material catch-up in wages after a long period of stagnation need not trigger a panicky response.
I don’t think Warsh understands the foundations of Fed’s approach to inflation forecasting. From Yellen’s lengthy discussion of the topic in September 2015:
To summarize, this analysis suggests that economic slack, changes in imported goods prices, and idiosyncratic shocks all cause core inflation to deviate from a longer-term trend that is ultimately determined by long-run inflation expectations. As some will recognize, this model of core inflation is a variant of a theoretical model that is commonly referred to as an expectations-augmented Phillips curve. Total inflation in turn reflects movements in core inflation, combined with changes in the prices of food and energy.
Wages aren’t in that description. Wages are primarily a guide to estimating full employment (economic slack). Rising wage growth indicates the economy is approaching full employment. Wage growth in excess of the inflation target plus productivity growth raises warning signs that the economy is operating beyond full employment. Also, commodity prices are included as idiosyncratic shocks. Finally, the labor market data is very clearly not the ultimate arbiter of price stability. In the long-run, inflation expectations are the ultimate arbiter of price stability.
Warsh’s next reform:
Fourth, the Fed should assess monetary policy by examining the business cycle and the financial cycle. Continued quantitative easing—which Fed leaders praise unabashedly—increases the value of financial assets like stocks, while doing little to bolster the real economy. Finance, money and credit curiously are at the fringe of the Fed’s dominant models and deliberations. That must change, because booms and busts take the central bank farthest afield from its objectives.
Note that earlier Warsh complained that the Fed reacted to the financial cycles – easing policy when equity prices were falling and vice-versa. Now he wants the Fed to react to those cycles? In actuality, the Fed does take financial considerations seriously. See, for example Governor Jerome Powell here. Vice Chair Stanley Fischer here. Governor Daniel Tarullo here. Go back to the work of former Governor Jeremy Stein. And with regards to quantitative easing, the Fed would argue that their actions have indeed bolstered the real economy. And while busts in particular do take the Fed far away from its mandate, so too would strangling the economy to address a theoretical financial risk. Incorporating a financial stability term in the Taylor Rule is easier said than done.
Fifth, the Fed should institutionalize its new strategy and boldly pursue it with a keen eye toward the medium-term.
As I noted earlier, the Fed does have a strategy, the focus of that strategy is the medium run forecast, and the Fed changes their behavior in a systematic way to pursue that strategy. In short, the Fed’s already acts in accord with this supposed “reform.” Move along, folks, nothing to see here.
Bottom Line: If you want to understand the Federal Reserve and monetary policy, I don’t think reading Warsh’s op-ed gives you much to work with.

Sunday, January 29, 2017

Fed Watch: FOMC Preview

Tim Duy:

FOMC Preview, by Tim Duy: The Fed will take a pass at this week’s FOMC meeting. The median policy participant forecasts just three 25bp rate hikes this year and incoming data offers no surprises to force one of those this month. March, however, remains in play.
The three forecasted rate hikes is not a promise. It could be one hike or could be four or more. The actual outcome will depend on the path of actual economic outcomes and what those outcomes imply for the forecast.
The Fed is aware that crosscurrents in the economy – such as potentially significant changes to fiscal and economic policy – create substantial uncertainties about the course of monetary policy this year. From the most recent minutes:
…many participants emphasized that the greater uncertainty about these policies made it more challenging to communicate to the public about the likely path of the federal funds rate.
Translation: The Fed’s crystal ball is as cloudy as everyone else’s, but that’s hard to explain. For example, the potential positive demand shock from expected deficit spending could be overwhelmed by a potential negative supply shock from an increasingly xenophobic Trump Administration.
What does this mean for March? Currently, market participants place low odds of a March rate hike. The underlying bet is that if the Fed moves three times this year, the most likely timing will be June, September, and December. I think this is reasonable; bringing March into that mix requires a change in the tone of the data.
Specifically, to pull a rate hike forward, the Fed needs evidence that either inflation is firming more than anticipated or that unemployment is more significantly undershooting its natural rate. Both would be cause for concern for policymakers. But, in practice, given the inflation inertia evident in recent years, the labor market would most likely be the driving force of behind a March rate hike. From the minutes:
Several members noted that if the labor market appeared to be tightening significantly more than expected, it might become necessary to adjust the Committee's communications about the expected path of the federal funds rate, consistent with the possibility that a less gradual pace of increases could become appropriate.
The December labor report was largely consistent with the Fed’s forecasts, and thus will have little impact on the March meeting. The same is true for the GDP report for the final quarter of 2016. Notable is that domestic demand has held up well the last three quarters:


They will also be heartened that equipment investment, broke a string of four consecutive negative quarters with a 3.1 percent gain. Also, note that core durable goods orders are finally back to making year over year gains:


This too is consistent with the small uptick in growth anticipated by the Fed for 2017.

But we still have plenty of data between now and March. In particular, watch incoming data and how they impact the forecast of key variables such as unemployment and inflation. The Fed will pay close attention to:
  • Nonfarm payrolls. They expect payroll growth to continue slowing to something close to 100k a month. A re-acceleration would raise eyebrows on Constitution Ave.
  • The unemployment rate. The Fed’s estimate of the natural rate of unemployment firmed over the past year. Hesitation to drop it lower means that surprise falls in unemployment would prompt more aggressive Fed action.
  • Faster wage growth. Some policy makers argued in December that subdued wage growth gave them more time to respond to an unemployment overshoot. But wage growth accelerated in December to 2.9% annually, the highest pace since 2009. Watch this space (and see this from Bloomberg on competition for workers in the fast food industry).
  • Inflation numbers. Although, as noted earlier, inflation has been fairly inertial, that could change at the economy settles further into full employment/potential output.
  • Acceleration? The Fed is not anticipating a large acceleration in activity this year, so any indication that activity is picking up more than expected will be watched with wary eyes.
At this point I still do not anticipate a March hike. And note that a March move doesn’t guarantee a faster pace of rate hikes; it could be largely pre-emptive, just displacing a subsequent rate hike. But if they could justify a March move and you were anticipating two to three rate hikes this year, you should probably be thinking of three to four. Not to mention some action on the balance sheet added to the mix.

Tuesday, January 24, 2017

Fed Watch: Quantifying The Changing Rate Forecast

Tim Duy:

Quantifying The Changing Rate Forecast, by Tim Duy: In my last post, I asserted:
The actual amount of tightening will ultimately depend on the evolution of the forecasts for unemployment and inflation. If the expectation for unemployment drifts lower for this year, for instance, the median dots are likely to shift higher to ensure that the Fed continues to meet its mandate.
Can we quantify the impact of a changing economic forecast on the projected amount of tightening this year? Yes, using the methodology of Federal Reserve Bank of San Francisco economists Fernanda Nechio and Glenn Rudebusch. In a recent article, they argue the change in the Federal Reserve’s 2016 projected rate increase from 100bp to 25bp was consistent with a simple extension of a Taylor-type policy rule, specifically:
Funds rate revision = neutral rate revision + (1.5 × inflation revision) – (2 × unemployment gap revision).
Recall that the interest rate projections contained in the Fed’s Summary of Economic Projections (SEP) are not policy commitments. They are forecasts that we should expect to change with evolving forecasts of key variables, notably inflation and unemployment. The Fed’s credibility should not be judged on the accuracy of its rate forecast. It should be judged on its ability to meet its mandate. Actual policy should shift relative to the rate forecast as economic conditions change.
We can look to the December 2016 SEP as an example of the Nechio-Rudebusch approach. The Fed’s median rate forecast for 2017 rose 0.3 percentage points relative to the September SEP (Note: There is a rounding issue here. Effectively, the forecast changed from two to three 25bp hikes). The median neutral rate estimate (the longer run forecast of the funds rate) rose 0.1 percentage points. The inflation forecast (Nechio-Rudebusch use core inflation) was unchanged. The unemployment forecast fell 0.1 percentage points while the estimate of the natural rate of unemployment (the longer run forecast of the unemployment rate) remained unchanged. Thus the Fed revised down the unemployment gap estimate by 0.1 percentage points.
Applying the Nechio-Rudebusch policy rule:
0.3 percentage points = 0.1 percentage points + (1.5 x 0.0 percentage points) – (2 x (-0.1 percentage points)
In other words, the changing economic forecast for 2017 explains the magnitude of the change in the 2017 rate projection. Thus, we should watch incoming data for its impact on the forecasts for key variables to estimate its impact on policy.
In practice, we might expect minimal revisions of the longer run rates of interest and unemployment over the course of 2017. The estimate of the neutral interest rate declined substantially in 2015 and early 2016, but I suspect that pattern will not repeat in 2017. The estimate has already held fairly steady since the June 2016 SEP. Also note that the Laubach-Williams estimates of the natural rate of interest are now edging upward:


The era of declining estimates of the natural rate of interest may be over. Likewise, the estimate of the natural rate of unemployment remains at the March 2016 SEP. Assuming these parameters remain constant in 2017, the variation in the fed funds rate projection will depend on the unemployment and inflation and inflation forecasts.
As a practical example, I view the December employment report as consistent with the December SEP economic forecasts. The pace of underlying job growth continues to slow toward a range that is likely consistent with a steady unemployment rate after the demographic impacts on labor participation reassert themselves. This suggests the Fed’s forecast for a fairly small (0.2 percentage points) fall in the unemployment rate is largely unchanged. Hence, the employment report should not impact the median rate forecast for 2017.
Bottom Line: The Fed’s policy stance shifts in consistent manner. Important to understanding these shifts is estimating the impacts of incoming data on the Fed’s medium term forecast. In my opinion, the policymakers spend too little time discussing the impact of incoming data on their forecasts, leading to the perception that policy is more backward than forward looking. The above example illustrates, however, the importance of the latter for monetary policy.

Wednesday, January 18, 2017

The Goals of Monetary Policy and How We Pursue Them

Janet Yellen:

The Goals of Monetary Policy and How We Pursue Them:'s fair to say, the economy is near maximum employment and inflation is moving toward our goal. The unemployment rate is less than 5 percent, roughly back to where it was before the recession. And, over the past seven years, the economy has added about 15-1/2 million net new jobs. Although inflation has been running below our 2 percent objective for quite some time, we have seen it start inching back toward 2 percent last year as the job market continued to improve and as the effects of a big drop in oil prices faded. Last month, at our most recent meeting, we took account of the considerable progress the economy has made by modestly increasing our short-term interest rate target by 1/4 percentage point to a range of 1/2 to 3/4 percent. It was the second such step--the first came a year earlier--and reflects our confidence the economy will continue to improve.
Now, many of you would love to know exactly when the next rate increase is coming and how high rates will rise. The simple truth is, I can't tell you because it will depend on how the economy actually evolves over coming months. The economy is vast and vastly complex, and its path can take surprising twists and turns. What I can tell you is what we expect--along with a very large caveat that our interest rate expectations will change as our outlook for the economy changes. That said, as of last month, I and most of my colleagues--the other members of the Fed Board in Washington and the presidents of the 12 regional Federal Reserve Banks--were expecting to increase our federal funds rate target a few times a year until, by the end of 2019, it is close to our estimate of its longer-run neutral rate of 3 percent. ...

Friday, January 13, 2017

The Fed and Fiscal Policy

Ben Bernanke:

The Fed and fiscal policy: Markets have responded strongly to Donald Trump’s election victory, pushing up equities, longer-term interest rates, and the dollar. While many factors influence asset prices, expectations of a much more expansionary fiscal policy under the new administration—higher spending, lower taxes, and larger deficits—appear to be an important driver of the recent market moves.
The Federal Reserve’s reaction to prospective fiscal policy changes has been much more cautious than that of the markets, however. Janet Yellen in December described the central bank as operating under a “cloud of uncertainty,” and the forecasts of Fed policymakers released after the December FOMC meeting showed little change in either their economic outlooks or their interest-rate projections for the next few years. How does the Fed take fiscal policy into account in its planning? What explains the large difference between the reactions of the Fed and the markets to the change in fiscal prospects since the election? I’ll discuss these questions in this post, concluding that the Fed’s cautious response to the possible fiscal shift makes sense, given what we know so far. ...

Friday, January 06, 2017

Fed Watch: Solid Employment Report Keeps Fed On Track

Tim Duy:

Solid Employment Report Keeps Fed On Track, by Tim Duy: The labor market finished out the year on a solid note. Solid, not spectacular, and largely consistent with the Fed's expectations. Consequently, the final employment report for 2016 should not impact the Fed's median forecast for 75bp of rate hikes in 2017.
Payrolls rose 156k in December and jobs gains the previous two months were revised upwards by 19k. While good numbers, job growth continues to slow:


Since January 2015, the 12-month moving average of monthly job growth slowed from 262k to 180k. Still, that remains greater than the pace necessary to hold the unemployment rate constant once the demographic impacts again dominate the cyclical factors (Federal Reserve Vice Chair Stanley Fischer estimates that number to be 65k-115k). But the economy continues to trend toward that pace.
Supported by an increase labor force participation, the unemployment rate ticked up to 4.7%, holding just below the Fed's estimate of the natural rate of unemployment:


Measures of underemployment are now again showing signs of improvement, albeit the pace of improvement has slowed along with the pace of job growth:


The pace of wage growth accelerated to 2.9%, the highest rates since 2009:


Overall, the report should win hearts and minds on Constitution Ave. The economy looks to be tracking exactly where the Fed expects it to go, with job growth slowing sufficiently such that the unemployment rate holds steady just below full employment. Such a situation would allow for continued improvement in measures of underemployment while maintaining healthy but not excessive pressure on wage growth. In contrast, recall the concerns about about undershooting the natural rate of unemployment that surfaced during the December FOMC meeting. From the minutes:
...In discussing the possible implications of a more significant undershooting of the longer-run normal rate, many participants emphasized that, as the economic outlook evolved, timely adjustments to monetary policy could be required to achieve and maintain both the Committee's maximum-employment and inflation objectives.
...Several members noted that if the labor market appeared to be tightening significantly more than expected, it might become necessary to adjust the Committee's communications about the expected path of the federal funds rate, consistent with the possibility that a less gradual pace of increases could become appropriate...
The economy is now at a point where a sudden boost in activity would prompt the Fed to accelerate the pace of rate increases. This employment report, however, suggests this isn't happening just yet.
One note of caution, though. Manufacturing employment rose in this latest report by 17k, the largest gain since January 2016. This comes on top of improved data from the manufacturing sector:


This serves as further evidence that the inventory correction process over the past year has run its course. Note also the improvement in the service sector in recent months:


This suggests to me that risks for growth and hence rates are currently weighted to the upside.
Bottom Line: A solid report largely consistent with expectations among monetary policymakers. Hence it should have little impact on interest rate forecasts for the coming year. But watch out for upside risks to the outlook; the economy gained some traction in the final months of 2016. It is reasonable to believe that traction will hold in 2017.

Friday, December 30, 2016

A World at Risk

Narayana Kocherlakota:

A World at Risk: My last day as President of the Federal Reserve Bank of Minneapolis was on December 31, 2015. I began blogging on January 2, 2016... In my first post, I wrote that “economic policymakers can do better. Indeed, I increasingly believe that they must do better.” In my view, the global political events of 2016 show why I wrote those words.
That first post argued that macroeconomic policy remained much too tight around the developed world. It closed with the following warning and admonition:
“We are only beginning to see the impact of tight policy choices on our economies … 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.”
The process of “social fracturing and disengagement” to which I referred continued apace in 2016. In the UK, Britons voted to break away from the European Union. In the US, a political outsider used a platform of economic isolationism to defeat a string of establishment candidates from both major parties.
There will be elections in France and Germany in 2017. I expect large, and possibly decisive, repudiations of the political establishment in both votes.
Will policymakers begin to engage in the kind of fiscal/monetary easing that is needed to heal our economies and our societies? Possibly – there is talk from the incoming American administration of increases in government spending and tax cuts. But many elected officials (and professional economists) have also expressed strong opposition to these policy choices.
Those opponents should bear in mind that there are grave risks associated with overly tight macroeconomic policy and the accompanying shortfall of aggregate demand. As I wrote on January 8 of this year,
“Much of the world experienced a significant global demand shortfall throughout the 1930s … It is true that if we fast forward to 1950, the demand shortfall had been largely cured. Unfortunately, I suspect that the destruction associated with World War II was an important part of the “solution”. During the course of that War, over 50 million people were killed, and many others were injured severely. Much of the physical capital of Asia and Europe had been destroyed. The world didn’t put [its] “idle men and machines” to work - it destroyed them instead … the experience of the 1930s and 1940s is unfortunately suggestive of how the economic pressures of a global demand shortfall can give rise to highly adverse geo-political outcomes.”
Unfortunately, I see many more signs to support the possibility of “adverse geo-political outcomes” (to use my euphemism) than I did in early 2016.
So, as we enter 2017, the world needs easier fiscal and monetary policy in the form of more government debt, lower taxes (especially on investment), more infrastructure and lower interest rates. But this prescription has been the right one for at least eight years. We can only hope that we have not left the problem unattended for too long.

Tuesday, December 27, 2016

Fed Watch: Is The Fed About To Experience A Repeat of 2016?

Tim Duy:

Is The Fed About To Experience A Repeat of 2016?, by Tim Duy: In the most recent Summary of Economic Projections, Fed officials penciled in three 25bp rate hikes for 2017. The reality, however, could be very different. We all remember how “four” became “one” in 2016. The median dots are neither a promise nor an official forecast. As 2016 progressed, forecasts associated with a lower path of SEP “dots” evolved as the consensus view of policymakers. Will the same happen this year? I don’t think so; it is hard to see the Fed on pause for another twelve months.
As a starting point, I think it best to assume the US economy is near full-employment. But the US economy was near full-employment at this time last year as well. I think the key difference between then and now is that then the after-effect of the oil price slide and dollar surge placed a drag on the US economy sufficient to ease hiring pressure. At the same time, labor force participation perked up, setting the stage for a flat unemployment rate for most of the year. Inflationary pressures eased as well; the January inflation pop proved to be short-lived:


In effect, the US economy settled into a nice little equilibrium in 2016 that obviated the need for additional rate hikes. To expect a repeat scenario in 2017, one would need to assume that the US economy does not pick up speed and threaten that equilibrium by pushing past full employment.
Evidence, however, piles up suggesting that the slowdown of the past year is drawing to a close. ISM manufacturing and nonmanufacturing surveys are stronger, temporary help employment is heading up again, new manufacturing orders for nondefence, nonair capital goods have flattened out, and the broader inventory overhang is easing:


All of this occurs in the context of an unemployment rate that suddenly dipped toward the lower end of the Fed’s estimates of the natural rate of unemployment. And if the demographic forces reassert themselves, there is likely to be further downward pressure on the unemployment rate – job growth is well above estimates necessary to hold unemployment constant.
But would a total of 75bp of hikes be necessary to hold inflation in check? That depends in part the sensitivity of inflation to greater resource utilization. Greg Ip of the Wall Street Journal noted last week:
Unlike in 2009, this fiscal stimulus will be hitting when the economy is close to full employment with far less spare capacity. Yet it’s premature to assume inflation will therefore jump. In the last decade inflation, excluding swings due to energy, has proven surprisingly inertial, barely moving in response to high unemployment. The same is likely true if unemployment drops further below its “natural” level.
It is true that inflation is fairly inertial, although some policymakers will dismiss the lack of response to high unemployment as a consequence of downward nominal wage rigidity. Moreover, others will claim the reason for inertial inflation is that the Fed has properly responds to weak or strong economic conditions to hold inflation and, importantly, inflation expectations, in check. In other words, you won’t see inflation if the Fed acts preemptively.
Still, the broader point remains true that while further declines in unemployment will pressure the Fed to hiking rates more aggressively, low inflation like seen in November will temper that response.
In addition, policy going forward depends on the relative tightness of financial markets in general, and the dollar in particular. And the dollar has been on a tear in recent weeks:


The dollar serves as a break on the US economy. If activity expands as I anticipate, and the economy is near full employment as I believe, then some demand will be offshored as the rising dollar prompts the trade deficit to widen. Consequently, the Fed needs to be wary of feedback effects from the dollar as they tighten policy.
Bottom Line: The economic situation on the ground is very different from December of last year. Whereas the decision to raise rates at that time looked ill-advised, this latest action appears more appropriate given the likely medium-term path of the US economy. Assuming the US economy is near full employment, that path likely contains enough upward pressure on activity to justify more than one more rate increase in 2017. Three I think is more likely than one. That said, the change in administrations and the path of fiscal policy creates uncertainties in both directions.

Thursday, December 15, 2016

Fed Watch: Fed Turns Hawkish

Tim Duy:

Fed Turns Hawkish, by Tim Duy: The FOMC raised the target range for the federal funds rate by 25bp today, as expected. But the tone of the press conference and the summary of economic projections were more hawkish than I anticipated. The Fed is shifting gears, a shift I did not expect until more data piled up in the first quarter of 2017. 
My error in analyzing this meeting was thinking that the Fed would nudge down the longer term estimate of unemployment - essentially, the natural rate of unemployment - on the basis the 4.6% unemployment rate in November. Such a downward drift happened in 2015:


I expected something similar given that the pace of inflation and wage gains remains moderate. But the Fed stuck to their prior estimates, 4.8% with a central tendency of 4.7-5.0% and an overall range of 4.5-5.0%. They didn't budge.

What did budge was the rate forecast, the dots. The median dot shifted up 25bp; the September median forecast of 50bp of rate hikes for 2017 is now 75bp. My interpretation is that rather than showing up in a declining estimate of the natural rate, the unemployment drop showed up as a rise in the rate forecast. This is important. It is almost as if the Fed is drawing a line in the sand with an increased confidence that they have the correct natural rate estimate. Their tolerance for further declines below that line is wearing thin.

Assuming that the natural rate forecast does not change - which essentially depends on the path of wages and inflation - this means that you should anticipate that further declines in unemployment will be met with a more aggressive Fed in 2017. I don't think this will be the last increase in the median rate forecast for 2017. 

It is reasonable to argue that the median dot doesn't really represent the Fed's forecast for rates. But I think the shifts in the dots at a minimum reflect general changes in sentiment. Down for more dovish. Up for more hawkish. This is more hawkish.

Federal Reserve Chair Janet Yellen exuded confidence in the economic outlook during the press conference. Three points were particularly notable:

  1. The Fed is obviously watching the path of fiscal policy, but it is too early to say what it meant for monetary policy. She did note, however, that fiscal stimulus was not needed to help the economy reach full employment. The implication was that fiscal policy designed to boost demand rather than productivity would be met by a faster pace of rate increases. This sets the stage for a potential conflict with the Trump Administration. 
  2. She repeatedly argued that her run a "high-pressure" economy comments from October were misinterpreted. She was recommending a research program, not a policy path. If you were expecting otherwise, time to get over it.
  3. She did not dismiss the possibility of staying on as a board member after her term as Chair ends. Another potential conflict with the Trump Administration.

Bottom Line: Sentiment on Constitution Ave. is shifting toward a modestly more hawkish stance a few months ahead of my schedule.  Policymakers finally see the light at the end of the tunnel.

Wednesday, December 14, 2016

FOMC Raises its Target Range for the Federal Funds Rate

"the Committee decided to raise the target range for the federal funds rate to 1/2 to 3/4 percent":

Press Release, Release Date: December 14, 2016, For release at 2:00 p.m. EST: Information received since the Federal Open Market Committee met in November indicates that the labor market has continued to strengthen and that economic activity has been expanding at a moderate pace since mid-year. Job gains have been solid in recent months and the unemployment rate has declined. Household spending has been rising moderately but business fixed investment has remained soft. Inflation has increased since earlier this year but is still below the Committee's 2 percent longer-run objective, partly reflecting earlier declines in energy prices and in prices of non-energy imports. Market-based measures of inflation compensation have moved up considerably but still are low; most survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market conditions will strengthen somewhat further. Inflation is expected to rise to 2 percent over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further. Near-term risks to the economic outlook appear roughly balanced. The Committee continues to closely monitor inflation indicators and global economic and financial developments.
In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 1/2 to 3/4 percent. The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a return to 2 percent inflation.
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. 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 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. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.
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, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee's holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; James Bullard; Stanley Fischer; Esther L. George; Loretta J. Mester; Jerome H. Powell; Eric Rosengren; and Daniel K. Tarullo.

Monday, December 12, 2016

Fed Watch: December FOMC Preview

Tim Duy:

December FOMC Preview, by Tim Duy: The Federal Reserve will nudge rates 25bp higher this week. This will not end the policy tension among FOMC members. How will that unfold in 2017? My expectation is that whereas 2016 began with excessively high expectations for rate hikes, 2017 will be the opposite. My tendency is think that the risks to the Fed’s median forecast of 50bp of rate hikes in 2017 are more weighted to the upside than the downside. Beware then of a more aggressive than expected Fed.
The FOMC statement represents a compromise position. Broadly speaking, some policymakers rely on earlier paradigms calling for preemptive policy action as the economy heads toward estimates of full employment. Another group questioned those estimates given the apparent decreased sensitivity of inflation to unemployment in addition to risk management concerns at the zero lower bound.
Slower growth, an uptick in the labor force participation rate, and low inflation in 2016 lent support to the latter group, keeping the Fed on the sidelines since last December. Support from the data, however, has waned.
To be sure, incoming data does not entirely resolve the debate. On one hand, the unemployment rate plunged 0.3 percentage points in November to 4.6 percent:


This is below the range of the longer-run central tendency (4.7 – 5.0 percent), sufficient to prompt a preemptive rate hike in December without dissent.
Still, unemployment continues to decline in the absence of widespread wage or inflationary pressures. Wage growth declined in November:


and the October read on inflation was tepid:


Consequently, we shouldn’t be surprised by a modest downward revision to the Fed’s longer-run estimate of unemployment. Moreover, measures of underemployment remain elevated, suggesting that labor slack remains even near estimates of full employment, allowing for unemployment to dip below those estimates without much concern. These factors provide breathing room to maintain a slow pace of rate hikes of 50bp in 2017 implied by the Fed’s Summary of Economic Projections.
But job growth continues to exceed estimates of that necessary to exert downward pressure on the unemployment rate. Plus, temporary help employment is picking up, suggesting that broad employment growth will accelerate as well:


Incoming data indicates the Fed should place higher weight on upside risks to the medium run growth forecast. The Institute of Supply Management’s positive manufacturing report for November adds to the evidence in the third quarter GDP report that the sector’s inventory correction process is drawing to a close. The non-manufacturing counterpart also gained traction, including a sharp rebound in the employment component. Finally, the third quarter GDP number – a respectable 3.2 percent – might be underestimating economic strength. Gross domestic income (GDI) jumped a whopping 5.2 percent during the quarter.
And then there is the fiscal picture. Fed policymakers will maintain a careful approach to that topic – see New York Federal Reserve President William Dudley and Chicago Federal Reserve President Charles Evans here. But the prospect of wider fiscal deficits should tilt the balance of risks toward a faster pace of rate hikes as 2017 progresses.
Altogether, whereas in late 2015 the economy passed through an inflection point that derailed expectations for 100bp of rate hike, the economy looks to be hitting in the opposite infection point as 2016 draws to a close. That suggests that the central tendency of the Fed’s rate projections will prove to be too low this year.
In other words maybe, just maybe, this is the year the economy starts to feel “normal.” Rather than the Fed moving closer to the markets, the markets will move to the Fed.
Bottom Line: The Fed will hike rates this week; the unemployment drop will give added weight to case for a preemptive rate hike. They will play it close to the vest regarding future policy; although the stars are beginning to align for stronger growth next year, this represents more of a risk than a reality. Expect Federal Reserve Chair Yellen to emphasize that policy is data dependent.

Sunday, December 11, 2016

The In-Betweeners

Frances Coppola (the full post is much longer):

The in-betweeners: How effective is monetary policy?

Highly effective, according to the Governor of the Bank of England. In a speech earlier this week, Mark Carney robustly defended the Bank of England's record...

Well, lots of us might agree that monetary policy did help to offset the damaging effects of bank and household deleveraging in the aftermath of the worst financial crisis since the 1930s. ...

But the most persistent criticism of monetary policy is that it has, in the words of HSBC's Stephen King, "unfortunate distributional effects". It benefits the holders of financial assets - primarily the rich - at the expense of those dependent on interest income, who are believed to be much poorer, though not necessarily the poorest.

Carney is having none of it. He rejected the distributional criticism of monetary policy... He points to these two charts as evidence that the poor have done better than the rich from monetary policy...

It is all very well crowing that the poorest have been supported. They have, to some extent, though perhaps not quite as much as you claim. But it is painfully evident that the "in-betweeners" have had much less support. Relative to the rich, they have lost out both in wealth and in income. And relative to the poor, they have lost out too: they no longer qualify for many benefits and other public support, and they are seeing public money going to people not much poorer than them while they are left to struggle on their own. These are people who see themselves as having done everything right: they have worked hard, saved and paid into the system. Now, they think the system has abandoned them. And with reason.

To be fair, it is not the Bank of England that has abandoned them, though some of them blame you for their woes: "in-betweener" pensioners are those who have been hardest hit by very low interest rates. The real failures lie on the fiscal side, and are of very long standing.

The promise of "cradle to grave" support upon which the British welfare state was founded has been systematically dismantled. Now, only the poorest are supported. The neglected in-betweeners are on their own. And their anger is shaking our political establishment to its foundations.

Tuesday, November 29, 2016

Recent Economic Developments and Longer-Run Challenges

Federal Reserve Governor Jerome Powell (for a more optimistic take on the "new normal," see Is Our Economic Future Behind Us? by Joel Mokyr):

Recent Economic Developments and Longer-Run Challenges: ...Longer-Run Challenges Productivity and Growth
Let's turn to longer-run challenges, and start by asking why growth has been so slow, and how fast we are likely to grow going forward. This next slide shows the five-year trailing average annual real GDP growth rate (figure 8). By this measure, growth averaged about 3.2 percent annually through the 1970s, the 1980s, and the 1990s. But growth began to decline after 2000 and then nose-dived with the onset of the Global Financial Crisis in 2007 and the slow expansion that followed. Since the financial crisis ended in 2009, forecasters have gradually reduced their estimates of long-run trend growth from about 3 percent to about 2 percent--a seemingly small difference that would make a huge difference in living standards over time.3 
How much of this decline is just a particularly bad business cycle, and how much represents a long-run downshift? To get at that question, let's take a deeper look at the growth slowdown. We can think of economic growth as coming from two sources: more hours worked (labor supply) or higher output per hour (productivity). Hours worked mainly depends on growth in the labor force, which has been slowing since the mid-2000s as the baby-boom generation ages. As you can see, the labor force is now growing at only about 0.5 percent per year (figure 9). Another way to see this is through the sustained increase in the ratio of people over 65 to those who are in their prime working years (figure 10). This long-expected demographic fact has now arrived, and it has challenging implications for our potential growth and also for our fiscal policy.4 
The unexpected part of the growth slowdown reflects weak productivity growth rather than lower labor supply. Labor productivity has increased only 1/2 percent per year since 2010--the smallest five-year rate of increase since World War II and about one-fourth of the average postwar rate (figure 11). The slowdown in productivity has been worldwide and is evident even in countries that were little affected by the crisis (figure 12). Given the global nature of the phenomenon, it is unlikely that U.S.-specific factors are mainly responsible.
A portion of the productivity slowdown is undoubtedly due to low levels of investment by businesses. The financial crisis and the Great Recession left firms with excess capacity, reducing incentives to invest. If businesses expect slower growth to continue, that will also hold down investment.
The other important factor is the decline in what economists call total factor productivity, or TFP, which is the part of productivity that is not explained by capital investment or increases in the skills of the labor force. TFP is thought to be mainly a function of technological innovation and efficiency gains.
There is no consensus about the future direction of productivity.5 The pessimists argue that the big paradigm-changing innovations, such as electrification or the advent of computers, are behind us. If that is so, then our standard of living will increase more slowly going forward. The optimists think that this slowdown is only a passing phase and that the age of robots and machine learning will transform our economy in coming decades. Still others argue that we are currently underestimating productivity and output because of the real difficulties we face in measuring GDP in a modern economy. For example, how do we measure the value-added of free digital services like Facebook or Twitter?6 
The future is, as always, uncertain. But I would sum up the growth discussion as follows. Growth in the labor force has slowed, and we can estimate it with reasonable confidence to be only about 0.5 percent. Growth in productivity is both more important and much harder to predict. Productivity varies significantly over time, as figure 11 showed. If productivity growth returns to, say, 1.5 percent, then the U.S. economy could grow at about 2.0 percent over the long term. Actual growth may turn out to be weaker or stronger, and the choices we make as a society will have something to say about that.
Why Are Long-Term Interest Rates So Low?
Let's turn to the related question of why long-term interest rates are so extraordinarily low in advanced economies around the world. The yield on our own benchmark 10-year U.S. Treasury security has increased lately, but at 2.3 percent it is still far below what was normal before the financial crisis. In fact, this next chart shows that, as growth and inflation have fallen, longer term interest rates have fallen as well over the past 35 years (figure 13).
So why are long-term interest rates so low? Many of you will no doubt be thinking, "They are low because you people at the Fed set them low!" While there is an element of truth there, that is not the whole story. The FOMC has considerable control over short-term interest rates. We have much less influence over long-term rates, which are set in the marketplace. Long-term interest rates represent the price that balances the supply of saving by lenders and demand for funds by borrowers, such as businesses needing to fund their capital expenditures. Lenders expect to receive a real return and to be compensated for inflation and for the risk of nonpayment. Meanwhile, borrowers adjust their demand for funds based on their changing assessment of the risks and expected returns of their investment projects. When desired saving rises or investment demand falls, then long-term interest rates will decline. Today's very low level of long-term rates suggests that both of these factors are at play.
Both expectations of slower growth and the aging of our population are having significant effects on desired saving and investment and are thus important causes of lower interest rates. If the economy is expanding more slowly, then the level of investment needed to meet demand will be lower. The lower path of growth reduces future income prospects of households, and they will tend to raise their saving. The pending retirement of baby boomers means higher saving, because people tend to save the most in the years just before their retirement. In addition, the lower rate of return on capital owing to lower productivity growth will lead to less investment and lower interest rates.
As with productivity, the factors behind the fall in U.S. interest rates include an important global component, as rates are low around the world. Indeed, although our rates are near historical lows, U.S. Treasury rates are among the highest among the major advanced economy sovereigns (figure 14).
Is This the New Normal?
What can we do to prevent low growth, low inflation, and low interest rates from becoming the new normal? We need to focus on ways to increase our long-term growth and spread that prosperity as broadly as possible. I hasten to add that these policies are, for the most part, outside the purview of the Federal Reserve. We need policies that support productivity growth, business hiring and investment, labor force participation, and the development of skills. We need effective fiscal and regulatory policies that inspire public confidence. Increased spending on public infrastructure may raise private-sector productivity over time, particularly with the growth of the stock of public infrastructure near an all-time low.7 Greater support for public and private research and development, and policies that improve product and labor market dynamism may also be fruitful.8 Monetary policy can contribute by supporting a strong and durable expansion in a context of price stability.
Monetary Policy
The low interest rate environment presents special challenges for monetary policy. In setting our target for the federal funds rate, a good place to start is to identify the rate that would prevail if the economy were at 2 percent inflation and full employment--the so-called neutral rate. "Neutral" in this context means that the rate is neither contractionary nor expansionary. If the fed funds rate is lower than the neutral rate, then policy is stimulative or accommodative, which will tend to raise growth and inflation. If the fed funds rate is higher than the neutral rate, then policy is tight and will tend to slow growth and reduce inflation.
But we can only estimate the neutral rate, and those estimates are subject to substantial uncertainty. Before the crisis, the long-run neutral rate was generally thought to be roughly stable at around 4.25 percent. Since the crisis, estimates have steadily declined, and the median estimate by FOMC participants stood at 2.9 percent in September. Many analysts believe that the neutral rate is even lower than that today and will only return to its long-run value over time.9 The low level of the neutral interest rate has several important implications. First, today's low rates are not as stimulative as they seem--consider that, despite historically low rates, inflation has run consistently below target and housing construction remains far below pre-crisis levels. Second, with rates so low, central banks are not well positioned to counteract a renewed bout of weakness. Third, persistently low interest rates can raise financial stability concerns. A long period of very low interest rates could lead to excessive risk-taking and, over time, to unsustainably high asset prices and credit growth. These are risks that we monitor carefully. Higher growth would increase the neutral rate and help address these issues.
Turning to the outlook for monetary policy, incoming data show an economy that is growing at a healthy pace, with solid payroll job gains and inflation gradually moving up to 2 percent. In my view, the case for an increase in the federal funds rate has clearly strengthened since our previous meeting earlier this month. Of course, the path of rates will depend on the path of the economy. With inflation below target, relatively slow growth, and some slack remaining in the economy, the Committee has been patient about raising rates. That patience has paid dividends. But moving too slowly could eventually mean that the Committee would have to tighten policy abruptly to avoid overshooting our goals.
To wrap up, since the end of the Great Recession in 2009, our economy has recovered slowly but steadily. Today, we are reasonably close to achieving full employment and our 2 percent inflation objective. But we face real challenges over the medium and longer terms. Our aging population will mean slower growth, all else held equal. If living standards are to continue to rise, we need policies that will support productivity and allow our dynamic economy to generate widespread gains in prosperity.

Thursday, November 17, 2016

Yellen: The Economic Outlook

Federal Reserve Chair Janet L. Yellen:

The Economic Outlook, Before the Joint Economic Committee, U.S. Congress, Washington, D.C., November 17, 2016: ...The U.S. economy has made further progress this year toward the Federal Reserve's dual-mandate objectives of maximum employment and price stability. Job gains averaged 180,000 per month from January through October, a somewhat slower pace than last year but still well above estimates of the pace necessary to absorb new entrants to the labor force. The unemployment rate, which stood at 4.9 percent in October, has held relatively steady since the beginning of the year. The stability of the unemployment rate, combined with above-trend job growth, suggests that the U.S. economy has had a bit more "room to run" than anticipated earlier. ...
While above-trend growth of the labor force and employment cannot continue indefinitely, there nonetheless appears to be scope for some further improvement in the labor market. ... Further employment gains may well help support labor force participation as well as wage gains; indeed, there are some signs that the pace of wage growth has stepped up recently. While the improvements in the labor market over the past year have been widespread across racial and ethnic groups, it is troubling that unemployment rates for African Americans and Hispanics remain higher than for the nation overall, and that the annual income of the median African American household and the median Hispanic household is still well below the median income of other U.S. households.
Meanwhile, U.S. economic growth appears to have picked up from its subdued pace earlier this year. ...
Turning to inflation... Core inflation, which excludes the more volatile energy and food prices and tends to be a better indicator of future overall inflation, has been running closer to 1-3/4 percent.
With regard to the outlook, I expect economic growth to continue at a moderate pace sufficient to generate some further strengthening in labor market conditions and a return of inflation to the Committee's 2 percent objective over the next couple of years. ... As the labor market strengthens further and the transitory influences holding down inflation fade, I expect inflation to rise to 2 percent.
Monetary Policy I will turn now to the implications of recent economic developments and the economic outlook for monetary policy. The stance of monetary policy has supported improvement in the labor market this year, along with a return of inflation toward the FOMC's 2 percent objective. In September, the Committee decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent and stated that, while the case for an increase in the target range had strengthened, it would, for the time being, wait for further evidence of continued progress toward its objectives.
At our meeting earlier this month, the Committee judged that the case for an increase in the target range had continued to strengthen and that such an increase could well become appropriate relatively soon if incoming data provide some further evidence of continued progress toward the Committee's objectives. This judgment recognized that progress in the labor market has continued and that economic activity has picked up from the modest pace seen in the first half of this year. And inflation, while still below the Committee's 2 percent objective, has increased somewhat since earlier this year. Furthermore, the Committee judged that near-term risks to the outlook were roughly balanced.
Waiting for further evidence does not reflect a lack of confidence in the economy. Rather, with the unemployment rate remaining steady this year despite above-trend job gains, and with inflation continuing to run below its target, the Committee judged that there was somewhat more room for the labor market to improve on a sustainable basis than the Committee had anticipated at the beginning of the year. Nonetheless, the Committee must remain forward looking in setting monetary policy. Were the FOMC to delay increases in the federal funds rate for too long, it could end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of the Committee's longer-run policy goals. Moreover, holding the federal funds rate at its current level for too long could also encourage excessive risk-taking and ultimately undermine financial stability.
The FOMC continues to expect that the evolution of the economy will warrant only gradual increases in the federal funds rate over time to achieve and maintain maximum employment and price stability. This assessment is based on the view that the neutral federal funds rate--meaning the rate that is neither expansionary nor contractionary and keeps the economy operating on an even keel--appears to be currently quite low by historical standards. ... With the federal funds rate currently only somewhat below estimates of the neutral rate, the stance of monetary policy is likely moderately accommodative, which is appropriate to foster further progress toward the FOMC's objectives. But because monetary policy is only moderately accommodative, the risk of falling behind the curve in the near future appears limited, and gradual increases in the federal funds rate will likely be sufficient to get to a neutral policy stance over the next few years.
Of course, the economic outlook is inherently uncertain, and, as always, the appropriate path for the federal funds rate will change in response to changes to the outlook and associated risks.

Tuesday, November 15, 2016

Is higher inflation just around the corner?

Me, at MoneyWatch:

Why interest rates will likely rise faster than inflation: Is higher inflation just around the corner? That seems to be how the bond market sees it: As soon as traders heard Donald Trump had won the presidency, bond yields spiked (chart below). That’s because it’s widely assumed that inflation and interest rates will be higher under Trump than they would have been under Democrat Hillary Clinton.

There are two reasons to expect higher interest rates and rising inflationary pressure with Trump rather than Clinton as president...

Monday, November 14, 2016

Fed Watch: December Still A Go

Tim Duy:

December Still A Go, by Tim Duy: Some back of the envelope calculations: The Fed's long-run real GDP growth estimate - the rate of potential GDP growth - is 1.8%. According to Federal Reserve Vice Chair Stan Fischer last week:
If labor force participation was to remain flat, job gains in the range of 125,000 to 175,000 would likely be needed to prevent unemployment from creeping up. However, if labor force participation was to decline, as might be expected given demographic trends, the neutral rate of payroll gains would be lower. If we assumed a downward trend in participation of about 0.3 percentage point per year, in line with estimates of the likely drag from demographics, job gains in the range of 65,000 to 115,000 would likely be sufficient to maintain full employment.
Labor force growth of 0.3%. Together, these two points imply a productivity estimate of 1.5%. The Fed's inflation target is 2%. The 2% inflation target plus 1.5% productivity growth suggests that the Fed anticipates wage growth of 3.5% when the economy settles into full employment.
Roughly; these are just back-of-the envelope calculations. Notice though that the 3-month moving average for average wage growth ticked up to 3.3% last month:


To be sure, 12-month wage growth still lags at 2.8%, but you can see where that trend is headed. Just like inflation, headed higher.
Under these conditions, it is reasonable to believe the economy is very close to full employment. Of course, some slack may still lurk in the background. Perhaps it exists in the underemployment estimates:


Or perhaps labor force participation will feel more cyclical pull before demographics begin to dominate again. But that would be a short-term impact. Longer run, the aging population will take its toll on the labor force. Anyway you slice it, the Fed's comfort level with their estimate of full employment must be on the rise:


Indeed, given the current pace of job growth, the Fed anticipates the economy is positioned to soon reach their mandates. Perhaps even more so. Fischer from last week:
...the more interesting and important questions relate to the next few years rather than the next few months. They relate in large part to the secular stagnation arguments that were laid out yesterday in Larry Summers' Mundell-Fleming lecture--in particular the behavior of the rate of productivity growth. The statement that the problem we face is largely one of demand--and we do face that problem--seems to imply either that productivity growth is called forth by aggregate demand, or a Say's Law of productivity growth, namely that productivity growth produces its own demand.
That is not an issue that can be answered purely by theorizing. Rather, it will be answered by the behavior of output and inflation as we approach and perhaps to some extent exceed our employment and inflation targets.
The Fed faces a familiar dilemma in December. Act preemptively, or hold still waiting for labor force and productivity growth to comes along? Most likely the Fed will take the opportunity in December to act preemptively and reiterate that doing so allows for them to retain their "move gradually" plan.
Does the election throw a wrench in their plans? Financial markets were buoyed by the prospect of a Republican dominated government, sending stocks higher and bonds lower. Would the bond sell off induce the Fed to take a pass in December, on the theory that higher interest rates imply tighter financial conditions? In this case, I think not. The steepening of the yield curve:


likely reflects the prospect of a reflationary policy mix. Note also that market-based inflation expectations tell the same story:


The Fed finally has the chance to chase the yield curve higher; I think they take it.
The situation differs from the steepening of the infamous "taper tantrum." Then the sell-off on the long end reflected a perceived change in the path of monetary policy, a perception the Fed did not share. Hence they needed to act in such a way to communicate their true intentions. In this case, the market is digesting new developments and raising estimates of the medium-run economic outlook and the likely monetary policy path.
Note that the Fed sees the prospect of fiscal stimulus as well. Fischer again, via Reuters:
"On more expansionary fiscal policy, I think many members of the open market committee and of the Federal Reserve Board have commented it would be useful to have a more expansionary fiscal policy," Fischer said.
It is not exactly a secret that the Fed would like a more expansionary fiscal policy to take on more of the macroeconomic policy burden. The Fed believes that a more expansionary fiscal policy would provide them greater room to "normalize" interest rates. Hence they will be closely watching the evolving fiscal agenda. It is too early for them to update their economic projections dramatically, but with regards to the December rate decision, the prospect of substantial fiscal stimulus must count as an upside risk for growth and inflation.
Given that the economy is already near the Fed's estimates of full employment, the risk of fiscal stimulus should imply a risk of a higher rate path in 2017 and beyond. Assuming no change in productivity or labor force growth, it is reasonable to anticipate that the Fed would consider a full monetary offset to any fiscal stimulus; the alternative from their perspective would be substantially higher inflation. President-elect Donald Trump might not take too kindly to such an agenda, thinking that it would undermine his efforts to
"make America great" again. The risk is that he would attempt to further politicize the Fed, nominating friendly governors willing to minimize the monetary offset. Beware of higher inflation in such an environment.
Bottom Line: With the economy hovering near full employment, the Fed will want to press forward with a December rate hike. Market odds of 85% are reasonable. Watch for signs the Fed will feel they have little choice but to offset fiscal stimulus if they want to preserve their inflation target. This is particularly the case for any large stimulus; Republican administrations have historically been pro-deficit spending. The stage is set for a contentious relationship with the next Administration. Watch for increasing politicization of the Federal Reserve.

Wednesday, November 02, 2016

Fed Watch: Fed Remains On The Sidelines

Tim Duy:

Fed Remains On The Sidelines, by Time Duy: As expected, the Federal Reserve left policy unchanged this month. The statement itself was largely unchanged as well. The near term inflation outlook improved, going from this is in September:

Inflation is expected to remain low in the near term, in part because of earlier declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further.

To this in November:

Inflation is expected to rise to 2 percent over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further.

With the year-over-year impacts of oil prices falling out of the data, headline inflation will track back upwards. Not a big surprise. With regards to the timing of the next move, the Fed went from this in September:

The Committee judges that the case for an increase in the federal funds rate has strengthened but decided, for the time being, to wait for further evidence of continued progress toward its objectives.

To this now:

The Committee judges that the case for an increase in the federal funds rate has continued to strengthen but decided, for the time being, to wait for some further evidence of continued progress toward its objectives.

See what they did there? Conditions are moving in the right direction, but the Fed still waits for some "further" evidence. Continuation of recent trends is likely sufficient to be that "further" evidence needed to justify a rate hike in December.

What would derail a December rate hike? Greg Ip at the Wall Street Journal speculates that a Trump win in next week's election would do the trick:

...a Trump victory would probably cast enough of a pall over the outlook to give the Fed reason to delay its next rate increase into next year. Ironically, Mr. Trump may discover that he, not Mr. Obama, is the reason the Fed hasn’t tightened.

Agreed, although this doesn't seem likely at this juncture. More likely to stay the Fed's hands would be a slowdown in hiring to something closer to 100k a month. That would probably end the downward pressure on the unemployment rate and raise questions about the Fed's basic forecast that the unemployment rate will continue to decline in the absence of additional rate hikes. We get two employment reports before the December meeting; for the Fed to stay on the sidelines yet again, we probably need to see both reports come in weak. The first one - for October - comes Friday morning. ADP estimates that private payrolls will be up 147k - not surging, but still easily sufficient for the Fed to justify a rate hike. If this comes to pass, we would probably need a deluge of soft numbers to keep the Fed on hold again.

Bottom Line: Fed is looking past the election to the December meeting for its second move in this rate hike cycle. Probably need some unlikely softer numbers to hold them back again.

FOMC Leaves Policy Unchanged

From the FOMC Press Release today, no change in rates but " the case for an increase in the federal funds rate has continued to strengthen":

 ... the Committee decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent. The Committee judges that the case for an increase in the federal funds rate has continued to strengthen but decided, for the time being, to wait for some further evidence of continued progress toward its objectives. The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation. ...

Full statement: Press Release, November 2, 2016.

Tuesday, October 18, 2016

Yellen Poses Important Post-Great Recession Macroeconomic Questions

Nick Bunker:

Yellen poses important post-Great Recession macroeconomic questions: Last week at a Federal Reserve Bank of Boston conference, Federal Reserve Chair Janet Yellen gave a speech on macroeconomics research in the wake of the Great Recession. She ... lists four areas for research, but let’s look more closely at the first two groups of questions that she elevates.
The first is the influence of aggregate demand on aggregate supply. As Yellen notes, the traditional way of thinking about this relationship would be that demand, a short-run phenomenon, has no significant effect of aggregate supply, which determines long-run economic growth. The potential growth rate of an economy is determined by aggregate supply...
Yellen points to research that increasingly finds so called hysteresis effects in the macroeconomy. Hysteresis, a term borrowed from physics, is the idea that short-run shocks to the economy can alter its long-term trend. One example of hysteresis is workers who lose jobs in recessions and then aren’t drawn back into the labor market bur rather are permanently locked out... Interesting new research argues that hysteresis may affect not just the labor supply but also the rate of productivity growth.
If hysteresis is prevalent in the economy, then U.S. policymakers need to rethink their fiscal and monetary policy priorities. The effects of hysteresis may mean that economic recoveries need to run longer and hotter than previous thought in order to get workers back into the labor market or allow other resources to get back into full use.
The other set of open research questions that Yellen raises is the influence of “heterogeneity” on aggregate demand. In many models of the macroeconomy, households are characterized by a representative agent... In short, they are assumed to be homogeneous. As Yellen notes in her speech, overall home equity remained positive after the bursting of the housing bubble, so a representative agent would have maintained positive equity in their home.
Yet a wealth of research in the wake of the Great Recession finds that millions of households whose mortgages were “underwater” and didn’t have positive wealth—a big reason for the severity of the downturn. Ignoring this heterogeneity in the housing market and its effects on economic inequality seems like something modern macroeconomics needs to resolve. Economists are increasingly moving in this direction, but even more movement would very helpful.
Yellen raises other areas of inquiry in her speech, including better understanding how the financial system is linked to the real economy and how the dynamics of inflation are determined. ... As Paul Krugman has noted several times over the past several years, the Great Recession doesn’t seem to have provoked the same rethink of macroeconomics compared to the Great Depression, which ushered in Keynesianism, and the stagflation of the 1970s, which led to the ascendance of new classical economics. The U.S. economy is similarly dealing with a “new normal.” Macroeconomics needs to respond this reality.