Category Archive for: Monetary Policy [Return to Main]

Monday, December 11, 2017

Expect the Fed to Stand By Its 2018 Outlook

Tim Duy:

Expect the Fed to Stand By Its 2018 Outlook, by Tim Duy: As the Federal Reserve prepares to hike interest rates at this week’s Open-Market Committee meeting, market participants are bidding up short-term rates -- moving toward the Fed expectations of more increases in 2018. That move could continue when the central bank reaffirms its commitment to further tightening next year. ...Continued here at Bloomberg Prophets...

Wednesday, December 06, 2017

Will Growth Slow In 2018? And Why?

Tim Duy:

Will Growth Slow In 2018? And Why?, by Tim Duy: Thinking about the path of policy next year, this quote from Chicago Federal Reserve President Charles Evans (via the New York Times), seems like an important issue:
I think the economy is doing very well. I think it continues to show strength. The second half is looking like very good growth: 2.5 to 3 percent growth. And this is to be measured against our assessment that sustainable growth is more like 1.75 percent. So 2.5 to 3 percent is very strong growth, which should continue to lead to improved labor market activity.
Unless something structural improves to increase trend growth, we’re going to be decelerating to something under 2 percent — and that will still be a pretty good economic picture.
On the surface, this is a fairly straightforward analysis. The supply side of the economy currently grows at roughly 1.75 percent. The demand side is growing at 2.5-3 percent. So it must be true that activity slows to something under 2 percent. ...Continued here...

Tuesday, November 28, 2017

Fed Frets About Inflation While Preparing Another Rate Hike

Tim Duy:

Fed Frets About Inflation While Preparing Another Rate Hike, by Tim Duy: The minutes of the Oct. 31-Nov. 1, 2018 FOMC meeting made a bit of a splash with their mixed message. The minutes revealed widespread concern with the weak inflation numbers of the past year. Yet the minutes also showed that committee members were committed to a December rate hike. Damn the torpedoes, full speed ahead! Why the mixed message? Two words: “gradual” and “lags.” ...Continued here (blog and newsletter)...

Monday, November 13, 2017

Taking Stock

Tim Duy:

UandPi

Taking Stock, by Tim Duy: At some point every year I sense a need to reset and clarify my baseline views on the economy and monetary policy. This is that time. ...Continued here...

Monday, November 06, 2017

Fed Will Keep the Rate Hikes Coming

Tim Duy:

Fed Will Keep the Rate Hikes Coming, by Tim Duy: Lots of news from last week, most of which supported the Fed’s current anticipated rate path of one 25bp hike in December followed by three more in 2018. The only potential obstacle on that path is the persistent weakness of inflation. But the ongoing decline in the unemployment rate, along with the promise of further declines in the months ahead, will dominate lingering concerns at the Fed regarding the inflation numbers. ...Continued as newsletter...

Friday, November 03, 2017

Economy Not Likely Easy For Next Fed Chair

Tim Duy:

Economy Not Likely Easy For Next Fed Chair, by Tim Duy: The U.S. appears set to enter a more risky phase of the business cycle as the Federal Reserve attempts to glide the economy into a so-called soft-landing. For President Donald Trump’s likely nominee as chair, Jerome Powell, this means tightening policy enough to settle the economy into full employment, but not so much that it trips into recession.
Navigating this transition will be challenging for investors and the Fed alike. Market participants should be wary of assuming that a slowing economy means a recession is near. At the same time, central bankers need to be wary that they don’t slow the economy too much and set the stage for the next recession. Altogether, this means the relative calm of the past year is likely to end soon. ...[Continued at Bloomberg]...

Wednesday, November 01, 2017

Federal Reserve Independence: The Never-Ending Story

I have a new article on the past, present, and future of Federal Reserve Independence (it was written during the summer):

Federal Reserve Independence: The Never-Ending Story, by Mark Thoma: In December 1965, President Lyndon Johnson met with Federal Reserve Chairman William McChesney Martin at the president’s surprisingly modest ranch in the Texas Hill Country. Johnson was upset with Martin for tightening credit despite Johnson’s expressed preference for more accommodative policy. At one point, the president began pushing the Fed chairman around the room, haranguing him with one of his patented hard sells, “Martin, my boys are dying in Vietnam, and you won’t print the money I need.”
Martin resisted Johnson at the time, but eventually moved policy in the direction the White House demanded. Looking back years later, Martin, who was dubbed the “happy Puritan” by one journalist, lamented, “To my everlasting shame, I finally gave in to him.”
The idea that monetary policy should be made independent of political influence is widely (though hardly completely) accepted today. As former Fed Chairman Ben Bernanke (2006-14) noted, “Careful empirical studies support the view that more-independent central banks tend to deliver better inflation outcomes than less-independent central banks, without compromising economic growth.” But as the LBJ anecdote suggests, the Fed did not always enjoy the degree of independence it has today. Before the era that began with Paul Volcker (1979-87), political influence on monetary policy was the rule rather than the exception.
The independence of today’s Fed is supported by its unusual institutional framework. But the primary bulwark against interference is psychological, driven less by laws and regulations and more by the convictions of key players that the economy is better off with a central bank that can exercise broad discretion in monetary policy. Hence a president inclined to dismiss Bernanke’s “careful empirical studies” who is abetted by a Congress unwilling to resist meddling could reverse the four-decade precedent. ...[continue]...

Monday, October 30, 2017

Fed Meeting the Nonevent of the Week

Tim Duy:

Fed Meeting the Nonevent of the Week: [Newsletter version here] Central bankers will meet this week, but only to sign off on the existing policy stance. Although it pains this fedwatcher to admit, the FOMC meeting is arguably the least important event of the week. It competes with a slew of critical data, including the employment report for October, to be released Friday. Plus, we should learn President Trump’s pick to lead the Fed when Yellen’s term expires next February. An FOMC meeting widely expected to yield no change in policy and likely little in the accompanying statement simply can’t compete with this week’s news flow. ...Continued here...

Tuesday, October 24, 2017

Paul Krugman: The Doctrine of Trumpal Infallibility

"What happens to economists who never admit mistakes, and never change their views in the light of experience?":

The Doctrine of Trumpal Infallibility, by Paul Krugman, NY Times: ...we are living in the age of Trumpal infallibility: We are ruled by men who never admit error, never apologize and, crucially, never learn from their mistakes. Needless to say, men who think admitting error makes you look weak just keep making bigger mistakes; delusions of infallibility eventually lead to disaster, and one can only hope that the disasters ahead don’t bring catastrophe...
Which brings me to the subject of the Federal Reserve. ...
You see, when the 2008 financial crisis struck, the Federal Reserve ... cut interest rates to zero and “printed money” on a huge scale — not literally, but it bought trillions of dollars’ worth of bonds by creating new bank reserves.
Many conservatives were aghast. ... In 2010 a who’s who of conservative economists and pundits published an open letter warning that the Fed’s policies would cause inflation and “debase the dollar.”
But it never happened..., the Fed’s preferred measure of inflation has consistently fallen short of its target of 2 percent... Four years after that open letter..., Bloomberg tracked down many of the signatories to ask what they had learned..., not one ... was even willing to admit having been wrong.
So what happens to economists who never admit mistakes, and never change their views in the light of experience? The answer, apparently, is that they get put on the short list to be the new Fed chair.
Consider, for example, the case of Stanford’s John Taylor (one of the signatories of that open letter). ...
Since the financial crisis ... he has repeatedly demanded that the Fed raise interest rates in line with a policy rule he devised a quarter-century ago. Failing to follow that rule was supposed to cause inflation... — but seven years of being consistently wrong hasn’t inspired any rethinking on his part.
What it has inspired is a descent into increasingly strange reasons the Fed should raise rates despite low inflation. ... And never, ever, an admission that maybe something was wrong with his initial analysis.
Again, everyone makes forecast errors. ... But it’s much worse if you can never bring yourself to admit past errors and learn from them.
That kind of behavior makes it all too likely that you’ll keep making the same mistakes; but more than that, it shows something wrong with your character. And men with that character flaw should never be placed in positions of policy responsibility.

Monday, October 23, 2017

In Defense of the Conventional Wisdom

Tim Duy:

In Defense of the Conventional Wisdom: Let’s revisit this from San Francisco Federal Reserve Resident John Williams:
If you look until 2015 or so, the inflation data basically followed our models, emphasizing the role of weakness in the economy. Where this mystery has happened is really in the last year or two. I view both inflation picking up faster than expected in early 2017 and now the pullback as just part of the variability that’s going to happen. I don’t see any signs that somehow the inflation process is fundamentally changed.
I’ve been doing this a long time, and the Phillips curve has been declared dead far more times than Mark Twain.
This is representative of the conventional wisdom at the Fed, summed up succinctly as adherence to a basic expectations-augmented Phillips curve as a primary policy guide. As unemployment falls toward and below full employment, capacity constraints in the economy tighten and eventually create inflationary pressures. The central bank needs to offset these pressures via tighter policy to contain inflation and maintain inflation expectations, the center of gravity for actual inflation over time. ...Continued here...

Thursday, October 19, 2017

Incoming Data Supportive of December Rate Hike

Tim Duy:

Incoming Data Supportive of December Rate Hike: If we ignore inflation, then nothing is really standing in the way of a rate hike in December. Of course, given that arguably the primary job of a central bank is to meet its definition of price stability, the Fed shouldn’t really ignore inflation. Policymakers, however, would counter that they are not ignoring inflation. They are simply favoring the inflation forecast over actual inflation. And they would further argue they have good cause – with the economy chugging along, it is only a matter of time before resource constraints become evident and price pressures rise. That’s their story, and they are sticking to it. ...Continued here...

Wednesday, October 18, 2017

Monetary Policy in a New Era (Video) - Ben Bernanke

Monday, October 16, 2017

Is The Fed Setting Itself Up To Fail In The Next Recession?

Tim Duy:

 

Is The Fed Setting Itself Up To Fail In The Next Recession?: The Federal Reserve remains committed to a December rate hike, persistent low inflation not withstanding. With unemployment below Fed estimates of its longer-run natural rate, most FOMC participants do not need evidence of stronger inflation to justify further rate hikes. Ongoing solid job growth will be sufficient cause for tighter policy, especially in what they perceive to be an environment of loosening financial conditions. The main risk from this scenario is that the US economy enters the next recession with diminished inflation expectations, which could further hobble central bankers already facing the prospect of returning to the effective lower bound in the next cycle. ...Continued here as a newsletter...

 

Tuesday, October 10, 2017

Fed Watch: Kevin Warsh, Very Serious Person

Tim Duy:

Kevin Warsh, Very Serious Person, by Tim Duy: Scott Sumner is perplexed by Fed chair candidate Kevin Warsh. He reads the 2010 FOMC transcripts and finds Warsh explaining:
First, my views on policy. As I said when we met by videoconference, my views are increasingly out of step with the views of most people around this table. The path that you’re leading us to, Mr. Chairman, is not my preferred path forward. I think we are removing much of the burden from those that could actually help reach these objectives, particular the growth and employment objectives, and we are putting that onus strangely on ourselves rather than letting it rest where it should lie. We are too accepting of dangerous policies from others that have been long in the making, and we should put the burden on them.
I can think, Mr. Chairman, of a tough weekend that the Europeans had, particularly your counterpart at the ECB, in the spring or summer, when we all knew that the European Central Bank, rightly or wrongly, was going to take action. But Jean-Claude Trichet did not take action until very late that Sunday night, until the fiscal authorities did their part. He thought that if on Friday night he were to say all of the things he’d be willing to do, he’d be taking the burden off the fiscal authorities. He chose to wait. I think we would be far better off waiting. If we proceed on this path, as I suspect we will, I would still encourage you to put the burden where it rightly belongs, which is on other policymakers here in Washington, and to do so in a way that is respectful of different lines of responsibility.
Sumner is understandably scratching his head, trying to figure out what Warsh is getting at:
His reasoning process is poor and he lacks good communication skills.  He has very poor judgment when interpreting data.  I really don’t know what he’s trying to say here, but the reference to Trichet is interesting.  Trichet was trying to encourage fiscal authorities to adopt more contractionary fiscal policies, not expansionary policies.  Trichet did not want to “bail out” expansionary policies with ultra-low interest rates, and Warsh seems to be endorsing Trichet’s approach.  And given Warsh’s reputation as a conservative, and the massive deficits being run by Obama back in 2010, I find it odd that Warsh would be advocating fiscal stimulus, as Brannon suggests.  But again, the passage is so garbled that I could easily be wrong.
I don’t think Warsh was advocating for more fiscal stimulus at this meeting. Warsh is a Very Serious Person, and all Very Serious People know that deficits are bad. I believe that Warsh was at this juncture advocating a Trichet-style approach to the crisis, using the independence of the central bank to force the fiscal authorities to rein in those bad deficits, because of course everything wrong in the economy can be tied back to deficit spending. All Very Serious People know this. Of course, Trichet’s approach proved to be disastrous, which is why Sumner is rightfully puzzled when hearing a Fed governor suggest the same.
Sadly, Warsh was not the only Fed official who advocated such an approach. Warsh is apparently cut from the same cloth as the person I believe was the worst regional bank president in recent memory. Recall when the FOMC statement contained this sort of reference:
Household spending and business fixed investment advanced, and the housing sector has strengthened further, but fiscal policy is restraining economic growth.
Of course, if you bothered to know what the FOMC was saying, you knew the complaint was that they believed monetary policy had reached its limits to stimulate the economy, and that faster growth required a more stimulative monetary policy.
Then Dallas Federal Reserve President Richard Fisher either didn’t understand what the FOMC said, or deliberately misinterpreted the FOMC. In a 2013 speech, Fisher says:
Even if we at the Dallas Fed are right and the overall outlook for the economy is better than the current dashboard or the conventional prognostications of economists, there exists a formidable brake on growth. It was referred to point-blank in the last statement issued by the FOMC: “…fiscal policy is restraining economic growth.”
Fiscal policy is inhibiting the transmission of monetary policy into robust job creation…
…The propensity of members of Congress has been to spend in excess of revenues to give pleasure to their constituents and garner their affection…Until the Congress and the president provide a clear road map as to how fiscal rectitude will be implemented, this lack of credible details for limiting the debt-to-GDP ratio and reengineering fiscal policy to stimulate rather than constrain growth is creating undue uncertainty about future tax rates, future government purchases, future retiree benefits and all manner of factors that impact employment and economic growth. Meanwhile, the divisive nature and petty posturing of those who must determine the fiscal path of the nation is further undermining confidence and limiting the effectiveness of monetary policy…
…I argue that the Fed has no hope of moving the economy to full employment unless our fiscal authorities get their act together…Until then, I argue that the Fed is, at best, pushing on a string and, at worst, building up kindling for a massive shipboard fire of eventual inflation.
These aren’t the kind of people you want in charge of monetary policy. We need policymakers that understand their role is not to withhold monetary stimulus to force fiscal authorities to pursue countercyclical policy simply because Very Serious People know that deficit spending is always bad and cutting deficits is the solution to every problem. Monetary policy is about independently assessing the economy and enacting the policy necessary to maintain full employment and price stability. And oftentimes that means taking fiscal policy as an exogenous factor.
What is particularly discouraging is that neither Warsh nor Fisher appears to understand that during a recession, at a minimum automatic stabilizers themselves will swell the deficit. Taking aim at the deficit in such times is naive at best, deliberately spiteful at worst.
My concern remains that a Fed with someone like Kevin Warsh at the helm would prove to be disastrous for Wall Street and Main Street alike when the next recession hits. Neither group needs a central banker that believes a recession is an opportunity to inflict more pain.

Friday, October 06, 2017

Paul Krugman: Will Trump Trumpify the Fed?

"The Fed, which sets monetary policy, is by far our most important economic agency":

Will Trump Trumpify the Fed?, by Paul Krugman, NY Times: By all accounts, Rex Tillerson has demoralized and degraded the State Department to the point of uselessness. Tom Price did much the same to Health and Human Services before jetting off. Scott Pruitt has moved rapidly to eliminate the “protection” aspect of the Environmental Protection Agency. And similar stories are unfolding throughout the executive branch. ...
And one question I don’t see being asked often enough is, will the same thing happen to the Federal Reserve? And if it does, how disastrous will that end up being for the world economy?
The Fed, which sets monetary policy, is by far our most important economic agency...
When the financial crisis struck in 2008, it was essential that the Fed engage in aggressive monetary expansion...
But congressional leaders fought these necessary measures every step of the way. Most notably, Paul Ryan, who gets his ideas about monetary policy from Ayn Rand novels, berated Bernanke, claiming that his policies would debase the dollar and lead to runaway inflation. ...
And it goes more or less without saying that none of the people who kept warning that the Fed would cause terrible inflation have admitted having been wrong, or learned anything from the experience.
What all this means is that if congressional Republicans play a large role in selecting the next Fed chair, they’ll insist that it be someone who has been wrong about everything for the past decade.
Kevin Warsh, a former Fed governor widely considered a favorite for the job, certainly fits the bill. He warned about inflation in the midst of global economic collapse; he argued vigorously against doing anything, monetary or other, to fight 10 percent unemployment; he warned that the United States was about to turn into Greece, Greece I tell you. And he has shown no hint of being chastened by the failure of events to play out the way he expected.
Now, I don’t know who Trump will actually pick to head the Federal Reserve. It might actually end up being someone smart, knowledgeable and honest. Hey, there’s a first time for everything.
But surely it’s possible, even probable, that the Federal Reserve, like other government agencies, is about to get Trumpified, that one of American policy’s last remaining havens of competence and expertise will soon share in the general degradation. And won’t that be fun when the next crisis hits?

Wednesday, October 04, 2017

Hurricanes Help Boost Data While Powell Reportedly Rises to The Top of The Pack

Tim Duy:

Hurricanes Help Boost Data While Powell Reportedly Rises to The Top of The Pack, by Tim Duy: The ISM manufacturing report for September came in stronger than expected. To be sure, hurricane impacts accounted for some of the boost, particularly in supplier deliveries and prices; anecdotal responses made this clear. But it isn’t all hurricanes. Manufacturing has been gaining steam since last year. The sector continues to throw off the 2015/2016 weakness associated with the oil price decline and rise in the dollar. I often feel this improvement has been overlooked. ...Continued here...

Monday, October 02, 2017

Fed Poised To Downplay Weak Data

Tim Duy:

Fed Poised To Downplay Weak Data, by Tim Duy: Big data week ahead that ends with the employment report for September. Considering the ongoing inflation weakness, one would think the Fed would be looking for a series of very strong job reports to justify a rate hike in December. But with Fed officials largely convinced that the soft inflation numbers are transitory, a middling jobs report would likely be sufficient to keep them on track, and even a weak report if they can attribute disappointing data to the busy hurricane season. ...Continued here...

Thursday, September 28, 2017

"Inflation Weakness Is Temporary"

Tim Duy:

“Inflation Weakness Is Temporary,” by Tim Duy: Federal Reserve Chair Janet Yellen made clear two things this week. First, that her and her colleagues are somewhat confounded by the inflation data. And second, that confusion does not yet deter them from their plan for gradual rate hikes. December is still on. ...Continued in newsletter form here...

Tuesday, September 26, 2017

Dueling Federal Reserve Presidents

Tim Duy:

 

Dueling Federal Reserve Presidents, by Tim Duy: The battle over that final rate hike of 2017 continues as some policymakers find it increasingly difficult to ignore weak inflation numbers in recent months. Such concerns, however, do not appear likely to take center stage in December. Indeed, the Fed looks fairly committed to a rate hike at that meeting. But the consensus on that meeting and beyond is being held together by forecasts of a rebound of inflation next year. It will be hard to maintain that consensus if inflation numbers don’t soon give more hope to those forecasts. ...Continued here in new, experimental newsletter format...

 

Sunday, September 24, 2017

Has The Fed Abandoned Its Reaction Function?

Tim Duy:

Has The Fed Abandoned Its Reaction Function?, by Tim Duy: The immediate policy outcomes of the FOMC meeting were largely as expected. Central bankers left interest rates unchanged while announcing that the reduction of the balance sheet will begin in October as earlier outlined in June. The real action was in the Summary of Economic Projections. Policymakers continue to anticipate one more rate hike this year and three next. This policy stance looks inconsistent with the downward revisions to projections of inflation and the neutral rate; under the Fed’s earlier reaction function, the combination of the two would drive down rate projections. Arguably, policy is thus no longer as data dependent as the Fed would like us to believe. That or the reaction function has changed. ... Continued here in new, experimental newsletter format...

Wednesday, September 20, 2017

FOMC statement

No change in the target range for the federal funds rate, balance sheet unwinding to begin in October:

Federal Reserve issues FOMC statement: Information received since the Federal Open Market Committee met in July indicates that the labor market has continued to strengthen and that economic activity has been rising moderately so far this year. Job gains have remained solid in recent months, and the unemployment rate has stayed low. Household spending has been expanding at a moderate rate, and growth in business fixed investment has picked up in recent quarters. On a 12-month basis, overall inflation and the measure excluding food and energy prices have declined this year and are running below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Hurricanes Harvey, Irma, and Maria have devastated many communities, inflicting severe hardship. Storm-related disruptions and rebuilding will affect economic activity in the near term, but past experience suggests that the storms are unlikely to materially alter the course of the national economy over the medium term. Consequently, the Committee continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, and labor market conditions will strengthen somewhat further. Higher prices for gasoline and some other items in the aftermath of the hurricanes will likely boost inflation temporarily; apart from that effect, inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee's 2 percent objective over the medium term. Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.
In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1 to 1-1/4 percent. The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.
In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.
In October, the Committee will initiate the balance sheet normalization program described in the June 2017 Addendum to the Committee's Policy Normalization Principles and Plans.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Patrick Harker; Robert S. Kaplan; Neel Kashkari; and Jerome H. Powell.

Tuesday, September 19, 2017

Fed Would Surprise Markets If It Stays Hawkish

Tim Duy:

Fed Would Surprise Markets If It Stays Hawkish, by Tim Duy: The Federal Reserve meeting this week will likely end with unchanged policy rates and the initiation of balance-sheet normalization. Market participants widely expect these outcomes, so they will come as no surprise. The real action in this meeting will come from the Fed’s description of the economy, the quarterly economic projections and Chair Janet Yellen’s press conference. The totality of the commentary should lean dovish as the Fed expresses concerns about the inflation outlook. The surprise would be a Fed that still leans more heavily toward the hawkish side of policy spectrum. ...[Continued at Bloomberg Prophets]...

Friday, September 15, 2017

Fed May Have Too Much Faith in Inflation Forecasts

Tim Duy:

Fed May Have Too Much Faith in Inflation Forecasts, by Tim Duy: Despite a low unemployment rate, inflation slowed this year, confounding central bankers who set in motion a tightening cycle on the expectation of firming prices. This leaves the Federal Reserve stuck in a quandary. Either transitory factors restrain inflation only temporarily, or perhaps expectations sink below the Fed’s 2 percent target. If the former, the central bank can continue along the current path of gradual rate hikes. The majority of monetary policy makers lean in this direction. But if the latter, sticking to the current plan risks excessive slowing and even recession. It is the type of policy mistake we should fear in the mature stages of a business cycle... ...[Continued at Bloomberg Prophets]...

Friday, September 08, 2017

Fed Watch: Fed Round-Up For September 7, 2017

Tim Duy:

Fed Round-Up For September 7, 2017, by Tim Duy: Federal Reserve hawks were on the march today, laying the groundwork for an additional rate hike this year despite weak inflation. 
First off, Cleveland Federal Reserve President Loretta Mester (voter next year), reiterated the "it's only temporary story" regarding inflation:
In assessing where we are relative to the inflation goal, it’s always a good idea to look through temporary movements in the numbers, both those above and those below our goal, and focus on where inflation is going on a sustained basis. For example, when assessing the underlying trend in inflation, we should look through a temporary increase in gasoline prices stemming from disruptions caused by Hurricane Harvey. Similarly, some of the weakness in recent inflation reports reflects special factors, like the drop in the prices of prescription drugs and cell phone service plans earlier in the year. It may take a couple more months for these factors to work themselves through, but these types of price declines aren’t signaling a general downward trend in consumer prices from weak demand. Instead, they reflect supply-side factors and relative price changes.
She did give a nod to Federal Reserve Governor Lael Brainard's argument that maybe trend inflation has fallen:
At the same time, we need to recognize that weak inflation numbers, no matter what the source, can become a problem if they start to undermine the public’s expectations about future inflation. If inflation expectations were to become unanchored and began steadily declining, it would be much more difficult to raise inflation back to the Fed’s goal.
But she doesn't buy it:
I don’t expect the economy to get to that point, and my current assessment is that inflation will remain below our goal for somewhat longer but that the conditions remain in place for inflation to gradually return over the next year or so to our symmetric goal of 2 percent on a sustained basis. These conditions include growth that’s expected to be at or slightly above trend, continued strength in the labor market, and reasonably stable inflation expectations.
On the inflation forecast, this is interesting:
We need to recognize that there are risks around any inflation projection—both upside risks, considering the current and future expected strength in labor markets, and downside risks, given the softness in recent inflation readings. In fact, inflation is difficult to forecast: based on historical forecast errors over the past 20 years, the 70 percent confidence range for forecasts of PCE inflation one year ahead is plus or minus 1 percentage point, and a significant portion of the variation in inflation rates comes from idiosyncratic factors that can’t be forecasted. Indeed, since the 1990s, assuming that inflation will return to 2 percent over the next one to two years has been one of the most accurate forecasts. In the recent period, this is perhaps a testament to the importance of well-anchored inflation expectations and of the FOMC’s commitment to its 2 percent symmetric inflation goal. In any case, I will be scrutinizing incoming data on inflation and inflation expectations and the reports from my business contacts to help me assess the inflation outlook.
Since 1990, a 2 percent forecast has worked more than not, so lets just stick with that as the baseline for policy? By that logic, since the great recession, a 1.75% forecast has worked more than not, a testament to the Fed's one-sided inflation target and falling inflation expectations. I am not buying into her inflation forecast story yet.
Regardless, Mester's commitment to the faith on the inflation forecast means that as of now, she is probably sticking with the current rate path, including a December hike.
Meanwhile, FOMC heavyweight New York Federal Reserve William Dudley stuck to his guns as well tonight. His basic outlook:
Overall, the economy remains on a trajectory of slightly above-trend growth, which is gradually tightening the U.S. labor market.  Over time, this should support a rise in wage growth.  When combined with a firmer import price trend—partly reflecting recent depreciation of the dollar—and the fading of effects from a number of temporary, idiosyncratic factors, that causes me to expect inflation will rise and stabilize around the FOMC’s 2 percent objective over the medium term.  In response, the Fed will likely continue to remove monetary policy accommodation gradually.  But, the upward trajectory of the policy rate path should continue to be shallow, in part because the level of short-term interest rates consistent with keeping the economy on a sustainable long-run growth path is likely to be considerably lower than it was in prior business cycles. 
Dudley, however, will continue watching the inflation numbers, looking for this story:
If it turns out that structural changes have played a significant role, I would generally view this as a positive, rather than negative, development.  It would imply that the U.S. economy could operate at a higher level of labor resource utilization without generating a troublesome large rise in inflation.  More people could be put to work on a sustainable basis, enabling them to gain opportunities not just to earn greater income, but also to develop their skills and grow their human capital.
This opens up a downward revision of estimates of the natural rate of unemployment. Still, he thinks the Fed should continue hiking rates, in part due to easing financial conditions:
This judgment is supported by the fact that financial conditions have eased, rather than tightened, even as the Fed has raised its short-term interest rate target range by 75 basis points since last December. 
Yep, this is an expected response from Dudley. So is his pushback on inflation concerns:
 In addition, the long and variable lags between monetary policy adjustments and their impact on the economy imply that the FOMC may need to remove accommodation even when inflation is below its goal.  In particular, if the unemployment rate were already below its longer-run natural rate, as may be the case currently, the impact on wage growth and price inflation would still likely take some time to become evident. 
But, OMG, he follows up with this:
This would be particularly true if inflation expectations were well-anchored at or slightly below our 2 percent objective, as is the case currently. 

Brainard strikes again! But notice that HE SEES IT AS MORE LIKELY THAT INFLATION EXPECTATIONS ARE BELOW THAN ABOVE TARGET! One would think this would give him a bit more concern before pushing forward with more rate hikes, but no.

Fundamentally, Dudley wants to keep hiking as long as financial conditions keep easing. 
That's enough on Fed speakers for now. Time to return to yesterday's topic of new Fed appointees. This from Bloomberg:
The White House is considering at least a half-dozen candidates to be the next head of the Federal Reserve, including economists, executives with banking experience and other business people, according to three people familiar with the matter.
The breadth of the search goes against the narrative that has taken hold in Washington and on Wall Street that the Fed chair nomination is a two-horse race between National Economic Council Director Gary Cohn and current Fed Chair Janet Yellen, whose term expires in February.
Some of the other possible contenders include former Fed Governor Kevin Warsh, Columbia University economist Glenn Hubbard and Stanford University professor John Taylor, one of the people familiar said. Lawrence Lindsey, a former economic adviser to President George W. Bush, has been discussed. Former US Bancorp CEO Richard Davis and John Allison, the former CEO of BB&T Corp., have also been considered.
This doesn't sound good for Yellen. Sounds like a wide-open field that will keep us guessing for weeks. 
Separately, on the data front, we get this from Commerce, via Reuters:
The U.S. economy probably grew faster than reported in the second quarter, with data on Thursday suggesting stronger consumer spending than previously estimated. 
The quarterly services survey, or QSS, from the Commerce Department implied consumer spending increased more briskly than the 3.3 percent annualized rate reported last week in its second estimate of gross domestic product.
The Fed forecasts are based on more modest growth numbers. Stronger growth numbers will tilt them toward further rate hikes.
On the other hand, the anecdotal evidence via the Beige Book was less optimistic. In that read of the economy, activity was only modest to moderate with limited wage and inflation pressures. That said, I tend to believe that data trumps anecdotal evidence when it comes to policy.
Bottom Line: Hawks are still pushing for additional rate hikes, holding to the story that low inflation is all about transitory factors. This I think remains the dominant position on the FOMC. For what its worth, market participants do not believe this is how it will play out. The odds of a December rate hike are now hovering around 25%. Markets participants are not seeing the same story as most central bankers. Something's gotta give.

Thursday, September 07, 2017

Fed Watch: The Times They Are A-Changin'

Tim Duy:

The Times They Are A-Changin' , by Tim Duy: The Federal Reserve is now destined to get a dramatic makeover in the next few months. That is assuming that the Trump administration carves some time out of their busy schedule of managing chaos to nominate more governors. And the Senate finds the time to confirm those nominations.
Until the time the administration and Senate get their acts together, the balance of power at the Federal Reserve will shift to the regional presidents. And that could put monetary policy on a less certain course over the next year as doves on the FOMC are replaced with hawks and the Board lacks sufficient person-power to hold a steady line.
The Board of Governors of the Federal Reserve is supposed to have seven members. At the beginning of the Trump era, two spots were open. Then former Governor Daniel Tarullo resigned. That left four members and three openings.
Today we learned that Vice Chair Stanley Fischer will soon depart, on or around October 13 of this year. The stated explanation for his departure is "personal reasons." I fear this means a serious health issue. If so, my thoughts and prayers go out to him and his family.
That leaves three members and four openings. To give a sense of what this means operationally for the Fed, take a gander at the Board Committee assignments:

FedCommittees

Federal Reserve Governor Lael Brainard is serving on SEVEN committees! Federal Reserve Governor Jerome Powell is on FIVE. You might think he is slacking, but he is the chair of those committees. Fischer currently has four assignments. Unless we get some new governors soon, Brainard and Powell will have to step it up a bit more to cover for him. I am thinking they are overworked. Just a bit.
Hats off to Brainard and Powell. Committee work is some of my least favorite work.
Who am I kidding? It is my least favorite work.
So now we are down to three governors and five regional presidents on the FOMC. At least in theory, this means the regional presidents can roll the governors on policy votes. Which means I have to start taking the presidents a little more seriously. Because in all honestly when the Board is fully staffed, that is where the power resides. And there is only so much time in the day to read speeches. The presidents talk a lot (but will the come speak at my events in Portland, a little hop from San Francisco - noooo), the governors too little.
Moreover, the Board generally offers a certain consistency of thought across years, whereas the regional presidents on the FOMC rotate. So next year, for example, the torch will pass from the dovish Minneapolis and Chicago Presidents Neal Kashkari and Charles Evans to the more hawkish San Francisco and Cleveland Presidents John Williams and Loretta Mester. Also added will be the still-to-be-announced Richmond Federal Reserve President, a hawkish spot in recent years.
The tide might turn on the hawks this year though, as it is easy to tell a story where Chair Yellen, Powell, Philadelphia President Patrick Harker, and New York President William Dudley all support a December rate hike while Brainard, Kashkari, Evans, and Dallas President Robert Kaplan oppose. What fun would that meeting be?
Of course, Randy Quarles is waiting in the wings for Senate confirmation, so perhaps he would tip the balance to the hawkish side. Marvin Goodfriend is rumored for another open position, but has yet to be nominated (I can see both hawk and dove in his record, but I am thinking he will lean hawkish). So it may be that by the beginning of the year the voting power will tip back to the Board, backed by a fairly hawkish rotation of presidents. So if the doves want to take a longer pause before hiking rates again, they need to ensure Yellen is on their side going into the end of the year.
Speaking of Yellen, a decision on the Chair will soon need to be made. Yellen term expires in February of next year. Trump has toyed with the financial press by claiming she is in the running. I hope this is true, but Trump appears more interested in wiping the slate clean of Obama appointees than anything else. And she would be the pro-regulatory fly in the ointment, opposing Trump's preferred deregulatory agenda. So I can't get on board the Yellen train just yet.
White House economic advisor Gary Cohn had been thought to be in the front-running for the spot, but the latest word is that he tanked that opportunity with his frank (but belated) criticism of Trump's handling of the Charlotsville incident. What a way to go - catching it on one end for not speaking out soon enough and then, after already having lost that battle, grows a conscience and then catches it on the other end. Long story short, the White House is scrambling for a new name - and now need to get a replacement for Fischer (who could have stayed after his term as Vice Chair ended).
The Washington Post is reporting that Powell could be up for the job. That would be a good pick in my opinion. Former Governor Keven Warsh is also reportedly in the running. He has something few can match: Trump's childhood friend Ron Lauder is Warsh's father-in-law. It's not what you know, it's who you know. My feelings about Warsh are not warm.
Also, to add a bit more excitement into the mix, Yellen can stay on as Governor even if she is not the chair. Would she stay? Maybe not. Maybe. No chair has stayed since Mariner Eccles. Maybe it is a good time for one to stick around a few more years.
Bottom Line: Phew. I think that is the current state of play. Many potentially significant changes happening at the Fed over the next several months, and it is hard to predict how it will all end. All we know for now is a reported debt-ceiling deal removes the final potential obstacle to balance sheet reduction this month. That first step of unwinding the quantitative easing of the crisis years has wide support at the Fed; central bankers would like to get it underway before leadership changes begin in earnest.

Wednesday, September 06, 2017

Fed Watch: Can She Do It Again?

Tim Duy:

Can She Do It Again?, by Tim Duy: In the fall of 2015, Federal Reserve Governor Lael Brainard began building the intellectual framework to slow the pace of rate increases. Not soon enough to stop the rate hike of December that year, but the rest of the Fed soon fell in line, and the projected four rate hikes in 2016 became only one actual hike, a hike delayed until December of 2016.
Can she shift the focus of the FOMC again? She made a valiant effort today. But will her colleagues get on board as they did last time?  A key issue: he doesn't have the downtrend in the economy and financial markets of 2016 to back her up.
 Brainard begins by acknowledging the problem facing the Federal Reserve:
The labor market continues to bring more Americans off the sidelines and into productive employment, which is a very welcome development. Nonetheless, there is a notable disconnect between signs that the economy is in the neighborhood of full employment and a string of lower-than-projected inflation readings, especially since inflation has come in stubbornly below target for five years. 
The US economy is in the midst of what could easily become a record breaking expansion. Labor markets have shown dramatic improvement in that time as steady job growth pushed the economy into the range of full employment. Moreover, the outlook remains bright:
There has been a noteworthy pickup in business investment this year compared with last year. Investment in the equipment and intellectual property category has risen at an annual rate of 6 percent so far this year after remaining roughly flat last year. The latest data on orders and shipments of capital equipment suggest that solid growth will likely continue in the second half of the year. In addition, oil drilling had rebounded this year after dropping sharply last year, although Hurricane Harvey creates uncertainty about drilling in coming months. While lackluster consumer spending was one of the key reasons for the weak increase in first-quarter gross domestic product (GDP), growth in personal consumption expenditures (PCE) bounced back strongly in the second quarter, and recent readings on retail sales suggest another solid increase in consumer spending this quarter.
And, as Brainard notes, even if the anticipated fiscal stimulus has failed to materialize, the economy has been supported by a global upturn in growth as well. Sure, Hurricane Harvey may dent the short-term numbers, the medium term picture is solid.
But all is not well:
In contrast, what is troubling is five straight years in which inflation fell short of our target despite a sharp improvement in resource utilization. 
Brainard runs through the usual suspects offered as explanations for the inflation numbers - import prices, resource utilization, and transitory factors - and finds them all wanting. So what's going on? Brainard turns her attention to a fundamental element of the Fed's inflation model:
...In many of the models economists use to analyze inflation, a key feature is "underlying," or trend, inflation, which is believed to anchor the rate of inflation over a fairly long horizon. Underlying inflation can be thought of as the slow-moving trend that exerts a strong pull on wage and price setting and is often viewed as related to some notion of longer-run inflation expectations.
There is no single highly reliable measure of that underlying trend or the closely associated notion of longer-run inflation expectations. Nonetheless, a variety of measures suggest underlying trend inflation may currently be lower than it was before the crisis, contributing to the ongoing shortfall of inflation from our objective...
This is a big deal. Brainard suggests that inflation expectations are not anchored at 2 percent. And they have not become unanchored to the upside as so many of her colleagues fear will happen if they do not act preemptively. Expectations are unanchored to the downside.
Why are expectations falling? Brainard posits that perhaps households and firms are reacting to the persistent undershooting in recent years. She also relates this to low neutral interest rates, noting that the resulting lack of conventional monetary policy power increases the episodes of below target inflation, further entrenching low inflation expectations.
Now comes the tricky part. How should policymakers respond? Can low unemployment do the job? This is interesting:
Given the flatness of the Phillips curve, it could take a considerable undershooting of the natural rate of unemployment to achieve our inflation objective if we were to rely on resource utilization alone. 
For all these reasons, achieving our inflation target on a sustainable basis is likely to require a firming in longer-run inflation expectations--that is, the underlying trend. The key question in my mind is how to achieve an improvement in longer-run inflation expectations to a level that will allow us to achieve our inflation objective. The persistent failure to meet our inflation objective should push us to think broadly about diagnoses and solutions.
It is not enough to just force down unemployment. Policymakers need to match such a policy with a commitment mechanism that pulls up inflation expectations. And that mechanism likely includes explicit overshooting of the inflation target
She highlights this point in the context of setting rates. Brainard believes the neutral rate is low and likely to stay low (this will be exacerbated by the balance sheet run off). Consequently, the Fed might reach the neutral level of the federal funds rate in very short order. That means they need to be cautious moving forward, and should adjust down the expected path of tightening accordingly. Moreover, central bankers need to match the policy with a stronger goal:
To the extent that the neutral rate remains low relative to its historical value, there is a high premium on guiding inflation back up to target so as to retain space to buffer adverse shocks with conventional policy. In this regard, I believe it is important to be clear that we would be comfortable with inflation moving modestly above our target for a time
But will Brainard's colleagues listen as they did in 2016? At that point the economic conditions appeared fragile as the impact of the oil price crash filtered through the manufacturing sector. Moreover, financial conditions had tightened with a period of higher corporate yield spreads, declining equity prices, and a strong dollar. The opposite is true now - not only does the economy look healthier, but financial conditions have loosened despite Fed tightening. So I am not yet convinced she can carry the day. But this is undoubtedly a space worth watching.
Bottom Line: Brainard is making a push to slow the pace of rate hikes. I am not sure she will be as successful as her last effort to change the course of policy. But she still has two important takeaways for investors. First, if you think interest rates will rise sharply, think again. The neutral rate of interest is too low to expect much more tightening - we need much faster growth to justify a higher estimate of the neutral rate. Second, assuming she is right and the Fed doesn't take her advice, her colleagues are positioning themselves for a substantial policy error that would both bring the expansion to an end sooner than later and further entrench disinflationary expectations. And that would only make the Fed's job harder in the future.

Tuesday, September 05, 2017

Fed Watch: Mediocre To Solid Data Flow, But Weak Inflation Still Key

Tim Duy:

Mediocre To Solid Data Flow, But Weak Inflation Still Key, by Tim Duy: The data flow is generally supportive of additional Fed action, surely enough to allow the Fed to move forward with balance sheet action later this month. But what about another rate hike? That remains an open question as low inflation remains an obstacle to further rate hikes for a sizable faction within the Fed.
The employment report disappointed with job growth of 156k, shy of expectations for 180k. Previous months were revised downward. Looking through the monthly volatility, the report does little to change the basic story that job growth continues the slow downward trend that began in 2015: 

Con0917

Mediocre, but not disastrous. A key issue for the Fed is where does this slowdown stop? If they were reasonably confident job growth would soon stabilize around 100k a month, then the pressure for additional rate hikes would ease substantially. For the Fed that figure would be sufficient to bring stability to the unemployment rate. For now, though, it looks like the current pace of job growth is likely to bring further declines in the unemployment rate:

Con0917

In other words, the recent stability in unemployment around 4.3-4.4% is only temporary. A significant faction of the Fed will worry that additional declines in unemployment will signal that the economy is operating beyond full employment, placing inflation stability at risk. Hence that faction will press for additional pre-emptive tightening.
That said, tepid wage growth calls into question the Fed's current estimates of full employment:

Con0917

I think that going forward the Fed will essentially split the difference by edging down estimates of full employment while remaining concerned that the pace of job growth still exceeds that required for inflation stability over the medium-term. On net, that leaves December still open for a rate hike. More on that later.
In the meantime, it looks like the manufacturing sector continues to shake off the 2015-6 doldrums. The latest ISM report was strong:

Con0917

To be sure, a slowdown in auto sales will weigh on manufacturing in the months ahead. That said, Hurricane Harvey wiped out a half a million vehicles in Texas, so that throws some needed support to that sector going forward. 
Overall, consumer spending looks solid, continuing to hold the pace of the last 18 months:

Con0917

Not the best of the cycle, but not the worst either. Something that might be expected in a more mature phase of the cycle, which is probably about right. And within a reasonable margin of error of what might be expected given consumer sentiment numbers:

Con0917

 And then there is inflation. Or, more accurately there isn't inflation, at least any to be concerned about:

Con0917

It is fairly clear that the disinflation this year is more persistent than the Fed would like to believe. It seems like too many one-sided errors to be just coincidence. Truth be told, looking at that chart makes me think that inflation expectations are anchored around 1.75% rather than the Fed's target of 2%. I don't think the Fed thinks that, but I also don't think it is an unreasonable idea either.
Bottom Line: So where does this leave us? The Fed continues to be caught between the push of the generally positive momentum of the US economy and the pull of the surprise weakness on the wage/inflation front. Luckily for them, they don't need to decide between the two until December. Their next move is to start reducing the balance sheet - they want to have that process underway before any leadership changes next year. Moreover, they would like to ensure the process begins smoothly before returning to the issue of rate hikes. My expectations about December are, not surprisingly, data dependent. If the current mix of activity continues - generally upward momentum suggestive of actual or forecasted declines in unemployment, coupled with what the Fed will view as fairly easy financial conditions (watch the dollar!) - the Fed will hike in December even if inflation remains tepid. I think the Fed will need to see more evidence of slowing in the real economy before they cease rate hikes - I suspect they will see the economy as operating to close to full employment to risk the potential inflationary consequences of delaying additional rate hikes.

Tuesday, August 29, 2017

Yellen's Odds of Being Reappointed Get Slimmer

Tim Duy:

Yellen's Odds of Being Reappointed Get Slimmer: The Federal Reserve Bank of Kansas City’s annual Jackson Hole conference offered little direct insight into the path of monetary policy for this year and next. But that doesn’t mean it was a nonevent. Perhaps the biggest takeaway is that the already small odds of Chair Janet Yellen being reappointed by the Trump administration when her term ends in February just got a lot slimmer. ...Continued at Bloomberg Prophets...

Friday, August 25, 2017

The Market Is Behaving Much Like It Did in the Past

Tim Duy:

The Market Is Behaving Much Like It Did in the Past: The prevailing wisdom these days is that markets are behaving in inexplicable ways.
I have a different view. If the market means U.S. equities, the behavior since the Federal Reserve began this tightening cycle has been very consistent with the behavior of past cycles. It's not sure all that complicated -- it’s about consistent economic growth -- and I am pretty sure fighting it is a losing bet. ...Continued at Bloomberg Prophets...

Thursday, August 24, 2017

Fed Has Good Reason to Expect Faster Wage Growth

Tim Duy:

Fed Has Good Reason to Expect Faster Wage Growth: Federal Reserve officials must think that something soon has to give in this economy. The current equilibrium, characterized by low inflation, low unemployment, low wage growth and high corporate profit margins, isn’t sustainable indefinitely, but they don’t know how or when it will crack. ...Continued at Bloomberg Prophets...

Tuesday, August 15, 2017

Fed Watch: Retail Sales, Dudley, Wages

Tim Duy:

Retail Sales, Dudley, Wages, by Tim Duy: Some quick thoughts for the day.
First, New York Federal Reserve President William Dudley gave an extended interview to the Associate Press. Definitely worth the time to read. Some highlights:
1.) Dudley never put a Trump bump in his forecast, so his forecast is essentially unchanged:
 I think we’re still on the same trajectory we’ve been on for several years. Above trend growth, gradually tightening labor market, inflation -- somewhat below our objective -- but we do expect as the labor market continues to tighten, to see firmer wage gains and that will ultimately filter into inflation moving up towards our 2% objective.
2.) He expects inflation numbers to improve. He wants us to ignore the year-over-year numbers (of course, recent month-over-month numbers are not great):
Well, the reason why inflation won’t get up to 2% very quickly on a year-over-year basis is because we’ve had these very low inflation readings over the last 4 or 5 months. So it’s going to take time for those to sort of drop out of the year-over-year calculation.
3.) Assuming the forecast continues as he expects, he believes the Fed will hike rates again: 
I think it depends on how the economic forecast evolves. If it evolves in line with my expectations, I would expect -- I would be in favor of doing another rate hike later this year.
4.) Bubble? What bubble?
My own view is that -- I’m not particularly concerned about where our asset prices are today for a couple of reasons. The main one is that I think that the asset prices are pretty consistent with what we’re seeing in terms of the actual performance of the economy.
5.) But - and I think this is important - financial conditions continue to easy despite rate hikes:
Now the reason why I think you’d want to continue to gradually remove monetary policy accommodation, even with inflation somewhat below target, is that 1) monetary policy is still accommodative, so the level of short-term rates is pretty low, and 2) and this is probably even more important, financial conditions have been easing rather than tightening. So despite the fact that we’ve raised short-term interest rates, financial conditions are easier today than they were a year ago.
The stock market’s up, credit spreads have narrowed, the dollar has weakened, and those have more than offset the effects of somewhat higher short-term rates and the very modest increases that we’ve seen in longer-term yields.
6.) Balance sheet normalization is coming:
Well, we obviously have to have the FOMC meeting to make that decision at the next FOMC meeting. But, I don’t think the expectations of market participants are unreasonable. In June, following the June FOMC meeting, we laid out a plan in terms of how we would actually do our balance sheet normalization. How we would allow Treasury and agency mortgage-backed securities to gradually run off our portfolio over time.
And so the plan is out there. It’s been I think generally well-received, and fully anticipated. People expect it to take place. In the last FOMC statement, we said that we expected this to happen relatively soon. So, I expect it to happen relatively soon.
7.) At the end of the day, the balance sheet reduction might amount to very little:
My own view is, if I had to say today, we’re probably going to see a balance sheet five years from now that’s probably in the order of 2-1/2 to 3-1/2 trillion rather than the 4-1/2 trillion dollar balance sheet.
Overall, Dudley continues to adhere to what amounts to the Fed's median forecast, and that means he thinks another rate hike this year is solidly in play.
Separately, retail sales for July were up:

Retail0817

The monthly data is noisy, so be wary that it reflects the true state of spending. The three-month and twelve-month changes (for core sales) are similar at 3.2% and 3.6% respectively and more likely reflect the underlying trend. Basically, the consumer continues to press forward at a modest pace. Stop worrying about consumer spending. It isn't an imminent threat to the outlook.
And why should it be a threat? Like, job growth, wage growth is actually fairly solid. The headline weakness in wage growth is all about demographic shift, at least according to new research from Mary Daly of the Federal Reserve Bank of San Francisco. Via Bloomberg:
Fresh research from the San Francisco Fed provides an explanation: baby boomers. As they retire in droves, their exit from the workforce is distorting the data for average earnings, according to a blog post published Monday on the bank’s website.
“Wage growth isn’t as disappointing as it looks,” Mary Daly, director of economic research at the San Francisco Fed, said in an interview. “Wage growth, when cleaned up, looks consistent with other measures seen in the labor market.”
 The implication is that the labor market low wage growth does not necessarily imply the labor market is weak. It is an artifact of demographic change. That change has been fairly persistent, but at the end of the note Daly holds out some hope that it may be changing:
Overall, these factors have combined to hold down growth in the median weekly earnings measure by a little under 2 percentage points (Figure 2), a sizable effect relative to the normal expected gains.
Most recently, the effect from flows into and out of full-time work has started to tick upward and might be a sign of stronger growth ahead.
We will see.

Fed Shouldn't View Productivity as an Exogenous Factor

Tim Duy:

Fed Shouldn't View Productivity as an Exogenous Factor: The Federal Reserve has an opportunity to test a hypothesis critical to the health of the U.S. economy: Can persistently loose monetary policy boost the pace of productivity growth? Sadly, for now, an adherence to a strict Phillips curve framework for the economy and fear of financial instability will prevent the Fed from venturing down this path. ...[Continued at Bloomberg Prophets]...

Monday, August 14, 2017

Fed Watch: Don't Add To The Fire

Tim Duy:

Don't Add To The Fire: Vox has an article out this morning with the title "The real "deep state" sabotage is happening at the Fed." It begins:
Trump administration officials are notorious for their suspicion that a “deep state” of career military, intelligence, diplomatic, or civil service professionals is seeking to sabotage their work. But for a clearer example of sabotage — albeit without much in the way of a conspiracy — Trump would do well to cast his gaze at the Federal Reserve, which, dating back to before his inauguration, has been waging war on an inflationary menace that appears not to exist.
I have no qualms with the criticism that the Fed's is excessively focused on inflation or, more accurately, possibly working with a broken model of inflation. That's fair game. 
What I find disturbing and quite frankly irresponsible is the use of "deep state" language to describe the Fed. This is the language used by the far right to discredit and undermine faith in our government institutions. For the left to adopt the same language adds to the fire already burning. 
Take this language into consideration with the rage already directed against the Federal Reserve. This, for instance:
A Sayre man has been arrested in connection with what authorities says is a foiled plot to blow up a bank building in Downtown Oklahoma City with a truck filled with fake explosives.
Jerry Drake Varnell, 23, of Sayre, initially wanted to blow up the Federal Reserve Building in Washington, D.C., but settled on attempting to detonate a bomb at the BancFirst building at 101 N Broadway in downtown Oklahoma City, according to court documents.
An undercover FBI agent posed as someone who could help Varnell to blow up the building, according to a complaint filed Sunday in U.S. District Court for the Western District of Oklahoma. Varnell allegedly told an FBI informant that he wanted to blow up the Federal Reserve Building in Washington, D.C., with a device similar to the one used in the 1995 Oklahoma City bombing because he was upset with the government.
I am honestly just simply disappointed that Vox chose to add to the hate directed at the Fed by using the inflammatory language of the far right. I have had plenty of criticisms of the Fed over the years. I am concerned that their model of inflation isn't working, and that their estimate of the natural rate of interest is too high. But that type of criticism is a far cry from describing the institution as the "deep state." We have seen time and time again that fomenting that kind of thought only leads to bloodshed. The last thing we need is the left helping to incite another Oklahoma City bombing on Constitution Ave. - or anywhere for that matter.

Monday, August 07, 2017

Fed Watch: July Employment Recap

Tim Duy:

July Employment Recap, by Tim Duy: The July employment report came in on the high side of expectations and sufficiently strong to keep the Fed's policy plans for this year and next intact despite low inflation. On average central bankers will have a hard time backing down from rate hike plans with job growth still in excess of that necessary to hold unemployment stable. They may believe the economy is not yet at full employment, but they don't want to be too far below their estimate of the neutral interest rate before they hit full employment. And they don't think that point can be very far off.
Nonfarm payrolls gained 209k, solidly above expectations of 180k:NfpA0817
The pace of job growth is easing, but only gradually. The 12-month average was 180k, compared to 205k in July of last year. The unemployment rate edged down to 4.3%, back to the level of June. The labor force participation rate rose, but remains in the range it has enjoyed since 2016:

NfpD0817

The Fed will take note that job growth remains in excess of labor force growth. That difference generally drives unemployment lower:

NfpD0817

The big labor force gains occurred at the beginning of 2016, which helped stabilize the unemployment rate. The current dynamic will almost certainly push unemployment lower and past the Fed's comfort levels, probably sooner than later.
The Fed will see hopeful signs in the wage numbers. Average wages grew at a 4.19% annualized rate in July, giving credence to the theory that the slowdown in wage growth earlier this year was temporary:
Nfpb0817
To be sure though, one month does not a trend make. But the Fed will not be making a decision on one month of data. Balance sheet normalization will almost certainly begin in September (barring a disruptive debt ceiling battle), leaving December for a potential rate hike. If wage data continues to come in closer to July's number than June's, the Fed will feel more confident that they a.) have the correct estimate of the natural rate of unemployment and b.) that inflation will return to their 2% target over the medium run. Hence, the December rate hike remains in play.
Solid job growth seems likely to continue. That at least is the story told by temporary help payrolls:

NfpD0817
We are well past the flattening out of early last year. For those looking for an imminent recession, this isn't showing one. And for those looking for a market crash, look at the similar behavior of this indicator in 1995. As is now well known, that market crash was still a long ways off.
Bottom Line: A solid report that suggests further declines in the unemployment rate in the months ahead. The Fed will want to stay preemptive in this environment. I don't foresee them backing off their rate forecast for this year and next very easily.

Thursday, August 03, 2017

Why These Job Numbers Matter to the Fed

Tim Duy:

Why These Job Numbers Matter to the Fed: Even though the Federal Reserve is poised to start shrinking its $4.5 trillion balance sheet, the outlook for continued rate increases is very much in doubt following the recent slowdown in inflation. That makes the monthly jobs report on Friday even more important than usual as investors and analysts try to figure out whether the central bank will continue to take its cues from labor market strength rather than inflation weakness as it charts a course for monetary policy. ...[Continued at Bloomberg Prophets]...

Thursday, July 27, 2017

Fed Watch: FOMC Snoozefest

Tim Duy:

The Federal Reserve completed its July meeting with statement that pretty much everyone anticipated in advance. Interest rates were left unchanged and the Fed opened the door to begin balance sheet reduction "relatively soon." That means September. There was no reason to believe that the Fed does not still expect a third rate hike for this year which, if it comes, will be in December. That hike is of course data dependent.
A couple of quick notes. Regarding balance sheet reduction, I think this via Bloomberg is correct:
“September is the most likely outcome” for the launch of the balance-sheet drawdown, said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. “But I can’t rule out the idea that they would wait until November if the debt ceiling really looks messy.”
Clearly, the Fed will stand pat if certain policymakers in Congress and the White House (you know who you are) insist on sending the US economy down the path of debt default (I can't believe I even have to consider such insanity).
On inflation, some I think interpreted this as dovish:
On a 12-month basis, overall inflation and the measure excluding food and energy prices have declined and are running below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.
First, this is simply a factual statement, an acknowledgement of what everyone and their brother already knows. Second, what is important is the forecast, and that remains unchanged:
Inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee's 2 percent objective over the medium term. Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.
And third, pay attention to the "12-month" language that first appeared in the May statement. Pay close attention. They Fed is telling us to stop paying attention to all those year-over-year inflation charts we like to make. They have accepted that level effects from inflation shortfalls in the first half of this year will live in the year-over-year numbers until next year. Pay attention to the path of the month-over-month numbers (blue bars):

Corecpi717

If those numbers climb back up toward 2 percent this year, the Fed will feel vindicated even if the year-over-year numbers remain below target. Not just vindicated, but also inclined to raise rates as expected.
Bottom Line: Fed remains on its existing policy path.

Tuesday, July 25, 2017

Easier Financial Conditions Will Keep the Fed on Track

Tim Duy:

Easier Financial Conditions Will Keep the Fed on Track: The path laid out by the Federal Reserve at the beginning of the year for three interest-rate increases plus the start of reducing its $4.5 trillion balance sheet looks shaky due to the slowdown in inflation. There’s no question that the Fed is nervous about the persistent inflation shortfall. Chair Janet Yellen made note of the issue during her congressional testimony earlier this month. ...[Continued at Bloomberg Prophets.]...

Tuesday, July 18, 2017

This Expansion Will End in a Fizzle, Not a Bang

Tim Duy:

This Expansion Will End in a Fizzle, Not a Bang: The Fed is growing increasingly concerned that this expansion will end like the last two, with a collapse in asset prices that brings down the economy. That concern will lead the central bank down the path of excessive tightening. Worse, that logic misses a key point. In both of the last two cycles, there was a sizable imbalance in the economy that extended beyond financial assets themselves. So far, the current environment lacks such an imbalance. That suggests the expansion ends with more of a fizzle than a bang. ...[Continued at Bloomberg Prophets]...

Monday, July 10, 2017

Fed Watch: June Employment Report Recap

Tim Duy:

June Employment Report Recap, by Tim Duy: A generally upbeat June 2017 employment report supports the Fed's case for additional monetary tightening, most likely in the form of balance sheet action in September followed up by a 25bp rate hike in December. Moreover, the solid pace of job growth will encourage the Fed to maintain 2018 policy projections as well. Although the unemployment rate ticked up, ongoing job growth at this pace will eventually push it back down. Weak wage growth continues to restrain the Fed from accelerating the pace of easing; the tepid pace of wage gains suggests the Fed's estimates of full employment remain too high.
Nonfarm payrolls rose by 22sk in June, above expectations. Moreover, both April and May were revised higher. The three month and twelve month paces are just below 200k. Job growth continues to slow, but the rate of decline is very shallow:

Nfp1

Looking into the future, temporary help payrolls continues to climb after the transitory slowdown in 2015:

Nfp2

This typically indicates sustained broad job growth in future months. Further evidence of a solid job market is visible in the accelerating of aggregate hours worked:

Nfp3

Payroll growth remains above the roughly 100k the Fed believes is necessary to hold the unemployment rate constant once demographic impacts outweigh cyclical impacts on labor force growth. For June, however, the unemployment rate ticked up on the back of higher labor force participation:

Nfp5

Still, the Fed won't take much relief in the gain. For all intents and purposes, labor force participation has been move sideways since 2014:

Nfp4

The monthly variance so far has been just noise.
Despite low unemployment, wage growth remains anemic:

Nfp6

One would have expected a pickup in wage growth if the economy were indeed operating substantially beyond full employment. This gives the Fed something to think about in the latter half of this year - they don't want to choke out growth too quickly if the natural rate of unemployment is in fact much lower than current estimates. Still, concern that wage growth will soon spike if their estimates are correct encourage most Fed policymakers to keep their foot gently on the brake. 
Bottom Line: Even as weak wage growth couples with soft inflation to raise a bit of caution among central bankers, the overall tenor of the labor markets remains sufficient for the Fed to maintain its tightening bias. They really need softer job numbers to thrown in the towel on their expected policy path for 2017 and 2018.

Thursday, July 06, 2017

Fed Watch: Employment Report Coming Up

Tim Duy:

Employment Report Coming Up, by Tim Duy: The BLS will release the June employment report tomorrow. Wall Street is looking for an NFP gain of 170k. That sounds about right to me:

Nfp0717

There may be an upside surprise if the May number was low due to new college graduates not yet on the payroll during the survey week. 
The Fed believes this pace of job growth would be consistent with further downward pressure on the unemployment rate, keeping them stuck between concerns they will overheat the economy by undershooting the natural rate of unemployment and that pesky low inflation number. With that in mind, Wall Street anticipates the unemployment rate holds steady at 4.3%, which would likely only provide temporary relief for the Fed. They would be more willing to slow the pace of rate hikes if the unemployment rate held steady and the pace of job growth slowed to something closer to 100k per month. If that happens by the end of the year and inflation remains tepid, I anticipate the Fed would pull back on rate hike expectations for 2018.
That said, my baseline expectation is that economic growth proves sufficient to place further downward pressure on unemployment, leaving the Fed stuck in their current conundrum. 
Last but not least, the Fed will be carefully watching measures of wage growth. Wage growth softened in recent months, suggesting that the goal of full employment remains elusive. That said, some of that weakness might be the delayed impact of flattening unemployment in 2016. Hence, the impact of lower unemployment this year on unemployment might still lie ahead. Firming to accelerating wage growth would signal to the Fed that the economy is indeed at full employment as many policymakers suspect. Such confirmation would enable them to dig in their heels on expected rate hikes.

Monday, June 26, 2017

The Forward Guidance Paradox

Alex Haberis, Richard Harrison and Matt Waldron at Bank Underground:

The Forward Guidance Paradox: In textbook models of monetary policy, a promise to hold interest rates lower in the future has very powerful effects on economic activity and inflation today. This result relies on: a) a strong link between expected future policy rates and current activity; b) a belief that the policymaker will make good on the promise. We draw on analysis from our Staff Working Paper and show that there is a tension between (a) and (b) that creates a paradox: the stronger the expectations channel, the less likely it is that people will believe the promise in the first place. As a result, forward guidance promises in these models are much less powerful than standard analysis suggests. ...

Thursday, June 22, 2017

Fed's Labor Market Forecasts Don't Make Sense

Tim Duy:

Fed's Labor Market Forecasts Don't Make Sense, by Tim Duy: The Federal Reserve’s unemployment forecast doesn’t add up. It is neither consistent with the median of policy makers’ growth forecasts nor consistent with Chair Janet Yellen’s description of labor market strength. Hence, central bankers will likely find unemployment undershooting their forecast in the second half of 2017. That will keep the central bank in a hawkish mood even if lackluster inflation continues. ...Continued at Bloomberg Prophets...

Wednesday, June 21, 2017

Does the Fed Have a Financial Stability Mandate?

From the Federal Reserve Bank of Richmond:

Does the Fed Have a Financial Stability Mandate?, by Renee Haltom and John A. Weinberg, FRB Richmond: The 2007–08 financial crisis and the Fed's unprecedented response raised new questions about the Fed's role in maintaining the stability of the U.S. financial system.
Central banks have a natural role in financial stability for several reasons. First, monetary policy affects financial conditions in ways that can contribute to either stability or instability; erratic policy or volatile inflation could be destabilizing, for instance. Second, they obtain and develop insights useful for financial stability policy through the course of their other functions. Third, financial conditions are among the broad set of factors considered by central banks in assessing the state of the economy and the appropriate stance of monetary policy.
But for many central banks, the full scope of what they're expected to do in support of financial stability — the extent to which they have an explicit or implicit financial stability mandate — is ambiguous. This is important because a central bank's policy actions and its responses to developments in the economy and financial markets are shaped by its understanding of its mandate. So the nature of the mandate matters for economic outcomes, market expectations (the ex ante "rules of the game"), and accountability.
One reason this issue is inherently challenging is that there is no single definition of "financial stability." Most recent discussions focus on banking crises like the 2007–08 financial crisis, which tend to feature failures of large or many financial institutions, cascading losses, and government interventions. But central banks also have played a role in other types of financial market disturbances, for example, sharp asset price declines (like the Fed's liquidity assurances after the 1987 stock market crash), sovereign debt crises (like the European Central Bank's role in the recent eurozone crisis), and currency crises (like the Fed's role in Mexico's 1994 bailout).
This challenge is clear in the breadth of a definition for financial stability offered in the latest Purposes and Functions publication from the Board of Governors of the Federal Reserve System: "A financial system is considered stable when financial institutions — banks, savings and loans, and other financial product and service providers — and financial markets are able to provide households, communities, and businesses with the resources, services, and products they need to invest, grow, and participate in a well-functioning economy." The publication further states that a financial system ought to have the ability to do so "even in an otherwise stressed economic environment."1
This Economic Brief takes a descriptive look at the Fed's role in financial stability, including how that role has changed over time, and raises some fundamental questions. ...

Tuesday, June 20, 2017

New Evidence for a Lower New Normal in Interest Rates

This is an FRBSF Economic Letter by Jens H.E. Christensen and Glenn D. Rudebusch:

New Evidence for a Lower New Normal in Interest Rates: The general level of U.S. interest rates has gradually fallen over the past few decades. In the 1980s and 1990s, lower inflation expectations played a key role in this decline. But more recently, actual inflation as well as survey-based measures of longer-run inflation expectations have both stabilized close to 2%. Therefore, some researchers have argued that the decline in interest rates since 2000 reflects a variety of persistent economic factors other than inflation. These longer-run real factors—such as slower productivity growth and an aging population—affect global saving and investment and can push down yields by lowering the steady-state level of the short-term inflation-adjusted interest rate (Bauer and Rudebusch 2016 and Williams 2016). This normal real rate is often called the equilibrium or natural or neutral rate of interest—or simply “r-star.”
However, other observers have dismissed the evidence for a new lower equilibrium real rate and downplayed the role of persistent factors. They argue that yields have been held down recently by temporary factors such as the headwinds from credit deleveraging in the aftermath of the financial crisis. So far, this ongoing debate about a possible lower new normal for interest rates has focused on estimates drawn from macroeconomic models and data. In this Economic Letter, we describe new analysis that uses financial models and data to provide an alternative perspective (see Christensen and Rudebusch 2017). This analysis uses a dynamic model of the term structure of interest rates that is estimated on prices of U.S. Treasury Inflation-Protected Securities (TIPS). The resulting finance-based measure provides new evidence that the equilibrium interest rate has gradually declined over the past two decades.
Macro-based estimates of the equilibrium interest rate
The issue of whether there has been a persistent shift in the equilibrium interest rate is quite important. For investors, this short-term real rate of return that would prevail in the absence of transitory disturbances serves as a key foundation for valuing financial assets. For policymakers and researchers, the equilibrium interest rate provides a neutral benchmark to calibrate the stance of monetary policy: Monetary policy is expansionary if the short-term real interest rate lies below the equilibrium rate and contractionary if it lies above. Therefore, determining a good estimate of the equilibrium real rate has been at the center of recent policy debates (Nechio and Rudebusch 2016 and Williams 2017).
Given the significance of the equilibrium interest rate, many researchers have used macroeconomic models and data to try to pin it down. As Laubach and Williams (2016, p. 57) define it, the equilibrium interest rate is based on “a ‘longer-run’ perspective, in that it refers to the level of the real interest rate expected to prevail, say, five to 10 years in the future, after the economy has emerged from any cyclical fluctuations and is expanding at its trend rate.” Laubach and Williams (2003, 2016) estimate this equilibrium interest rate using a simple macroeconomic model and data on a nominal short-term interest rate, consumer price inflation, and the output gap. Similarly, Johannsen and Mertens (2016) and Lubik and Matthes (2015) provide closely related estimates also by using macroeconomic models and data.
The blue line in Figure 1 summarizes the results of these three fairly similar studies. It shows the average of their three estimated equilibrium real interest rates, which smooths across specific modeling assumptions in each study. In the 1980s and 1990s, this simple macro-based summary measure remained around 2½%. This effectively constant equilibrium interest rate is consistent with the conventional wisdom of that time. It is only in the late 1990s that a decided downtrend begins, and the macro-based measure falls to almost zero by the end of the sample.

Figure 1
Estimates of the equilibrium real interest rate
2017-17-1.FRBSF-EL

However, the various macro-based approaches for identifying a new lower equilibrium interest rate have several potential shortcomings. First, these estimates depend on having the correct specification of the complete model, including the output and inflation dynamics. One difficulty in this regard is how to account for the period after the Great Recession when nominal interest rates were constrained by the zero lower bound. During that episode, the link between interest rates and other elements in the economy was altered in ways that are difficult to model. Finally, these estimates use extensively revised macroeconomic data to create historical equilibrium interest rate estimates that would not have been available in real time.
A new finance-based estimate of the equilibrium interest rate
Given the possible limitations of the macro-based estimates, we turn to financial models and data to provide a complementary estimate of the equilibrium interest rate. As detailed in Christensen and Rudebusch (2017), we use the market prices of TIPS, which have coupon and principal payments adjusted for changes in the consumer price index (CPI). These securities compensate investors for the erosion of purchasing power due to price inflation, so they provide a fairly direct reading on real interest rates. We assume that the longer-term expectations embedded in TIPS prices reflect financial market participants’ views about the steady state of the economy including the equilibrium interest rate. Unlike the macro-based estimates, one advantage of this market-based measure is that it can be obtained in real time at a high frequency—even daily. In addition, it doesn’t depend on an uncertain specification of the dynamics of output and inflation. Furthermore, because real TIPS yields are not subject to a lower bound, we avoid complications associated with zero nominal interest rates altogether.
Our analysis focuses on a term structure model that is based only on the prices of TIPS. This choice contrasts with previous TIPS research that has jointly modeled inflation-indexed and standard nominal U.S. Treasury yields (for example, Christensen, Lopez, and Rudebusch 2010). Such joint specifications can also be used to estimate the steady-state real rate—though earlier work has emphasized only the measurement of inflation expectations and risk. However, a joint specification requires additional modeling structure—including specifying an inflation risk premium and inflation expectations. The greater number of modeling elements—along with the requirement that this more elaborate structure remain stable over the sample—raise the risk of model misspecification, which can contaminate estimates of the equilibrium interest rate. By relying solely on TIPS yields, we avoid these complications as well as problems associated with the lower bound on nominal rates.
Still, the use of TIPS for measuring the steady-state short-term real interest rate poses its own empirical challenges. One difficulty is that inflation-indexed bond prices include a real term premium. In addition, despite the fairly large amount of outstanding TIPS, these securities face appreciable liquidity risk resulting in wider bid-ask spreads than nominal Treasury bonds. To estimate the equilibrium rate of interest from TIPS in the presence of liquidity and real term premiums, we use an arbitrage-free dynamic term structure model of real yields augmented with a liquidity risk factor as described in Andreasen, Christensen, and Riddell (2017). The identification of the liquidity risk factor comes from its unique loading for each individual TIPS. This loading assumes that, over time, an increasing proportion of any bond’s outstanding inventory is locked up in buy-and-hold investors’ portfolios. Given forward-looking investor behavior, this lock-up effect implies that a particular bond’s sensitivity to the market-wide liquidity factor will vary depending on how seasoned the bond is and how close to maturity it is. Our analysis uses prices of the individual TIPS rather than the more usual input of yields from fitted synthetic curves. By observing prices from a cross section of TIPS that have different age characteristics, we can identify the liquidity factor. With estimates of both the liquidity premium and real term premium, we calculate the equilibrium interest rate as the average expected real short rate over a five-year period starting five years ahead.
Our finance-based estimate of the natural rate of interest is shown as the green line in Figure 1. These estimates are adjusted slightly upward to account for a persistent 0.23 percentage point measurement bias in CPI inflation. The model uses data back to the late 1990s around the time when the TIPS program was launched. Fortuitously, TIPS were introduced about the same time as the macro-based estimates started to decline, so the available sample is particularly relevant for discerning shifts in the equilibrium real rate. During their shared sample, the macro- and finance-based estimates exhibit a similar general trend—starting from just above 2% in the late 1990s and ending the sample near zero. Most importantly, both methodologies imply that the equilibrium rate is currently near its historical low. The finance- and macro-based estimates of the equilibrium rate rely on different assumptions about the structure of the economy and different data sources. Thus, they have different pros and cons, so their broad agreement about the level of the equilibrium rate is mutually reinforcing.
There are differences between the precise trajectories over time of the two estimates. The macro-based estimate of the natural rate shows only a modest decline from the late 1990s until the financial crisis and the start of the Great Recession. Then, it drops precipitously to less than 1% and edges only slightly lower thereafter. Arguably, the timing of the macro-based path leaves open the possibility that the recession played a key role in causing the decline in the equilibrium rate. This suggests that the drop could be at least partly reversed by a cyclical boom. In contrast, the finance-based estimate falls in the early 2000s, levels off a bit above 1%, and then declines more in 2012. Therefore, the drop in the finance-based estimate does not coincide with the Great Recession, which is consistent with more secular drivers such as demographics or a productivity slowdown.
Finally, we should note that the model dynamics of fluctuations in the equilibrium rate are estimated to be very persistent. Thus, looking ahead, our model also suggests that the natural rate is more likely than not to remain near its current low for at least the next several years.
Conclusion
Given the historic downtrend in yields in recent decades, many researchers have investigated the factors pushing down the steady-state level of the short-term real interest rate. To complement earlier empirical work based on macroeconomic models and data, we estimate the equilibrium real rate using only prices of inflation-indexed bonds. From 1998 to the end of 2016, we estimate that the equilibrium real rate fell from just over 2% to just above zero. Accordingly, our results show that about half of the 4 percentage point decline in longer-term Treasury yields during this period represents a reduction in the natural rate of interest.
Jens H.E. Christensen is a research advisor in the Economic Research Department of the Federal Reserve Bank of San Francisco.
Glenn D. Rudebusch is senior policy advisor and executive vice president in the Economic Research Department of the Federal Reserve Bank of San Francisco.
References
Andreasen, Martin M., Jens H.E. Christensen, and Simon Riddell. 2017. “The TIPS Liquidity Premium.” FRB San Francisco Working Paper 2017-11.
Bauer, Michael D., and Glenn D. Rudebusch. 2016. “Why Are Long-Term Interest Rates So Low?” FRBSF Economic Letter 2016-36 (December 5).
Christensen, Jens H.E., Jose A. Lopez, and Glenn D. Rudebusch. 2010. “Inflation Expectations and Risk Premiums in an Arbitrage-Free Model of Nominal and Real Bond Yields.” Journal of Money, Credit, and Banking 42(6), pp. 143–178.
Christensen, Jens H.E., and Glenn D. Rudebusch. 2017. “A New Normal for Interest Rates? Evidence from Inflation-Indexed Debt.” FRB San Francisco Working Paper 2017-07.
Johannsen, Benjamin K., and Elmar Mertens. 2016. “The Expected Real Interest Rate in the Long Run: Time Series Evidence with the Effective Lower Bound.” FEDS Notes, Board of Governors of the Federal Reserve System, February 9.
Laubach, Thomas, and John C. Williams. 2003. “Measuring the Natural Rate of Interest.” Review of Economics and Statistics 85(4, November), pp. 1,063–1,070.
Laubach, Thomas, and John C. Williams. 2016. “Measuring the Natural Rate of Interest Redux.” Business Economics 51(2), pp. 57–67.
Lubik, Thomas, and Christian Matthes. 2015. “Calculating the Natural Rate of Interest: A Comparison of Two Alternative Approaches.” FRB Richmond Economic Brief 15-10 (October 15).
Nechio, Fernanda, and Glenn D. Rudebusch. 2016. “Has the Fed Fallen behind the Curve This Year?” FRBSF Economic Letter 2016-33 (November 7).
Williams, John C. 2016. “Monetary Policy in a Low R-star World.” FRBSF Economic Letter 2016-23 (August 15).
Williams, John C. 2017. “Three Questions on R-star.” FRBSF Economic Letter 2017-05 (February 21).

Opinions expressed in FRBSF Economic Letter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System.

Friday, June 16, 2017

Janet Yellen Is Her Own Best Successor

Narayana Kocherlakota:

Janet Yellen Is Her Own Best Successor: President Donald Trump has reportedly begun the process of deciding who will lead the U.S. Federal Reserve after Janet Yellen's term ends early next year. If he wants the best outcome for the economy, he can't do better than Janet Yellen. ...
Yellen's policies have contributed to a surprisingly strong labor market recovery, yet also been sufficiently cautious to keep inflation below target. Some would see this as an all-around success, though the Fed's caution does have a downside: Markets appear to believe that the central bank is unwilling or unable to hit its inflation target with consistency. ... If it persists, this loss of credibility means that the Fed will have less ammunition to fight the next recession.  
So could any of the other potential appointees do better? ...
Warsh, Taylor, and Hubbard all reportedly see Yellen’s Fed as having been too dovish, suggesting that that they would have done less to support the economic recovery. This approach would have led to higher unemployment and lower inflation -- an inferior fulfilment of the Fed's dual mandate that marks them as worse candidates than Yellen.  It's also important to remember that Taylor and Warsh argued publicly against additional monetary stimulus in November 2010, when the unemployment rate was almost 10 percent and the inflation rate had fallen nearly to 1 percent. Their concerns about excessive inflation proved to be completely unjustified. Yellen, by contrast, supported stimulus.
Yellen has a proven track record that's hard to beat. ... The president should reappoint her to the position of Fed chair.

Tuesday, June 13, 2017

FOMC Ahead

Tim Duy:

The recent inflation data doesn't exactly support the Federal Reserve’s monetary tightening plans. Chair Janet Yellen and her colleagues will surely take note of the weakness at this week’s Federal Open Market Committee meeting, but they will downplay any such concerns as transitory. At the moment, low unemployment remains the focus. Add to that loosening financial conditions and you get a central bank that is more likely than not to stay the course on its plan to hike interest rates. [...Continued at Bloomberg Prophets...]

Tuesday, June 06, 2017

Fed Watch: Fed Just Sort Of Confident About Full Employment

Tim Duy:

Fed Just Sort Of Confident About Full Employment, by Tim Duy: Over at Project Syndicate, Brad DeLong takes issue with Fed policy decisions. Importantly, he identifies, correctly, that the Fed's forecasting record in recent years has been less than optimal. Much less. The repeated optimism that inflation will soon revert to target is a most significant problem for a central bank with a formal inflation target. On this point the Fed has faced disappointment time and time again.
Brad is correct in his summary that the Fed needs to reassess its forecasting methodology to ensure that it is not biased toward high inflation forecasts. That said, I believe the issue is not quite as severe as Brad believes. In particular, I think this may be a bit unfair:
The FOMC’s blind spot stems from the fact that it is relying more on its assessment of the labor market, which it considers to be at or above “full employment,” than on noisy month-to-month inflation data. But “full employment” is a rather tenuous and unreliable construct. It has now been 20 years since economists Douglas Staiger, James Stock, and Mark Watson showed that Fed policymakers should not be so confident in estimates of “full employment.” And yet, for some reason, the Fed community has not let this essential message sink in.
I think there is actually quite a bit of uncertainty among Fed officials about the exact level of full employment. To be sure, policymakers repeatedly argue that they believe they are near full employment. But first, take that into context of changing estimates of full employment:

Full

Clearly policymakers are willing to change their minds as new information becomes available.
Second, if they were fairly inflexible regarding their estimates of full employment and the implications for inflation, they would have raised rates after unemployment fell to 6.5% - the threshold for maintaining zero rates under the Evans Rule.
Third, and probably most importantly, if they clung to a strict confidence in their estimates of full employment, they would have long ago abandoned their gradual approach to raising interest rates. As of now, the unemployment rate at 4.3% is a full 0.4 percentage points below the median estimate of the longer run unemployment rate and below the 4.5-5.0% range of estimates of that measure. Moreover, job growth remains strong enough to drive the unemployment rate further down. So if they were very confident of their estimates of full employment, Fed officials would be much more concerned that they had already fallen behind the inflation curve. They would be raising rates at every meeting, not just an expected three times this year. They wouldn't be dragging their heels on raising interest rates back to their estimate of neutral. They would be racing to do so.
The unemployment rate in May stood 0.5 percentage points below the January level. At this pace, the rate will fall below 4% by the end of this year. That is not unreasonable at this point. Yet policymakers largely continue to expect just two more rate hike this year - which I find incredibly patient given that I doubt there is any FOMC participant who believes that inflation can remain contained if the unemployment rate holds consistently below 4%.
Fourth, recall the conclusion of Federal Reserve Governors Lael Brainard's recent speech:
While that remains my baseline expectation, I will be watching carefully for any signs that progress toward our inflation objective is slowing. With a low neutral real rate, achieving our symmetric inflation target is more important than ever in order to preserve some room for conventional policy to buffer adverse developments in the economy. If the soft inflation data persist, that would be concerning and, ultimately, could lead me to reassess the appropriate path of policy.
I take this at face value - the Fed will likely reduce the path of expected rate hikes if inflation does not firm in the next few months.
Finally, I understand the hesitancy to raise rates in the face of low inflation. I too have an innate desire to hold back policy until we see the "whites in the eyes" of the inflation beast. But I also understand the position of policymakers - the uncertainty cuts both ways. There is a chance that the Phillips curve is nonlinear and the economy is close to an inflection point. And if that inflection point hits, they don't have confidence they can easily slow the economy without triggering a recession. So, from their perspective, restraining the economy a notch now may maximize the net present value of output if it prevents a recession later.
Bottom Line: The Fed's gradual, data-dependent path is almost perfectly designed to make no one happy. Too slow for some, too fast for others. Perhaps that means it is more right than wrong after all.

Ben Bernanke Interview

One part of a long interview of Ben Bernanke:

... Jim Tankersley: But you don’t think, particularly in those first moments of the crisis when Fed officials and Treasury officials were trying to work together to stop the bleeding, there weren’t more things that could have been done for homeowners, for folks who were just those underwater people that you mentioned in the very beginning of your answer.
Ben Bernanke: Again, I focused first on what the Fed could do. The Fed has a certain set of tools. We were successful in stabilizing the financial system after the crisis. We were successful in getting the economy back on a recovery track, as we’ve seen. Now the specific example you give is homeowners — that was the responsibility of the Treasury, although we were very interested in that at the Fed; we had many conversations with the Treasury about what they were doing.
I think the Treasury made a pretty serious effort on that front. There was money appropriated under the TARP to help homeowners, and the Treasury set up programs both to help people refinance their mortgages and to modify or restructure troubled mortgages. And some millions of people were helped by those programs.
My perceptions of that effort, though, speaking from someone who was outside of that policy effort, was that there were two big sets of constraints. One was that it’s just a lot harder than you think to, for example, to modify or restructure mortgages when the borrower is possibly unemployed, possibly not interested in talking to the bank or participating in a program. It was awfully difficult as a practical manner to manage the restructuring programs.
But the other part was that, people don’t remember this necessarily, it was actually very politically unpopular to help troubled homeowners. And Congress put lots of restrictions on what could be done, and tried to make sure there wasn’t any significant subsidy, for example. So within the inherent logistical difficulties, which were substantial, and the political constraints from Congress, the Treasury was hampered, I think, in its efforts. It did make, I think, a good-faith effort, and it did help millions of people.
Again, whether a bigger effort would’ve had more effect on the recovery, I’m not sure that it was a first-order issue. It certainly would’ve helped a lot of individual people, a lot of families. From the political point of view, it cuts both ways. The story is that the Tea Party was triggered not by anger necessarily at the financial players, but at the idea that the government would be helping people who had “overborrowed” or been irresponsible in taking out mortgages. ...

Monday, June 05, 2017

Anxious About the Economy?

Tim Duy:

Anxious About the Economy?, by Tim Duy: The current U.S. economic expansion is one of the longest on record. The longer it lasts, the more likely growth will become tepid and uneven, raising angst about its sustainability. See the May employment report, with its disappointing 138,000 gain in payrolls, downward revisions to previous months, and soft wage growth. Yet, at the same time, the unemployment rate fell to the lowest level since 2001. Anxiety is elevated with speculation that the Trump administration's pro-growth, fiscal stimulus plans are on the ropes. ...
Continue reading at Bloomberg Prophets...

Thursday, June 01, 2017

Fed Watch: Brainard, Powell, Employment Report Ahead

Tim Duy:

Brainard, Powell, Employment Report Ahead, by Tim Duy: Federal Reserve policymakers are turning a cautious eye to the inflation numbers, but for now believe special factors account for much of the weakness. Consequently, they remain more focused on the labor market in their policy deliberations. For now, that implies they will resist changing their expectations of further tightening this year as the US jobs market continues to hold strong. Tomorrow we should see more evidence of that strength.
Inflation continues to come in below expectations. The latest PCE inflation report, for example, was better than March but still anemic:

Corepce617

This weakness has not gone unnoticed on Constitution Ave, but Fed officials are not ready to call it quits on the expected path of monetary policy. Federal Reserve Governor Lael Brainard said earlier this week:
Even so, I see some tension between signs that the economy is in the neighborhood of full employment and indications that the tentative progress we had seen on inflation may be slowing. If the tension between the progress on employment and the lack of progress on inflation persists, it may lead me to reassess the expected path of the federal funds rate in the future, although it is premature to make that call today.
Her colleague Governor Jerome Powell appears less concerned:
Core inflation was 1.5 percent for the 12 months through April. This measure has also risen since 2015, although its gradual increase appears to have paused because of weak inflation readings for March and April. Some of the recent weakness can be explained by transitory factors. And there are good reasons to expect that inflation will resume its gradual rise.
On the other side of the country, San Francisco Federal Reserve President John Williams repeats the same:
Meanwhile, although inflation has been running somewhat below the Fed’s goal of 2 percent, with the economy doing well and some of the factors that have held inflation down waning, I expect we’ll reach that goal by next year.
The tendency to dismiss weak inflation numbers will continue as long as unemployment plumbs fresh lows for this cycle. Central bankers believe they are in the range of full employment, and don't want to risk being too far below their estimates of the neutral interest rate when inflation finally does take hold a bit more aggressively.
But will unemployment continue to push lower? The labor market appears to maintain considerable momentum. Initial claims remain low, ADP anticipates private sector job growth for May at 253k, and the ISM employment index picked up. See Calculated Risk for the rundown. Wall Street anticipates job growth of 185k for May within a range of 140k to 231k. My expectation is just on the north side of the consensus number: Nfp617
This should be enough job growth to maintain downward pressure on unemployment; as the economy matures, the Fed anticipates a requirement of only roughly 100k jobs per months to hold unemployment steady. A number closer to 200k will leave them concerned that sooner or later inflation will eventually emerge and they need to be ahead of that emergence not behind.
Two more interesting points on this from Powell. First, he thinks that labor force participation is near trend levels:
The labor force participation rate, which had declined sharply after the crisis, has now been roughly stable for 3-1/2 years, which represents an improvement against its estimated downward trend. Participation is now close to estimates of its trend level.
This implies that he anticipates need to slow job growth sooner than later to avoid excessive undershooting of the unemployment rate. Second, he see wages growth as just about right after accounting for productivity:
Wage data have gradually moved up, consistent with a tightening labor market. Although average hourly earnings are rising only about 2.5 percent per year, slower than before the crisis, much of that downshift may reflect the slowdown in productivity growth we have experienced. For example, over the past three years, unit labor costs--that is, nominal wages adjusted for increases in productivity--have been generally rising a bit faster than prices.
If productivity growth is 50bp lower than just prior to the recession, then real wages are close to target:

Realwages617

So, assuming the Fed maintains its assumptions regarding productivity growth, we don't need to see much faster wage growth for policymakers to become more convinced the economy is near full employment. Another point to remember when analyzing the labor report.
Bottom Line: The Fed's focus remains on the labor market. Hence, they remain focused on two rate hikes and balance sheet action still to come this year. One of those rate hikes will come this month. If sustained, weak inflation will eventually push them to rethink the path of policy. But the impact of those changes might fall more on 2018 than on 2017.