Category Archive for: Monetary Policy [Return to Main]

Sunday, August 17, 2014

'The Treasury and the Fed are at Loggerheads'

Roger Farmer:

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

Friday, August 15, 2014

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

Narayana Kocherlakota, President of the Minneapolis Fed:

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

Paul Krugman: The Forever Slump

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

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

Thursday, August 14, 2014

'The Gold Standard and Price Inflation'

David Andolfatto of the St. Louis Fed:

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

Wednesday, August 13, 2014

Fed Watch: Heading Into Jackson Hole

Tim Duy:

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

JOLTS081214

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

Monday, August 11, 2014

'Celebrating Greenspan's Legacy of Failure'

Barry Ritholtz:

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

Barry concludes with:

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

Friday, August 08, 2014

'Getting There?'

David Altig (Research Director at the Atlanta Fed):

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

Atlanta Fed Labor Market Spider Chart

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

Total Private Earnings, year/year % change, sa

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

'Trends' in the June Core PCE

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

Thursday, August 07, 2014

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

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

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

Wednesday, August 06, 2014

Fed Watch: Fed Hawks Squawk

Tim Duy:

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

InfC080514

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

InfD080514

inflation expectations have been remarkably stable:

InfE080514

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

InfA080514

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

Inf080514

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

Friday, August 01, 2014

Fed Watch: July Employment Report

Tim Duy:

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

NFPc080114

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

NFPa080114

NFPb080114

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

PCEa080114

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

PCEb080114

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

Thursday, July 31, 2014

Fed Watch: On That ECI Number

Tim Duy (see Dean Baker too):

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

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

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

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

ECIa073114

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

ECIb073114

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

ECIc073114

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

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

At MoneyWatch:

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

Wednesday, July 30, 2014

Fed Watch: FOMC Statement

Tim Duy:

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

FOMCa073014

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

FOMCb073014

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

Thursday, July 24, 2014

Should the Fed be Forced to Follow a Rule?

Me, at MoneyWatch:

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

Friday, July 18, 2014

Paul Krugman: Addicted to Inflation

What does "inflation addiction" tell us?:

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

Wednesday, July 16, 2014

'Risk Aversion and the Natural Interest Rate'

From the NY Fed's Liberty Street Economics blog:

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

Tuesday, July 15, 2014

Fed Watch: Yellen Testimony

Tim Duy:

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

BULLARD071514

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

Monday, July 14, 2014

Congress and Monetary Policy

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

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

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

Sunday, July 13, 2014

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

Simon Wren-Lewis:

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

Saturday, July 12, 2014

Are Interest Rates Artificially Low? Nope.

Discouraging:

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

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

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

Friday, July 11, 2014

Paul Krugman: Who Wants a Depression?

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

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

Thursday, July 10, 2014

Fed Explores Overhaul of Its Target Interest Rate

Robin Harding reports:

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

Fed Watch: QEInfinity Not

Tim Duy:

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

BN-DP809_dwindl_G_20140709142508

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

INF070914

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

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

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

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:

INFb062314

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:

JOLTS0612014

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:

UNEMP0612014

and inflation potentially bottoming out and turning up:

PCE0612014

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:

FUNCTION0612014

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

TAYLOR0612014

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.

Thursday, June 05, 2014

Do Low Rates Cause 'Reach for Yield'?

John Cochrane:

Sugar Mountain: ...Itamar Drechsler, Alexi Savov, and Philipp Schnabl's "Model of Monetary Policy and Risk Premia" ... addresses a very important issue. The policy and commentary community keeps saying that the Federal Reserve has a big effect on risk premiums by its control of short-term rates. Low interest rates are said to spark a "reach for yield," and encourage investors, and too big to fail banks especially, to take on unwise risks. This story has become a central argument for hawkishness at the moment. The causal channel is just stated as fact. But one should not accept an argument just because one likes the policy result.
Nice story. Except there is about zero economic logic to it. The level of nominal interest rates and the risk premium are two totally different phenomena. Borrowing at 5% and making a risky investment at 8%, or borrowing at 1% and making a risky investment at 4% is exactly the same risk-reward tradeoff. ...
OK, enter  Drechsler, Savov, and Schnabl. They have a real, economic model of the phenomenon. That's great. We may disagree, but the only way to understand this issue is to write down a model, not to tell stories. ...
Read the paper for more. I have come to praise it not to criticize it. Real, solid, quantiative economic models are just what we need to have a serious discussion. This is a really important and unsolved question, which I will close by restating:

Does monetary policy, by controlling the level of short term rates, substantially affect risk premiums? If so, how?

Of course, maybe the answer is "it doesn't."

[See the original post for the technical arguments and "money illusion" intuition for the results in the paper. This has been a key argument behind the call to increase the Fed's target rate now rather than later, so it's an important issue.]

Wednesday, May 28, 2014

A Wedge in the Dual Mandate: Monetary Policy and Long-Term Unemployment

Glenn Rudebusch and John Williams:

A Wedge in the Dual Mandate: Monetary Policy and Long-Term Unemployment, by Glenn D. Rudebusch and John C. Williams, Federal Reserve Bank of San Francisco: Abstract In standard macroeconomic models, the two objectives in the Federal Reserve's dual mandate -- full employment and price stability -- are closely intertwined. We motivate and estimate an alternative model in which long-term unemployment varies endogenously over the business cycle but does not a ect price in ation. In this new model, an increase in long-term unemployment as a share of total unemployment creates short-term tradeoffs for optimal monetary policy and a wedge in the dual mandate. In particular, faced with high long-term unemployment following the Great Recession, optimal monetary policy would allow inflation to overshoot its target more than in standard models.

I'll believe the Fed will allow *intentional overshooting* of its inflation target when I see it.

Fed Watch: Policy Induced Mediocrity?

Tim Duy:

Policy Induced Mediocrity?, by Tim Duy: Why did the Federal Reserve lean against their optimistic 2014 forecast? It seems that monetary policy over the past year can be summarized as a missed opportunity to supercharge the recovery, thereby locking the US economy into a suboptimal growth path.
Last week's speech by New York Federal Reserve President William Dudley noted the reasons monetary policymakers expected the economy to improve this year:
Since the downturn ended in mid-2009, real GDP growth has averaged only 2.2 percent per year despite a very accommodative monetary policy. This performance reflects three major factors—the significant headwinds resulting from the bursting of the housing bubble, the shift of fiscal policy from expansion toward restraint, especially in 2012 and 2013, and a series of shocks from abroad—most notably the European crisis.
The good news is that all three of these factors have abated. With respect to the headwinds resulting from the financial crisis, they are gradually becoming less severe. In particular, the sharp decline in household wealth due to the decline in housing prices and the weakness in equity prices has been largely reversed...On the fiscal side, the amount of restraint has diminished sharply. For 2014, the projected drag is about ½ percent of GDP, roughly half the level of 2013. Moreover, much of this restraint was frontloaded into the beginning of the year...In terms of the outlook abroad, the circumstances are more mixed.
The Federal Reserve could have chosen to lean into this generally upbeat forecast. Yet instead they chose to lean against it by turning to tapering and setting the stage for interest rate hikes. And the data so far suggests that once again the turn toward policy normalization was premature. The weak first quarter report is more suggestive of holding the recent pace of growth over the next year rather than an acceleration of activity. What is remarkable is that the Federal Reserve understood that their forecasts have tended toward optimism. Dudley again:
But, there remains considerable uncertainty about that forecast and, given the persistent over-optimism about the growth outlook by Federal Reserve officials and others in recent years, we shouldn’t count our chickens before they hatch.
Yet they choose to act prior to data confirmation. Why? I really don't quite know. Sure, we can tell a story about the declining unemployment rate and expected subsequent inflation pressures, but ultimately the turn toward less policy accommodation never made sense in the context of the Fed's own forecasts and questions about the degree of slack in the economy. It makes me wonder how seriously the Fed is truly interested in closing the output gap:

REALPOT051114

It seems reasonable to believe that if the economy regains potential output by the end of at best 2016, it will be attributable only to further downward revisions to potential output. And I even wonder whether the Fed would act to achieve their current growth forecasts or ultimately be content to continue along the current trend. The economy appears to be already molding itself around the lower output path. Despite the housing troubles and related weak rebound in construction, and the declines in government hiring, job growth is, on average, plugging along at a rate roughly consistent to that during the housing boom:

NFP051114

With that growth labor slack gradually steadily declines by any measure, the Fed appears reasonably comfortable with the resulting path. To be sure, arguably there still remains substantial slack. The failure of wage gains to accelerate is consistent with that story. But the Fed seems content to use that story only to justify its current policy path rather than justify an even easier policy to more quickly reduce slack.
Given the generally consistent overall reaction of the labor market to the current growth path, it is reasonable to believe that the faster pace of growth in the Fed's forecast would accelerate the pace of labor utilization and thus place upward pressure on inflation forecasts. In this case, we would expect the Fed to pull forward and steepen the pace of rate hikes to moderate the pace of activity. Thus, ultimately the Fed's commitment to regaining potential output could be even less than we have come to believe.
But even more telling would be the monetary policy reaction if growth continues along its current path. The weak first quarter results already place the forecast at risk, and the housing recovery is not progressing as smoothly as initially believed. Yet neither event prevented the Fed from continuing to cut asset purchases at the last FOMC meeting. Moreover, I still can't see any reason to expect the Fed will slow the tapering process unless the economy falls decisively off its current path. It could be that by the time they are sufficiently convinced growth will continue to fall short of forecast, asset purchases will be almost complete anyway. And I think the bar to restarting asset purchases would be very high. They want out of that business.
And if neither fiscal or monetary policy makers are interested in accelerating the pace of growth, should we really expect the pace of growth to accelerate? In other words, it appears to me that monetary policy largely amounts to setting expectations that reinforce the current growth path. Which was a recent topic of Bloomberg's Rich Miller who, reporting on the Fed's diminished expectations, quotes me:
By lowering its assessment of how fast the economy can expand and conducting policy accordingly, the Fed runs the risk of locking the U.S. into a slow-growth path, said Tim Duy, a former Treasury Department economist who is now a professor at the University of Oregon in Eugene...
...“They offset fiscal austerity on the downside but then arguably also offset the upside,” Duy said. “They seem to have lost interest in speeding the pace of the recovery.”
Bottom Line: The Federal Reserve has set reasonably clear expectations that rates will remain low for a long time. That path, however, seems to be a consequence of doing too little now to ensure a stronger recovery. In other words, the Fed seems to be taking a lower-rate future as a given rather than as a result of insufficient policy. Instead of acting to ensure a stronger forecast, they seem more interesting in acting to lock-in the lower path of activity. And that in turn will tend to lock in a low level of long-term rates. This, I think, is the best explanation for the inability of markets to sustain higher rates. It is simply reasonable to expect that the conditions which justify higher long rates will be met with tighter policy sufficient to contain growth to something closer to the current path of output than to current estimates of potential output.

Wednesday, May 21, 2014

Fed Watch: Dudley Revisits Exit Strategy

Tim Duy:

Dudley Revisits Exit Strategy, by Tim Duy: Today New York Federal Reserve President William Dudley gave what was both an interesting and depressing speech. Interesting in that he provides some new thoughts on the exit strategy. Depressing in that he outlines a case for persistently low interest rates. One wonders why, given such an outlook, the Fed is so firmly focused on the exit strategy to begin with, rather than accelerating the pace of the recovery.
Dudley tries to sound an optimistic note regarding the outlook, including dismissing the first quarter GDP report, but his optimism is tempered, very tempered:
With the fundamentals of the economy improving and fiscal drag abating, I expect the economy to get back on to a roughly 3 percent growth trajectory over the remainder of this year, with some further strengthening likely in 2015. But, there remains considerable uncertainty about that forecast and, given the persistent over-optimism about the growth outlook by Federal Reserve officials and others in recent years, we shouldn’t count our chickens before they hatch.
Three percent growth is not exactly anything to write home about; the only thing exciting about 3 percent is that we just can't seem to get there. Dudley specifically notes weak capital spending and housing markets as key concerns. He senses that the capital spending issue is transitory, but housing less so:
I think housing has been weaker than anticipated because several significant headwinds persist for this sector. First, mortgage credit is still not readily available to households with lower credit scores. Second, some people are coping with higher student loan debt burdens that have delayed their entry into the housing market as first-time homebuyers. This, in turn, makes it more difficult for existing homeowners to sell and trade-up. Third, there may be some ongoing difficulties increasing housing supply. The housing downturn was very deep and protracted. It takes time to shift resources back into this area. Also, in some markets house prices still appear to be below the cost of building a new home. Thus, in those markets, it remains uneconomic to undertake new home construction. Although I expect that the housing recovery will resume, the pace will likely be slow, especially relative to past economic recoveries.
Notice that he does not mention the mortgage rate increase over the past year, instead focusing on issues largely outside the control of the Federal Reserve. In other words, housing is a problem that they can't fix and thus will simply contribute to weak growth. Regarding inflation, Dudley is optimistic that the trajectory will prove to be in the right direction, but sees little reason to expect any sharp increases. There is simply too much slack in the labor market, evidenced by low wage growth. Here he paints a bleak picture and lays down some markers:
...the trend of labor compensation is running at only about a 2 percent annualized pace. This is far below the roughly 3½ percent pace that would be consistent with trend productivity growth of 1 to 1½ percent and the FOMC’s 2 percent inflation objective.
Trend productivity growth of just 1 to 1.5 percent is very, very low and feeds into the Fed's belief that potential growth is in the 2.2 to 2.3 percent range. Dudley's expected 3 percent growth thus hardly eats into excess capacity. Still surprises me that the Fed remains focused on policy firming when arguably conditions require a delay in the tapering process.
On that inflation target, Dudley argues against the "2 percent is a ceiling" hypothesis:
...once we reach 2 percent, I would expect that we would spend as much time slightly above 2 percent as below it, recognizing that we will hardly ever be exactly at 2 percent because of the inherent volatility in prices. If inflation were to drift above 2 percent, all else equal, then we would tend to resist such a rise. But, if inflation were slightly above 2 percent even as unemployment remained far above levels consistent with maximum employment, then the unemployment consideration would dominate because we would be further from the unemployment objective than we are from the inflation objective. This should not surprise anyone. This is what our “balanced approach” implies.
The operative word here is "slightly." What is "slightly" above 2 percent? My guess is that as long as inflation remains below 2.25 percent and employment outcomes remain subpar, the Fed will remain on a low-interest rate path (though not a zero rate path). Above 2.25 would be more disconcerting but, realistically, it is unlikely that the US economy would experience higher inflation in the absence of clear evidence that labor market slack had evaporated. In other words, I suspect that if inflation were above 2.25 percent, the Fed would not need to choose between the elements of the dual mandate; the case for a higher rate trajectory would be clear.
Dudley anticipates that the tapering process will continue, and thus turns his attention to the lift-off from the zero bound. Here he admits the reality of the situation. They really have no idea when the first rate increase will occur:
Turning first to the timing of lift-off, how the outlook evolves matters. We currently anticipate that a considerable period of time will elapse between the end of asset purchases and lift-off, but precisely how long is difficult to say given the inherent uncertainties surrounding the outlook.
I would congratulate him for avoiding the use of a date, but then he includes a footnote pointing to the March Summary of Economic Projections and the embedded anticipation that rates will rise in the middle of next year. Fed officials simply can't decide whether those projections are meaningful or not.
As far as the pace of timing, that too is data dependent, although given the current forecasts Dudley anticipates a tame trajectory:
With respect to the trajectory of rates after lift-off, this also is highly dependent on how the economy evolves. My current thinking is that the pace of tightening will probably be relatively slow. This depends, however, in large part, not only on the economy’s performance, but also on how financial conditions respond to tightening.
And he too expects rates will be subdued over the longer term, laying out three reasons:
First, economic headwinds seem likely to persist for several more years...Second, slower growth of the labor force due to the aging of the population and moderate productivity growth imply a lower potential real GDP growth rate as compared to the 1990s and 2000s. Because the level of real equilibrium interest rates appears to be positively related to potential real GDP growth, this slower trend implies lower real equilibrium interest rates even after all the current headwinds fully dissipate...Third, changes in bank regulation may also imply a somewhat lower long-term equilibrium rate.
When it comes to the Fed's exit from extraordinary monetary policy, Dudley throws in a new twist. Conventional wisdom is that the Fed would stop reinvesting the principal payments on assets held by the Fed prior to raising rates. Dudley suggests this might not be a wise decision. First, he argues that this might send the wrong signal to financial markets:
Ending reinvestments as an initial step risks inadvertently bringing forward any tightening of financial conditions as this might foreshadow the impending lift-off date for rates in a manner inconsistent with the Committee’s intention.
Second - which seems to be in contradiction to the first - it that he prefers lifting rates to enhance policy flexibility:
Second, when conditions permit, it would be desirable to get off the zero lower bound in order to regain some monetary policy flexibility. This goal would argue for lift-off occurring first followed by the end of reinvestment, rather than vice versa. Delaying the end of reinvestment puts the emphasis where it needs to be—getting off the zero lower bound for interest rates. In my opinion, this is far more important than the consequences of the balance sheet being a little larger for a little longer.
Dudley is saying that the Fed can reduce accommodation via raising rates or reducing the balance sheet, and they should should begin with the former to normalize policy. This reveals his confidence in being able to manage the balance sheet while raising rates, the topic of which takes up the remainder of his speech. Note the qualifier "when conditions permit." This is not about tightening policy simply in order to get rates higher; it is about how to tighten policy - what mix of tools to use - when the time to tighten comes.
I don't quite see the communications challenges Dudley describes. In order to prevent expectations of an earlier rate hike we should hike rates rather than end reinvestments? Not sure this makes much sense. Maybe better to just say that they will reduce accommodation further when appropriate, and that process will involve some mix of rate hikes and balance sheet reduction, the exact mix to be determined by evolving economic and financial conditions.
Bottom Line: Dudley reinforces expectations that the low rate environment will persist long into the future. The data flow is not providing reason to think otherwise at this point; we would need to see higher inflation numbers coupled with real reason to believe labor market slack was rapidly evaporating, probably in the form of stronger wage growth. It remains interesting that the Fed does not view their own outlook as reason to accelerate the pace of activity. They seem relatively content to accept what they themselves acknowledge is an ongoing disappointment.
[PS: Still in light blogging mode. Preoccupied with teaching this term.]

Tuesday, May 20, 2014

Why the Fed Should Not Raise Interest Rates

New column:

Why the Fed Should Not Raise Interest Rates, by Mark Thoma: The Fed’s target interest rate has been at the zero lower bound since December of 2008, and Fed watchers are trying to predict when the Fed will begin reversing this policy. The consensus appears to be that the Fed will begin raising the target rate at the beginning of next year, but many economists believe the policy reversal should have already started. There are four main justifications for the call to raise interest rates sooner rather than later, all of which are misguided...

Friday, May 16, 2014

'Which Flavor of QE?'

David Altig:

Which Flavor of QE?: Yesterday's report on consumer price inflation from the U.S. Bureau of Labor Statistics moved the needle a bit on inflation trends—but just a bit. Meanwhile, the European Central Bank appears to be locked and loaded to blast away at its own (low) inflation concerns. From the Wall Street Journal:

The European Central Bank is ready to loosen monetary policy further to prevent the euro zone from succumbing to an extended period of low inflation, its vice president said on Thursday.

"We are determined to act swiftly if required and don't rule out further monetary policy easing," ECB Vice President Vitor Constancio said in a speech in Berlin.

One of the favorite further measures is apparently charging financial institutions for funds deposited with the central bank:

On Wednesday, the ECB's top economist, Peter Praet, in an interview with German newspaper Die Zeit, said the central bank is preparing a number of measures to counter low inflation. He mentioned a negative rate on deposits as a possible option in combination with other measures.

I don't presume to know enough about financial institutions in Europe to weigh in on the likely effectiveness of such an approach. I do know that we have found reasons to believe that there are limits to such a tool in the U.S. context, as the New York Fed's Ken Garbade and Jamie McAndrews pointed out a couple of years back.

In part, the desire to think about an option such as negative interest rates on deposits appears to be driven by considerable skepticism about deploying more quantitative easing, or QE.

A drawback, in my view, of general discussions about the wisdom and effectiveness of large-scale asset purchase programs is that these policies come in many flavors. My belief, in fact, is that the Fed versions of QE1, QE2, and QE3 can be thought of as three quite different programs, useful to address three quite distinct challenges. You can flip through the slide deck of a presentation I gave last week at a conference sponsored by the Global Interdependence Center, but here is the essence of my argument:

  • QE1, as emphasized by former Fed Chair Ben Bernanke, was first and foremost credit policy. It was implemented when credit markets were still in a state of relative disarray and, arguably, segmented to some significant degree. Unlike credit policy, the focus of traditional or pure QE "is the quantity of bank reserves" (to use the Bernanke language). Although QE1 per se involved asset purchases in excess of $1.7 trillion, the Fed's balance sheet rose by less than $300 billion during the program's span. The reason, of course, is that the open-market purchases associated with QE1 largely just replaced expiring lending from the emergency-based facilities in place through most of 2008. In effect, with QE1 the Fed replaced one type of credit policy with another.
  • QE2, in contrast, looks to me like pure, traditional quantitative easing. It was a good old-fashioned Treasury-only asset purchase program, and the monetary base effectively increased in lockstep with the size of the program. Importantly, the salient concern of the moment was a clear deterioration of market-based inflation expectations and—particularly worrisome to us at the Atlanta Fed—rising beliefs that outright deflation might be in the cards. In retrospect, old-fashioned QE appears to have worked to address the old-fashioned problem of influencing inflation expectations. In fact, the turnaround in expectations can be clearly traced to the Bernanke comments at the August 2010 Kansas City Fed Economic Symposium, indicating that the Federal Open Market Committee (FOMC) was ready and willing pull the QE tool out of the kit. That was an early lesson in the power of forward guidance, which brings us to...
  • ...QE3. I think it is a bit early to draw conclusions about the ultimate impact of QE3. I think you can contend that the Fed's latest large-scale asset purchase program has not had a large independent effect on interest rates or economic activity while still believing that QE3 has played an important role in supporting the economic recovery. These two, seemingly contradictory, opinions echo an argument suggested by Mike Woodford at the Kansas City Fed's Jackson Hole conference in 2012: QE3 was important as a signaling device in early stages of the deployment of the FOMC's primary tool, forward guidance regarding the period of exceptionally low interest rates. I would in fact argue that the winding down of QE3 makes all the more sense when seen through the lens of a forward guidance tool that has matured to the point of no longer requiring the credibility "booster shot" of words put to action via QE.

All of this is to argue that QE, as practiced, is not a single policy, effective in all variants in all circumstances, which means that the U.S. experience of the past might not apply to another time, let alone another place. But as I review the record of the past seven years, I see evidence that pure QE worked pretty well precisely when the central concern was managing inflation expectations (and, hence, I would say, inflation itself).

Tuesday, May 13, 2014

'Asymmetric Misinformation'

Paul Krugman:

Asymmetric Misinformation: A follow-up to my post about Jaime Caruana at the BIS. One other thing that struck me was his claim that

policymakers respond asymmetrically over successive business and financial cycles, hardly tightening or even easing during booms and easing aggressively and persistently during busts

Is this true? Anyway, is symmetry in policy responses inherently desirable?

The claim that policymakers have an easy-money bias is one of those things usually said with an air of worldy wisdom; of course people don’t want to take away the punchbowl when everyone is having fun. But the reality doesn’t look at all like that. After all, if policy were consistently doing too much to fight slumps and not enough to curb booms, what you would expect is a steady ratcheting up of inflation — which isn’t at all what has happened over the past 35 years. This supposed piece of wisdom is actually a cliche from the 1970s, which hasn’t been remotely true for a generation. ...

Incidentally, the fake wisdom on monetary policy resembles a corresponding piece of fake wisdom on fiscal policy — the claim that fiscal stimulus inevitably turns into a permanent rise in government spending, because the programs never go away. That didn’t happen this time... And in fact it has never happened in the United States, as far as I can tell...

Beyond that, there are in fact good reasons for asymmetry in the response to booms and slumps...

He goes on to explain why. I'd add another reason why "symmetry is not a virtue," the difference in costs between inflation and unemployment. I believe that the costs of unemployment are much higher than the costs of inflation running a point or two (or three of four) above target, so if there is a mistake to be made, it's best to err on doing too much in a recession.

Sunday, May 11, 2014

'Inflation Targeting vs Price-Level Targeting: A New Survey of Theory and Empirics'

Price level targeting appears to be better than inflation targeting, particular at the zero bound, but the "beneficial effects hang importantly on the structure of New Keynesian models and rational expectations":

Inflation targeting vs price-level targeting: A new survey of theory and empirics, by Michael Hatcher, Patrick Minford, Vox EU: Price stability is the key goal of almost every central bank in the world. But does that mean prices levels or inflation rates? The main difference between inflation targeting and price-level targeting is the consequence of missing the target.

  • Unanticipated shocks to inflation lead to corrective action when the price is the target.
  • Under inflation targeting, past mistakes and shocks are treated as ‘bygones’.

If, for example, inflation is unexpectedly high today, this would be followed in the future by below average inflation under a price-level targeting regime. By contrast, inflation targeting aims for average (i.e. on-target) inflation in future years regardless of the level of current inflation (see Figure 1).

Figure 1 Inflation and price-level targeting compared

Hatcher10mayfig1

Figure 1 makes clear that expectations depend crucially on the regime in place. For example, suppose the central bank announces an inflation target of 2%. When inflation unexpectedly rises to 3% in period 3, rational households and firms will anticipate future inflation of 2% in periods 4 and 5. By contrast, expected inflation in period 5 would be only 1% with a price-level target, because price targeting calls for below-average inflation in this period. Because the central bank is obliged to offset past inflationary shocks in this way, targeting prices is ‘history dependent’ (Woodford 2003). This mechanism is important for understanding why price-level targeting gives different outcomes to inflation targeting in New Keynesian models.
A survey of new evidence and thinking
This question of targets – inflation or the aggregate price level – has excited economists for decades. Knut Wicksell first presented the view that Swedish monetary policy should stabilize the price level in 1898. A little over three decades later, Sweden experimented with price-level targeting for the first time (see Berg and Jonung 1999). But price-level targeting did not take-off; it has not been adopted by a major central bank since.
In recent years, however, economists have re-assessed the merits of price-level targeting in the light of new research and better models.1  We recently wrote a survey of this new research (Hatcher and Minford 2014), designed to bring an earlier survey by Ambler (2009) up to date. A key new development is the potential role of price-level targeting in helping monetary policy deal with the ‘zero bound’ on nominal interest rates.
Inflation targeting and the zero bound on interest rates
Consider, for instance, a situation where the economy has been hit by a large negative shock to aggregate demand, and nominal interest rates have been cut to zero in an attempt to stimulate the economy back to full capacity. Because inflation expectations remain anchored at 2% under inflation targeting, the only route by which monetary policy could stimulate the economy is further cuts in nominal interest rates – an option which has been exhausted at this point.
If households and firms understand the impotence of monetary policy in this situation, they might even expect lower future inflation. This would raise real interest rates, thus pushing down demand even further. With real interest rates either constant or rising, a lengthy recession is likely to ensue.
Targeting the price level leads to a different dynamic for inflation expectations. After the demand shock has hit and inflation falls below 2%, a credible price-level target would create the expectation of future inflation of more than 2%. In turn, this expectation will lower real interest rates today and provide necessary stimulus to aggregate demand and upward pressure on prices. This expectations mechanism has additional bite in New Keynesian models because an increase in expected inflation raises current inflation, and higher output expectations raise aggregate demand.
Both Eggertsson and Woodford (2003) and Nakov (2008) confirm this intuition. Welfare losses conditional on reaching the lower bound are much larger under inflation targeting than price targeting in New Keynesian models. More recently, Coibion et al. (2012) consider an extended model with the feature that the optimal rate of inflation can be computed. Because targeting the price level reduces the frequency and severity of zero bound episodes through its effect on expectations, the optimal inflation rate is somewhat lower than under inflation targeting. Since there are additional welfare gains associated with a lower trend rate of inflation, the potential welfare gains from price-level targeting are much larger and amount to 0.4% of GDP per year.2
Covas and Zhang (2010) and Bailliu et al. (2012) show that including in the New Keynesian model some basic financial frictions underlined by the recent financial crisis does not overturn the beneficial effects of price targeting – essentially because the main mechanism via expectations remains powerful in these models. It is important to note, however, that this mechanism rests crucially on the assumption that the price-level target is credible. Also, we cannot yet say much about the relative merits of price-level targeting in models with more sophisticated financial frictions, though we expect to see additional research soon. 
The importance of rational expectations
Because the expectations mechanism under targeting the price is central to its performance, the crucial issue for policymakers is whether expectations are rational and the economy New Keynesian. One way to get at whether expectations are rational is surveys and experiments. Like many economists, however, we remain skeptical about the usefulness of these approaches and think applied macro evidence is preferable when it can be established on strong statistical grounds.3
We, therefore, turn to this literature. Early attempts to test rational expectations in macro models were made by Fair (1993) and several others. When we look at modern New Keynesian models with rational expectations imposed, we find a steady improvement over time in their empirical performance. For instance, Christiano et al. (2005) and Smets and Wouters (2007) show that New Keynesian models can match key dynamic features of US data and perform impressively in out-of-sample forecast tests. Nowadays, most major central banks consider New Keynesian models useful tools for policy analysis.4
The next logical step is to test these models directly against the data using statistical tests that accept or reject the basic model and variants of it. This challenge has been taken on by a recent strand of applied macro literature that exploits vector autoregressions (VARs) as a description of macro data. A statistical testing procedure can be built on this, known as indirect inference (see Smith 1993). The basic idea is to simulate the models to create a large number of counter-factual histories, and the VAR relationships implied by them, and then to ask whether the actual history and the VAR estimated on this actual data could be rejected as coming from this distribution at some level of statistical confidence. It turns out that this test has substantial power against mis-specified models (Le et al. 2012), quite a lot more so than tests based on likelihood which can struggle to distinguish between alternative models (see Canova and Sala 2009). Bayesian ranking is based on likelihood and can also suffer from lack of power. Though this could, in theory, be remedied by the use of strong priors, in practical terms it is difficult to come up with a set of at once uncontroversial and strong priors.
The indirect inference test can be applied to any model and its proposed parameters. Furthermore, the possibility that the original set of parameters could simply be wrongly calibrated can be explored by searching over the full range of parameter values permitted by theory.5  In recent years, a number of studies have carried out this test on New Keynesian models with rational expectations, largely on US data. For example, Le et al. (2011) reworked the Smets and Wouters (2007) model by adding a competitive sector to both the labor and the product markets and re-estimating it as above. They found that for the post-1984 Great Moderation period, the model passed the indirect inference test comfortably (p-value = 0.16), and that the ‘best’ model over this period was strongly New Keynesian.
Liu and Minford (2012) considered, again on US data, a smaller New Keynesian model. Usefully for our focus here, they tested the model under both rational expectations and behavioural expectations as in De Grauwe (2010). The behavioral expectations are the weighted average of a ‘fundamentalist’ forecasting rule, in which the output gap or inflation are forecasts at their steady state values, and a rule extrapolating the most recent value. Many policymakers have considered such behavioral rules to be probable and have had doubts about the ‘strong’ rational expectations assumption. So, the comparison is pertinent for them. Perhaps surprisingly, the rational expectations model does far better than the behavioral version. Indeed, the latter is strongly rejected even after full re-estimation, whereas the rational expectations version passes after re-estimation by a fair margin (p-value = 0.20).
Conclusion
Price-level targeting is found in modern macro models to be a good mechanism for helping the economy to recover from deflationary shocks driving monetary policy to the zero bound. It does this because when such shocks occur price-level targeting implies that future inflation will be boosted and so real interest rates are lowered. Moreover, this mechanism would make it feasible for trend inflation to be lowered, which would bring additional benefits. These beneficial effects hang importantly on the structure of New Keynesian models and rational expectations. The empirical literature we have surveyed does not reject these assumptions and favors rational expectations over behavioral ones. We, therefore, conclude that policymakers should continue to pay attention to price-level targeting in the future.
References
Ambler, S. (2009), “Price-level targeting and stabilisation policy: a survey”, Journal of Economic Surveys 23(5), 974–997.
Ambler, S. (2007), “The costs of inflation in New Keynesian models”, Bank of Canada Review (Winter), 5–14.
Andolfatto, D., Hendry, S., Moran, K. (2008), “Are inflation expectations rational?”, Journal of Monetary Economics 55(2), 406–422.
Bailey, M.J. (1956), “The welfare cost of inflationary finance”, Journal of Political Economy 64(2), 93–110.
Bailliu, J., Meh, C. and Zhang, Y. (2012), “Macroprudential rules and monetary policy when financial frictions matter”, Bank of Canada Working Paper 2012-6.
Bank of Canada (2011), Renewal of the inflation-control target.
Berg, C., Jonung, L. (1999), “Pioneering price-level targeting: the Swedish experience 1931-1937”, Journal of Monetary Economics 43(3), 525–551.
Canova, F., Sala, L. (2009), “Back to square one: Identification issues in DSGE models”, Journal of Monetary Economics 56, 431–449.
Christiano, L.J., Eichenbaum, M.S., Evans, C.L. (2005), “Nominal rigidities and the dynamic effects of a shock to monetary policy”, Journal of Political Economy 113(1), 1–45.
Coibion, O., Gorodnichenko, Y., Wieland, J. (2012), “The optimal inflation rate in New Keynesian models: should central banks raise their inflation targets in light of the zero lower bound?”, Review of Economic Studies 79, 1371–1406.
Covas, F. and Zhang, Y. (2010), “Price-level versus inflation targeting with financial market imperfections”, Canadian Journal of Economics 43(4), 1302–1332.
De Grauwe, P. (2010), “Top-down versus bottom-up macroeconomics”, CESifo Economic Studies 56(4), 465–497.
Eggertsson, G.B. and Woodford, M. (2003), “The zero bound on interest rates and optimal monetary policy”, Brookings Papers on Economic Activity 1:2003, 139–211.
Fair, R.C. (1993), “Testing the rational expectations hypothesis in macroeconometric models”, Oxford Economic Papers 45(2), 169–190.
Hatcher, M., Minford, P. (2014), “Stabilization policy, rational expectations and price-level versus inflation targeting: a survey”, CEPR Discussion Paper No. 9820.
Le, V.P.M., Meenagh, D., Minford, P. and Wickens, M.R. (2011), “How much nominal rigidity is there in the US economy? Testing a New Keynesian DSGE model using indirect inference”, Journal of Economic Dynamics and Control 35(12), 2078–2104.
Le, V.P.M., Meenagh, D., Minford, P., and Wickens, M. (2012), “Testing DSGE models by Indirect inference and other methods: some Monte Carlo experiments”, Cardiff University Economics working paper E2012_15.
Liu, C., Minford, P. (2012), “Comparing behavioural and rational expectations for the US post-war economy”, CEPR Discussion Paper 9132.
Nakov, A. (2008), “Optimal and simple monetary policy rules with zero floor on the nominal interest rate”, International Journal of Central Banking 4(2), 73–127.
Smets, F. and Wouters, R. (2007), “Shocks and frictions in US business cycles: a Bayesian DSGE approach”, American Economic Review 97(3), 586–606.
Smith, A.A. Jr. (1993), “Estimating nonlinear time-series models using simulated vector autoregressions”, Journal of Applied Econometrics 8, 63–84.
Woodford, M. (2003), Interest and prices: Foundations of a theory of monetary policy, NJ: Princeton University Press.
Footnotes
1 This re-assessment has not been confined to academia: the Bank of Canada recently investigated in detail whether it should switch to a price-level targeting mandate (Bank of Canada 2011).
2 Positive trend inflation has three distinct costs in New Keynesian models (see Ambler 2007). The traditional welfare cost due to inflation acting as a tax on money holdings (see Bailey 1956) is not one of them. It is therefore conceivable that the welfare gains attainable from lowering trend inflation under price-level targeting could be larger than estimated by Coibion et al. (2012). The figure of 0.4% of GDP was arrived at by multiplying the gain of 0.5% of aggregate consumption reported in Coibion et al. by the model ratio of consumption to GDP of 0.8.
3 We provide a brief discussion of the pros and cons of survey and experimental evidence in Hatcher and Minford (2014). One important caveat highlighted by recent research is that statistical results in which survey inflation expectations differ persistently from actual inflation cannot be construed as conclusive evidence against rational expectations because this behaviour could be the result of occasional changes in monetary policy regime combined with a period of (rational) learning by the private sector (see Andolfatto et al. 2008).
4 In practice, most central banks rely on a variety of models, some of which are heavily reliant on economic theory and others which are closer to econometric models.
5 In effect this search amounts to re-estimation via indirect inference (which is asymptotically equivalent to full-information maximum likelihood but in small samples finds the model that gets closest to passing the test).
The weights on each type of forecasting rule vary over time according to the relative past success of each rule.

Wednesday, May 07, 2014

Yellen: The Economic Outlook

This is from Janet Yellen's prepared testimony before the Joint Economic Committee (the actual speech is much longer than this extract):

The Economic Outlook, by Janey Yellen, FRB, May 7, 2014: Chairman Brady, Vice Chair Klobuchar, and other members of the Committee, I appreciate this opportunity to discuss the current economic situation and outlook along with monetary policy before turning to some issues regarding financial stability.
Current Economic Situation and Outlook The economy has continued to recover from the steep recession of 2008 and 2009. Real gross domestic product (GDP) growth stepped up to an average annual rate of about 3-1/4 percent over the second half of last year, a faster pace than in the first half and during the preceding two years. Although real GDP growth is currently estimated to have paused in the first quarter of this year, I see that pause as mostly reflecting transitory factors, including the effects of the unusually cold and snowy winter weather. With the harsh winter behind us, many recent indicators suggest that a rebound in spending and production is already under way, putting the overall economy on track for solid growth in the current quarter. One cautionary note, though, is that readings on housing activity--a sector that has been recovering since 2011--have remained disappointing so far this year and will bear watching.
Conditions in the labor market have continued to improve. ...
While conditions in the labor market have improved appreciably, they are still far from satisfactory. ...
Inflation has been quite low even as the economy has continued to expand. Some of the factors contributing to the softness in inflation over the past year, such as the declines seen in non-oil import prices, will probably be transitory. Importantly, measures of longer-run inflation expectations have remained stable. That said, the Federal Open Market Committee (FOMC) recognizes that inflation persistently below 2 percent--the rate that the Committee judges to be most consistent with its dual mandate--could pose risks to economic performance, and we are monitoring inflation developments closely.
Looking ahead, I expect that economic activity will expand at a somewhat faster pace this year than it did last year, that the unemployment rate will continue to decline gradually, and that inflation will begin to move up toward 2 percent. A faster rate of economic growth this year should be supported by reduced restraint from changes in fiscal policy, gains in household net worth from increases in home prices and equity values, a firming in foreign economic growth, and further improvements in household and business confidence as the economy continues to strengthen. Moreover, U.S. financial conditions remain supportive of growth in economic activity and employment.
As always, considerable uncertainty surrounds this baseline economic outlook. At present, one prominent risk is that adverse developments abroad, such as heightened geopolitical tensions or an intensification of financial stresses in emerging market economies, could undermine confidence in the global economic recovery. Another risk--domestic in origin--is that the recent flattening out in housing activity could prove more protracted than currently expected rather than resuming its earlier pace of recovery. Both of these elements of uncertainty will bear close observation. ...
While we have seen substantial improvements in labor market conditions and the overall economy since the financial crisis and severe recession, we recognize that more must be accomplished. Many Americans who want a job are still unemployed, inflation continues to run below the FOMC's longer-run objective, and work remains to further strengthen our financial system. I will continue to work closely with my colleagues and others to carry out the important mission that the Congress has given the Federal Reserve. ...

Tuesday, May 06, 2014

Interview with Mark Gertler

From an interview with Mark Gertler:

EF : Is there anything you’ve learned from the Great Recession about the role of finance that you weren’t aware of before?
Gertler: I liken the crisis to 9/11; that is, there was an inkling that something bad could happen. I think there was some sense it wa s going to be associated with all the financial innovation, but just like with 9/11, we couldn’t see it coming. When we look back, we can piece everything together and make sense of things, but what w e didn’t really understand was the fragility in the shadow banking system, how it made the economy very vulnerable. I always think of the Warren Buffet line, “You don’t know who’s naked until you drain the swimming pool.” That’s sort of what happened here.
I think when we look back on the crisis, we can explain most of what happened given existing theory. It’s just we couldn’t see it at the time.
EF : What do you think is the best explanation for the policies that were pursued?
Gertler: At the time, I think it was partly unbridled belief in the market — that financial markets are competitive markets, and they ought t o function w el l, not taking int o account that any individual is just concerned about his or her welfare, not about the market as a whole or the exposure of the mark et a s a whole. And so you had this whole system grow up without any outside monitoring by the government. It just had individuals making these trades and making these bets; nobody was adding everything up and understanding the risk exposure. And there was this attitude that we ought to be inclusive about homeownership — that was going on as well. Plus, complacency set in. We had the Great Moderation of the 1980s and 1990s, and we all thought we’d solved the major problems in macroeconomics. There were some prominent macroeconomists saying, “Look, we shouldn’t be wasting our time on these conventional issues; we’ve already solved them.” That led to most people just being asleep at the wheel.

Much more here.

Monday, May 05, 2014

Fed Watch: Difficult Labor Report

Tim Duy:

Difficult Labor Report, by Tim Duy: The headlines numbers from the April employment report are at first blush a challenge to the Fed's low rate commitment.  One doesn't have to dig much deeper into the data, however, to see that the near term implications are minimal as the Fed maintains its strong focus on measures of labor market slack.  Still, the rapid drop in unemployment - if it continues - will leave policymakers increasingly anxious that their one-way bet on labor market slack will quickly turn sour.
Nonfarm payrolls grew pay 288k, well above expectations of 215k.  While this numbers pushes the three-month moving average higher, the longer-term trend remains the same:

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Maybe this is the month the acceleration begins.  Maybe not.  Either way, the report supports the dismissal of the weak first quarter growth numbers (now tracking in negative territory) as transitory.  Just as has been the case for the last three years, there is nothing here to suggest a dramatic change in the pace of underlying economic activity.
The unemployment rate decline was a bit more intersting as it collapsed to 6.3% on the back of falling labor force participation:

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The downward trend accelerated in the second half of 2013, pushing us ever closer to levels traditionally associated with greater inflationary pressures and with those pressures tighter monetary policy.  Policymakers, however, appear to remain content dismissing the unemployment rate in favor of a wider range of labor market indicators that suggest plenty of slack left in the economy.  Federal Reserve Chair Janet Yellen's current four favorites:

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The wage story is, in my opinion, the key.  It is hard to argue against the labor slack story when employees can't push wages significantly higher.  That alone should be enough to stay the Fed's hand.  And if it isn't enough, they can always draw additional comfort from the inflation figures:

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Inflation is, at best, only in the process of bottoming.  
All that said, policymakers will be a little anxious that they are too quickly dismissing traditional metrics that would indicate they should be  be adjusting their inflation forecasts higher in light of the unemployment decline.  As I am relatively confident will be much discussed this week, variants of the Taylor rule suggest that policymakers should already be raising rates:

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In this environment, policymakers will increasingly worry about the policy lags.  They will want to hold rates low, but the further unemployment drops, the more they will fear that they risk falling behind the curve - that by the time the pace of wages growth accelerates, inflationary pressure will already be well established.  This is especially the case if they view the 2% target as a ceiling.  Hence I remain concerned that the risk is that policy turns sharply tighter relative to current expectations.  
I am also challenged to see why I should not expect the now-infamous dots in the summary of economic projections to be pulled forward on the basis of the falling unemployment rate.  I am looking forward to the next FOMC meeting for that alone.
I emphasize, however, that any substantially tighter policy remains only a "risk," not a baseline. I anticipate that in her Congressional testimony this week, Yellen will emphasize the alternative measures of labor market slack and the Fed's expectation that policy rates will remain well below "normal" rates for a protracted period.  As a general rule one report doesn't change policy.
Bottom Line: Overall, the general contours of the employment report suggest reason to (very) modestly bring forward expected rates hikes, but little to suggest any dramatic change to the Fed's reaction function overall.  Policymakers, however, will worry that the current reaction function is overly dependent on dismissing the unemployment rate as an indicator of inflationary pressure. And there is a risk that they will move quicker than expected if that bet starts to sour.  Risk, not baseline.