Category Archive for: Monetary Policy [Return to Main]

Friday, October 17, 2014

'Perspectives on Inequality and Opportunity'

Janet Yellen at the Conference on Economic Opportunity and Inequality, FRB Boston, Boston:

Perspectives on Inequality and Opportunity from the Survey of Consumer Finances, by Janet Yellen, Chair, FRB: The distribution of income and wealth in the United States has been widening more or less steadily for several decades, to a greater extent than in most advanced countries.1 This trend paused during the Great Recession because of larger wealth losses for those at the top of the distribution and because increased safety-net spending helped offset some income losses for those below the top. But widening inequality resumed in the recovery, as the stock market rebounded, wage growth and the healing of the labor market have been slow, and the increase in home prices has not fully restored the housing wealth lost by the large majority of households for which it is their primary asset.
The extent of and continuing increase in inequality in the United States greatly concern me. The past several decades have seen the most sustained rise in inequality since the 19th century after more than 40 years of narrowing inequality following the Great Depression. By some estimates, income and wealth inequality are near their highest levels in the past hundred years, much higher than the average during that time span and probably higher than for much of American history before then.2 It is no secret that the past few decades of widening inequality can be summed up as significant income and wealth gains for those at the very top and stagnant living standards for the majority. I think it is appropriate to ask whether this trend is compatible with values rooted in our nation's history, among them the high value Americans have traditionally placed on equality of opportunity.
Some degree of inequality in income and wealth, of course, would occur even with completely equal opportunity because variations in effort, skill, and luck will produce variations in outcomes. Indeed, some variation in outcomes arguably contributes to economic growth because it creates incentives to work hard, get an education, save, invest, and undertake risk. However, to the extent that opportunity itself is enhanced by access to economic resources, inequality of outcomes can exacerbate inequality of opportunity, thereby perpetuating a trend of increasing inequality. Such a link is suggested by the "Great Gatsby Curve," the finding that, among advanced economies, greater income inequality is associated with diminished intergenerational mobility.3 In such circumstances, society faces difficult questions of how best to fairly and justly promote equal opportunity. My purpose today is not to provide answers to these contentious questions, but rather to provide a factual basis for further discussion. I am pleased that this conference will focus on equality of economic opportunity and on ways to better promote it.
In my remarks, I will review trends in income and wealth inequality over the past several decades, then identify and discuss four sources of economic opportunity in America--think of them as "building blocks" for the gains in income and wealth that most Americans hope are within reach of those who strive for them. The first two are widely recognized as important sources of opportunity: resources available for children and affordable higher education. The second two may come as more of a surprise: business ownership and inheritances. Like most sources of wealth, family ownership of businesses and inheritances are concentrated among households at the top of the distribution. But both of these are less concentrated and more broadly distributed than other forms of wealth, and there is some basis for thinking that they may also play a role in providing economic opportunities to a considerable number of families below the top.
In focusing on these four building blocks, I do not mean to suggest that they account for all economic opportunity, but I do believe they are all significant sources of opportunity for individuals and their families to improve their economic circumstances. ...[continue]...

See also Neil Irwin, "What Janet Yellen Said, and Didn’t Say, About Inequality," who says:

If there was any doubt that Janet Yellen would be a different type of Federal Reserve chair, her speech Friday in Boston removed it. ...
Ms. Yellen’s speech is a thorough airing of some of the latest research on how much inequality has widened in recent years and why. ...
It seems like Ms. Yellen offered this speech as a way to use her bully pulpit to cast public attention on an issue she cares about deeply, deliberately avoiding areas where inequality intersects with the policy areas under which she has direct control. And it is true that the future of inequality in the United States is surely shaped more by decisions on the levels of certain taxes and the size of the social welfare state more than by anything that the Fed does.
Perhaps in future appearances, Ms. Yellen will give us a sense not just of what is wrong with inequality, but what it might mean for the policies over which she has some control.

Wednesday, October 15, 2014

''The Long-Term Unemployment Rate is NOT 'Sticky' or 'Stubborn'''

Josh Bivens has an adjective quibble:

Adjective Quibble: The Long-Term Unemployment Rate is NOT “Sticky” or “Stubborn”: A Wall Street Journal blog post this morning describes an Obama administration initiative to combat long-term unemployment. In the opening sentence, the author follows a too-common convention in describing the long-term unemployment rate as “sticky.” Sometimes the adjective is “stubborn.”
I know that this will sound like quibbling, but in this case adjectives really matter for understanding the problem. As a paper I co-wrote shows pretty clearly, the long-term unemployment rate (LTUR) has not been sticky or stubborn for years. In fact, the LTUR has fallen faster than one would expect given the overall pace of labor market improvement. It is true that the LTUR remains too high, but that is because it skyrocketed during the Great Recession and in the six months after its official end. But the LTUR has since then not become resistant to wider labor market improvement.
The concrete policy implication of recognizing this is that by far the most important thing that can be done to lower the still too-high LTUR is to maintain support for economic recovery more broadly. In today’s far too narrow macroeconomic policy debate, this simply means the Fed should not boost short-term interest rates until the labor market is much, much healthier (including a much lower LTUR). ...

And it's still far from too late for fiscal policy -- infrastructure spending for example -- to make a difference. But don't get your hopes up...

'Urgent Need to Boost Demand in the Eurozone'

Biagio Bossone and Richard Wood

To G-20 Leaders: Urgent Need to Boost Demand in the Eurozone: The economies in the Eurozone are continuing to slide into recession and depression.  Senior officials of G-20 countries (including those in Australia, the host government) have not understood, or anticipated, that the Eurozone crisis is a major threat to global recovery. The officials have provided sub-standard advice to their leaders.  The deepening crisis must be addressed.  This article identifies a strong monetary/fiscal policy combination that could boost consumer and aggregate demand, and simultaneously address high public debt burdens and deflation.

Paul Krugman:

1937: From the beginning, economists who had studied the Great Depression warned that policy makers needed, above all, to be careful not to pull another 1937 — a reference to the fateful year when FDR prematurely tried to balance the budget and the Fed prematurely tried to normalize monetary policy, aborting the recovery of the previous four years and sending the economy on another big downward slope.
Unfortunately, these warnings were ignored. ... And now things are sliding everywhere. Actually, Europe already had one 1937, with its slide into a double-dip recession; but now it’s very much looking like another. And the world economy as a whole is weakening fast. ...
I hope that the Fed will stop talking about exit strategies for a while. We are by no means out of the Lesser Depression.

Update: See also The Depressing Signals the Markets Are Sending About the Global Economy - NYTimes.com

Monday, October 13, 2014

Fed Watch: The Methodical Fed

Tim Duy:

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

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

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

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

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

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

PCE101214

INFXa101214

INFXb101214

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

SPREAD101214

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

Tuesday, October 07, 2014

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

Tim Duy:

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

LMCI2

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

LMCI1

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

Sunday, October 05, 2014

Fed Watch: Is There a Wage Growth Puzzle?

Tim Duy:

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

WOLFERS

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

PHILa100314

Same swirlogram. Compare the two recessions:

PHILd100314

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

PHILb100314

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

PHILc100314

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

PHILf100314

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

PHILg100314

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

Wednesday, October 01, 2014

The Unemployment Rate is an 'Inadequate Measure of Slack'

Jared Bernstein says there's more slack in the labor market than you'd think from just looking at the unemployment rate:

...So why not just look at the unemployment rate and call it a day? Because special factors in play right now make the jobless rate an inadequate measure of slack. In fact, at 6.1 percent last month, it’s within spitting distance of the rate many economists consider to be consistent with full employment, about 5.5 percent (I think that’s too high, but that’s a different argument).
There are at least two special factors that are distorting the unemployment rate’s signal. First, there are over seven million involuntary part-time workers, almost 5 percent of the labor force, who want, but can’t find, full-time jobs. That’s still up two percentage points from its pre-recession trough. Importantly, the unemployment rate doesn’t capture this dimension of slack at all...
The second special factor masking the extent of slack as measured by unemployment has to do with participation in the labor force. Once you give up looking for work, you’re no longer counted in the unemployment rate, so if a bunch of people exit the labor force because of the very slack we’re trying to measure, it artificially lowers unemployment, making a weak labor market look better.
That’s certainly happened over the recession and throughout the recovery...

There's still plenty of room, and plenty of time for fiscal policymakers to do more to help the unemployed (and with infrastructure, our future economic growth at the same time). Unfortunately, Congress has been captured by other interests. As for monetary policy, let's hope that the FOMC listens to Charles Evans' call for patience. Raising rates too late and risking a temporary outbreak of inflation is far less of a mistake than raising them too early and slowing the recovery of employment. And there's this too: Unemployment Hurts Happiness More Than Modest Inflation.

Tuesday, September 30, 2014

'Why Have Policymakers Abandoned the Working Class?'

I have a new column:

Why Have Policymakers Abandoned the Working Class?, by Mark Thoma: The risks associated with a negative economic shock can vary widely depending on the wealth of a household. Wealthy households can, of course, absorb a shock much easier than poorer households. Thus, it’s important to think about how economic downturns impact various groups within the economy, and how policy can be used to offset the problems experienced by the most vulnerable among us.
When thinking about the effects of an increase in the Fed’s target interest rate, for example, it’s important to consider the impacts across income groups. I was very pleased to hear monetary policymakers talk about the asymmetric risks associated with increasing the interest rate too soon and slowing the recovery of employment and output, versus raising rates too late and risking inflation. ...
But there is more to it than this. ...

Sunday, September 28, 2014

'The Fed Would be Crazy to Worry about Runaway Wages'

Rex Nutting:

The Fed would be crazy to worry about runaway wages: Richard Fisher and Charles Plosser, the two biggest inflation hawks at the Federal Reserve, are retiring soon. But their pernicious ideas will stay alive at the Fed and elsewhere, threatening the middle class with another lost decade of underemployment and low wages.
Fisher, Plosser and the other hawks say inflation is becoming our greatest economic worry. They want the Fed to raise interest rates soon to keep the unemployment rate from dropping too far and to prevent American workers from getting a raise.
They would rather have you to stay jobless and poor.
You may think I’m exaggerating their views, but I’m not. ...

Friday, September 26, 2014

'Why the Fed Is So Wimpy'

Justin Fox:

Why the Fed Is So Wimpy, by Justin Fox: Regulatory capture — when regulators come to act mainly in the interest of the industries they regulate — is a phenomenon that economists, political scientists, and legal scholars have been writing about for decades.  Bank regulators in particular have been depicted as captives for years, and have even taken to describing themselves as such.
Actually witnessing capture in the wild is different, though, and the new This American Life episode with secret recordings of bank examiners at the Federal Reserve Bank of New York going about their jobs is going to focus a lot more attention on the phenomenon. It’s really well done, and you should listen to it, read the transcript, and/or read the story by ProPublica reporter Jake Bernstein.
Still, there is some context that’s inevitably missing, and as a former banking-regulation reporter for the American Banker, I feel called to fill some of it in. Much of it has to do with the structure of bank regulation in the U.S., which actually seems designed to encourage capture. But to start, there are a couple of revelations about Goldman Sachs in the story that are treated as smoking guns. One seems to have fired a blank, while the other may be even more explosive than it’s made out to be. ...

'Targeting Two'

Carola Binder:

Targeting Two: In the Washington Post, Jared Bernstein asks why the Fed's inflation target is 2 percent. "The fact is that the target is 2 percent because the target is 2 percent," he writes. Bernstein refers to a paper by Laurence Ball suggesting that a 4% target could be preferable by reducing the likelihood of the economy running up against the zero lower bound on nominal interest rates.

Paul Krugman chimes in, adding that a 2 percent target:

"was low enough that the price stability types could be persuaded, or were willing to concede as a possibility, that true inflation — taking account of quality changes — was really zero. Meanwhile, as of the mid 1990s modeling efforts suggested that 2 percent was enough to make sustained periods at the zero lower bound unlikely and to lubricate the labor market sufficiently that downward wage stickiness would have minor effects. So 2 percent it was, and this rough guess acquired force as a focal point, a respectable place that wouldn’t get you in trouble. 

The problem is that we now know that both the zero lower bound and wage stickiness are much bigger issues than anyone realized in the 1990s."

Krugman calls the target "the terrible two," and laments that "Unfortunately, it’s now very hard to change the target; anything above 2 isn’t considered respectable."

Dean Baker also has a post in which he explains that Krugman's discussion of the 2 percent target "argues that it is a pretty much arbitrary compromise between the idea that the target should be zero (the dollar keeps its value constant forever) and the idea that we need some inflation to keep the economy operating smoothly and avoid the zero lower bound for interest rates. This is far too generous... Not only is there not much justification for 2.0 percent, there is not much justification for any target."

I'll add three papers, in reverse chronological order, that should be relevant to this discussion. ...

Thursday, September 25, 2014

'What Should Monetary Policy Be?'

Brad DeLong wants to know if he is off his rocker (on this particular point):

What Should Monetary Policy Be?: Chicago Federal Reserve Bank President Charles Evans’s position seems to me to be the position that ought to be the center of gravity of the Federal Open Market Committee’s thoughts right now, with wings on all sides of it taking different views as part of a diversified intellectual portfolio. ... Yet Evans is out there on his own–with perhaps Narayana Kocherlakota beside him. ...

As I see it:

  1. The past decade has demonstrated that to properly reduce the risks of hitting the zero nominal lower bound on safe short-term interest rates, we need not a 5%/year but at least a 6.5%/year business-cycle peak safe short nominal rate.1 With a 3%/year short-term peak real natural interest rate, we need not a 2%/year but a 3.5%/year inflation target instead.

  2. It is likely that the safe natural real rate of interest has fallen by 1%-point/year. That means that a healthy economy properly distant from the ZLB requires not a 3.5%/year but a 4.5%/year inflation target.

  3. It is very important when the economy hits the zero lower bound on nominal interest rates that expectations be that the time spent at the ZLB will be short. To build those expectations, it is important that when the economy emerges from the ZLB it undergo a period in which the long-run inflation target is overshot.

  4. The likelihood is that downward movements in labor force participation that are cementing into structural impediments to employment can be reversed if high demand pulls workers back into the labor force before the cement has set, but only with difficulty otherwise. The benefit-cost analysis thus calls for an additional inflation overshoot in order to satisfy the Federal Reserve’s dual mandate.

  5. If the Federal Reserve aims at a 2%/year inflation target and fails to raise interest rates sufficiently early, it may wind up with 4%/year inflation and have to raise short-term real interest rates to 6%/year–a nominal interest rate of 10%/year–to return the economy to its inflation target. If the Federal Reserve prematurely raises interest rates, it may wind up with 0%/year inflation and wish to lower short-term real interest rates to -2%/year to return the economy to its inflation rate. With inflation at 0%/year, it cannot do that. Thus the risks are asymmetric: raising interest rates later than optimal under perfect foresight carries much lower risks than does raising interest rates earlier than optimal.

  6. Since 1979 the Federal Reserve has built up enormous credibility as the guardian of price stability and has wrecked whatever credibility it had as the guardian of low unemployment. A situation in which the general expectation is that the Federal Reserve will do too little to guard against high unemployment is worse than a situation in which the general expectations is that the Federal Reserve will too little to guard against inflation–”it is worse, in an impoverished world, to provoke unemployment than to disappoint the rentier”.2

  7. The PCE price index is now undershooting its pre-2008 trend by fully 5%: the proper optimal-control response to a large negative real demand shock is not a price level track that falls below but rather one that rises above the previously-anticipated trend path.

IMHO, you need to reject all 7 of the above points completely in order to think that the FOMC’s goal of returning inflation to 2%/year and keeping it there is anywhere close to an optimal-control path for an institution governed by its dual mandate. I really do not see how you can reject all seven.

Moreover, financial markets right now believe that the Federal Reserve’s policy is not going to attain 2%/year inflation–not now, not over the next five years. Since June the on-track-to-recovery Confidence Fairy–to the extent that she was present–has flown away...

Thus right now justifying the Federal Reserve’s policy track seems to me to require rejecting all seven of the points above, plus rejecting the financial markets’ read on monetary policy, plus rejecting the consideration that depressed financial markets–even irrationally-depressed financial markets–should be offset with additional demand stimulus.

Yet only two of the seventeen FOMC participants are with me. Am I off my rocker? Have they been consumed by groupthink? How am I to understand all this?

Tuesday, September 23, 2014

Fed Watch: Fisher on Wages

Tim Duy:

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

FISHER092214

Another version:

FISHERa092214

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

FISHERb092214

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

Monday, September 22, 2014

'Forecasting with the FRBNY DSGE Model'

The NY Fed hopes that someday the FRBNY DSGE model will be useful for forecasting. Presently, the model has "huge margins for improvement. The list of flaws is long..." (first in a five-part series):

Forecasting with the FRBNY DSGE Model, by Marco Del Negro, Bianca De Paoli, Stefano Eusepi, Marc Giannoni, Argia Sbordone, and Andrea Tambalotti, Liberty Economics, FRBNY: The Federal Reserve Bank of New York (FRBNY) has built a DSGE model as part of its efforts to forecast the U.S. economy. On Liberty Street Economics, we are publishing a weeklong series to provide some background on the model and its use for policy analysis and forecasting, as well as its forecasting performance. In this post, we briefly discuss what DSGE models are, explain their usefulness as a forecasting tool, and preview the forthcoming pieces in this series.
The term DSGE, which stands for dynamic stochastic general equilibrium, encompasses a very broad class of macro models, from the standard real business cycle (RBC) model of Nobel prizewinners Kydland and Prescott to New Keynesian monetary models like the one of Christiano, Eichenbaum, and Evans. What distinguishes these models is that rules describing how economic agents behave are obtained by solving intertemporal optimization problems, given assumptions about the underlying environment, including the prevailing fiscal and monetary policy regime. One of the benefits of DSGE models is that they can deliver a lens for understanding the economy’s behavior. The third post in this series will show an example of this role with a discussion of the forces behind the Great Recession and the following slow recovery.
DSGE models are also quite abstract representations of reality, however, which in the past severely limited their empirical appeal and forecasting performance. This started to change with work by Schorfheide and Smets and Wouters. First, they popularized estimation (especially Bayesian estimation) of these models, with parameters chosen in a way that increased the ability of these models to describe the time series behavior of economic variables. Second, these models were enriched with both endogenous and exogenous propagation mechanisms that allowed them to better capture patterns in the data. For this reason, estimated DSGE models are increasingly used within the Federal Reserve System (the Board of Governors and the Reserve Banks of Chicago and Philadelphia have versions) and by central banks around the world (including the New Area-Wide Model developed at the European Central Bank, and models at the Norges Bank and the Sveriges Riksbank). The FRBNY DSGE model is a medium-scale model in the tradition of Christiano, Eichenbaum, and Evans and Smets and Wouters that also includes credit frictions as in the financial accelerator model developed by Bernanke, Gertler, and Gilchrist and further investigated by Christiano, Motto, and Rostagno. The second post in this series elaborates on what DSGE models are and discusses the features of the FRBNY model.
Perhaps some progress was made in the past twenty years toward empirical fit, but is it enough to give forecasts from DSGE models any credence? Aren’t there many critics out there (here is one) telling us these models are a failure? As it happens, not many people seem to have actually checked the extent to which these model forecasts are off the mark. Del Negro and Schorfheide do undertake such an exercise in a chapter of the recent Handbook of Economic Forecasting. Their analysis compares the real-time forecast accuracy of DSGE models that were available prior to the Great Recession (such as the Smets and Wouters model) to that of the Blue Chip consensus forecasts, using a period that includes the Great Recession. They find that, for nowcasting (forecasting current quarter variables) and short-run forecasting, DSGE models are at a disadvantage compared with professional forecasts. Over the medium- and long-run terms, however, DSGE model forecasts for both output and inflation become competitive with—if not superior to—professional forecasts. They also find that including timely information from financial markets such as credit spreads can dramatically improve the models’ forecasts, especially in the Great Recession period.
These results are based on what forecasters call “pseudo-out-of-sample” forecasts. These are not truly “real time” forecasts, because they were not produced at the time. (To our knowledge, there is little record of truly real time DSGE forecasts for the United States, partly because these models were only developed in the mid-2000s.) For this reason, in the fourth post of this series, we report forecasts produced in real time using the FRBNY DSGE model since 2010. These forecasts have been included in internal New York Fed documents, but were not previously made public. Although the sample is admittedly short, these forecasts show that while consensus forecasts were predicting a relatively rapid recovery from the Great Recession, the DSGE model was correctly forecasting a more sluggish recovery.
The last post in the series shows the current FRBNY DSGE forecasts for output growth and inflation and discusses the main economic forces driving the predictions. Bear in mind that these forecasts are not the official New York Fed staff forecasts; the DSGE model is only one of many tools employed for prediction and policy analysis at the Bank.
DSGE models in general and the FRBNY model in particular have huge margins for improvement. The list of flaws is long, ranging from the lack of heterogeneity (the models assume a representative household) to the crude representation of financial markets (the models have no term premia). Nevertheless, we are sticking our necks out and showing our forecasts, not because we think we have a “good” model of the economy, but because we want to have a public record of the model’s successes and failures. In doing so, we can learn from both our past performance and readers’ criticism. The model is a work in progress. Hopefully, it can be improved over time, guided by current economic and policy questions and benefiting from developments in economic theory and econometric tools.

Fed Watch: Hawkish Undertone

Tim Duy:

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

TAYLOR091714

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

Yellen20121113a

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

Thursday, September 18, 2014

Interview with Michael Woodford

From the Minneapolis Fed:

Interview with Michael Woodford: Columbia University economist on Fed mandates, effective forward guidance and cognitive limits in human decision making.

Thursday, September 11, 2014

'The Economics of Digital Currencies'

The Bank of England examines bitcoin:

Overview Digital currencies represent both innovations in payment systems and a new form of currency. This article examines the economics of digital currencies and presents an initial assessment of the risks that they may, in time, pose to the Bank of England’s objectives for monetary and financial stability. A companion piece provides an introduction to digital currency schemes, including some historical context for their development and an outline of how they work.
From the perspective of economic theory, whether a digital currency may be considered to be money depends on the extent to which it acts as a store of value, a medium of exchange and a unit of account. How far an asset serves these roles can differ, both from person to person and over time. And meeting these economic definitions does not necessarily imply that an asset will be regarded as money for legal or regulatory purposes. At present, digital currencies are used by relatively few people. For these people, data suggest that digital currencies are primarily viewed as stores of value — albeit with significant volatility in their valuations (see summary chart) — and are not typically used as media of exchange. At present, there is little evidence of digital currencies being used as units of account.
This  article argues that the incentives embedded in the current design of digital currencies pose impediments to their widespread usage. A key attraction of such schemes at present is their low transaction fees. But these fees may need to rise as usage grows and may eventually be higher than those charged by incumbent payment systems.
Most digital currencies incorporate a pre-determined path towards a fixed eventual supply. In addition to making it extremely unlikely that a digital currency, as currently designed, will achieve widespread usage in the long run, a fixed money supply may also harm the macroeconomy: it could contribute to deflation in the prices of goods and services, and in wages. And importantly, the inability of the money supply to vary in response to demand would likely cause greater volatility in prices and real activity. It is important to note, however, that a fixed eventual supply is not an inherent requirement of digital currency schemes.
Digital currencies do not currently pose a material risk to monetary or financial stability in the United Kingdom, given the small size of such schemes. This could conceivably change, but only if they were to grow significantly. The Bank continues to monitor digital currencies and the risks they pose to its mission.

Monday, September 08, 2014

Fed Watch: Forward Guidance Heading for a Change

Tim Duy:

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

NFPa090814

NFPb090814

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

What were they thinking? The Federal Reserve in the Run-Up to the 2008 Financial Crisis

At Vox EU:

What were they thinking? The Federal Reserve in the run-up to the 2008 financial crisis, by Stephen Golub, Ayse Kaya, Michael Reay: Since the Global Crisis, critics have questioned why regulatory agencies failed to prevent it. This column argues that the US Federal Reserve was aware of potential problems brewing in the financial system, but was largely unconcerned by them. Both Greenspan and Bernanke subscribed to the view that identifying bubbles is very difficult, pre-emptive bursting may be harmful, and that central banks could limit the damage ex post. The scripted nature of FOMC meetings, the focus on the Greenbook, and a ‘silo’ mentality reduced the impact of dissenting views.

Thursday, September 04, 2014

Fed Watch: August Employment Report Tomorrow

Tim Duy:

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

CLAIMS083114

The employment components of both ISM reports where solid:

EMPb090414

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

EMPa090414

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

EMPc090414

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

EMPd090414

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

EMPe090414

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

Tuesday, September 02, 2014

Fed Watch: Solid Start to September

Tim Duy:

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

ISMa090114

Moreover, strength was evident throughout the internal components:

ISM090114

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

ISMb090114

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

Fed Watch: Fed Positioning to Normalize Policy

Tim Duy:

Fed Positioning to Normalize Policy, by Tim Duy: With the leaves turning to gold signaling the end of summer, so too will the Fed be facing its own change of seasons as quantitative easing comes to an end. With asset purchases likely ending in October, time is growing short for the Fed to communicate a plan for the normalization of policy. To be sure, the outline of the plan is already in place, with interest on reserves playing a primary role backed by overnight repurchase operations. The timing of any action to raise rates, however, is likely to become a more contentious issue during the fall. Hawks will be pitted against doves as the former focus on improving labor markets while the latter point to underemployment and low inflation as reason for patience. The baseline scenario is that Fed Chair Janet Yellen guides the Fed to a delayed and gradual rate hike scenario. Given that this is just about the most dovish scenario imaginable at this juncture, the balance of risks is weighted toward a more aggressive approach to normalization.
The FOMC next meets Sept. 16 and 17. The almost certain outcome of that meeting will be another $10 billion cut from the Fed's asset purchase program. The subsequent press conference provides the opportunity to communicate more clearly the technical elements of the normalization process if the Fed feels sufficiently confident in the broad outlines of their plan. Less certain is a change in the forward guidance to reflect the the dissent of Philadelphia Federal Reserve Charles Plosser:
Voting against was Charles I. Plosser who objected to the guidance indicating that it likely will be appropriate to maintain the current target range for the federal funds rate for "a considerable time after the asset purchase program ends," because such language is time dependent and does not reflect the considerable economic progress that has been made toward the Committee's goals.
The ability to maintain the considerable period language will likely be dependent on the next employment report. The pattern of initial unemployment claims data points toward fairly strong momentum in labor markets:

CLAIMS083114

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

InfA083114

InfB083114

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

RateA083114

RateB083114

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

RateC083114

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

Wednesday, August 27, 2014

'On the Relationships between Wages, Prices, and Economic Activity'

This is from Edward S. Knotek II and Saeed Zaman of the Cleveland Fed:

On the Relationships between Wages, Prices, and Economic Activity: Labor costs and labor compensation have garnered considerable attention from economists in the wake of the financial crisis and recession. Across a range of measures, wage growth slowed sharply during the recession. Recently, wage growth has remained near historically low levels despite improvements in the labor market.
Subdued wage growth has been variously seen as both a cause and a consequence of the slow pace of economic growth and persistently low inflation rates. It also may have contributed to rising inequality. In some forecast narratives, a pickup in wage growth is viewed as a necessary condition for a stronger recovery and rising inflation. In others, it is a natural consequence of a tightening labor market.
This Commentary takes a closer look at the relationships between wages, prices, and economic activity. It finds that the connections among wages, prices, and economic activity are more akin to a tangled web than a straight line. In the United States, wages and prices have tended to move together, and causal relationships are difficult to identify. We do find that wages are sensitive to economic activity and the level of slack in the economy, but our forecasting results suggest that the ability of wages to help predict future inflation is limited. Thus, wages appear to be useful in assessing the current state of labor markets, but not necessarily sufficient for thinking about where the economy and inflation are going. ...

So even if wages do finally begin rising, policymakers shouldn't panic about inflation (wishful thinking).

Filling the Gap: Monetary Policy or Tax Cuts or Government Spending?

Simon Wren-Lewis (a bit technical):

Filling the gap: monetary policy or tax cuts or government spending: Suppose there is a shortfall in aggregate demand associated with a rise in involuntary unemployment in a simple closed economy with no capital. Do we try and raise private consumption (C) or government consumption (G)? If the former, why do we prefer to use monetary policy rather than tax cuts? ...

Friday, August 22, 2014

'Three Conditions Must be Satisfied for Helicopter Money Always to Boost Aggregate Demand'

David Keohane at FT Alphaville:

Buiter on helicopter drops: Some further, further reading on Friday — a new paper from Citi’s Willem Buiter, on why helicopter drops of money always work. From the abstract...:

Three conditions must be satisfied for helicopter money always to boost aggregate demand. First, there must be benefits from holding fiat base money other than its pecuniary rate of return. Second, fiat base money is irredeemable – viewed as an asset by the holder but not as a liability by the issuer. Third, the price of money is positive. Given these three conditions, there always exists – even in a permanent liquidity trap – a combined monetary and fiscal policy action that boosts private demand – in principle without limit. Deflation, ‘lowflation’ and secular stagnation are therefore unnecessary. They are policy choices.

The full paper is here.

Paul Krugman: Hawks Crying Wolf

The inflation "obsession" continues despite the fact that there is little evidence that inflation is likely to be a problem. Why?:

Hawks Crying Wolf, by Paul Krugman, Commentary, NY Times: According to a recent report in The Times, there is dissent at the Fed: “An increasingly vocal minority of Federal Reserve officials want the central bank to retreat more quickly” from its easy-money policies, which they warn run the risk of causing inflation. ...
That may well be the case. But there’s something you should know: That “vocal minority” has been warning about soaring inflation more or less nonstop for six years. And the persistence of that obsession seems, to me, to be a more interesting and important story than the fact that the usual suspects are saying the usual things. ...
The point is that when you see people clinging to a view of the world in the teeth of the evidence, failing to reconsider their beliefs despite repeated prediction failures, you have to suspect that there are ulterior motives involved. So the interesting question is: What is it about crying “Inflation!” that makes it so appealing that people keep doing it despite having been wrong again and again? ...
Eight decades ago, Friedrich Hayek warned against any attempt to mitigate the Great Depression via “the creation of artificial demand”; three years ago, Mr. Ryan all but accused Ben Bernanke, the Fed chairman at the time, of seeking to “debase” the dollar. Inflation obsession is as closely associated with conservative politics as demands for lower taxes on capital gains.
It’s less clear why. But faith in the inability of government to do anything positive is a central tenet of the conservative creed. Carving out an exception for monetary policy ... may just be too subtle a distinction to draw in an era when Republican politicians draw their economic ideas from Ayn Rand novels.
Which brings me back to the Fed, and the question of when to end easy-money policies.
Even monetary doves like Janet Yellen, the Fed chairwoman, generally acknowledge that there will come a time to take the pedal off the metal. And maybe that time isn’t far off...
But the last people you want to ask about appropriate policy are people who have been warning about inflation year after year. Not only have they been consistently wrong, they’ve staked out a position that, whether they know it or not, is essentially political rather than based on analysis. They should be listened to politely — good manners are always a virtue — then ignored.

Wednesday, August 20, 2014

'What Does the Fed Have to do with Social Security? Plenty'

Dean Baker:

What does the Fed have to do with Social Security? Plenty: Most of the people who closely follow the Federal Reserve Board’s decisions on monetary policy are investors trying to get a jump on any moves that will affect financial markets. Very few of the people involved in the debate over the future of Social Security pay much attention to the Fed. That’s unfortunate because the connections are much more direct than is generally recognized. ...

Sunday, August 17, 2014

'The Treasury and the Fed are at Loggerheads'

Roger Farmer:

...How successful was operation twist at changing the maturity structure of Treasury securities held by the public? ...I break down Treasuries held by the public as a fraction of total debt outstanding. This ... shows that although the Fed switched its holdings from yields of three months to two years to yields in the two to ten year range (Figure 3) this operation was swamped, after November of 2008, by Treasury operations that increased the supply of maturities in the two to ten year range (Figure 4).  The end result was that the public ended up holding more of these two to ten year bonds in 2010 than before the recession hit.
Could we have a little coordination here guys?

Friday, August 15, 2014

'Persistently Below-Target Inflation Rate is a Signal That the U.S. Economy is Not Taking Advantage of all of its Available Resources'

Narayana Kocherlakota, President of the Minneapolis Fed:

..I’m a member of the Federal Open Market Committee—the FOMC—and, as a monetary policymaker, my discussion will be framed by the goals of monetary policy. Congress has charged the FOMC with making monetary policy so as to promote price stability and maximum employment. I’ll discuss the state of the macroeconomy in terms of these goals.
Let me start with price stability. The FOMC has translated the price stability objective into an inflation rate goal of 2 percent per year. This inflation rate target refers to the personal consumption expenditures, or PCE, price index. ... That rate currently stands at 1.6 percent, which is below the FOMC’s target of 2 percent. In fact, the inflation rate has averaged 1.6 percent since the start of the recession six and a half years ago, and inflation is expected to remain low for some time. For example, the minutes from the June FOMC meeting reveal that the Federal Reserve Board staff outlook is for inflation to remain below 2 percent over the next few years.
In a similar vein, earlier this year, the Congressional Budget Office (CBO) predicted that inflation will not reach 2 percent until 2018—more than 10 years after the beginning of the Great Recession. I agree with this forecast. This means that the FOMC is still a long way from meeting its targeted goal of price stability.
The second FOMC goal is to promote maximum employment. What, then, is the state of U.S. labor markets? The latest unemployment rate was 6.2 percent for July. This number is representative of the significant improvement in labor market conditions that we’ve seen since October 2009, when the unemployment rate was 10 percent. And I expect this number to fall further through the course of this year, to around 5.7 percent. However, this progress in the decline of the unemployment rate masks continued weakness in labor markets.
There are many ways to see this continued weakness. I’ll mention two that I see as especially significant. First, the fraction of people aged 25 to 54—our prime-aged potential workers—who actually have a job is still at a disturbingly low rate. Second, a historically high percentage of workers would like a full-time job, but can only find part-time work. Bottom line: I see labor markets as remaining some way from meeting the FOMC’s goal of full employment.
So I’ve told you that inflation rates will remain low for a number of years and that labor markets are still weak. It is important, I think, to understand the connection between these two phenomena. As I have discussed in greater detail in recent speeches, a persistently below-target inflation rate is a signal that the U.S. economy is not taking advantage of all of its available resources. If demand were sufficiently high to generate 2 percent inflation, the underutilized resources would be put to work. And the most important of those resources is the American people. There are many people in this country who want to work more hours, and our society is deprived of their production. ...

Paul Krugman: The Forever Slump

The risks from tightening policy too soon are much greater than the risks from leaving policy in place too long:

The Forever Slump, by Paul Krugman, Commentary, NY Times: It’s hard to believe, but almost six years have passed since the fall of Lehman Brothers ushered in the worst economic crisis since the 1930s. ... Recovery is far from complete, and the wrong policies could still turn economic weakness into a more or less permanent depression.
In fact, that’s what seems to be happening in Europe as we speak. And the rest of us should learn from Europe’s experience. ...
European officials eagerly embraced now-discredited doctrines that allegedly justified fiscal austerity even in depressed economies (although America has de facto done a lot of austerity, too, thanks to the sequester and cuts at the state and local level). And the European Central Bank, or E.C.B., not only failed to match the Fed’s asset purchases, it actually raised interest rates back in 2011 to head off the imaginary risk of inflation.
The E.C.B. reversed course when Europe slid back into recession, and, as I’ve already mentioned, under Mario Draghi’s leadership, it did a lot to alleviate the European debt crisis. But this wasn’t enough. ...
And now growth has stalled, while inflation has fallen far below the E.C.B.’s target of 2 percent, and prices are actually falling in debtor nations. It’s really a dismal picture. ... Europe will arguably be lucky if all it experiences is one lost decade.
The good news is that things don’t look that dire in America, where job creation seems finally to have picked up and the threat of deflation has receded, at least for now. But all it would take is a few bad shocks and/or policy missteps to send us down the same path.
The good news is that Janet Yellen, the Fed chairwoman, understands the danger; she has made it clear that she would rather take the chance of a temporary rise in the inflation rate than risk hitting the brakes too soon, the way the E.C.B. did in 2011. The bad news is that she and her colleagues are under a lot of pressure to do the wrong thing from [those] who seem to have learned nothing from being wrong year after year, and are still agitating for higher rates.
There’s an old joke about the man who decides to cheer up, because things could be worse — and sure enough, things get worse. That’s more or less what happened to Europe, and we shouldn’t let it happen here.

Thursday, August 14, 2014

'The Gold Standard and Price Inflation'

David Andolfatto of the St. Louis Fed:

The Gold Standard and Price Inflation: Why doesn’t the U.S. return to the gold standard so that the Fed can’t “create money out of thin air”?
The phrase “create money out of thin air” refers to the Fed’s ability to create money at virtually zero resource cost. It is frequently asserted that such an ability necessarily leads to “too much” price inflation. Under a gold standard, the temptation to overinflate is allegedly absent, that is, gold cannot be “created out of thin air.” It would follow that a return to a gold standard would be the only way to guarantee price-level stability.
Unfortunately, a gold standard is not a guarantee of price stability. It is simply a promise made “out of thin air” to keep the supply of money anchored to the supply of gold. To consider how tenuous such a promise can be, consider the following example. On April 5, 1933, President Franklin D. Roosevelt ordered all gold coins and certificates of denominations in excess of $100 turned in for other money by May 1 at a set price of $20.67 per ounce. Two months later, a joint resolution of Congress abrogated the gold clauses in many public and private obligations that required the debtor to repay the creditor in gold dollars of the same weight and fineness as those borrowed. In 1934, the government price of gold was increased to $35 per ounce, effectively increasing the dollar value of gold on the Federal Reserve’s balance sheet by almost 70 percent. This action allowed the Federal Reserve to increase the money supply by a corresponding amount and, subsequently, led to significant price inflation.
This historical example demonstrates that the gold standard is no guarantee of price stability. Moreover, the fact that price inflation in the U.S. has remained low and stable over the past 30 years demonstrates that the gold standard is not necessary for price stability. Price stability evidently depends less on whether money is “created out of thin air” and more on the credibility of the monetary authority to manage the economy’s money supply in a responsible manner.

Wednesday, August 13, 2014

Fed Watch: Heading Into Jackson Hole

Tim Duy:

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

JOLTS081214

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

Monday, August 11, 2014

'Celebrating Greenspan's Legacy of Failure'

Barry Ritholtz:

Celebrating Greenspan's Legacy of Failure: On this day in 1987, Alan Greenspan became chairman of the Federal Reserve Board. This anniversary allows us to take a quick look at what followed over the next two decades. As it turned out, it was one of the most interesting and, to be blunt, weirdest tenures ever for a Fed chairman.
This was largely because of the strange ways Greenspan's infatuation with the philosophy of Ayn Rand manifested themselves. He was a free marketer who loved to intervene in the markets, a chief bank regulator who seemingly failed to understand even the most basic premise of bank regulations. ...
The contradictions between Greenspan's philosophy and his actions led to many key events over his career. The ones that stand out the most in my mind are as follows...

Barry concludes with:

It's worth noting that, Greenspan’s intellectual hero, Rand, also turned her back on her own philosophy, living off of Social Security and other government aid before she died of cancer in 1982.
In the end, a central banker cannot be both concerned with asset prices yet comfortable with collapsing bubbles. These are inherently contradictory beliefs. That is why Greenspan’s tenure was both disastrous and fascinating.

Friday, August 08, 2014

'Getting There?'

David Altig (Research Director at the Atlanta Fed):

Getting There?, by David Altig, Macroblog: To say that last week was somewhat eventful on the macroeconomic data front is probably an exercise in understatement. Relevant numbers on GDP growth (past and present), employment and unemployment, and consumer price inflation came in quick succession.
These data provide some of the context for our local Federal Open Market Committee participant’s comments this week (for example, in the Wall Street Journal’s Real Time Economics blog, with similar remarks made in an interview on CNBC’s Closing Bell). From that Real Time Economics blog post:
Although the economy is clearly growing at a respectable rate, Federal Reserve Bank of Atlanta President Dennis Lockhart said Wednesday it is premature to start planning an early exit from the central bank’s ultra-easy policy stance.
“I’m not ruling out” the idea the Fed may need to raise short-term interest rates earlier than many now expect, Mr. Lockhart said in an interview with The Wall Street Journal. But, at the same time, “I’m a little bit cautious” about the policy outlook, and still expect that when the first interest rate hike comes, it will likely happen somewhere in the second half of next year.
“I remain one who is looking for further validation that we are on a track that is going to make the path to our mandate objectives pretty irreversible,” Mr. Lockhart said. “It’s premature, even with the good numbers that have come in...to draw the conclusion that we are clearly on that positive path,” he said.
Why so “cautious”? Here’s the Atlanta Fed staff’s take on the state of things, starting with GDP:
With the annual benchmark revision in hand, 2013 looks like the real deal, the year that the early bet on an acceleration of growth to the 3 percent range finally panned out. Notably, fiscal drag (following the late-2012 budget deal), which had been our go-to explanation of why GDP appeared to have fallen short of expectations once again, looks much less consequential on revision.
Is 2014 on track for a repeat (or, more specifically, comparable performance looking through the collection of special factors that weighed on the first quarter)? The second-quarter bounce of real GDP growth to near 4 percent seems encouraging, but we are not yet overly impressed. Final sales—a number that looks through the temporary contribution of changes in inventories—clocked in at a less-than-eye-popping 2.3 percent annual rate.
Furthermore, given the significant surprise in the first-quarter final GDP report when the medical-expenditure-soaked Quarterly Services Survey was finally folded in, we’re inclined to be pretty careful about over-interpreting the second quarter this early. It’s way too early for a victory dance.
Regarding labor markets, here is our favorite type of snapshot, courtesy of the Atlanta Fed’s Labor Market Spider Chart:

Atlanta Fed Labor Market Spider Chart

There is a lot to like in that picture. Leading indicators, payroll employment, vacancies posted by employers, and small business confidence are fully recovered relative to their levels at the end of the Great Recession.
On the less positive side, the numbers of people who are marginally attached or who are working part-time while desiring full-time hours remain elevated, and the overall job-finding rate is still well below prerecession levels. Even so, these indicators are noticeably better than they were at this time last year.
That year-over-year improvement is an important observation: the period from mid-2012 to mid-2013 showed little progress in the broader measures of labor-market performance that we place in the resource “utilization” category. During the past year, these broad measures have improved at the same relative pace as the standard unemployment statistic.
We have been contending for some time that part-time for economic reasons (PTER) is an important factor in understanding ongoing sluggishness in wage growth, and we are not yet seeing anything much in the way of meaningful wage pressures:

Total Private Earnings, year/year % change, sa

There was, to be sure, a second-quarter spike in the employment cost index (ECI) measure of labor compensation growth, but that increase followed a sharp dip in the first quarter. Maybe the most recent ECI reading is telling us something that hourly earnings are not, but that still seems like a big maybe. Outside of some specific sectors and occupations (in manufacturing, for example), there is not much evidence of accelerating wage pressure in either the data or in anecdotes we get from our District contacts. We continue to believe that wage growth is most consistent with the view that that labor market slack persists, and underlying inflationary pressures (from wage costs, at least) are at bay.
Clearly, it’s dubious to claim that wages help much in the way of making forward predictions on inflation (as shown, for example, in work from the Chicago Fed, confirming earlier research from our colleagues at the Cleveland Fed). And in any event, we are inclined to agree that the inflation outlook has, in fact, firmed up. At this time last year, it was hard to argue that the inflation trend was moving in the direction of the Committee’s objective (let alone that it was not actually declining).
But here again, a declaration that the risks have clearly shifted in the direction of overshooting the FOMC’s inflation goals seems wildly premature. Transitory factors have clearly elevated recent statistics. The year-over-year inflation rate is still only 1.5 percent, and by most cuts of the data, the trend still looks as close to that level as to 2 percent.

'Trends' in the June Core PCE

We do expect measured inflation trends to continue to move in the direction of 2 percent, but sustained performance toward that objective is still more conjecture than fact. (By the way, if you are bothered by the appeal to a measure of core personal consumption expenditures in that chart above, I direct you to this piece.)
All of this is by way of explaining why we here in Atlanta are “a little bit cautious” about joining any chorus singing from the we’re-moving-on-up songbook. Paraphrasing from President Lockhart’s comments this week, the first steps to policy normalization don’t have to wait until the year-over-year inflation rate is consistently at 2 percent, or until all of the slack in the labor market is eliminated. But it is probably prudent to be fairly convinced that progress to those ends is unlikely to be reversed.
We may be getting there. We’re just not quite there yet.

Thursday, August 07, 2014

'How the Incipient Inflation Freak-Out Could Wreck the Recovery'

Tim Duy dealt with this effectively a few days ago (see here too), but it's worth emphasizing:

How the incipient inflation freak-out could wreck the recovery, by Dean Baker and Jared Bernstein: As predictable as August vacations, numerous economists and Federal Reserve watchers are arguing that the nation’s central bank must raise interest rates or risk an outbreak of spiraling inflation. Their campaign has heated up a bit in recent months, as one can cherry pick an indicator or two showing slightly faster growth in prices or wages.
But an objective analysis of the recent data, along with longer-term wage trends, reveals that the stakes of premature tightening are unacceptably high. The vast majority of the population depends on their paychecks, not their stock portfolios. If the Fed were to slam on the breaks by raising interest rates as soon as workers started to see some long-awaited real wage gains, it would be acting to prevent most of the country from seeing improvements in living standards.
To understand why continued support from the Fed is unlikely to be inflationary, consider three factors: the current state of key variables, the mechanics of inflationary pressures and the sharp rise in profits as a share of national income in recent years, along with its corollary, the fall in the compensation share. ...

Wednesday, August 06, 2014

Fed Watch: Fed Hawks Squawk

Tim Duy:

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

InfC080514

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

InfD080514

inflation expectations have been remarkably stable:

InfE080514

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

InfA080514

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

Inf080514

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

Friday, August 01, 2014

Fed Watch: July Employment Report

Tim Duy:

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

NFPc080114

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

NFPa080114

NFPb080114

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

PCEa080114

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

PCEb080114

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

Thursday, July 31, 2014

Fed Watch: On That ECI Number

Tim Duy (see Dean Baker too):

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

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

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

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

ECIa073114

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

ECIb073114

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

ECIc073114

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

'Behind the Fed's Promise about Short-Term Rates'

At MoneyWatch:

Behind the Fed's promise about short-term rates, by Mark Thoma: Can promises about the future have an effect today? That's the theory behind the Federal Reserve's statement following Wednesday's monetary policy meeting.
The Fed said it "currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run."
How is this supposed to work? How can a promise about the future course of interest rates have a stimulative effect on the economy today? ...

Wednesday, July 30, 2014

Fed Watch: FOMC Statement

Tim Duy:

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

FOMCa073014

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

FOMCb073014

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

Thursday, July 24, 2014

Should the Fed be Forced to Follow a Rule?

Me, at MoneyWatch:

Should the Fed have to play by a rule?: What if the U.S. Federal Reserve Board had to implement monetary policy according to a specific rule that would require specific policy actions depending on the circumstances?
That's the intent of a bill Republicans in the House of Representatives recently proposed. The Federal Reserve Accountability and Transparency Act would force the Fed's conduct of monetary policy to follow a prescribed rule...
Economists have long debated whether specific rules are better than giving central bankers the discretion to set monetary policy as they see fit. Here are the arguments for and against policy rules, and a compromise position that many economists advocate. ...

Friday, July 18, 2014

Paul Krugman: Addicted to Inflation

What does "inflation addiction" tell us?:

Addicted to Inflation, by Paul Krugman, Commentary, NY Times: The first step toward recovery is admitting that you have a problem. That goes for political movements as well as individuals. So I have some advice for so-called reform conservatives trying to rebuild the intellectual vitality of the right: You need to start by facing up to the fact that your movement is in the grip of some uncontrollable urges. In particular, it’s addicted to inflation — not the thing itself, but the claim that runaway inflation is either happening or about to happen. ...
Yet despite being consistently wrong for more than five years,... at best, the inflation-is-coming crowd admits that it hasn’t happened yet, but attributes the delay to unforeseeable circumstances. ... At worst, inflationistas resort to conspiracy theories: Inflation is already high, but the government is covering it up. The ... inflation conspiracy theorists have faced well-deserved ridicule even from fellow conservatives. Yet the conspiracy theory keeps resurfacing. It has, predictably, been rolled out to defend Mr. Santelli.
All of this is very frustrating to those reform conservatives. If you ask what new ideas they have to offer, they often mention “market monetarism,” which translates under current circumstances to the notion that the Fed should be doing more, not less. ... But this idea has achieved no traction at all with the rest of American conservatism, which is still obsessed with the phantom menace of runaway inflation.
And the roots of inflation addiction run deep. Reformers like to minimize the influence of libertarian fantasies — fantasies that invariably involve the notion that inflationary disaster looms unless we return to gold — on today’s conservative leaders. But to do that, you have to dismiss what these leaders have actually said. ...
More generally, modern American conservatism is deeply opposed to any form of government activism, and while monetary policy is sometimes treated as a technocratic affair, the truth is that printing dollars to fight a slump, or even to stabilize some broader definition of the money supply, is indeed an activist policy.
The point, then, is that inflation addiction is telling us something about the intellectual state of one side of our great national divide. The right’s obsessive focus on a problem we don’t have, its refusal to reconsider its premises despite overwhelming practical failure, tells you that we aren’t actually having any kind of rational debate. And that, in turn, bodes ill not just for would-be reformers, but for the nation.

Wednesday, July 16, 2014

'Risk Aversion and the Natural Interest Rate'

From the NY Fed's Liberty Street Economics blog:

Risk Aversion and the Natural Interest Rate, by Bianca De Paoli and Pawel Zabczyk: One way to assess the stance of monetary policy is to assert that there is a natural interest rate (NIR), defined as the rate consistent with output being at its potential. Broadly speaking, monetary policy can be seen as expansionary if the policy rate is below the NIR with the gap between the rates measuring the extent of the policy stimulus. Of course, there are many challenges in defining and measuring the NIR, with various factors driving its value over time. A key factor that needs to be considered is the effect of uncertainty and risk aversion on households’ savings decisions. Households’ tolerance for risk tends to be lower during downturns, putting upward pressure on precautionary savings, and thereby downward pressure on the natural interest rate. In addition, uncertainty dictates how much precautionary savings responds to changes in risk aversion. So policymakers need to be aware that rate moves to offset adverse economic conditions that are appropriate in tranquil times may not be sufficient in times of high uncertainty.
As nicely explained in an FRBSF Economic Letter, the NIR is unobservable, but can be tracked with a model that identifies the interest rate that would prevail when output is at its potential—or, absent cost shocks, at a level consistent with stable inflation. In a recent article, we describe the determinants of the natural rate of interest in a fairly standard economic model of the so-called New Keynesian (NK) variety. Our simple setup clearly doesn’t account for all factors driving the natural rate. For example, the closed-economy nature of the model excludes the possibility that global factors such as reserve purchases by foreign central banks or a significant increase in the global supply of savings could be pushing down the equilibrium interest rate. But our model does account for uncertainty and precautionary savings motives. The importance of both of these factors has been apparent during the recent recession, and both are typically ignored in the textbook NK model. Considering the ability of changes in risk aversion and uncertainty to affect the transmission mechanism of shocks and monetary policy allows our setup to clarify how these considerations affect the natural interest rate. ...
A recent IMF paper finds that two-fifths of the sharp increase in household saving rates between 2007 and 2009 can be attributed to the precautionary savings motive. An increase in precautionary savings is consistent with a lower natural interest rate. ...
What then is the policy implication of this insight? We argue that accounting for a cyclical change in precautionary savings points to a more accommodative stance during downturns by lowering the NIR. As negative shocks to demand are magnified by an increase in precautionary behavior, a larger policy rate response is required to curb deflationary pressures. Even negative supply shocks—which are generally inflationary—may be less so if they motivate people to save more for precautionary reasons. Accordingly, the policy rate that is consistent with stable prices ends up being lower when one takes into account that risk aversion falls during downturns.
By the same reasoning, this risk aversion propagation mechanism implies that the policy rate should be higher in boom periods when risk aversion is lower. To the extent that positive demand and supply shocks are relatively more inflationary if accompanied by a decrease in risk aversion, monetary policy needs to respond to these shocks more aggressively.
Policymakers should also be aware that changes in the NIR driven by precautionary savings are more dramatic in volatile times. And the arguments made here for the NIR hold for other approaches to measuring monetary policy. Namely, volatility needs to be accounted for when designing monetary policy rules as policy responses that are appropriate in relatively tranquil times may not be sufficient in times of high uncertainty.

Tuesday, July 15, 2014

Fed Watch: Yellen Testimony

Tim Duy:

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

BULLARD071514

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

Monday, July 14, 2014

Congress and Monetary Policy

Zero percent agree that Congress should impose a monetary policy rule on the Fed:

IGM Forum: Should the Fed be required to follow a rule?

I am surprised that 11% are uncertain, but see their accompanying comments (the question also asks about how certain respondents are of their answers -- some people are fairly certain they are uncertain).

Sunday, July 13, 2014

'Why Macroeconomists, Not Bankers, Should Set Interest Rates'

Simon Wren-Lewis:

Why macroeconomists, not bankers, should set interest rates: More thoughts on the idea that interest rates ought to rise because of the possibility that the financial sector is taking excessive risks: what I called in this earlier post the BIS case, after the Bank of International Settlements, the international club for central bankers. I know Paul Krugman, Brad DeLong, Mark Thoma, Tony Yates and many others have already weighed in here, but - being macroeconomists - they were perhaps too modest to draw this lesson. ...

Saturday, July 12, 2014

Are Interest Rates Artificially Low? Nope.

Discouraging:

The Meme is Out There, by Paul Krugman: I just answered some questions for Princeton magazine, and among them was this:

Please comment on how artificially low interest rates have impacted the current value of baby boomers’ retirement portfolios and should this be a consideration of the Federal Reserve?

I don’t blame the editor, who after all isn’t supposed to be an economist. But what this must reflect is what people are hearing on the financial news; I’m pretty sure that a lot of people think that all the experts regard interest rates as “artificially low”, and have no idea that to the extent that such a notion makes any sense at all — which is to say in terms of the Wicksellian natural rate — interest rates are too high, not too low.

Friday, July 11, 2014

Paul Krugman: Who Wants a Depression?

Why has there been so much "hysteria over Fed policy"?:

Who Wants a Depression?, by Paul Krugman, Commentary, NY Times: One unhappy lesson we’ve learned in recent years is that economics is a far more political subject than we liked to imagine. ...
It’s not that many years since the administration of George W. Bush declared that one lesson from the 2001 recession and the recovery that followed was that “aggressive monetary policy can make a recession shorter and milder.” Surely, then, we’d have a bipartisan consensus in favor of even more aggressive monetary policy to fight the far worse slump of 2007 to 2009. Right?
Well, no. I’ve written a number of times about the phenomenon of “sadomonetarism,” the constant demand that the Federal Reserve and other central banks stop trying to boost employment and raise interest rates instead, regardless of circumstances. I’ve suggested that the persistence of this phenomenon has a lot to do with ideology, which, in turn, has a lot to do with class interests. And I still think that’s true.
But I now think that class interests also operate through a cruder, more direct channel. Quite simply, easy-money policies, while they may help the economy as a whole, are directly detrimental to people who get a lot of their income from bonds and other interest-paying assets — and this mainly means the very wealthy, in particular the top 0.01 percent. ...
Complaints about low interest rates are usually framed in terms of the harm being done to retired Americans living on the interest from their CDs. But the interest receipts of older Americans go mainly to a small and relatively affluent minority..., and it surely explains a lot of the hysteria over Fed policy. The rich ... ensure that there are always plenty of supposed experts eager to find justifications for this attitude. Hence sadomonetarism.
Which brings me back to the politicization of economics.
Before the financial crisis, many central bankers and economists were, it’s now clear, living in a fantasy world, imagining themselves to be technocrats insulated from the political fray. ...
It turns out, however, that using monetary policy to fight depression, while in the interest of the vast majority of Americans, isn’t in the interest of a small, wealthy minority. And, as a result, monetary policy is as bound up in class and ideological conflict as tax policy.
The truth is that in a society as unequal and polarized as ours has become, almost everything is political. Get used to it.

Thursday, July 10, 2014

Fed Explores Overhaul of Its Target Interest Rate

Robin Harding reports:

Fed explores overhaul of key rate: The US Federal Reserve is exploring an overhaul of the Federal funds rate – a benchmark that underlies almost every financial transaction in the world – as it prepares for an eventual rise in interest rates. ...
According to people familiar with the discussions, the Fed is could redefine its main target rate so that it takes into account a wider range of loans between banks, making it more stable and reliable.  ...
In particular, the Fed is looking at redefining the Fed funds rate to include eurodollar transactions – dollar loans between banks outside the US markets – as well as traditional onshore loans between US banks. Other closely related rates that it could include are those on transactions for bank commercial paper and wholesale certificates of deposit between banks.

Fed Watch: QEInfinity Not

Tim Duy:

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

BN-DP809_dwindl_G_20140709142508

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

INF070914

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

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

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