Category Archive for: Monetary Policy [Return to Main]

Thursday, September 11, 2014

'The Economics of Digital Currencies'

The Bank of England examines bitcoin:

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

Monday, September 08, 2014

Fed Watch: Forward Guidance Heading for a Change

Tim Duy:

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

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

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

At Vox EU:

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

Thursday, September 04, 2014

Fed Watch: August Employment Report Tomorrow

Tim Duy:

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

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The employment components of both ISM reports where solid:

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

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

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

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

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

Tuesday, September 02, 2014

Fed Watch: Solid Start to September

Tim Duy:

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

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Moreover, strength was evident throughout the internal components:

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

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

Fed Watch: Fed Positioning to Normalize Policy

Tim Duy:

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

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

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

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

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

Wednesday, August 27, 2014

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

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

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

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

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

Simon Wren-Lewis (a bit technical):

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

Friday, August 22, 2014

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

David Keohane at FT Alphaville:

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

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

The full paper is here.

Paul Krugman: Hawks Crying Wolf

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

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

Wednesday, August 20, 2014

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

Dean Baker:

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

Sunday, August 17, 2014

'The Treasury and the Fed are at Loggerheads'

Roger Farmer:

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

Friday, August 15, 2014

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

Narayana Kocherlakota, President of the Minneapolis Fed:

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

Paul Krugman: The Forever Slump

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

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

Thursday, August 14, 2014

'The Gold Standard and Price Inflation'

David Andolfatto of the St. Louis Fed:

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

Wednesday, August 13, 2014

Fed Watch: Heading Into Jackson Hole

Tim Duy:

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

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

Monday, August 11, 2014

'Celebrating Greenspan's Legacy of Failure'

Barry Ritholtz:

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

Barry concludes with:

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

Friday, August 08, 2014

'Getting There?'

David Altig (Research Director at the Atlanta Fed):

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

Atlanta Fed Labor Market Spider Chart

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

Total Private Earnings, year/year % change, sa

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

'Trends' in the June Core PCE

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

Thursday, August 07, 2014

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

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

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

Wednesday, August 06, 2014

Fed Watch: Fed Hawks Squawk

Tim Duy:

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

InfC080514

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

InfD080514

inflation expectations have been remarkably stable:

InfE080514

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

InfA080514

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

Inf080514

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

Friday, August 01, 2014

Fed Watch: July Employment Report

Tim Duy:

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

NFPc080114

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

NFPa080114

NFPb080114

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

PCEa080114

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

PCEb080114

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

Thursday, July 31, 2014

Fed Watch: On That ECI Number

Tim Duy (see Dean Baker too):

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

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

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

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

ECIa073114

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

ECIb073114

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

ECIc073114

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

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

At MoneyWatch:

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

Wednesday, July 30, 2014

Fed Watch: FOMC Statement

Tim Duy:

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

FOMCa073014

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

FOMCb073014

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

Thursday, July 24, 2014

Should the Fed be Forced to Follow a Rule?

Me, at MoneyWatch:

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

Friday, July 18, 2014

Paul Krugman: Addicted to Inflation

What does "inflation addiction" tell us?:

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

Wednesday, July 16, 2014

'Risk Aversion and the Natural Interest Rate'

From the NY Fed's Liberty Street Economics blog:

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

Tuesday, July 15, 2014

Fed Watch: Yellen Testimony

Tim Duy:

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

BULLARD071514

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

Monday, July 14, 2014

Congress and Monetary Policy

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

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

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

Sunday, July 13, 2014

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

Simon Wren-Lewis:

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

Saturday, July 12, 2014

Are Interest Rates Artificially Low? Nope.

Discouraging:

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

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

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

Friday, July 11, 2014

Paul Krugman: Who Wants a Depression?

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

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

Thursday, July 10, 2014

Fed Explores Overhaul of Its Target Interest Rate

Robin Harding reports:

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

Fed Watch: QEInfinity Not

Tim Duy:

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

BN-DP809_dwindl_G_20140709142508

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

INF070914

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

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

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

Wednesday, July 09, 2014

Fed Watch: When The Fed Starts Raising Rates

Tim Duy:

When The Fed Starts Raising Rates, by Tim Duy: Via Twitter, modest proposal summarizes my last post:
Shorter @TimDuy, short the front end not the 10 year because the Fed will tighten before inflation is a problem http://t.co/1a0xRNueEO
— modest proposal (@modestproposal1) July 7, 2014
This made me think about the last tightening cycle. For those that hope to use tighter monetary policy to bolster the case against equities, recall that patience may be required:

FedTight1

For those making the bear case against long bonds, recall that initially long rates fell, and over the entire cycle rose just (roughly) 50bp:

FedTight2

The short end of the curve suffered, and the yield curve inverted:

FedTight3

How does this compare to now? If we consider last December's taper the beginning of this tightening cycle (the Fed does not; they prefer to think of it at reducing financial accommodation), stocks continue to power higher:

FedTight4

The 10 year bond initially fell on the taper talk and the yield curve steepened through the 10 year. But that steepening ended when the taper began:

FedTight5

More interesting is the flattening of the very long end after the taper began:

FedTight6

It looks like rates are signalling that the Fed will act to contain activity such that the economy does not overheat. Which, assuming the Fed maintains its current reaction function, tends to support modest porposal's interpretation - favor the long end of the curve over the short end.
I think the flattening of the yield curve should be a concern to the Fed. It suggests that while we frequently hear Janet Yellen described as a dove, the expectation is that her actual policy approach will be cautious bordering on hawkish. Not good if you think like Andy Harless:
I will consider Yellen's tenure a failure if the economy does not overheat.
— Andy Harless (@AndyHarless) July 5, 2014
I am sympathetic to this view. I would be a little more optimistic that the Fed would have more room to maneuver in the next recession if the long-end of the yield curve was signalling that the Fed was a little behind instead of a little ahead. And for more on why that is important, see Brad DeLong and his 17 tweet bear case for inflation.

Tuesday, July 08, 2014

'The Unemployment Cost of Below-Target Inflation'

Carola Binder:

The Unemployment Cost of Below-Target Inflation: Recently, inflation in the United States has been consistently below its 2% target. The situation in Sweden is similar, but has lasted much longer. The Swedish Riksbank announced a 2% CPI inflation target in 1993, to apply beginning in 1995. By 1997, the target was credible in the sense that inflation expectations were consistently in line with the target. From 1997 to 2011, however, CPI inflation only averaged 1.4%. In a forthcoming paper in the AEJ: Macroeconomics, Lars Svensson uses the Swedish case to estimate the possible unemployment cost of inflation below a credible target...

The unemployment rate would be about 0.8% lower if inflation averaged 2% (and presumable lower still if inflation averaged slightly above 2%). ...

Svensson concludes with policy implications:

"I believe the main policy conclusion to be that if one wants to avoid the average unemployment cost, it is important to keep average inflation over a longer period in line with the target, a kind of average inflation targeting (Nessén and Vestin 2005). This could also be seen as an additional argument in favor of price-level targeting...On the other hand, in Australia, Canada, and the U.K., and more recently in the euro area and the U.S., the central banks have managed to keep average inflation on or close to the target (the implicit target when it is not explicit) without an explicit price-level targeting framework.  
Should the central bank try to exploit the downward-sloping long-run Phillips curve and secretly, by being more expansionary, try to keep average inflation somewhat above the target, so as to induce lower average unemployment than for average inflation on target?...This would be inconsistent with an open and transparent monetary policy."

[See the full post for more details.]

Is Wage Growth a Problem?

Josh Bivens:

Is Wage Growth the Problem or the Solution?, by Josh Bivens, WSJ Think Tank: Lots of talk has percolated recently about whether a sudden burst of rapid wage growth would force the Fed’s hand in pulling back monetary stimulus... Some who, like me, do not see any evidence of an imminent wage take-off have argued that the Fed should wait for some evidence of wage inflation before hitting the brakes.
These arguments essentially treat a pickup of wage growth as a problem to be guarded against. But the most conspicuous failure in the U.S. economy over the past generation, by far, has been too slow wage growth for the vast majority of American workers. ...
So one part of the “how much slack” debate that too often goes unaddressed is that there is not only a lack of evidence that wages are about to start growing rapidly but also that it wouldn’t be a big problem if they did. In fact, it would be a good thing.

'Why Hasn't the Yen Depreciation Spurred Japanese Exports?'

Mary Amiti, Oleg Itskhoki, and Jozef Konings:

Why Hasn't the Yen Depreciation Spurred Japanese Exports?, by Mary Amiti, Oleg Itskhoki, and Jozef Konings, Liberty Street Economics: The Japanese yen depreciated 30 percent from its peak in the fourth quarter of 2011 against its trading partners. This was expected to boost its exports as the lower yen makes Japanese goods more competitive on global markets. Instead, the volume of Japanese exports of goods actually fell by 0.6 percent over this same period, as can be seen in the chart below. Weaker external demand surely contributed to this poor export performance. Yet over the same period, U.S. goods exports grew by more than 6 percent, which suggests that other factors are also at play. In this post, we draw on our recent paper “Importers, Exporters, and Exchange Rate Disconnect” that highlights another channel to help explain these puzzling developments. In that study, we show that a key to understanding why there is low pass-through from exchange rates into export prices is that large exporters are also large importers, so they face offsetting exchange rate effects on their marginal costs. In the case of Japan, the connection between the yen and production costs has been made stronger since the country replaced nuclear power with imported fuels in the aftermath of the 2011 earthquake.
It has been well established that exchange rate changes are not fully passed through to export prices in foreign currency terms; that is, a 10 percent depreciation in the yen results in a less than a 10 percent fall in Japanese export prices and, thus, a relatively smaller boost to export quantities in response to a depreciation. This low pass-through has generally been attributed to “local currency pricing” and to “pricing-to-market.” If firms choose to invoice their exports in foreign currency terms, then prices are “sticky” in that currency, so exchange rate changes mechanically translate into changes in the exporter’s markup, with a weaker yen increasing the profit margin of exporters. A local currency pricing study shows that Japanese exporters to the United States generally invoice in U.S. dollars. In addition, exporting firms often tend to adjust their markups in response to an exchange rate depreciation, even if they do not invoice in the foreign currency, with the size of this adjustment depending on demand conditions in each export market.
The new finding in our study is that the incomplete pass-through is the most pronounced for exporters with large import shares—each additional 10 percentage points of imports in total variable costs reduces exchange rate pass-through by over 6 percentage points. We also show that large exporters are import-intensive, have high foreign market shares, set high markups, and actively move them in response to changes in their marginal costs. Thus, the prices of the largest firms, which account for a disproportionate share of trade, are insulated from exchange rate movements both through the hedging effect of imported inputs and through active offsetting markup adjustment in response to cost shocks. ...

Monday, July 07, 2014

Fed Watch: Inflation Hysteria Redux

Tim Duy:

Inflation Hysteria Redux, by Tim Duy: I am in general agreement with Calculated Risk on this point:

I also think the economy is picking up, and I agree that as slack diminishes, we will probably see real wage growth and an uptick in inflation.

Moreover, note that this is largely consistent with the Federal Reserve's outlook as well. Recall St. Louis Federal Reserve President John Williams from April, via Bloomberg:

Williams, who forecast the Fed will start raising interest rates in the second half of next year, said inflation has “bottomed out” and will gradually accelerate to the central bank’s 2 percent target. He said prices have been held down by temporary forces such as a slowdown in health care costs.

The Federal Reserve has consistently predicted higher inflation, and consistently been surprised that that inflation has not yet arrived despite rapidly falling unemployment rates. It would appear, however, that their forecasts are finally coming true. Hence, I also agree with Calculated Risk when he says:

On inflation: I'm sympathetic to people like Joe Weisenthal at Business Insider who is looking for signs of inflation increasing; I'm starting to look for signs of real wage increases and inflation too. I just think inflation isn't a concern right now (Weisenthal was correct on inflation over the last several years in contrast to the people who were consistently wrong on inflation).

It is enough to simply say that inflation is coming. That in and of itself is insufficient. Any inflation call needs to be placed in the context of magnitude and expected monetary policy response. Regarding both, follow Calculated Risk's warning:

Monetary policy can't halt the violence in Iraq or make it rain in California - and this is why it is important to track various core measures of inflation.

The Fed doesn't target core inflation. They target headline inflation. But they also believe that headline inflation will revert to core, and as such tend to be more concerned with core inflation in excess of 2%. Consider the history of core inflation since 1985:

INFLATION2

I included a 25pb "forecast error" band around the Federal Reserve stated 2% target for PCE inflation; no one believes they can consistently hit 2% in the short-term, hence it is a medium term target. The most obvious feature is that for the last twenty years, core measures of inflation have more often than not been at or below the the upper range of the Fed's error band, especially for core-PCE inflation. Average core-PCE inflation: 1.7%. Average core-CPI inflation: 2.2%. Indeed, if core-PCE were the target, it is fairly clear that the Fed would have been on average undershooting its objective for the past two decades.
It is simply difficult for me to become too worried about inflation given the history of the past twenty years - twenty years in which the US economy was at times substantially outperforming the current environment no less. Underlying inflation simply has not be a problem.
It was not a problem because the Federal Reserve tightened policy multiple times to preempt inflation. Expect the same during this cycle as well - the Fed will begin to gradually raise interest rates sometime next year, and they will maintain a gradual pace of tightening as long as they believe core-PCE will consistently average 2.25% or less. Currently, I anticipate the first rate hike will occur in the second quarter of 2015. If the unemployment rate falls to 5.5% by the end of this year, I would expect the first hike to be in the first quarter of 2015.
What about headline inflation? Headline inflation is at the mercy of the Middle East and the weather, leaving it more volatile than core:

INFLATION

Average PCE inflation since 1994: 1.9%. Average CPI inflation since 1994: 2.4%. Arguably a pretty good track record. It is really no wonder that it is so difficult to motivate the inflation lectures in Principles of Macroeconomics. All the students are twenty or less years old. They simply have no experience with inflation as a troubling 1970s-style phenomenon.
How will headline inflation influence monetary policy? If you combine headline inflation well in excess of 2.25% (I suspect something more like 3%) with tight labor markets and rapid wage/unit labor cost growth, I think the Fed will accelerate the pace of tightening (indeed, the second two conditions alone would probably do the trick). If we experience high headline inflation in the context of weak wage growth, expect the gradual pace of tightening to continue. Under those circumstances, the Fed will believe that headline inflation will depress demand and lessen inflationary pressures endogenously.
Bottom Line: If you are making a short-term bet on higher headline inflation, primarily you are making a bet on energy and food. That bet is about the Middle East and weather, not monetary policy. I don't have an opinion on that bet. If you are betting on inflation over the medium-term, primarily you are making a bet on higher core inflation. More to the point, you are betting against the Fed. You are essentially betting that the Fed will not do what it has done since Federal Reserve Chair Paul Volker - tighten policy in the face of credible inflationary pressures. I would think twice, maybe three times before making that bet.

Thursday, July 03, 2014

Fed Watch: June Employment Report

Tim Duy:

June Employment Report, by Tim Duy: The BLS reported solid numbers for the labor market in June, although there may be somewhat less acceleration than meets the eye. On net, the ongoing rapid fall in the unemployment rate nudges forward my expectation of when the Fed makes history and begins to lift rates from the zero bound. Still, there does not appear to be sufficient reason yet to believe the Fed will steepen the pace of increases.
Nonfarm payrolls rose by 288k, ahead of expectations for 211k. Job growth was broad-based and earlier months were revised higher. The three-month average for job growth is at its highest since 2011 while the 12-month average is slowly crawling up and now stands above 200k:

EMPDAYd070314

It is worth remembering that in order to maintain constant percentage changes over time, the absolute change has to increase. Indeed, the acceleration in percentage terms over the past year looks less than impressive:

EMPDAYb070314

Still somewhat below that experienced at the height of the housing bubble, clearly weaker then the late 1990s, and note in particular the acceleration in the early 1990's. It was that kind of acceleration that caught the Fed's attention. We are not seeing anything like that yet.
Also note that while hours worked has recovered from the winter doldrums, it too is not growing at some blockbuster pace:

EMPDAYh070314

EMPDAYc070314

In short, in some sense the excitement over the recent improvement in absolute job growth says less about an acceleration in actual activty and more about our diminished expectations for this recovery.
The persistent decline in the unemployment rate will undoubtedly cause consternation among the more hawkish FOMC members:

EMPDAYf070314

Recall St. Louis Federal Reserve President James Bullard recent warning:
The Federal Open Market Committee is closer to its goals for full employment and low and stable inflation than many investors realize, Bullard said. He predicted the pace of economic growth will accelerate to 3 percent this year after an unexpectedly deep first-quarter contraction.
“Inflation is picking up now. It is still below target but it has been moving up in recent months,” he said in response to a question at a forum organized by the Council on Foreign Relations. “I don’t think financial markets have internalized how close we are to our ultimate goals, and I don’t think the FOMC has internalized how close we are.”
Bullard's story in a picture:

EMPDAYg070314

As the Fed closes in on its traditional policy goals, the pressure from the hawks, and even the center, for a rate increase will increase. Still, the doves are not without a defence. Federal Reserve Chair Janet Yellen's measures of underemployment are still underwhelming:

EMPDAYa070314

In particular, wage growth has stalled, adding additional credence to the argument that substantial labor market slack remains despite the decline in the unemployment rate:

EMPDAYe070314

Also note that there is nothing here yet to challenge the more general consensus among policymakers that equilibrium interest rates are lower than in past cycles.
Bottom Line: The jobs report is generally good news, albeit I would argue there remains room for substantial improvement. That room for improvement continues to restrain the Fed from dramatically tighter policy. My expectations for the first rate hike center around the middle of next year. On net, this report drags my expectations forward somewhat and suggests a higher probability of a hike before June than after June. Score one for the FOMC hawks. But I also see little here yet to suggest the need for any dramatic tightening; I doubt FOMC's expectation of a long, gradual tightening cycle is much altered. That's one for the doves.

Wednesday, July 02, 2014

'Monetary Policy and Financial Stability'

Janet Yellen:

... Because these issues are both new and complex, there is no simple rule that can prescribe, even in a general sense, how monetary policy should adjust in response to shifts in the outlook for financial stability. As a result, policymakers should clearly and consistently communicate their views on the stability of the financial system and how those views are influencing the stance of monetary policy.

To that end, I will briefly lay out my current assessment of financial stability risks and their relevance, at this time, to the stance of monetary policy in the United States. In recent years, accommodative monetary policy has contributed to low interest rates, a flat yield curve, improved financial conditions more broadly, and a stronger labor market. These effects have contributed to balance sheet repair among households, improved financial conditions among businesses, and hence a strengthening in the health of the financial sector. Moreover, the improvements in household and business balance sheets have been accompanied by the increased safety of the financial sector associated with the macroprudential efforts I have outlined. Overall, nonfinancial credit growth remains moderate, while leverage in the financial system, on balance, is much reduced. Reliance on short-term wholesale funding is also significantly lower than immediately before the crisis, although important structural vulnerabilities remain in short-term funding markets.

Taking all of these factors into consideration, I do not presently see a need for monetary policy to deviate from a primary focus on attaining price stability and maximum employment, in order to address financial stability concerns. That said, I do see pockets of increased risk-taking across the financial system, and an acceleration or broadening of these concerns could necessitate a more robust macroprudential approach. For example, corporate bond spreads, as well as indicators of expected volatility in some asset markets, have fallen to low levels, suggesting that some investors may underappreciate the potential for losses and volatility going forward. In addition, terms and conditions in the leveraged-loan market, which provides credit to lower-rated companies, have eased significantly, reportedly as a result of a "reach for yield" in the face of persistently low interest rates. The Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation issued guidance regarding leveraged lending practices in early 2013 and followed up on this guidance late last year. To date, we do not see a systemic threat from leveraged lending, since broad measures of credit outstanding do not suggest that nonfinancial borrowers, in the aggregate, are taking on excessive debt and the improved capital and liquidity positions at lending institutions should ensure resilience against potential losses due to their exposures. But we are mindful of the possibility that credit provision could accelerate, borrower losses could rise unexpectedly sharply, and that leverage and liquidity in the financial system could deteriorate. It is therefore important that we monitor the degree to which the macroprudential steps we have taken have built sufficient resilience, and that we consider the deployment of other tools, including adjustments to the stance of monetary policy, as conditions change in potentially unexpected ways.

Conclusion In closing, the policy approach to promoting financial stability has changed dramatically in the wake of the global financial crisis. We have made considerable progress in implementing a macroprudential approach in the United States, and these changes have also had a significant effect on our monetary policy discussions. An important contributor to the progress made in the United States has been the lessons we learned from the experience gained by central banks and regulatory authorities all around the world. The IMF plays an important role in this evolving process as a forum for representatives from the world's economies and as an institution charged with promoting financial and economic stability globally. I expect to both contribute to and learn from ongoing discussions on these issues.

Friday, June 27, 2014

The Panic Over Inflation Is 'Perplexing'

Greg Ip echoes Tim Duy on 'Inflation Hysteria':

The spontaneous combustion theory of inflation: In the last few weeks, ominous warnings of inflation's imminent resurgence have multiplied... On factual, theoretical and strategic grounds, I find the panic over inflation perplexing.
First, factual. Yes, core CPI inflation has rebounded to 2% from 1.6% in February and today we learned that core PCE inflation has risen to 1.5% from 1.1%. What should we infer from this? Nothing. In the short run inflation oscillates...
Second, theoretical. ... The New Keynesian theory, to which the Fed subscribes, considers inflation a function of slack and expectations. The evidence is pretty persuasive that while slack has shrunk in the last five years..., it remains ample. Expectations, likewise, have oscillated but shown no trend up or down. ...
What if you consider inflation always and everywhere a monetary phenomenon? I consider the money supply pretty useless for forecasting anything, but even if were a monetarist, I wouldn't be worried..., M2 is up just 6.5% in the last year...
Third, strategic. ... Of course, the Fed might wait too long to tighten and inflation could eventually rise above the 2% target. But,... overshooting inflation is clearly a lesser evil than undershooting inflation. This, more than anything else, is why the panic over inflation is misplaced.

Wednesday, June 25, 2014

'That Big Negative Q1 GDP Revision'

Jared Bernstein:

Whoa! Whassup With That Big Negative Q1 GDP Revision?: Yes, you read those headlines right: real GDP contracted at a 2.9% rate according to revised data released this AM. That’s contracted, as in went down.
So, are we, like, back in recession (granting that a lot of people think we never left)?
Nope. That was a truly lousy quarter but it’s highly unlikely to be repeated any time soon. The particularly bad winter weather played a role; both residential and commercial building were negative. Heavy inventory buildups in earlier quarters were reversed, which usually implies a positive bounce-back in coming quarters. Exports were revised down and imports up, so the trade deficit subtracted a large 1.5 points from the bottom line; that drag will likely diminish in coming quarters.
Health care spending, a strong contributor in earlier estimates of Q1 growth, went from contributing 1 percentage point to growth in an earlier vintage of Q1 GDP to subtracting 0.16 points in this update, suggesting earlier estimates of the pace of increased coverage were overstated. That doesn’t mean they’re not happening; it just means they’ll be spread out over more quarters. [Update: check that--a colleague tells me that what's really happening here is that people didn't use as many services as first thought. I'll try to look further into this.] ...
Year-over-year—a good way to squeeze out some quarterly noise—real GDP is up 1.5%. That’s better than the headline number, but it too is actually a weak number. The trend over the last two years is 2.1% growth... I don’t believe today’s revisions really signal a decline in that trend rate and most analysts expect coming quarters to clock in at 2.5-3%. ...

I still think that policymakers should revise their priors (downward), particularly given their tendency to brush off any bad news as temporary changes that will surely be reversed in coming quarters.

Monday, June 23, 2014

Fed Watch: Inflation Hysteria

Tim Duy:

Inflation Hysteria, by Tim Duy: It appears that a case of inflation hysteria is gripping Wall Street. Joe Weisenthal at Business Insider sums up the current state of play:
Here's what's on Wall Street's mind right now: Inflation is finally happening, and the Fed will end up being behind the curve.
...there were two big moments this week.
1) There was the jump in Core CPI that was the biggest since 2009.
2) And then there was the Janet Yellen press conference, in which she said that the CPI jump could be just "noise" and that the recent drop in the unemployment rate was not actually reflective of the true state of the labor market (which she regards as considerably weaker due to measures of worker discouragement).
In other words, despite data showing that the Fed is getting close to hitting its economic goals, Yellen doesn't believe the numbers.
But Wall Street does believe the numbers. 
Hence the view that the Fed will be behind the curve.
Goodness, you would think it is 1975. It is probably instructive to stop and see what all the fuss is about:

INFf062314

Missed it?  Maybe we should zoom in:

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Although core-CPI is about to brush up on 2%, core-PCE remains well below, and it is the latter that is most important to policy. You might note that the Fed was raising interest rates in the late 1990s despite sub-2% core PCE, apparently responding to high CPI inflation. But that episode needs to be considered in light of the job market at the time, which, if you recall, was clearly on fire. There was no concern that broader measures of unemployment were signalling excess slack:

INFe062314

The current situation is different - there is excess slack in the labor market, as revealed by restrained wage growth. This is important. Wall Street might believe the CPI numbers that Yellen dismissed, but that is jumping the gun in any event.  As Across the Curve explains succinctly:
The labor market remains less than robust and wage gains are stagnant. Until we see consistent wage gains which would foster spending which fosters revenue and net income and then the virtuous cycle fulfills itself via business investment it is hard to imagine that we get a sustained uptick in inflation.
Which is essentially what Federal Reserve Chair Janet Yellen explained in her press conference:
You know, I see compensation growth broadly speaking as having been very well contained. By most measures, compensation growth is running around 2 percent. So that's real wage growth or real compensation growth that's essentially flat rather than rising, and real wage growth really has not been rising in line with productivity. My own expectation is that as the labor market begins to tighten, we will see wage growth pick up some to the point where real wage growth, where compensation or nominal wages are rising more rapidly than inflation, so households are getting a real increase in their take home pay. And within limits--well, that might be signs of a tighter labor market. Within limits, it's not a threat to inflation because consistent with the level of inflation we have for our 2 percent inflation objective, we could see wages growing at a more rapid rate and a somewhat more rapid rate. And indeed, that would be part of my forecast of what we would see as the labor market picks up. If we were to fail to see that, frankly I would worry about downside risk to consumer spending. So I think part of my confidence and the fact we'll see a pickup in growth relates to the fact that I think consumer spending will continue to grow at a healthy rate. And in part, that's premised on some pickup in the rate of wage growth so that it's rising greater more than inflation.
So what is going on here?  Inflation is not a sustained phenomenon in the absence of participation from wage dynamics.  If inflation accelerates while wage growth remains stagnant, demand will soften and so too will any incipient price pressures. Hence why Yellen sees the potential for downside risk for consumer spending in the absence of stronger wage growth.  Moreover, as she notes, wage growth itself is not inflationary. We would expect wage growth should exceed inflation such that real wages grow to account for rising productivity. We might then expect inflation to be correlated with unit labor costs, and it is:

INFa062314

If you expect to see sustained higher inflation, you need to see sustained higher unit labor cost growth.  No way around it. And even then you need to assume that firms respond by raising prices, rather than seeing profit erode.  Note in particular sustained high unit labor cost growth in the late 1990s. 
In short, you shouldn't be looking at the inflation numbers without understanding the underlying wage dynamic. It isn't until wages start to push higher that inflation becomes a more interesting issue.  
So how should we be thinking about this? The Fed recognizes that they are coming closer to meeting their goals based on their traditional unemployment metrics. They are discounting those metrics for the moment, and with good reason. In the absence of accelerated wage growth, pops of inflation are just noise. They anticipate that wage growth will not emerge more forcefully until after underemployment measures fall to more normal levels. Hence as the measures approach normal levels - sometime next year - they will begin raising interest rates. I suspect this will be prior to a substantial acceleration in wage growth, on the assumption that they will feel a need to be somewhat ahead of the curve.  
What would accelerate this process? First, a more rapid improvement in underemployment. Second, sufficient wage acceleration such that they are confident labor market slack has been eliminated prior to normalization of unemployment measures (in essence, the acceptance of permanent damage from the recession). If conditions one and two hold, but core-PCE measures hold below 2.25%, they will likely raise rates gradually. If core-PCE accelerates beyond 2.25%, the pace of rate increases will accelerate. 
Finally, the Fed will likely be watching 5-year, 5-year forward inflation expectations as a gauge of how far they are falling behind the curve. I can't imagine they are worried yet:

INFd062314

Bottom Line:  Tighter policy is coming. If you are worried the Fed will accelerate the timing and pace of tightening (and I do believe the risk is weighted in this direction), your focus should be on the labor market and wage growth dynamic. Note too that if Wall Street believes the Fed will need to tighten more aggressively than currently planned on the basis of recent inflation readings, market participants must clearly expect that Yellen and Co. take the 2% inflation target more than seriously.  

Sunday, June 22, 2014

Is Monetary policy Keeping Real Wages and Productivity Low?

Simon Wren-Lewis:

...suppose that at the moment real wages or inflation begin to rise, the central bank tightens monetary policy. This would raise the cost of capital, and could be interpreted as an attempt to prevent real wages rising. ... Monetary policy, which in theory is just keeping inflation under control, is in fact keeping real wages and productivity low.
Monetary policy makers would describe this as unfair and even outlandish. A gradual rise in interest rates, begun before inflation exceeds its target, is designed to maintain a stable environment. ...  
I also have another concern about a monetary policy which tightens as soon as real wages start increasing. What little I know about economic history suggests an additional dynamic. As long as the firm is employing labour rather than buying a machine, there is no incentive for anyone to improve the productivity of machines. The economy where real wages and labour productivity stay low may also be an economy where innovation slows down. The low productivity economy becomes the low productivity growth economy.

[The extract does not fully reflect the argument in the post -- see here for more.]

Saturday, June 21, 2014

'Monetary Policy Target Regimes: Inflation, Price Level, Nominal GDP, etc.'

Cecchetti & Schoenholtz

Monetary policy target regimes: inflation, price level, nominal GDP, etc.: Should central banks target inflation, the price level or nominal GDP? The question of the appropriate policy target has been a subject of analysis at least since the 1980s and has become a matter of intense debate (see here and here) for the past several years. Many proponents of price-level or nominal GDP targeting share the idea that – by credibly committing to make up the shortfalls in the price level or in nominal GDP relative to the pre-crisis trend – policymakers could drive down the current real interest rate and accelerate the economic recovery.
Looking at where we are today, what would this mean? ...

The bottom line:

All of this leads us to conclude that returning to the price path implied by the pre-crisis trend is a realistic possibility. Returning to the earlier nominal GDP path is not. That said, the inflation overshoot that our rough calculations suggest is moderate, so the benefits are likely to be limited. But the costs could include a loss of credibility in the inflation-targeting framework. Would that really be worth it?

Thursday, June 19, 2014

Fed Watch: Janet Yellen the Hawk

One more from Tim Duy:

Janet Yellen the Hawk, by Tim Duy: Yesterday I wrote a fairly conventional analysis of the outcome of the FOMC meeting and the subsequent press conference by Federal Reserve Chair Janet Yellen.  I think that analysis is consistent with that of the median policymaker on Constitution Avenue:  As long as the economy continues to grind upward at a moderate pace and inflation pressures remain constrained, the expected path of short term interest rates is one of a slow rise with the first hike somewhere around a year away.
That view is, of course, data dependent, and given the current readings on inflation and unemployment, combined with a policy stance that is basically ignoring both in favor of untested measures of underemployment, the risk is that the rate path is steeper, and the first hike comes sooner, than currently anticipated.  Under the current circumstances, I expect the median policymaker's willingness to risk falling behind the curve will decrease during the next six months. 
Moreover, I would caution against interpreting Yellen's soft inflation outlook as her being soft on inflation.  I think quite the opposite message came through at yesterday's press conference.  Yellen was showing her hawkish side. 
First, note that the Fed's terminal Federal Funds rate edged down to 3.75% from 4% in March, a consequence of falling estimates of potential growth.  The Fed thus appears to be conforming to the "new normal" in which equilibrium interest rates have fallen.  In short, the Fed appears to take the terminal Fed Funds rates as exogenous.  
The terminal Fed Funds rates, however, is not exogenous.  It is an inflation markup over estimates of potential growth.  The Fed could allow interest rates to return to normal by allowing expected inflation to rise.  From the Fed's point of view, however, the inflation rate is really not an endogenous choice.  They view the 2% target is essentially exogenous, a number handed down in scripture, an element of the Ten Commandments.  That the Fed should allow estimates of the terminal Fed Funds rate to fall is a testament to their commitment to the 2% target.
Second, it is not clear that the potential growth rate is entirely exogenous.  In her press conference, Yellen commented that lower potential growth estimates are a consequence of slower investment (less capital formation) and persistent damage to the labor market.  In the secular stagnation scenario, however, these are arguably the consequences of holding real interest rates too high and deliberately allowing the cyclical damage to become structural.  But at the zero bound, the Fed would need to target higher inflation expectations to lower the real interest rate further.  That is not on the table.  The lower bound on real interest rates is -2% because the upper bound on inflation is 2%.
In other words, Yellen and Co. are so committed to the 2% inflation target that they are willing to tolerate a persistently lower level of national output to maintain that target.   That sounds pretty hawkish to me.
Finally, Yellen's willingness of allow overshooting of the inflation target are, in my opinion, less than meets the eye.  Financial reporters very much need to pin her and other policymakers down on this topic.  I suspect when they say overshooting, what they mean is no more than 25bp over target in the context of anchored inflation expectations.  If inflation expectations are anchored, however, expected real interest rates are not changing.  The loose comments about overshooting are nothing more than a commitment to not overreact to forecast errors.  It doesn't mean that the Fed will not raise interest rates in the face of overshooting, only that they will calibrate the rate of increase relative to their confidence that the overshooting is a forecast error.
Bottom Line:  Soft on the inflation forecast is not the same as soft on inflation.  Don't underestimate the Fed's commitment to the 2% target.  That commitment is what pushes the risk to the hawkish side of the policy equation in the current environment.

Fed Watch: Still a Dove

Tim Duy:

Still a Dove, by Tim Duy: The FOMC delivered as expected today, with virtually no change to policy.  The tapering continues with another $10 billion cut to the pace of asset purchases, which was essentially the only change to the FOMC statement aside from the description of the economy.  The Wall Street Journal tracks the changes here.
The Fed downgraded their GDP forecast, as expected given the weak Q1 numbers.  They did not include any upward offsets in subsequent years.  Consequently, the expected trajectory of output falls further short of current estimates of potential:

  FED061814

Expect estimates of potential output to come down even further.  In contrast, the unemployment forecast was revised to the more optimistic side:

  FED2061814

while the inflation forecast was virtually unchanged.  As might be expected given an improving unemployment outlook, the interest rate projections were slightly more hawkish.  Still, Yellen cautioned against reading this as a change in the outlook, instead attributing it to a change in FOMC members.  The unstated implication is that the FOMC has moved in a slightly more hawkish direction, raising the possibility that Yellen could become more isolated in the months ahead in her generally dovish stance, assuming of course that the tension between the Fed's stated policy goals and the stance of policy continues to grow.
And, as Joe Weisenthal at Business Insider notes, Yellen again proves she is indeed a dove.  She dismissed recently higher inflation readings as noise, specifically drew attention to broad measures of unemployment, and said (correctly) that wage growth itself does not necessarily indicate inflation pressures would be far behind.  No indication that she is in any rush to raise rates whatsoever.
Bottom Line:  Policy remains the same - the Fed continues to expect a long-period of relatively low interest rates.  Given current unemployment and inflation numbers, I continue to expect the risk remains on the more hawkish side of that story.  But that is my assessment of the risk, not of the baseline.
Sorry for the quick post - scheduled to be in Portland in a few hours. 

Wednesday, June 18, 2014

How Close Are We To Full Employment?

Dear FOMC: Please be patient:

How close are we to full employment?, by Mark Thoma: How far is the economy from a full recovery? When should Federal Reserve policymakers, who are finishing their two-day meeting today, begin raising interest rates? Should the Fed speed the pace of its tapering of quantitative easing?

All of these questions depend critically on a piece of data economists call the output gap...

Monday, June 16, 2014

Fed Watch: FOMC Preview

Tim Duy:

FOMC Preview, by Tim Duy: The FOMC is set this week to cut another $10 billion from its asset purchase program.  The statement itself will most likely point toward additional confidence that the first quarter slowdown was an aberration, and may even point to signs that inflation has bottomed and is headed higher.  Both will give the Federal Reserve more confidence in their existing forecasts.  The forecasts will likely be very similar to those issued in January, albeit with some modifications.  The output forecast may be adjusted to account for Q1 weakness, while the unemployment forecast is likely to be edged down once again.  The latter is more important; the expected timing of the first rate hike may be pulled forward slightly.  The addition of new board members puts something of a wildcard into play, but my expectation is that if a policy change is brewing, it would more likely to show itself in Federal Reserve Chair Janet Yellen's post-FOMC press conference rather than the statement itself.
Incoming data continues to indicate the extreme weakness of the first quarter - estimates continue to fall, with Goldman Sachs now expecting -1.9% - was temporary.  Job growth has proved to be resilient, albeit I still feel it remains fairly restrained.  The recent bounce above the longer term trend does not signal to me a sizable acceleration in underlying economy:

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Neither does the path of aggregate weekly hours:

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Nor the growth of retail sales:

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Nor industrial indicators:

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The JOLTS report is a little more reassuring with the gain in job openings:

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In short, maybe the economy is set to take-off as Joe Weisenthal at Business Insider expects, but my read is a little more cautious.  Regardless, the data are sufficient for Federal Reserve members to hold true to the basic outline of their January forecasts.  Any lingering thought of delaying the taper is long gone.  
Nor do I think that even if the economy does accelerate the Fed will step up the pace of tapering.  It is all about the calendar - by the time the Fed is confident that stronger growth is sustainable, the asset purchase program will be almost complete anyway.  At best it would impact the size of the final cut - $15 billion in October or $5 billion in December.  Little difference in either case.  For the most part, when and if stronger growth shows up in policy, it will show up in the form of moving forward the first rate hike and accelerating the pace of subsequent rate hikes.
The question on my mind is the possibility the Fed turns more hawkish in the months ahead even if output progresses along their existing expectation.  Even along the tepid pace of growth seen to date, the combination of falling unemployment:

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and inflation potentially bottoming out and turning up:

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means the Federal Reserve is closer to meeting their stated policy goals, a point made by St. Louis President James Bullard with pictures like this:

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And note too that traditional indicators of monetary policy also continue to point higher:

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This kind of data will put increasing strain on the underemployment story.  To date, the Fed has been committed to that story on the basis of low wage growth:

WAGEFEDFUNDS

Increasingly the Fed will be concerned that the balance of risks is shifting from prematurely reducing financial accommodation to concern about falling behind the curve.  And that transition may be abrupt - not unlike what we witnessed recently on the other side of the pond.  Via Bloomberg:
Mark Carney said rising U.K. mortgage debt may threaten Britain’s recovery as he signaled interest rates might start to rise earlier than anticipated.
While investors don’t see the Bank of England’s benchmark rate increasing until next April, the central bank governor said it “could happen sooner than markets currently expect.” Higher borrowing costs could stretch over-leveraged households and undermine financial stability, he said.
All that said, if such a change were to occur, it will not be in this week's statement.  My expectation is that Yellen sticks to the fairly dovish tune she has been singing.  If there are clues that the tenor of the tune is changing I think they would be subtle.  Watch for any language from Yellen regarding proximity to goals, optimism on the JOLTS numbers, or references to inflation bottoming out and turning higher.  These would be hints that the Fed is increasingly concerned of the possibility of falling behind the curve.  Such talk would also hint at the possibility that the new Board members seek to edge policy in a different direction.
On the other side of the coin, look for policymakers to make note of geopolitical risk.  The mess in Iraq is already pushing oil prices higher, which the Fed should read as more likely to soften the recovery rather than fuel inflation
Bottom Line:  My baseline expectation is minimal policy changes this week.  Moreover, my baseline remains a still long period of low rates.  I think the Federal Reserve would like to hold onto the "low wage growth means plenty of slack and no inflation story" as long as possible.   Watch also the geopolitical risk, as that will tend to reinforce the Fed's existing path.  Overall, the situation altogether still argues for the first rate hike in the second half of next year.  The Fed's low rate story, however, will come under increasing pressure as the Fed gets closer to reaching its policy goals.  And that pressure will only intensify if growth does in fact accelerate.  That leaves me feeling that the risk to my baseline assumption is that the first rate hike comes sooner than currently anticipated.