Category Archive for: Monetary Policy [Return to Main]

Thursday, May 26, 2016

Fed Watch: Powell, Data

Tim Duy:

Powell, Data, by Tim Duy: Federal Reserve Governor Jerome Powell kept the prospects for a near-term rate hike alive and well in a speech today:

For the near term, my baseline expectation is that our economy will continue on its path of growth at around 2 percent. To confirm that expectation, it will be important to see a significant strengthening in growth in the second quarter after the apparent softness of the past two quarters. To support this growth narrative, I also expect the ongoing healing process in labor markets to continue, with strong job growth, further reductions in headline unemployment and other measures of slack, and increases in wage inflation. As the economy tightens, I expect that inflation will continue to move over time to the Committee's 2 percent objective.
If incoming data continue to support those expectations, I would see it as appropriate to continue to gradually raise the federal funds rate. Depending on the incoming data and the evolving risks, another rate increase may be appropriate fairly soon.
Will these conditions be met for Powell by the time of the next FOMC meeting in June? On one hand, the Atlanta Fed tracking estimate for Q2 is up solidly:

Gdpnow-forecast-evolution

That said, the tracking estimate is famously volatile and could easily collapse after the June meeting. So while a hopeful sign, I would not take it for granted yet that Q2 GDP will come in at a 3 percent pace. And given that Powell views this rebound as an "important" signal, I suspect he will want to be more certain of the Q2 results than allowable by the data available on June 14-15.
Note also he is expecting "further reductions in headline unemployment and other measures of slack" to justify a rate hike. This echoes my recent theme that stagnating progress toward full employment should be something that stays the Fed's hand for the moment. Powell also identifies evolving risks as an important factor in the timing of the next rate hike. As I said earlier this week, I think FOMC members need to shift to a balanced risk assessment prior to hiking. They were closer in April than March on that point, but I still think will fall short in June. Or at best are balanced in June and thus can justify setting the stage for a July hike. Either way, Powell made clear that if the data holds, he would support a rate hike in the near-term.
Powell tempers the rate hike message with a reminder that the path forward is likely to be very, very slow:
Several factors suggest that the pace of rate increases should be gradual, including the asymmetry of risks at the zero lower bound, downside risks from weak global demand and geopolitical events, a lower long-run neutral federal funds rate, and the apparently elevated sensitivity of financial conditions to monetary policy. Uncertainty about the location of supply-side constraints provides another reason for gradualism.
Earlier in the speech Powell, while commenting on slow productivity growth, said:
Lower potential growth would likely translate into lower estimates of the level of interest rates necessary to sustain stable prices and full employment. Estimates of the long-run "neutral" federal funds rate have declined about 100 basis points since the end of the crisis. The real yield on the 10-year Treasury is currently close to zero, compared with around 2 percent in the mid-2000s. Some of the decline in longer-term rates is explained by lower estimates of potential growth, and some by other factors such as very low term premiums.
I suspect that ongoing low productivity growth will lead to further reductions in the Fed's estimates of the longer run federal funds rate. I further suspect that this, combined with Powell's other concerns that limit the pace of rate hikes, means the likely medium-term path forward will be more shallow than the Fed anticipates. In other words, given current conditions, the Fed is still likely to move to the markets over the medium-term even if markets have moved somewhat toward the Fed in the near-term.
Housing data came in strong this week, including a jump in home home sales:

NEWSOLD

The shift from multifamily to single family looks well underway. While I wouldn't exactly expect sales to climb back up to 1.4 million units, there is clearly room for more upside here given a long period of under-building and high demand for housing. The latter was confirmed by the strong numbers in existing home sales. See Calculated Risk for more.
Initial unemployment claims was once again your weekly reminder that if you are looking for recession, you need to look somewhere else:

CLAIMSa0516

But the durable goods data was mixed, with an OK-ish headline but a weak core:

NEWORDERDSa0516

This weakness is consistent with soft regional ISM survey data that foreshadow a soft national ISM manufacturing number for May (to be released next week). Manufacturing data is likely to remain weak until the impacts of lower oil prices and a stronger dollar (both reversing this year) work their way through the sector, hopefully (keep your fingers crossed) by later this year.
While I do not believe current manufacturing numbers are indicative of a US recession, I would not be eager to hike rates into manufacturing weakness either. Moreover, if I were concerned about low productivity, like Powell and other FOMC participants, I would not be eager to hike into the low business investment numbers suggested by the core durable goods figures. Tend to think that this argues against June.
Bottom Line: Fed officials believe the data is lining up for a rate hike in the near future. Ultimately, I think they pass on June. Strategically, July offers a lot to like. They can wait for a more clear view of the 2nd quarter. They can use the June meeting and press conference to set the stage for July. They can broker a compromise between hawks and doves. The former should be happy because a strong signal in June is effectively a rate hike, the latter because it becomes an easily reversed rate hike (by skipping July if necessary) and they can bolster their case for gradualism. And a July hike will end the belief that the Fed can only hike on meetings with press conferences. My personal preference is to delay until September, but I don't run the show. All of the above assumes, of course, that data and financial conditions hold.

Wednesday, May 25, 2016

Fed Watch: Should The Fed Tolerate 5% Unemployment?

Tim Duy:

Should The Fed Tolerate 5% Unemployment?. by Tim Duy: In recent posts I highlighted the stagnant unemployment rate. I believe the Fed is on thin ice by raising rates when unemployment is moving sideways, especially when there exists evidence of substantial underemployment (see also this FEDS note). But there is also evidence of growing wage pressures, in particular the Atlanta Fed wage measure:

WAGESa0516

Would wage growth continue to accelerate if unemployment persisted at current levels? If so, would this mean the Fed had reached a tolerable equilibrium? My answers are "possibly" to the former question, and "probably not" to the latter.
Another way to consider the data is via a wage Phillips curve:

PHIL0516

I suspect the black dots around 4 percent unemployment are effectively incompatible with a 2 percent inflation target given current productivity growth. The economy is currently operating at the light blue dot. My expectation is that when when conditions are sufficiently tight to raise wage growth to the 4 percent range, they will also be sufficiently tight to raise inflation to the Fed's target. It is possible that this occurs near 5 percent unemployment - essentially a vertical move from the current position.
But while this might be possible (wage growth might just stall out at current levels of unemployment), I hesitate to say that it was optimal. Points up and to the left - lower unemployment but the same wage growth are likely consistent with the Fed's inflation target and thus obviously preferable as they entail higher levels of employment.
Getting to such points, however, includes a higher possibility of overshooting the inflation target (although I would suggest that the magnitude of the overshooting would be no more excessive than the magnitude of undershooting the Fed is currently willing to tolerate). So, and this is reiterating a point from yesterday, I would say that if the Fed slows activity now, they risk settling the economy into a suboptimal outcome with lower employment and, maybe, lower inflation than their mandate. This would seem to be the policy approach of a central bank hell-bent on approaching the inflation target from below. By avoiding further rate hikes until it is clear that activity is in fact sufficient to induce further declines in the unemployment rate, the Fed will maximize its odds of meeting its mandates, but at the cost of some risk of overshooting its inflation target.
It seems to me then that a central bank with a symmetric inflation target would choose to refrain from further rate hikes when progress toward full employment had clearly decelerated:

NFPc0516

(or even stalled):

NFPf0516

and inflation remains below target:

PCE0516

We will soon see if the Fed agrees.

Tuesday, May 24, 2016

Fed Watch: Curious

Tim Duy:

Curious, by Tim Duy: I find the Fed's current obsession with raising interest rates curious to say the least. The basic argument for rate hikes is that the economy, and in particular the labor market, sustained its momentum in the last two quarters better than market participants believe. Given that the economy is near or beyond full employment, the lack of excess slack will soon manifest itself in the form of inflationary pressures. Hence, to remain ahead of the inflation curve and maximize the chance that rate hikes will be gradual, they need to soon raise rates.
For instance, St. Louis Federal Reserve President today, from his press release:
“By nearly any metric, U.S. labor markets are at or beyond full employment,” Bullard said. For example, he noted that job openings per available worker are at a cyclical low, unemployment insurance claims relative to the size of the labor force are at a multi-decade low, and nonfarm payroll employment growth has been above longer-run trends. In addition, the level of a labor market conditions index created by staff at the Board of Governors continues to be well above average.
In a recent speech, Boston Federal Reserve President Eric Rosengren argued that employment was close to entering the danger zone:
However, the unemployment rate is now at 5 percent – relatively close to my estimate of full employment, 4.7 percent – and net payroll employment growth is averaging over 200,000 jobs per month over the past quarter. My concern is that given these conditions, an interest rate path at the pace embedded in the futures markets could risk an unemployment rate that falls well below the natural rate of unemployment. We are currently at an unemployment rate where such a large, rapid decline in unemployment could be risky, as an overheating economy would eventually produce inflation rising above our 2 percent goal, eventually necessitating a rapid removal of monetary policy accommodation. I would prefer that the Federal Reserve not risk making the mistake of significantly overshooting the full employment level, resulting in the need to rapidly raise interest rates – with potentially disruptive effects and an increased risk of a recession.
Both these claims appear to me to be hasty. I think this narrative rang true through last summer. But, by my read of the data, since then progress toward full employment has stalled. For instance:

UNDER0516

Part-time employment and long-term unemployment look to be moving sideways since the middle of last year, while progress in the U6 unemployment rate has decelerated markedly. And these shifts in momentum are occurring while at levels above those prior to the recession. Moreover, U3 unemployment is now moving sideways at a level above the Fed's estimate of full employment:

NFPf0516

I understand that this flattening is attributable to rising labor force participation. That fact, however, should not induce the Fed to tighten. Quite the opposite in fact, as it suggests that available slack is deeper than imagined and hence requires an even longer period of low rates.
To me then, it appears that by raising rates now the Fed is risking falling short on its employment mandate at a time when the price mandate is also challenged. And falling short on the employment mandate now suggests an economy with sufficient slack to prevent reaching that price mandate. And that is without considering neither the balance of risks to the outlook nor the possibility that escaping the zero bound requires approaching the inflation target from above rather than below. Consequently, it seems that the case for a rate hike in June should be quite weak.
I would think that Federal Reserve Chair Janet Yellen should also find it quite weak. But the minutes of the April FOMC meeting and recent Fedspeak indicate that a large number of monetary policymakers find the case for a rate hike quite compelling. Given her past concerns regarding underemployment, I would have expected Yellen to lean stronger in the opposite direction. But I don't know that she is in fact leaning against the logic driving a rate hike. I am hoping we learn as much via her upcoming speaking engagements.
But, Yellen aside, what is driving so many FOMC participants to the rate hike camp? I think they are driven in part by two ideas that I believe to be erroneous. First, they believe that tapering and ending QE was not tightening, and hence essentially they have removed no accommodation. I think tapering was tightening as it reduced expectations about the ultimate size of the Fed's balance sheet and signaled a tighter future path of monetary policy. One place to see the tighter stance of policy is the Wu-Xia shadow rate:

WUXIA0516

Second, the Fed may be too enamored with the end game, the idea of normalization itself, as reflected in the dot-plot. They have already decided that the equilibrium fed funds rate is north of 3 percent, and hence assume that the current rate is highly accommodative. They thus see a large distance that needs to be covered, and feel an urge to start sooner than later.
Bottom Line: I don't find it surprising that some Fed policymakers are eager to hike rates. I am surprised that such sentiments are widespread throughout FOMC participants. It does not seem consistent with my understanding of the Fed's reaction function. They seem to be dismissing the recent lack of progress in reducing underemployment. This I think also might help explain the previously wide distance between financial market participants and the policymakers. And that might perhaps be why financial market participants largely ignored the warnings that rate hikes were likely until the release of the April minutes.

Monday, May 23, 2016

Social Credit and "Neutral" Monetary Policies: A Rant on "Helicopter Money" and "Monetary Neutrality"

Brad DeLong:

Social Credit and "Neutral" Monetary Policies: A Rant on "Helicopter Money" and "Monetary Neutrality": Badly-intentioned or incompetent policymakers can mess up any system of macroeconomic regulation. And we now have two centuries of history of demand-driven business cycles in industrial and post-industrial economies to teach us that there is no perfect, automatic self-regulating way to organize the economy at the macroeconomic level.

Over and over again, the grifters, charlatans, and cranks ask: "Why doesn't the central bank simply adopt the rule of setting a "neutral" monetary policy? In fact, why not replace the central bank completely with an automatic system that would do the job?"

Over the decades many have promised easy definitions of "neutrality", along with rules-of-thumb for maintaining it. All had their day:

  • advocates of the gold standard,
  • believers in a stable monetary base,
  • devotees of a constant growth rate for the (narrowly defined) supply of money;
  • believers in a constant growth rate for broad money and credit aggregates;
  • various "Taylor rules".

And the answer, of course, is that by now centuries of painful experience have taught central bankers one thing: All advocates, wittingly or unwittingly, were simply selling snake oil. All such "automatic" rules and systems have been tried and found wanting.

It is a fact that all such rule-based central bank policies and all such so-called automatic systems have fallen down on the job. They have failed to properly manage "the" interest rate to set aggregate demand equal to potential output and balance the supply of whatever at that moment counts as "money", in whatever the operative sense of "money" is at that moment, to the demand for it.

Nudging interest rates to the level at which investment equals savings at full employment is what a properly "neutral" monetary policy really is.

Things are complicated, most importantly, by the fact that the business-cycle patterns of one generation are never likely to apply to the next. Consider: At any moment in the past century, the macroeconomic rules-of-thumb and models of economies' business-cycle behavior that had dominated forty, thirty, even twenty years before--the ones taught then to undergraduates, assumed as the background for op-eds, and including in the talking points of politicians whose aides wanted them to sound intelligent in answer to the first question and fuzz the answer to the follow-up before ducking away. We can now see that, for fifteen years now, central banks have been well behind the curve in their failure to recognize that the business-cycle pattern of the first post-World War II generations has definitely come to an end. The models and approaches developed to understand the small size of the post-WWII generation’s cycle and its bias toward moderate inflation are wrong today--and are worse than useless because they propagate error.

And this should not come as a surprise. ...

Sunday, May 22, 2016

Fed Watch: This Is Not A Drill. This Is The Real Thing.

Tim Duy:

This Is Not A Drill. This Is The Real Thing, by Tim Duy: The June FOMC meeting is live. That message came through loud and clear in the minutes, and was subsequently confirmed by New York Federal Reserve President William Dudley. Last week, via Reuters:

"We are on track to satisfy a lot of the conditions" for a rate increase, Dudley said. He added, though, that a key factor arguing for the Fed biding its time a little was the potential for market turmoil around Britain’s vote in late June about whether to leave the European Union...

..."If I am convinced that my own forecast is sort of on track, then I think a tightening in the summer, the June-July time frame is a reasonable expectation," said Dudley, a permanent voting member of the Fed's rate-setting committee.

Boston Federal Reserve President Eric Rosengren, the canary in the coal mine that was long ago alerting markets that they were underestimating June, subsequently gave a strong nod to June in his interview with Sam Fleming of the Financial Times:

We are still a month away from the actual meeting. We are going to get another employment rate in early June. We are going to get a second retail sales report. So I want to be sensitive to how the data comes in, but I would say that most of the conditions that were laid out in the minutes as of right now seem to be . . . on the verge of broadly being met...

Clearly, the Fed will be debating a rate hike at the next FOMC meeting. Will they or won't they? To answer that question, I need to begin with my main takeaways from the minutes:

1.) The Fed broadly agrees that the economic recovery remains intact. Overall there is broad agreement at the Fed that outside of manufacturing (for both domestic and external reasons), economic activity has moderated but remains near or somewhat below their estimates of potential growth and hence is sufficient to drive further improvement in labor markets. The weak first quarter numbers were largely statistical noise attributable to faulty seasonal adjustment mechanisms. Data since the April meeting generally supports this story. The economy is not falling over a cliff, recession is not likely, nothing to see here, folks.

2.) A contingent, however, disagreed with the benign scenario:

However, some participants were concerned that transitory factors may not fully explain the softness in consumer spending or the broad-based declines in business investment in recent months. They saw a risk that a more persistent slowdown in economic growth might be under way, which could hinder further improvement in labor market conditions.

This group will want fairly strong evidence that the first quarter was an anomaly before the sign off on the next rate hike.

3.) There was broad agreement of the obvious - global and financial market threats waned since the previous meeting. The Fed recognized that their hesitation to hike rates helped firm markets. It's important that they recognize that if the economy weathers a bout of financial market turbulence, it is often with the aid of easier Fed policy. Some Fed speakers appeared not to recognize this relationship earlier this year.

4.) Still, the risks are either balanced or to the downside. Apparently, none of the participants saw risks weighed to the upside. While some participants believe the threats had lessened sufficiently to justify a balanced outlook:

Several FOMC participants judged that the risks to the economic outlook were now roughly balanced.

the view was not widely shared:

However, many others indicated that they continued to see downside risks to the outlook either because of concerns that the recent slowdown in domestic spending might persist or because of remaining concerns about the global economic and financial outlook. Some participants noted that global financial markets could be sensitive to the upcoming British referendum on membership in the European Union or to unanticipated developments associated with China's management of its exchange rate.

It seems reasonable that this large group will need to see further diminishment of downside risks to justify a hike in June. Brexit doesn't derail a June hike unless it looks to be negatively impacting financial markets.

5.) The question of full employment deeply divides the Fed. Who wins this debate is critical to defining the policy path going forward. One group thinks the economy is not at full employment:

Many participants judged that labor market conditions had reached or were quite close to those consistent with their interpretation of the Committee's objective of maximum employment. Several of them reported that businesses in their Districts had seen a pickup in wages, shortages of workers in selected occupations, or pressures to retain or train workers for hard-to-fill jobs.

But others saw room for further improvement:

Many other participants continued to see scope for reducing labor market slack as labor demand continued to expand.

The Fed's plan had been to let the economy run hot enough for long enough to eliminate underemployment. One sizable camp within the Fed thinks this largely been accomplished. This is the group that is itching for more hikes earlier. This is a place where Federal Reserve Chair Janet Yellen should have an opinion and be willing to guide on that opinion. In the past, she has sided with the "still underemployment" camp.

6.) The Fed is also split on the inflation outlook but most believe inflation is set to trend toward target. A nontrivial contingent saw downside risks to the inflation outlook due to soft inflation expectations:

Several commented that the stronger labor market still appeared to be exerting little upward pressure on wage or price inflation. Moreover, several continued to see important downside risks to inflation in light of the still-low readings on market-based measures of inflation compensation and the slippage in the past couple of years in some survey measures of expected longer-run inflation.

But the majority were either neutral or dismissive of the signal from expectations:

However, for many other participants, the recent developments provided greater confidence that inflation would rise to 2 percent over the medium term.

7.) June is on the table. I have long warned that market participants were underestimating the odds of a rate hike in June. This came across loud and clear in the minutes:

Participants agreed that their ongoing assessments of the data and other incoming information, as well as the implications for the outlook, would determine the timing and pace of future adjustments to the stance of monetary policy. Most participants judged that if incoming data were consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the Committee's 2 percent objective, then it likely would be appropriate for the Committee to increase the target range for the federal funds rate in June.

Consider that the Fed's modus operandi is to delay an expected policy change for two meetings in the face of market turmoil. Hence given calmer financial markets, June could not be so easily dismissed. But it was not just the financial markets that stayed the Fed's hand. It was also softer Q1 data. As of April, participants had not concluded that they would see what they were looking for to justify a rate hike.

Participants expressed a range of views about the likelihood that incoming information would make it appropriate to adjust the stance of policy at the time of the next meeting. Several participants were concerned that the incoming information might not provide sufficiently clear signals to determine by mid-June whether an increase in the target range for the federal funds rate would be warranted. Some participants expressed more confidence that incoming data would prove broadly consistent with economic conditions that would make an increase in the target range in June appropriate.

Moreover, these are participants, not committee members. The actual voters members appeared less committed to June, saying only:

Regarding the possibility of adjustments in the stance of policy at the next meeting, members generally judged it appropriate to leave their policy options open and maintain the flexibility to make this decision based on how the incoming data and developments shaped their outlook for the labor market and inflation as well as their evolving assessments of the balance of risks around that outlook.

Here are my thoughts, assuming of course the data and the financial markets hold up over the next few weeks:

A.) There is a rate hike likely in the near-ish future. There seems to be broad agreement that, at a minimum, the pace of activity remains sufficient to bring the Fed's goals - both maximum employment and price stability - closer into view. Close enough that most voters will soon think another rate hike is appropriate. The doves can't push it off forever.

B.) The Fed will consider June, and there is likely some support among the voting members for a June hike. But ultimately, I think most will want a more complete picture of the second quarter before hiking rates. Also, the contingent that remains less convinced by the inflation outlook will press for more time. Moreover, they will also need broad agreement that the risks to the outlook are at least balanced. It would indeed be silly to plow forward with rate hikes if most members thought the risks were still weighted to the downside, even if the data were broadly consistent with the Fed's forecast. That agreement of balanced risks just might not be there by June.

C.) Fed doves might, however, need to strike a compromise to hold the line on June and avoid more than one or two dissents. That compromise could be a strong signal about the July meeting via the statement, the press conference, or, most likely, both. A July hike would also serve to end the idea that the Fed can't hike rates without a press conference.

D.) The reason compromise might be necessary is the possibility of a fairly stark divide between voting members. Assume Esther George, Eric Rosengren, and James Bullard will push for a rate hike in June. Furthermore, assume that Lael Brainard opposes a rate hike, and has sufficient leverage to pull Dan Tarullo and William Dudley to her side. Janet Yellen might prefer to negotiate a compromise rather than face the prospect of multiple dissents from either camp.

E.) Of all the divisive points above, I think the most important is the debate over the level of full employment. The ability of the doves to slow the pace of subsequent rate hikes will hinge on their willingness to push for below NAIRU unemployment to alleviate underemployment. If the doves maintain the upper hand, the path of subsequent rate hikes will be very, very shallow. I cannot emphasize enough that this is a debate in which Janet Yellen has the opportunity to take leadership that fundamentally defines her preferred rate path going forward. Does she stick with the bottom dots?

Bottom Line: This is not a drill. This meeting is the real thing - an undoubtedly lively debate that could end with a rate hike. I think we narrowly avoid a rate hike, but at the cost of moving forward the next hike to the July meeting.

Friday, May 20, 2016

Helicopter Money and Fiscal Policy

Simon Wren-Lewis:

Helicopter money and fiscal policy: ... We can have endless debates about whether HM is more monetary or fiscal. While attempts to distinguish between the two can sometime clarify important points (as here from Eric Lonergan) it is ultimately pointless. HM is what it is. Arguments that attempt to use definitions to then conclude that central banks should not do HM because its fiscal are equally pointless. Any HM distribution mechanism needs to be set up in agreement with governments, and existing monetary policy has fiscal consequences which governments have no control over. ...
At this moment in time, even if a global recession is not about to happen, public investment should increase in the US, UK and Eurozone. There is absolutely no reason why that cannot be financed by issuing government debt. ... Indeed there would be a good case for bringing forward public investment even if monetary policy was capable of dealing with the recession on its own, because you would be investing when labour is cheap and interest rates are low. ...
HM is fiscal stimulus without any immediate increase in government borrowing. It therefore avoids the constraint that Osborne and Merkel said prevented further fiscal stimulus. ... HM is not financed by increasing government debt.
Many argue that these concerns about debt are manufactured, and that in reality politicians on the right pushing austerity are using these concerns as a means of achieving a smaller state: what I call here deficit deceit. HM, particularly in its democratic form, calls their bluff. If we can avoid making the recession worse by maintaining public spending, financed in part by creating money while the recession persists, how can they object to that? Politicians who wanted to use deficit deceit will not like it, but that is their problem, not ours.
There is a related point in favour of HM... Independent central banks are a means of delegating macroeconomic stabilisation. Yet that delegation is crucially incomplete, because of the lower bound for nominal interest rates. While economists have generally understood that governments can in this situation come to the rescue, politicians either didn’t get the memo, or have proved that they are indeed not to be trusted with the task. HM is a much better instrument than Quantitative Easing, so why deny central banks the instrument they require to do the job they have been asked to do.

Thursday, May 19, 2016

Fed Watch: Minutes Say June Is On The Table

Tim Duy:

Minutes Say June Is On The Table, by Tim Duy: There is quite a bit of material in the minutes of the April 2016 FOMC meeting to work with, more than I have time for tonight.

The central message of the minutes was that financial market participants were too complacent in their expectations that the Fed would stand pat in June. The Fed clearly made no such decision in April. Instead, meeting participants hotly debated the likelihood that a rate hike would be appropriate in June:

Participants agreed that their ongoing assessments of the data and other incoming information, as well as the implications for the outlook, would determine the timing and pace of future adjustments to the stance of monetary policy. Most participants judged that if incoming data were consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the Committee's 2 percent objective, then it likely would be appropriate for the Committee to increase the target range for the federal funds rate in June.

Most participants, but not necessarily most voting members, thought a June hike would be appropriate if the economy firms as anticipated. Still, it was not clear to participants that the economy would evolve as expected:

Participants expressed a range of views about the likelihood that incoming information would make it appropriate to adjust the stance of policy at the time of the next meeting. Several participants were concerned that the incoming information might not provide sufficiently clear signals to determine by mid-June whether an increase in the target range for the federal funds rate would be warranted.

This has been essentially my position - that the Fed would not have sufficient data on Q2 at the time of the June meeting to justify a rate hike. Other were more optimistic:

Some participants expressed more confidence that incoming data would prove broadly consistent with economic conditions that would make an increase in the target range in June appropriate.

Note that "several" is greater than "some." Those same "some" were also likely those that expressed this concern:

Some participants were concerned that market participants may not have properly assessed the likelihood of an increase in the target range at the June meeting, and they emphasized the importance of communicating clearly over the intermeeting period how the Committee intends to respond to economic and financial developments.

This should have come as no surprise. Policymakers have repeatedly said as much in recent weeks. Too many participants in April felt June was a real possibility if the data cooperated - and it largely has cooperated - to so easily dismiss the possibility of a June hike.

Committee members were a bit more circumspect with respect to action in June:

Regarding the possibility of adjustments in the stance of policy at the next meeting, members generally judged it appropriate to leave their policy options open and maintain the flexibility to make this decision based on how the incoming data and developments shaped their outlook for the labor market and inflation as well as their evolving assessments of the balance of risks around that outlook. It was noted that communications could help the public understand how the Committee might respond to incoming data and developments over the upcoming intermeeting period. Some members expressed concern that the likelihood implied by market pricing that the Committee would increase the target range for the federal funds rate at the June meeting might be unduly low.

But it is clearly under consideration.

My initial reaction to the minutes was to call the June meeting a toss-up. Via Sam Fleming at the FT:

Hazards are still lurking overseas, and the minutes made it clear they are weighing on the inflation prospects in the minds of a number of policymakers. Tim Duy, a close Fed watcher who is a professor at the University of Oregon, still puts the odds of a move in June at just 50-50.

On further thought, I should have said toward 50-50. I don't like saying 50-50, because that just means you can't make a decision. And re-reading the minutes, I think the odds given the current data are less than 50% but more than 30%. Ultimately, the decision will depend on the willingness of the committee to move with only a partial view of Q2. I think that ultimately the partial view will not be sufficient.

Instead, I see a strong possibility that sufficiently good data makes a July hike probable. I had been thinking they would pass on July due to the lack of press conference, favoring September instead. But a strong signal about July might represent the compromise position between those members ready to hike and those that want a more complete picture of Q2 before acting. The press conference could then be used to clear the way for July. And it would have the added bonus of ending the idea that the Fed can only hike rates at a meeting with a press conference.

One final note. Consider this paragraph:

Labor market conditions strengthened further in recent months. Increases in nonfarm payroll employment averaged almost 210,000 per month over the first three months of 2016. Although the unemployment rate changed little over that period, the labor force participation rate moved up and the pool of potential workers, which includes the unemployed as well as those who would like a job but are not actively looking, continued to shrink. Many participants judged that labor market conditions had reached or were quite close to those consistent with their interpretation of the Committee's objective of maximum employment. Several of them reported that businesses in their Districts had seen a pickup in wages, shortages of workers in selected occupations, or pressures to retain or train workers for hard-to-fill jobs. Many other participants continued to see scope for reducing labor market slack as labor demand continued to expand. In that regard, a number of participants indicated that the recent rise in the participation rate was a positive development, suggesting that a tighter labor market could potentially draw more individuals back into the workforce on a sustained basis without adding to inflationary pressures and thus increase the productive capacity of the economy. It was also noted that businesses might satisfy increases in labor demand in part by converting involuntary part-time jobs to full-time positions.

There are two clear views here: One group feels the economy is near full employment, while another sees room for further improvement. The former group will want more hikes sooner, the latter fewer hikes later. Federal Reserve Chair Janet Yellen should be taking a side in this critical debate and thus driving the direction of policy. Watch for her to provide guidance on this and inflation when she speaks on June 6.

Bottom Line: June is a live meeting. Really. Many Fed officials think the US economy has proven sufficiently resilient to resume hiking rates and would like to retain the option for 3 gradual hikes this year. That leaves June in play. Ultimately, I think they pass on June, but harmony is maintained only by placing a bullseye on July. Meeting participants will be positioning themselves ahead of the meeting. A divided Fed leaves Yellen with a new challenge. Will she lead the FOMC, or will it lead her?

Tuesday, May 17, 2016

Fed Watch: Fed Officials Come Looking For A Fight

Tim Duy:

Fed Officials Come Looking For A Fight, by Tim Duy: Incoming data continues to support the narrative that the US economy is not, I repeat, not, slipping into recession. Instead, the US economy is most likely continuing to chug along around 2 percent year over year. Not exciting, but not a disaster by any means. Indeed, for Fed officials thinking the rate of potential growth is hovering around 1.75 percent, it is enough to keep upward pressure on labor markets, pushing to economy further toward full employment.
And if you think you want to hit the inflation target from below, then you need to hit the employment target from above. Which means a non-trivial contingent of the Fed does not want to leave June off the table. That is a message that came thorough loud and clear today.
Industrial production surprised on the upside, gaining 0.7 percent. Still down on a year over year basis, but it is worth repeating that the weakness is narrowly concentrated:

IP0516

In a recession, the weakness is broadly concentrated. Hence the softness in manufacturing is still best described as a sector specific shock, not an economy-wide shock.
Housing starts for April were also above expectations. The upward grind since 2011:

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Notably, the housing market is transitioning from multifamily to single family construction:

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Plenty of room to run in that direction, providing underlying support for the US economy. See Calculated Risk for more.
Inflation rose on the back of higher gas prices. Headline CPI gained 0.4 percent, although core rose a more modest 0.2 percent. Core CPI inflation is hovering just above 2 percent:

CPI0516

Fed hawks will be nervous that rising gas prices will quickly filter through to core inflation; doves will remind them that the Fed's target is PCE inflation, which remains well below 2 percent.
Fedspeak was decidedly hawkish today, with both Atlanta Federal Reserve President Dennis Lockhart and San Fransisco Federal Reserve President John Williams insisting that market participants are wrong to assume the Fed will pass on the June meeting. Via Greg Robb at MarketWatch:
Atlanta Fed President Dennis Lockhart and San Francisco Fed President John Williams, in a joint appearance at a lunch sponsored by the news site Politico, said that the decision on whether to raise rates at the June 14-15 meeting depends on the data.
June “certainly could be a meeting at which action could be taken,” Lockhart said.
“I think it is a little early at second-quarter data to draw a conclusion, so I am at this stage inconclusive about how I am going to be thinking about June, but I wouldn’t take it off the table,” Lockhart said.
He said he assumes there will be two to three rate hikes this year...
...Williams said he agreed with Lockhart and said he thought the economy was “doing great.”
“I think the incoming data have actually been quite good and reassuring in terms of policy decisions, so, in my view, June is a live meeting,” Williams said.
He added that there will a lot more data reported before the meeting.
In an interview with the Wall Street Journal prior to the Politico lunch, Williams said raising rates two or this times this year “makes sense.”
Separately, Dallas Federal Reserve President Robert Kaplan argued for a rate hike in June or July. Via Ann Saphir at Reuters:
"Whether that’s June or July, I can’t say right now," Kaplan told reporters after a speech. He said would prefer to pause after that first 2016 rate hike to assess conditions, and while he would "hope" to continue to normalize rates thereafter, the pace of rate hikes will depend on incoming economic data.
None of these three are voters. Still, there is a message here - many FOMC participants want to go into the June meeting with a reasonable chance that they will hike rates. They don't want the outcome of this meeting to be a foregone conclusion. Two other thoughts:
1.) The more hawkish Fedspeak could be foreshadowing that the minutes of the April FOMC meeting will have a hawkish tilt.
2.) Kaplan puts July on the table. I had been thinking that July was off the table due to the lack of a press conference. That said, I should be open to the possibility that they use the June press conference to clear the way for July.
Market participants raised the probability of a June rate hike to 15% today. Still probably less than the probability assigned by the median FOMC participant. Meanwhile, the yield curve flattened further - signaling that the Fed needs to move very cautiously. At the moment, the Fed doesn't have much room before they invert the yield curve. In my opinion, the bond market continues to signal that Fed's expectation of normalizing short rates in the 3.5 - 4.0 percent range are wildly - and dangerously - optimistic.
Bottom Line: Today's Fed speakers came looking for a fight with financial market participants. They don't like the low odds assigned to the June meeting. I don't think June is a go; the data isn't quite there yet. But odds are greater than 15%, in my opinion.

A General Theory of Austerity

Simon Wren-Lewis:

A General Theory of Austerity: ...I have just completed a working paper... It has the title of this post: in part an allusion to Keynes who had been here before, but also because its scope is ambitious. The first part of the paper tries to explain why austerity is nearly always unnecessary, and the second part tries to understand why the austerity mistake happened.
I start by making a distinction which helps a great deal. It is between fiscal consolidation, which is a policy decision, and austerity, which is an outcome where that fiscal consolidation leads to an increase in aggregate unemployment. If you understand why monetary policy can normally stop fiscal consolidation leading to austerity, but cannot when interest rates are stuck near zero, then you are a long way to understanding why austerity was a mistake. Fiscal consolidation in 2010 was around 3 years too early. A section of the paper is devoted to showing that the idea that markets prevented such a delay in consolidation is a complete myth. ...
None of this theory is at all new: hence the allusion to Keynes in the title. That makes the question of why policy makers made the mistake all the more pertinent. One set of arguments point to an unfortunate conjunction of events: austerity as an accident if you like. Basically Greece happened at a time when German orthodoxy was dominant. I argue that this explanation cannot play more than a minor role: mainly because it does not explain what happened in the US and UK, but also because it requires us to believe that macroeconomics in Germany is very special and that it had the power to completely dominate policy makers not only in Germany but the rest of the Eurozone.
The set of arguments that I think have more force, and which make up the general theory of the title, reflect political opportunism on the political right which is dominated by a ‘small state’ ideology. It is opportunism because it chose to ignore the (long understood) macroeconomics, and instead appeal to arguments based on equating governments to households, at a time when many households were in the process of reducing debt or saving more. But this explanation raises another question in turn: how was the economics known since Keynes lost to simplistic household analogies. ....
If my analysis is right, it means that we cannot be complacent that when the next liquidity trap recession hits the austerity mistake will not be made again. Indeed it may be even more likely to happen, as austerity has in many cases been successful in reducing the size of the state. My paper does not explore how to avoid future austerity, but it hopefully lays the groundwork for that discussion.

Monday, May 16, 2016

Fed Watch: Fed Not As Convinced About June As Markets

Tim Duy:

Fed Not As Convinced About June As Markets, by Tim Duy: Market participants place less than 10 percent chance of a rate hike in June. In contrast, San Francisco Federal Reserve President John Williams continues hold out hope for a third. Via Reuters:
Two to three rate increases this year "definitely still makes sense," he said...
Williams, a centrist whose views are generally in line with those of Fed Chair Janet Yellen, said he has not yet conferred with his staff economists over whether the next rate increase would be best made in June, July or September...
...With most gauges of the labor market suggesting the United States is at or nearly at full employment, he said, and inflation set to rise to the Fed's 2 percent target in two years, "things are definitely looking good."
Delaying rate hikes for months, he said, "would force our hands a little bit to move much more quickly in 2017."
Williams follows on the heels of Kansas City Federal Reserve President Esther George and Boston Federal Reserve President Eric Rosengren. The former clearly wants a rate hike, the latter, like Williams, not convinced that June is off the table. Williams adds the possibility that market participants are in for a rude awakening come June:
"Hopefully, if the markets understand our strategy, understand the data the way we do, then they won’t be too surprised by what we do," Williams said. "I definitely don’t think we need to go into a meeting with the markets convinced that we are going to raise rates in order for us to raise rates."
I think the Fed increasingly believes the data is lining up in their favor. Friday's retail sales report likely went a long-way toward dispelling any lingering concerns they might have over the strength of the consumer. The tenor of that data has picked up markedly in the last few months:

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Note that one should not read much into the problems of department store retailers like Macy's. They are simply playing a losing game:

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This among other data, is pulling upward the Atlanta Fed's estimates of Q2 growth:

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Here though I would urge caution - this estimate can come down as quickly as it went up. If the Fed were confident that growth was in fact 2.8% in Q2, then they would move in June. But the reality is they are not likely to have sufficient data to justify that degree of confidence. That leaves me concluding that June is still not likely to happen.
But given the direction of the data, the improvement in financial markets, and the predisposition of a significant number of policymakers to raise early to raise slow, I would not be surprised that market participants revise their expectations that June is a sure thing. Remember that if we assume July and October are off the table (lack of press conferences and/or proximity to election), then retaining the option to hike three times requires a hard look at June. I think that will lead to a much more extensive discussion of a rate hike at the June meeting than many market participants appear to expect.
In the meantime, despite an improving Q2 outlook and healthier financial markets, the yield curve flattened further:

Spread0516

The 10-2 spread was just 95bp at the end of last week. Now, before anyway panics and screams that this implies slow growth, it is worth remembering that the spread was consistently below 100bp in the last half of the 1990s. And that was not exactly a slow growth period.
So why is the curve flattening? My story is this: The yield curve flattens whenever the Fed is in a tightening cycle. And the Fed most assuredly remains in a tightening cycle. They have not backed off their fundamental story that rates are headed higher. They see normalized interest rates on the short end as well above the current yield on the long-end. This seems entirely inconsistent with signals from the bond market and the global zero interest rate environment. In my opinion, the Fed continues to send signal that they intend to error on the side of excessively tight monetary policy.
That is the message of the dot plot. There is absolutely no reason the Fed needs to take stand on the level of short-term interest rates three years hence. They don't know any better than anyone else. So why pretend otherwise? Why not do as William's suggests and trust the markets to reach the right conclusion? In my opinion, the Fed's insistence on signaling an interest rate well above anything consistent with long-run rates isn't just bad policy. It is just plain stupid policy.
To expect the curve to steepen at this juncture, I think at a minimum you need the Fed to more aggressively commit to approaching the inflation target from above. You need to overshoot. That I think would be essentially an easing at this point. Chicago Federal Reserve President Charles Evans is already there. I think that Federal Reserve Chair Janet Yellen is getting there, but can't say it.
And even then, I don't know that approaching the target from above is enough. The dominance of the dollar in international finance means the Fed has a preeminent role in fostering global financial stability. A 2 percent US inflation target may not be consistent with global financial stability. And if not consistent with global financial stability, then not with US financial stability and thus not solid US economic performance. Which means if the Fed is the world's central bank, they need to adopt an inflation target consistent with maintaining global growth. That might be higher than 2 percent. And they aren't going down that road without a long and nasty fight.
Bottom Line: I don't think the data lines up to support a June rate hike. But I don't think the case will be as clear-cut as signaled by the low odds financial market participants place on a hike.

Thursday, May 12, 2016

Fed Watch: Fed Speak, Claims

Tim Duy:

Fed Speak, Claims, by Tim Duy: The Fed is not likely to raise rates in June. But not everyone at the Fed is on board with the plan. Serial dissenter Kansas City Federal Reserve President Esther George repeated her warnings that interest rates are too low:
I support a gradual adjustment of short-term interest rates toward a more normal level, but I view the current level as too low for today’s economic conditions. The economy is at or near full employment and inflation is close to the FOMC’s target of 2 percent, yet short-term interest rates remain near historic lows.
Her motivation stems primarily from concerns about financial imbalances:
Just as raising rates too quickly can slow the economy and push inflation to undesirably low levels, keeping rates too low can also create risks. Interest-sensitive sectors can take on too much debt in response to low rates and grow quickly, then unwind in ways that are disruptive. We witnessed this during both the housing crisis and the current adjustments in the energy sector. Because monetary policy has a powerful effect on financial conditions, it can give rise to imbalances or capital misallocation that negatively affects longer-run growth. Accordingly, I favor taking additional steps in the normalization process.
Separately, Boston Federal Reserve President Eric Rosengren, currently in a post-dove phase, reiterated his warning that financial markets just don't get it:
In my view, the market remains too pessimistic about the fundamental strength of the U.S. economy, and the likelihood of removing monetary accommodation is higher than is currently priced into financial markets based on current data.
He does see benefits from the current stance of policy:
I believe that one of the benefits of our current accommodative monetary policy, even as we approach full employment, is that it fosters continued gradual improvement in labor markets. As I have noted in the past, it is quite appropriate to probe on the natural rate of unemployment to see how low it might be, given the benefit to workers. We have seen workers rejoin the labor force, many of them previously having given up looking for work.
But, like George, the risks of imbalances are growing too large for his liking:
However, there can be potential costs to accommodation if rates stay too low for too long. One cost involves the potential of very low interest rates encouraging speculative behavior. One area where I have some concern in this regard is the commercial real estate market.
In addition, he worries that unemployment threatens to descend too far below the natural rate:
A second possible cost of keeping rates too low for too long relates to the limits we see in monetary policy’s ability to “fine tune” the economy...Once unemployment has reached its low point in the economic cycle, it is unusual for it to proceed smoothly back to the natural rate...There are no episodes in which unemployment rose a bit and remained stable at its natural employment rate. Instead, relatively soon after the periods shown here with red highlighting, unemployment rises significantly – that is, we experience a recession, as indicated by the gray shading.
The chart strongly suggests that it has proven difficult to calibrate policy so as to gradually increase the unemployment rate, gently nudging it back toward full employment. The lesson is that policymakers should avoid significantly overshooting their best estimates of the natural rate of unemployment.
Here I would suggest that the failure of policymakers to better manage the economy at turning points is not because it is impossible, but because they have overtightened in the latter stage of the cycle, forgetting to pay attention to the lags in policy they think are so important during the early stages of the cycle. He continues:
Today, the unemployment rate is still somewhat above my estimate of the natural rate, 4.7 percent. But waiting too long to have more normalized rates risks possibly overshooting on the unemployment rate, and needing to tighten more quickly than would be desirable.
Note that Rosengren is not deterred by the flattening of the unemployment rate:

NFPf0516

because he pegs his estimate of sustainable job growth at 80-100k per month, well below current rates of growth. Thus he expects the unemployment rate will soon resume its decline. I would say that he should be cautious of that estimate when labor force participation is rising.
I think it likely George will dissent again in June while Rosengren, a nonvoter, at a minimum would like to keep the June meeting alive. In an important difference from George and Rosengren, New York Federal Reserve President William Dudley is less concerned with potential financial imbalances at this point (be sure to read Gavyn Davies for more on Dudley):
I would say at this point I don’t see a lot of things that disturb me. The things that would disturb me would be things that are very excessive in terms of valuation and very large in terms of the weight that they carry for the economy. If you think back to the financial crisis, you had a big bubble for the U.S. housing sector which was very large and affects lots of people, so that was a huge bubble in terms of the consequences for the economy. Obviously it was magnified by the fact that there were structural weaknesses in the financial system that, rather than dampen the impact of the decline in housing, actually tended to amplify it. I don’t see anything like that today. There are some areas you might point to and say that those look excessive, but some of the areas you might have pointed to six months ago, they’ve actually sort of self-corrected.
Hence, Dudley remains more cautious on raising rates. His view is actually fairly optimistic:
My view is still that we’re looking for 2 percent real G.D.P. growth over the next year. If that’s right, the labor market should continue to improve. We should continue to see tightening of the U.S. labor market, probably a gradual acceleration in wages as the labor market gets tighter. And if that’s how the economy plays out, then I think we’re going to see further moves by the Fed to gradually normalize interest rates.
Note that 2 percent is above his estimate of potential growth (and Rosengren's, who puts it at 1.75 percent), and hence if he gets that as expected, it is reasonable to expect two rates hikes:
The expectations that were shown in the March summary of economic projections, the median of two rate hikes, seems like a reasonable expectation. But it depends on how the economy evolves. Two seems like a reasonable number sitting here today, but it could be more if the economy is stronger and inflation comes back more quickly, or it could be less if the economy disappoints.
Two is of course greater than market expectations, hence he is not inconsistent with Rosengren. But he doesn't feel the need to warn on this as strongly as Rosengren, nor does he share the concern regarding the financial imbalances. And Dudley still sees value in letting the economy somewhat "hot," suggesting more willingness to embrace a modest decline in unemployment below the natural rate. Hence he is less eager to raise rates. 
Finally, an bit on initial claims. Claims rose to their highest level in a year, but this was driven by a bump in New York that appears related to the Verizon strike and spring break schedules. Dispersion of claim weakness remains very low overall:

CLAIMS0516

In other words, move along, nothing to see here.
Bottom Line: Ultimately, I suspect the FOMC will not find sufficient reason in the data before June to convince the Fed that growth is sufficiently strong to justify a hike. Hence I anticipate that they will pass on that opportunity to raise rates. Look for an opportunity in September, assuming that growth firms to 2% and the unemployment rate resumes its decline over the summer. I doubt, however, that most on the Fed are pleased that market participants have already priced out a June hike on the basis of the April employment report. Even Dudley claims it did little to change his expectations. While they won't raise rates in June, they do not see the outcome as already preordained.

Democrats Want the Fed to Increase the Number of Minorities in Leadership Positions

The Fed is "overwhelmingly and disproportionately white and male":

Federal Reserve change sought by liberals: ...top Democratic lawmakers called on the Fed to increase the number of minorities in leadership positions. They also urged the central bank to consider the high unemployment rate among some racial groups as it debates whether to keep pulling back its support for the American economy.
In a letter to Fed Chair Janet Yellen, the lawmakers argued that more minority representation would help broaden the Fed’s internal discussions about the health of the economy. In addition to Sanders, 10 senators signed the letter, including banking committee members Elizabeth Warren of Massachusetts, Jeff Merkley of Oregon and Robert Menendez of New Jersey. California Rep. Maxine Waters, ranking member of the House financial services committee, was among the more than 100 House Democrats who joined the effort as well. ...

Monday, May 09, 2016

Fed Watch: June Fades Away

Tim Duy:

June Fades Away, by Tim Duy: At the beginning of last week, monetary policymakers were trying to keep the dream of June alive. Via Bloomberg:
“I would put more probability on it being a real option,” Lockhart told reporters at the Atlanta Fed’s financial markets conference at Amelia Island, Florida, when asked about the low implied odds of a move next month. “The communication of committee participants and members between now and mid-June obviously should try to prepare the markets for at least a realistic range of possibilities” for the next policy meeting...
...Williams, a former head of research to Fed Chair Janet Yellen, said he would support raising rates at the next meeting, provided the economy stayed on track.
“In my view, yes, it would be appropriate, given all of the things that we’ve talked about, to go that next step,” Williams told Kathleen Hays in an interview on Bloomberg Radio. “But you know, a lot can happen between now and June.” Williams is also not an FOMC voter this year.
Later in the week, however, financial market participants took one look at the employment report and concluded the Fed was all bark and no bite. Markets see virtually no possibility of a Fed rate hike in June.
That - a desire to keep June in play coupled with insufficient data to actually make June happen - all happened faster than I anticipated. But don't think the Fed will go down without a fight. New York Federal Reserve President William Dudley played down the April employment numbers. Via his must-read interview with Binyamin Applebaum of the New York Times:
I wouldn’t make too much about the headline payroll number being a little softer, because there’s other things in the report that are more positive. For example, total hours worked were up quite a bit; average hourly earnings were up quite a bit. So there’s actually a lot of income being generated from the labor market. And the data on payrolls is quite volatile month to month — 160,000 sounds like a lot weaker than the 200,000 people were expecting, but it’s actually well within what you’d expect in terms of normal volatility. It’s a touch softer, maybe, than what people were expecting, but I wouldn’t put a lot of weight on it in terms of how it would affect my economic outlook.
I would agree that the report is within the bounds from normal volatility. From my tweet ahead of the report:

NFPforecast516

The pace of job growth has softened, though only modestly so:

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But if we view the labor report through Janet Yellen's eyes, the picture becomes somewhat murkier:

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Generally solid numbers, but I can't help but notice the unemployment rate is flattening out, and so too has progress on part-time employment and long-term unemployment. Indeed, I found this from Dudley somewhat odd:
The news from this latest payroll unemployment report was actually quite positive in terms of the long-term unemployed. I think what’s happening is, as we’ve run the labor market to a higher degree of utilization, the long-term unemployed are getting picked up and getting more employment opportunities.
He appears to be focusing on just the last month of data while ignoring the trend over the last year. But someone at the next FOMC meeting will surely draw that trend to his attention.
Note that unemployment is settling into a level slightly above the Fed's estimate of the natural rate of unemployment:

NFPf0516

For Yellen, this should be something of a red flag. The plan was to let the economy run hot enough that unemployment sank somewhat below the natural rate, thereby more aggressively reducing underemployment. Now, you can argue that this plan has faltered for a good reason - the labor participation rate rose, placing upward pressure on the unemployment rate. That however gets you to the same place as a more negative story. It reveals that there is substantial excess capacity in the labor market, and consequently the Fed should not be in a rush to raise rates. Indeed, because they have underestimated the slack in the economy, they need to let the economy run hot for even longer if they wish to push inflation back up to target - of which it remains woefully below:

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Bottom Line: The Fed breathed a sigh of relief after financial markets stabilized. That opened up the possibility that June would still be on the table, leaving them the option for three rate hikes this year. I don't think that policymakers will abandon June as easily as financial market participants. My sense is that they will remain coy, implying odds closer to 50-50. But the data are not in their favor. The employment report was by no means a disaster, but nor was it a blowout. Moreover, I think they will be wary to hike rates until unemployment resumes its decline or underemployment more broadly improves. And we won't have enough data to see such a trend until September.

Wednesday, May 04, 2016

Ben Bernanke and Democratic Helicopter Money

Simon Wren-Lewis:

Ben Bernanke and Democratic Helicopter Money: “The fact that no responsible government would ever literally drop money from the sky should not prevent us from exploring the logic of Friedman’s thought experiment, which was designed to show—in admittedly extreme terms—why governments should never have to give in to deflation.”
The quote above is from a post by Ben Bernanke... I put it up front because it expresses a macroeconomic truth that no one should ever forget: persistent recessions and deflation are never inevitable, and always represent the failure of policy makers to do the right thing.
There are many useful points in his post, but I just want to talk about one: Bernanke is in fact not talking about helicopter money in its traditional sense, but what I have called elsewhere ‘democratic helicopter money’.
When most people talk about HM, they imagine some scheme whereby the central bank sends ‘everyone’ a cheque in the post, or transmits some money to each individual some other way. It is what economists would call a reverse lump sum tax, or reverse poll tax: the amount you get is independent of your income. That makes it different from a normal tax cut.
In practice the central bank could only really do this with the cooperation of governments. It would not want to take the decision about what 'everyone' means on its own. (Do we include children or not. How do we find everyone?) But once those details had been sorted out, a system would be in place that the central bank could operate whenever it needed to.
Bernanke suggests an alternative. The central bank sets aside a sum of newly created money, and the fiscal authorities then spend it as they wish. They could decide to use all the money to build bridges or schools rather than give it to individuals. There might be two reasons for doing HM this way. First, for some reason the fiscal authorities are reluctant to spend if they have to fund it by creating more debt, so it may allow them to get around this (normally self-imposed) ‘constraint’. Second, a money financed fiscal expansion could be more expansionary than a bond financed fiscal expansion. Lets leave the second advantage to one side, as the first is sufficient in a world obsessed by government debt.
I have talked about something similar in the past (first here, but later here and here), which I have called democratic helicopter money. This label also seems appropriate for Bernanke’s scheme, because the elected government decides on the form of fiscal expansion. The difference between what I had discussed earlier under this label and Bernanke’s suggestion is that in my scheme the fiscal authorities and the central bank talk to each other before deciding on how much money to create and what it will be spent on (although the initiative always comes from the central bank, and would only happen in a recession where interest rates were at their lower bound). The reason I think talking would be preferable is simply that it helps the central bank decide how much money it needs to create. ...
While democratic HM is not talked about much among economists (Bernanke excepted), I think there are good political economy reasons why it may be the form of HM that is eventually tried. As I have said, conventional HM of the cheque in the post kind almost certainly requires the involvement of government. Once governments realise what is going on, they may naturally think why set up something new when they could decide how the money is spent themselves in a more traditional manner. Democratic HM is essentially a method of doing a money financed fiscal expansion in a world of independent central banks.
Which brings me back to the quote at the head of this post. The straight macroeconomics of most versions of HM is clear: all the discussion is about institutional and distributional details. If it is beyond us to manage to set in place any of them before the next recession that would be a huge indictment of our collective imagination, and is probably a testament to the power of imaginary fears and taboos created in very different circumstances.

Neo-Fisherian Policies Impart Unavoidable Instability

My colleagues have a new paper on interest rate pegs in New Keynesian models:

Interest Rate Pegs in New Keynesian Models by George W. Evans and Bruce McGough Abstract: John Cochrane asks: "Do higher interest rates raise or lower inflation?" We find that pegging the interest rate at a higher level will induce instability and most likely lead to falling inflation and output over time. Eventually, this will precipitate a change of policy. ...
Conclusions: Following the Great Recession, many countries have experienced repeated periods with realized and expected inflation below target levels set by policymakers. Should policy respond to this by keeping interest rates near zero for a longer period or, in line with neo-Fisherian reasoning, by increasing the interest rate to the steady-state level corresponding to the target inflation rate? We have shown that neo-Fisherian policies, in which interest rates are set according to a peg, impart unavoidable instability. In contrast, a temporary peg at low interest rates, followed by later imposition of the Taylor rule around the target inflation rate, provides a natural return to normalcy, restoring inflation to its target and the economy to its steady state.

Monday, May 02, 2016

Paul Krugman: The Diabetic Economy

"How should we think about these incredibly low interest rates?":

The Diabetic Economy, by Paul Krugman, Commentary, NY Times: Things are terrible here in Portugal, but not quite as terrible as they were a couple of years ago. The same thing can be said about the European economy as a whole. That is, I guess, the good news.

The bad news is that eight years after what was supposed to be a temporary financial crisis, economic weakness just goes on and on... And that’s something that should worry everyone, in Europe and beyond. ...
Look at what financial markets are saying.
When long-term interest rates on safe assets are very low, that’s an indication that investors don’t see a strong recovery on the horizon. Well, German five-year bonds currently yield minus 0.3 percent...
How should we think about these incredibly low interest rates? Recently Narayana Kocherlakota ... offered a brilliant analogy. Responding to critics of easy money who denounce low rates as “artificial” ... he suggested that we compare low interest rates to the insulin injections that diabetics must take.
Such injections aren’t part of a normal lifestyle, and may have bad side effects, but they’re necessary to manage the symptoms of a chronic disease.
In the case of Europe, the chronic disease is persistent weakness in spending... The insulin of cheap money helps fight that weakness, even if it doesn’t provide a cure. ...
The thing is, it’s not hard to see what Europe should be doing to help cure its chronic disease. The case for more public spending, especially in Germany — but also in France, which is in much better fiscal shape than its own leaders seem to realize — is overwhelming. ...
But doing the right thing seems to be politically out of the question. Far from showing any willingness to change course, German politicians are sniping constantly at the central bank, the only major European institution that seems to have a clue...
Put it this way: Visiting Europe can make an American feel good about his own country.
Yes, one of our two major parties is poised to nominate a dangerous blowhard for president — but ... the odds are that he won’t actually end up in the White House.
Meanwhile, the overall economic and political situation in America gives ample grounds for hope, which is in very short supply over here.
I’d love to see Europe emerge from its funk. The world needs more vibrant democracies! But at the moment it’s hard to see any positive signs.

Saturday, April 30, 2016

When Europe Stumbled

Paul Krugman:

When Europe Stumbled: Doing some homework on the European economy...

... What was happening in 2011-2012? Europe was doing a lot of austerity. But so, actually, was the U.S., between the expiration of stimulus and cutbacks at the state and local level. The big difference was monetary: the ECB’s utterly wrong-headed interest rate hikes in 2011, and its refusal to do its job as lender of last resort as the debt crisis turned into a liquidity panic, even as the Fed was pursuing aggressive easing.
Policy improved after that... But I think you can make the case that the policy errors of 2011-2012 rocked the euro economy back on its heels...
Oh, and America might have turned European too if the Bernanke-bashers of the right had gotten what they wanted.

Friday, April 29, 2016

Fed Watch: Warning: Hawkishness Ahead

Tim Duy:

Warning: Hawkishness Ahead, by Tim Duy: The Fed has proven very dovish since their December rate hike. Tumultuous financial markets gave the Fed doves the upper hand, leading the Fed to pause in it’s “normalization” campaign and cut in half the expected pace of rate hikes this year.
But be prepared for the tenor of the song to change. I would not be surprised to see doves shedding their feathers to reveal the hawk underneath.
Boston Federal Reserve President Eric Rosengren exemplifies this shift. Twice in recent weeks, Rosengren, typically considered a notable dove, warned that financial markets were underestimating the odds of rates hikes this year. The Fed made clear in the dots they expect at least two hikes; financial markets anticipate only one.
What is going on here? First, as I said earlier this week, the Fed is not happy that markets wrote of a June rate hike. I am wary that the data arrives to support a rate hike, but don’t think the Fed is ready to give up on that hike just yet.
One thing to remember is that the Fed still prefers to hike early and slowly if possible. They are more aware of the asymmetric risks they face than in December, and hence recognize that they should error on the side of looser policy in an uncertain environment. Hence skip March and April. But once the risk subsides, they will return to old habits. And old habits in this case mean a return to quarterly rate hikes.
My assumption is that they want the option to both hike quarterly and hike three times should the economic environment shift. That means they are thinking June-September-December is a possibility still (the dots are just a forecast, they are not committed to just two rate hikes). So they really need to keep the June option open, otherwise they run a greater risk of bunching up the next few hikes. Which means they want to raise the odds of a June hike to something closer to 50-50. The recent FOMC statement, in which declined to mention the risks, was an early signal of the direction they want to move.
And note that not mentioning the risks at all is arguably a de facto assessment of balanced risks in the world of central banking. My suspicion is the Fed feared that actually saying “balanced” would be a stronger indicator than they wanted to send. But they still said a lot by saying nothing at all.
Now, why should the Fed have a change of heart? Didn’t Federal Reserve Chair Janet Yellen just go all dovish? How can they change their story so fast?
They can change their story within the scope of six weeks. Just like they did from the December to January meetings. And they have the one good reason to change the story: The dramatically change in financial market conditions.
The tightening in financial markets during the winter was the proximate cause of a more cautious Fed. The data didn’t help, to be sure, but more on that later. The combination of a surging dollar, collapsing oil, and a stock market headed only south signaled that the Fed’s policy stance has turned too hawkish, too fast. The Fed relented and heeded the market’s warnings.
But things are different now. US stock market rebounded. The dollar is languishing. And oil is holding its gains, despite disappointment with the lack of an output agreement.
This improvement will not go unnoticed on Constitution Ave. Even among the doves.
That brings us to the data story. To be sure, incoming data this quarter has been lackluster. But that might soon be changing. Gavyn Davies, writing for the FT, is spinning a more optimistic tale:
The Fulcrum nowcast suggest that US activity growth fell continuously from the beginning of 2015 to February 2016, by which time it was around 1.0 per cent. However, in a potentially important change, the nowcast moved sharply higher in March and April, and it is now fluctuating around 2.0-2.5 per cent. This change was rapidly reflected in the prices of US risk assets, which recovered slightly before, and then along with, the daily US nowcasts.
Financial markets do not wait for quarterly GDP to be published, and they often ignore it altogether when it does finally appear. We prefer to ignore the noise from quarterly GDP, while focusing attention on the underlying activity factor that is driving the business cycle.
He includes this picture:

Fulcrum

Be forewarned: The Fed is primed by financial markets to change their story. If the data shifts as well, they will be looking hard at June. I don’t think the data will line up in time, but the possibility should be on your radar. There is a lot of data between the April and June meetings – two releases of many critical indicators. Too much data to be complacent.
Bottom Line: Remember, the Fed can turn hawkish as quickly as it turned dovish.

Wednesday, April 27, 2016

No Rate Hike. Will it Happen in June?

Output growth has slowed, labor markets and inflation have improved, less concern about the global economy, no rate hike. An increase in the target rate is on the table for June, but far from certain at this point:

Press Release, Release Date: April 27, 2016: Information received since the Federal Open Market Committee met in March indicates that labor market conditions have improved further even as growth in economic activity appears to have slowed. Growth in household spending has moderated, although households' real income has risen at a solid rate and consumer sentiment remains high. Since the beginning of the year, the housing sector has improved further but business fixed investment and net exports have been soft. A range of recent indicators, including strong job gains, points to additional strengthening of the labor market. Inflation has continued to run below the Committee's 2 percent longer-run objective, partly reflecting earlier declines in energy prices and falling prices of non-energy imports. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market indicators will continue to strengthen. Inflation is expected to remain low in the near term, in part because of earlier declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further. The Committee continues to closely monitor inflation indicators and global economic and financial developments.

Against this backdrop, the Committee decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent. The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee's holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.

Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; James Bullard; Stanley Fischer; Loretta J. Mester; Jerome H. Powell; Eric Rosengren; and Daniel K. Tarullo. Voting against the action was Esther L. George, who preferred at this meeting to raise the target range for the federal funds rate to 1/2 to 3/4 percent.

Tuesday, April 26, 2016

The Fed Is Meeting in April to Talk About June

Tim Duy:

The Fed will stand pat this week. We know it, they know it. So what then will the Fed talk about for two days?
The April meeting of the Federal Open Market Committee (FOMC) will be about the June meeting. Policymakers' fundamental challenge is that the FOMC doesn't want to rule out a June hike, but the markets already have. They need to decide if they want to make a play for a June hike and how to communicate such a message. They'll probably want to keep the option for a June hike open and hence will alter this week’s statement accordingly. ... Continued at Bloomberg...

Sunday, April 24, 2016

Presidential Candidates and Fed Accountability

Carola Binder:

Presidential Candidates and Fed Accountability: In an interview with Fortune, Donald Trump gave his views on  Federal Reserve Chair Janet Yellen, who will come up for reappointment in 2018. "I don’t want to comment on reappointment, but I would be more inclined to put other people in," he remarked, despite his opinion that Yellen "has done a serviceable job." ...
Recently, Narayana Kocherlakota, who was President of the Federal Reserve Bank of Minneapolis from 2009 through 2015, has been urging Presidential candidates to address their views on the Fed. ...
The other candidate who has said most about the Fed is Bernie Sanders, who wrote an op-ed about the Fed in the New York Times in December. Sanders' remarks focus mainly on Fed governance and financial regulation, though he also comments on the Fed's interest rate policy...
I asked Bernanke whether he thought that the presidential candidates should talk about monetary policy and the (re)appointment of the Fed Chair. He agreed with Kocherlakota that candidates should talk about what they would like to see in a Fed Chair, but said that he does not think it's a good idea to politicize individual interest rate decisions, emphasizing that the Fed does not have goal independence, but does have instrument independence. In other words, Congress has given the Fed a monetary policy mandate—full employment and price stability—but does not specify what the Fed needs to do to try to achieve those goals.
Anyone who wants to is welcome to evaluate the Fed on how successfully they are achieving that mandate. Anyone who wants to is also welcome to evaluate the merits of the mandate itself. Different people will come to different evaluations depending on their own beliefs and preferences. But neither of these two evaluations requires an audit of monetary policy by the Government Accountability Office, as both Sanders and Trump have advocated.
Anyone who is dissatisfied with the mandate itself can go through the usual channels of political change in a democracy and pressure Congress to change the mandate. Congress, by design, is susceptible to such pressure: they need votes. Presidential candidates are in a good position to draw public attention to the Fed's mandate and urge change if they believe it is necessary. Sanders, for example, could propose redefining the Fed's full employment mandate to mean unemployment below 4 percent. I'm not quite sure what kind of mandate Trump would support. It is also fair game for any member of the public to evaluate the Fed on how successfully they are achieving their mandate. But Congress does not (or at least, should not) tell the Fed how to set interest rates to achieve its mandate, and Presidential candidates shouldn't either.

Friday, April 15, 2016

We Are so S---ed. Econ 1-Level Edition

Brad DeLong (the simple model he is using is in the original post):

We Are so S---ed. Econ 1-Level Edition: ...And as I am going to tell [my undegraduates] next Monday, real GDP Y will be equal to potential output Y* whenever "the" interest rate r is equal to the Wicksellian neutral rate r*...

If interest rates are low and inflation is not rising it is not because monetary policy is too easy, but because r* is low--and r* can be low because:

  • consumers are terrified (co low)
  • investors' animal spirits are depressed (Io low)
  • foreigners' demand for our exports inadequate (NX low)
  • or fiscal policy too contractionary (G low)

for the economy's productive potential Y*.

The central bank's task in the long run is to try to do what it can to stabilize psychology and so reduce fluctuations in r*. ...

One way of looking at it is that two things went wrong in 2008-9:

  • Asset prices collapsed.
  • And so spending collapsed and unemployment rose.

The collapse in asset prices impoverished the plutocracy. The collapse in spending and the rise in unemployment impoverished the working class. Central banks responded by reducing interest rates. That restored asset prices, so making the plutocracy whole. But while that helped, that did not do enough to restore the working class.

Then the plutocracy had a complaint: although their asset values and their wealth had been restored, the return on their assets and so their incomes had not been. And so they called for austerity: cut government spending so that governments can then cut our taxes and so restore our incomes as well as our wealth.

But, of course, cutting government spending further impoverished the working class, and put still more downward pressure on the Wicksellian neutral interest rate r* consistent with full employment and potential output.

And here we sit.

Thursday, April 14, 2016

Central Bank Mistakes: More on Count 2'

Since I posted excerpts from a post by Simon Wren-Lewis on threats to central bank independence, thought I should do the same for the follow up:

Central bank mistakes: more on count 2: Martin Sandbu in the FT picks up on my post on central bank mistakes. While he says that the first and third I identify are “on point”, he says the second is simply wrong. I think this is because he (and many others) misunderstand the point I am making... But it is really important.
My second criticism is that central banks did not make it clear what the impact of reaching the zero lower bound (ZLB) was, and as a result were too quiet about the adverse impact of fiscal austerity. That is not the same as saying there is nothing central banks can do at the ZLB... As I said in the post, what the ZLB meant is that central banks could no longer do their job effectively, and that unconventional policy “was untested, and it is just not responsible to pretend otherwise”. ...
...this strikes at the core of the independence issue. Without independence, the government would be able to choose the best instrument available, which at the ZLB is fiscal policy. But central banks have been made independent and the task of stabilising the economy has been delegated to them. This institutional change should not mean that we no longer use the best instrument to do the job.[1] But if the central bank fails to be frank, perhaps because it feels bad about admitting that it no longer has the best tools to do the job, that is a clear mistake on its part. In this respect it is not important whether the central bank being honest and clear would have actually made a difference on this occasion. That it might have done is all that matters.
I think central banks can at this point get confused with political neutrality. ... Here Tony Yates makes a good suggestion, which is that the central bank should be mandated to comment “on whether its ability to meet the inflation target [or whatever its objectives are] was being hampered by government fiscal policy.” 
Advocacy blogging is so ubiquitous that some presume that in pointing out this and other mistakes I must be arguing against central bank independence (CBI). To repeat, I am not. What I think is indisputable is that CBI done badly can be worse than no independence. It does not serve the cause of well designed and well implemented central bank independence to gloss over past mistakes.
______________
[1] Suppose you erroneously think concerns about government debt were valid. Was that a justification for central bankers to argue against fiscal expansion? Absolutely not. With QE, any fiscal expansion could have been money financed. What central bankers should have said is that short term concerns about excessive government debt were unfounded, because they were acting as a lender of last resort. They did not say this.

Sunday, April 10, 2016

Can Central Banks Make 3 Major Mistakes in a Row and Stay Independent?

Simon Wren-Lewis:

Can central banks make 3 major mistakes in a row and stay independent?: Mistake 1 If you are going to blame anyone for not seeing the financial crisis coming, it would have to be central banks. They had the data that showed a massive increase in financial sector leverage. That should have rung alarm bells...
Mistake 2 Of course the main culprit for the slow recovery from the Great Recession was austerity... But the slow recovery also reflects a failure of monetary policy. In my view the biggest failure occurred very early on in the recession. Monetary policy makers should have said very clearly, both to politicians and to the public, that with interest rates at their lower bound they could no longer do their job effectively, and that fiscal stimulus would have helped them do that job. Central banks might have had the power to prevent austerity happening, but they failed to use it. ...
What could be mistake 3 The third big mistake may be being made right now in the UK and US. It could be called supply side pessimism. Central bankers want to ‘normalise’ their situation... They want to declare that they are back in control. But this involves writing off the capacity that appears to have been lost as a result of the Great Recession.
The UK and US situations are different. ...
I think these differences are details. In both cases the central bank is treating potential output as something that is independent of its own decisions and the level of actual output. ...
Perhaps that is correct, but there has to be a fair chance that it is not. If it is not, by trying to adjust demand to this incorrectly perceived low level of supply central banks are wasting a huge amount of potential resources. Their excuses for doing this are not strong. It is not as if our models of aggregate supply and inflation are well developed and reliable... The real question to ask is whether firms with current technology would like to produce more if the demand for this output was there, and we do not have good data on that.
What central banks should be doing in these circumstances is allowing their economies to run hot for a time, even though this might produce some increase in inflation above target. If when that is done both price and wage inflation appear to be continuing to rise above target, while ‘supply’ shows no sign of increasing with demand, then pessimism will have been proved right and the central bank can easily pull things back. The costs of this experiment will not have been great...
It does not appear that the Bank of England or Fed are prepared to do that. If we subsequently find out that their supply side pessimism was incorrect ..., this could spell the end of central bank independence. ... The Great Moderation is becoming a distant memory clouded by more recent failures. ... Mainstream economics remains pretty committed to central bank independence. But as we have seen with austerity, at the end of the day what mainstream economics thinks is not decisive when it comes to political decisions on economic matters. ...

Thursday, April 07, 2016

How Much of an Overshoot?

Tim Duy:

How Much of an Overshoot?: The Federal Reserve formally adopted a 2 percent inflation target back in January of 2012.
Policymakers at the central bank amended their objective this year to clarify that they expect "symmetric errors" around the target; in other words there is the possibility of the central bank overshooting or undershooting its self-proclaimed goal on inflation. Despite this clarification, concerns about the Fed’s commitment to the target persist and have intensified following Fed Chair Janet Yellen's speech last month. Even before then, however, it was easy to see why such worries existed. The central bank began the process of policy “normalization,” first by ending quantitative easing and then by raising benchmark interest rates, even though inflation has fallen short of the Fed's self-proclaimed target every month since May of 2012.
This raises a simple question: Given consistently below-target inflation since the Fed adopted its target, how much, if any, overshooting might the Fed be willing to tolerate as the expansion continues? ... Continued at Bloomberg

Wednesday, April 06, 2016

Fed Watch: Dovish Minutes

Tim Duy:

Dovish Minutes, by Tim Duy: The FOMC minutes indicates the Fed is just a dovish as believed. This was somewhat surprising given the tendency of minutes to have a more balanced perspective which would appear to be hawkish relative to current market expectations. But not this time. This time the message was fairly clear: They can't ignore the asymmetry of policy risks any longer. Gradual went to glacial, with April now off the table, leaving June as the next possible data for a rate hike. Expect Fedspeak to sound somewhat hawkish given they will want to keep June on the table - but I am less than certain they will have the data in hand to justify another hike until the second half of the year.

Meeting participants were generally confident in the outlook:

With respect to the outlook for economic activity and the labor market, participants shared the assessment that, with gradual adjustments in the stance of monetary policy, real GDP would continue to increase at a moderate rate over the medium term and labor market indicators would continue to strengthen. Participants observed that strong job gains in recent months had reduced concerns about a possible slowing of progress in the labor market.

But outside of the consumer, all is not rosy:

Many participants, however, anticipated that relative strength in household spending would be partially offset by weakness in net exports associated with lackluster foreign growth and the appreciation of the dollar since mid-2014. In addition, business fixed investment seemed likely to remain sluggish. 

And global concerns loomed large:

Furthermore, participants generally saw global economic and financial developments as continuing to pose risks to the outlook for economic activity and the labor market in the United States. In particular, several participants expressed the view that the underlying factors abroad that led to a sharp, though temporary, deterioration in global financial conditions earlier this year had not been fully resolved and thus posed ongoing downside risks.

Caveats abound, however:

Several participants also noted the possibility that economic activity or labor market conditions could turn out to be stronger than anticipated. For example, strong expansion of household demand could result in rapid employment growth and overly tight resource utilization, particularly if productivity gains remained sluggish.

Is the economy at full employment? Maybe:

Some participants judged that current labor market conditions were at or near those consistent with maximum sustainable employment, noting that the unemployment rate was at or below their estimates of its longer-run normal level and citing anecdotal reports of labor shortages or increased wage pressures.

Maybe not:

In contrast, some other participants judged that the economy had not yet reached maximum employment. They noted several indicators other than the unemployment rate that pointed to remaining underutilization of labor resources; these indicators included the still-high rate of involuntary part-time employment and the low level of the employment-to-population ratio for prime-age workers. The surprisingly limited extent to which aggregate data indicated upward pressure on wage growth also suggested some remaining slack in labor markets.

The climb in the unemployment rate since the March meeting supports the latter over the former. There was mixed views regarding the inflation outlook:

Participants commented on the recent increase in inflation. Some participants saw the increase as consistent with a firming trend in inflation. Some others, however, expressed the view that the increase was unlikely to be sustained, in part because it appeared to reflect, to an appreciable degree, increases in prices that had been relatively volatile in the past. 

But concerns about too low inflation clear dominated:

Several participants indicated that the persistence of global disinflationary pressures or the possibility that inflation expectations were moving lower continued to pose downside risks to the inflation outlook. A few others expressed the view that there were also risks that could lead to inflation running higher than anticipated; for example, overly tight resource utilization could push inflation above the Committee's 2 percent goal, particularly if productivity gains remained sluggish. 

And there was concern that low inflation was bleeding into expectations:

Some participants concluded that longer-run inflation expectations remained reasonably stable, but some others expressed concern that longer-run inflation expectations may have already moved lower, or that they might do so if inflation was to persist for much longer at a rate below the Committee's objective.

Notably, no one was concerned that inflation expectations were trending up. The consensus was stable or deteriorating. One-sided risks.

The primary reason the Fed anticipates stable growth this year is because they marked down interest rate forecasts:

...most participants, while recognizing the likely positive effects of recent policy actions abroad, saw foreign economic growth as likely to run at a somewhat slower pace than previously expected, a development that probably would further restrain growth in U.S. exports and tend to damp overall aggregate demand. Several participants also cited wider credit spreads as a factor that was likely to restrain growth in demand. Accordingly, many participants expressed the view that a somewhat lower path for the federal funds rate than they had projected in December now seemed most likely to be appropriate for achieving the Committee's dual mandate. Many participants also noted that a somewhat lower projected interest rate path was one reason for the relatively small revisions in their medium-term projections for economic activity, unemployment, and inflation.

Altogether, the risks are simply too one-sided to ignore:

Several participants also argued for proceeding cautiously in reducing policy accommodation because they saw the risks to the U.S. economy stemming from developments abroad as tilted to the downside or because they were concerned that longer-term inflation expectations might be slipping lower, skewing the risks to the outlook for inflation to the downside. Many participants noted that, with the target range for the federal funds rate only slightly above zero, the FOMC continued to have little room to ease monetary policy through conventional means if economic activity or inflation turned out to be materially weaker than anticipated, but could raise rates quickly if the economy appeared to be overheating or if inflation was to increase significantly more rapidly than anticipated. In their view, this asymmetry made it prudent to wait for additional information regarding the underlying strength of economic activity and prospects for inflation before taking another step to reduce policy accommodation.

The winter turmoil made the asymmetric risks all-too-real. They need to allow the economy to run hot to justify sufficient rate hikes to drive a wedge between policy and the zero bound. They need to make a choice: Risk inflation, or risk returning to the zero bound? They are coming around to seeing the former as a less costly risk as the latter.

This begs the question of how quick they will be to react to inflation that overshoots 2%. I don't think they will react too quickly - they will need to tolerate some overshooting to avoid cutting the recovery off at the knees. It will still be about the balance of risks until interest rates are much higher.

Finally, the pretty much decided they wouldn't have enough data to hike rates in April:

A number of participants judged that the headwinds restraining growth and holding down the neutral rate of interest were likely to subside only slowly. In light of this expectation and their assessment of the risks to the economic outlook, several expressed the view that a cautious approach to raising rates would be prudent or noted their concern that raising the target range as soon as April would signal a sense of urgency they did not think appropriate. In contrast, some other participants indicated that an increase in the target range at the Committee's next meeting might well be warranted if the incoming economic data remained consistent with their expectations for moderate growth in output, further strengthening of the labor market, and inflation rising to 2 percent over the medium term.

Not clear that they will in June either. First quarter growth numbers are looking weak, so they may want a clear picture of the second quarter before acting. That speaks to July or September.

Bottom Line: The Fed is on hold until they are sufficiently confident they can make a liftoff stick. The bar is higher now given the focus on asymmetric risks. They won't want to take June off the table just yet, so expect them to say that it is still too early to rule it out. April, however, is set to be a yawner.

The Safe Asset Problem is Back: Negative Interest Rate Edition

David Beckworth:

The Safe Asset Problem is Back: Negative Interest Rate Edition: The safe asset shortage problem is back. Actually, it never went away..., yields on government bonds considered safe assets have been steadily declining since the crisis broke out. 
This problem is now manifesting itself in a new form: central banks tinkering with negative interest rates. Many view this development as the latest manifestation of central banks running amok. A more nuance read is that central banks are continuing to imperfectly respond to safe asset shortage problem. ...
But many observers miss this point. They confuse the symptom--central bankers tinkering with negative interest rates--for the cause--the safe asset shortage. So I want to revisit the safe asset shortage problem in this post by reviewing what exactly it is, why it has persisted for so long, and what can be done to remedy it. ...

Tuesday, April 05, 2016

Fed Watch: Fed Has Little Reason to Hike Rates

Tim Duy:

Fed Has Little Reason to Hike Rates, by Tim Duy: Despite some occasionally hawkish rhetoric from a handful of disaffected Federal Reserve bank presidents, expect the Fed to remain on hold until inflationary threats clearly emerge. In practice, that means the Fed is not likely to raise rates until the unemployment rate resumes its downward trajectory. Soft though generally positive data coupled with market turbulence over the winter scared most policymakers straight with regards to their overly-optimistic plans to normalize policy. The risks to the outlook are simply too one-sided too believe this is anything like the tightening cycles of the past.
Generally positive incoming data continues to defy the predictions of the recessionistas. ISM data, both manufacturing:

EMPREPf041616

and nonmanufacturing:

EMPREPg041616

posted improved headline numbers with general solid internals. The worst of the manufacturing downturn may be behind us. The JOLTS numbers:

EMPREPh041616

have remained fairly stable in recent months, suggesting no significant changes in dynamics in labor flows in and out of firms. Not surprisingly, nonfarm payroll growth remains on its steady path:

EMPREPa041616

The unemployment rate ticked up in March as the labor force grew:

EMPREPb041616

The Fed would like unemployment to settle somewhat below their estimates of the natural rate to promote further reduction of underemployment. So a stagnant unemployment rate at these levels argues for stable policy.
One red flag I see is that temporary employment has stalled, suggesting some loss of momentum:

EMPREPe041616

Nothing to panic about, just something I am watching. Indeed, in many ways the current dynamic is not dissimilar to the mid-90s, when the economy sputtered in the wake of tighter monetary policy. Then, like now, the Fed need to back down in response. The economy subsequently gathered steam.
Moreover, declining estimates of first quarter growth also give the Fed reason to remain on hold. Soft consumption, weaker auto sales, still anemic manufacturing, and a rising trade deficit have all conspired to bring the latest Atlanta Fed estimate of first quarter growth to an anemic 0.4%. To be sure, this might just be the first quarter curse of recent years. As such, the Fed may be confident it does not represent the pace of underlying activity. And they expect that the worst impact of the rising dollar and falling oil prices on manufacturing will soon be behind us. But they don't know these things - and it will take another three months of data at least until they know these things. That pushes that date of another rate hike into the until June at the earliest, but don't be surprised if they want to see a more complete picture of the second quarter before acting.
A steady unemployment rate at or above the Fed's estimate of the natural rate also argues for a substantial policy pause. I am hard pressed to see a reason for the Fed to resume hiking rates until unemployment clearly resumes declining. This holds true even if a growing labor force drives a flattening unemployment rate. The Fed will see that as evidence that excess slack remains in the economy, hence inflationary pressures are less than feared when the unemployment rate was heading steadily lower. 
Note also tamer inflation in February after a spike the previous month:

EMPREPk041616

This supports Federal Reserve Chair Janet Yellen's caution over reading too much into any one inflation reading. 
Financial indicators have firmed in recent months:

EMPREPj041616

EMPREPi041616

That said, the improvement for most indicators largely just offsets the damage done during the winter. And credit conditions for less than perfect debt remain less than perfect. 
In short, while the data is not indicating a recession it upon us, and supportive of the case for improvement later this year, it also gives little reason to justify a rate hike anytime soon.
Furthermore, the Fed appears to have stopped - at least for the moment - pursuing rate hikes for the sake of hiking rates. The financial market turmoil made them realize that yes, the policy risks are asymmetric, and they need to take the asymmetries seriously. Chicago Federal Reserve President Charles Evans concisely summaries the challenges of being hit with a negative shock while near the zero bound:
Faced with such uncertainty, policymakers could make two potential policy mistakes. The first mistake is that the FOMC could raise rates too quickly, only to be hit by one or more of the downside surprises. In order to put the economy back on track, we would have to cut interest rates back to zero and possibly even resort to unconventional policy tools, such as more quantitative easing. I think unconventional policy tools have been effective, but they clearly are second-best alternatives to traditional policy and something we would all like to avoid. I should note, too, that with the economy facing a potentially lower growth rate and lower equilibrium interest rates, the likelihood of some shock forcing us back to the effective lower bound may be uncomfortably high. The difficulties experienced in Japan and Europe come to mind.
And compares it to the challenges of being hit with a positive shock:
The second (alternative) potential policy mistake the Committee could make is that sometime during the gradual normalization process the U.S. economy experiences upside surprises in growth and inflation. Well, policymakers have the experience and the appropriate tools to deal with such an outcome; we probably could keep inflation in check with only moderate increases in interest rates relative to current forecasts. Given how gradual the rate increases are in the baseline SEP, policy could be made a good deal more restrictive, for example, by simply increasing rates 25 basis points at every meeting — just as we did during the measured pace adjustments of 2004–06. A question for the audience: Who thinks those were fast? So, to me, concerns about the risks of rapid increases in rates in this scenario seem overblown.
Until now, the driving argument for raising rates was that they needed to do so to avoid a faster pace of rate hikes. But as Evans points out, why the rush? Would it really be so bad to raise rates at a "moderate" pace rather than a "gradual" or what has become now a "glacial" place? After all, they have better tools to reduce inflation than to raise it. Clearly, many Fed officials did not appreciate the asymmetry of risks until this past winter. 
Separately, Boston Federal Reserve President Eric Rosengren argued that financial market participants are getting it wrong:
So, while problems could still arise, I would expect that the very slow removal of accommodation reflected in futures market pricing could prove too pessimistic. While it has been appropriate to pause while waiting for information that clarified the response of the U.S. economy to foreign turmoil, it increasingly appears that the U.S. has weathered foreign shocks quite well. As a consequence, if the incoming data continue to show a moderate recovery – as I expect they will – I believe it will likely be appropriate to resume the path of gradual tightening sooner than is implied by financial-market futures.
He seems to have learned little from Federal Reserve Vice-Chair Stanley Fisher's experience in January:
Well, we watch what the market thinks, but we can't be led by what the market thinks. We've got to make our own analysis. We make our own analysis and our analysis says that the market is underestimating where we are going to be. You know, you can't rule out that there is some probability they are right because there's uncertainty. But we think that they are too low .
They would probably be better off just stating their expectations as the baseline rather than appearing to challenge the markets so directly. But they can't seem to help themselves; they seem to view it as their job to warn that rate hikes are coming, that markets are getting it wrong, an unnecessarily hawkish message for a central bank trying to raise inflation while facing an asymmetric balance of risks. Not sure what the point is anyway - if Rosengren is at two rate hikes this year while the market is at one, is that difference really all that significant? Is he just priming us for Fed minutes that will also be more hawkish than current market expectations?
And the implied hawkish message has proven consistently wrong, for that matter. The history of this recovery is that while the Fed always sounds hawkish relative to market expectations, the Fed has consistently moved in the direction of market expectations.
Bottom Line: The Fed is on hold for at least a few months until the data provides a more definite reason to justify another hike. With any luck, if the Fed continues to hold steady now, maybe they will get the chance to chase the long-end of the curve higher later - which is exactly what they need to be able to "normalize" policy. Expect officials to remind us that they expect a faster pace of a rate hikes than markets anticipate. But I think the bar for further hikes has risen since December. An appreciation of the asymmetric policy risks will prod them to seek more definitive signs inflationary pressures are growing to justify the next rate hike.

Monday, April 04, 2016

Why the Fed has a Wary Eye on China's Economy

At MoneyWatch:

Why the Fed has a wary eye on China's economy, by Mark Thoma: Uncertainty about the global economy is making the Federal Reserve more cautious about raising U.S. interest rates. That was Fed Chair Janet Yellen's message in a speech to the Economic Club of New York last week. This uncertainty is reflected in the Fed's dialed-back forecast for rate increases this year. In December, the central bank signaled that rates would go up by 1 percent over the course of the year, but that projection dropped to a half-percent at the Fed's most recent meeting.
And when the topic is the health of the global economy, the discussion is largely about the performance of the Chinese economy. From 2002 through 2011, China's average growth rate was a remarkable 10.6 percent, according to International Monetary Fund data. But that has fallen steadily to 6.8 percent in 2015, and it's projected to slide further to 6 percent by 2017 then level off in subsequent years.
But this forecast itself has quite a bit of uncertainty. China faces several challenges that it must overcome to avoid an even lower growth rate -- and perhaps a "crash landing." ...

Friday, April 01, 2016

Fed Watch: Yellen Pivots Toward Saving Her Legacy

Tim Duy:

Yellen Pivots Toward Saving Her Legacy: As 2016 began to evolve, it quickly became apparent that Federal Reserve Chairman Janet Yellen faced the very real possibility that her legacy would amount to being just another central banker who failed miserably in their efforts to raise interest rates back into positive territory. The Federal Reserve was set to follow in the footsteps of the Bank of Japan and the Riksbank, seemingly oblivious to their errors. In September of last year, a confident Yellen declared the Fed would be different. From the transcript of her press conference:

ANN SAPHIR. Ann Saphir with Reuters. Just to piggyback on the global considerations—as you say, the U.S. economy has been growing. Are you worried that, given the global interconnectedness, the low inflation globally, all of the other concerns that you just spoke about, that you may never escape from this zero lower bound situation?

CHAIR YELLEN. So I would be very—I would be very surprised if that’s the case. That is not the way I see the outlook or the way the Committee sees the outlook. Can I completely rule it out? I can’t completely rule it out. But, really, that’s an extreme downside risk that in no way is near the center of my outlook.

Shuddering financial markets in the wake of the Fed’s first rate hike since 2006 certainty tested Yellen’s confidence that failure to exit the zero bound was nothing more than an “extreme” tail risk. Indeed, it looked all too possible, even as policymakers such as Federal Reserve Vice-Chair Stanley Fischer and San Francisco Federal Reserve President John Williams counseled dismissing financial market turbulence as something the economy could withstand as it has in the past (ignoring though the role the Fed play in such resilience).

Luckily for Yellen, she heeded the warnings of Federal Reserve Governor Lael Brainard, who has since last fall has cautioned that the Fed faced more danger than commonly believed within the confines of the Eccles Building. With her speech this week, Yellen clearly embraced Brainard’s warnings. She is choosing the risk of overheating the economy – and sending inflation above target – over the risk of failing at the one and perhaps only chance to leave the zero bound behind.

While the exit from the zero bound remains uncertain, Yellen’s new path is at least more likely to succeed than blindly ignoring financial market signals by following through with expected rate hikes. And that’s important for more than just Yellen’s legacy. Her legacy is intertwined with the health of the US economy.

There is much to be had in Yellen’s speech this week. Highlights include an awareness that the neutral rate of interest is not rising as quickly as expected, the global economy is a risk that cannot be ignored, the recent uptick in inflation might be less than meets the eye, and a recognition that falling long-rates represent an expectation of easier monetary policy, and the Fed needs to meet that expectation to ensure that financial market remain sufficiently accommodative.

But two points in particular caught me eye. The first was a deeper appreciation of the asymmetric risks facing policymakers. Yellen notes that although the Fed retains a litany of potential unconventional tools:

“…if the expansion was to falter or if inflation was to remain stubbornly low, the FOMC would be able to provide only a modest degree of additional stimulus by cutting the federal funds rate back to near zero.”

If you want to successful pull off the zero bound, you better make sure that you conditions give you some distance from that bound before you need to start cutting again. That distance is effectively almost none, and will likely remain limited for substantial time. Better to move glacially rather than gradually.

But more important was the role of deteriorating inflation expectations in her analysis. Recall that in her September speech, Yellen sought to emphasize her faith in the Phillips curve as a reason to begin rates hikes sooner than later. She noted the importance of anchored inflation expectations in her assessment, saying:

“…the presence of well-anchored inflation expectations greatly enhances a central bank's ability to pursue both of its objectives--namely, price stability and full employment...

… Although the evidence, on balance, suggests that inflation expectations are well anchored at present, policymakers would be unwise to take this situation for granted. Anchored inflation expectations were not won easily or quickly: Experience suggests that it takes many years of carefully conducted monetary policy to alter what households and firms perceive to be inflation's "normal" behavior, and, furthermore, that a persistent failure to keep inflation under control--by letting it drift either too high or too low for too long--could cause expectations to once again become unmoored.”

The stability of inflation expectations is now, however, less certain:

"The inflation outlook has also become somewhat more uncertain since the turn of the year, in part for reasons related to risks to the outlook for economic growth...

… Lately, however, there have been signs that inflation expectations may have drifted down. Market-based measures of longer-run inflation compensation have fallen markedly over the past year and half, although they have recently moved up modestly from their all-time lows. Similarly, the measure of longer-run inflation expectations reported in the University of Michigan Survey of Consumers has drifted down somewhat over the past few years and now stands at the lower end of the narrow range in which it has fluctuated since the late 1990s…

…Taken together, these results suggest that my baseline assumption of stable expectations is still justified. Nevertheless, the decline in some indicators has heightened the risk that this judgment could be wrong."

To be sure, Yellen recognizes that inflation may rebound more quickly than expected, but the overall thrust of her argument is that although labor markets have continues to improve and rising wages suggests the economy is reaching full employment, the risks to stable inflation expectations are now too on the downside. And if expectations become unanchored, the Fed will fail to meet it’s 2 percent inflation target anytime soon. Moreover, the Fed would be faced with trying to re-establish expectations in the absence of their conventional tools. That might be a tall order.

Bottom Line: Rising risks to the outlook placed Yellen’s legacy in danger. If the first rate hike wasn’t a mistake, certainly follow up hikes would be. And there is no room to run; if you want to “normalize” policy, Yellen needs to ensure that rates rise well above zero before the next recession hits. The incoming data suggests that means the economy needs to run hotter for longer if the Fed wants to leave the zero bound behind. Yellen is getting that message. But perhaps more than anything, the risk of deteriorating inflation expectations – the basis for the Fed’s credibility on its inflation target – signaled to Yellen that rates hike need to be put on hold. Continue to watch those survey-based measures; they could be key for the timing of the next rate hike.

Thursday, March 31, 2016

'Modelling Banking Sector Shocks and Unconventional Policy: New Wine in Old Bottles?'

This is from the B of E's Bank Underground:

Modelling banking sector shocks and unconventional policy: new wine in old bottles?, by James Cloyne, Ryland Thomas, and Alex Tuckett: The financial crisis has thrown up a huge number of empirical challenges for academic and professional economists. The search is on for a framework with a rich enough variety of financial and real variables to examine both the financial shocks that caused the Great Recession and the unconventional policies, such as Quantitative Easing (QE), that were designed to combat it. In a new paper we show how using an older structural econometric modelling approach can be used to provide insights into these questions in ways other models currently cannot. So what are the advantages of going back to an older tradition of modelling? An ongoing issue for central bank economists is that they typically want to look at a wide range of financial sector variables and at a more granular, sector-based level of aggregation than typically found in macroeconomic models with credit and asset market frictions. For example, we often want to distinguish between the credit provided to firms separately from that provided to households or between secured lending and unsecured lending. We may also want to compare and contrast a number of policy instruments that work through different channels such as central bank asset purchases (QE) and macroprudential tools such as countercyclical capital requirements.
It is a tough challenge to incorporate all of these effects in the theoretical and empirical models that are typically used by macroeconomists, such as structural vector autoregression (SVAR) models and micro-founded general equilibrium (DSGE) models. For these reasons turning back to the older tradition of building structural econometric models (SEMs) – built from blocks of simultaneously estimated equations with structural identifying restrictions – can be useful. This approach can be thought of as a blend of the more theory-free VAR methods and a more structural model-based approach. The main advantage of the structural econometric frameworks are that they produce quantitative results at a sector level, which can still be aggregated up to produce a general equilibrium response. They also allow models to be built up in a modular way that allows replacing and improving sets of equations for particular blocks of the model without necessarily undermining the logic of the model as a whole. This older school approach to modelling has begun to appear in a variety of modern vintages. ...

Wednesday, March 30, 2016

'Central Banks Need to Get Real (Not Nominal)'

In a tweet, Antonio Fatás says "I hope this does not sound too Neo-Fisherian":

Central Banks need to get real (not nominal): While the ECB and Bank of Japan are exploring negative interest rates, the US Federal Reserve is preparing us for a slow and cautious increase in short-term interest rates. Long-term rates remain at very low levels and inflation expectations have come under pressure and also remain below what they were a few months or years ago. And as this is going on markets are trying to figure out if they like low or high interest rates. And even if they decide that they like low rates, are negative rates too low?
In all these debates there seems to be an unusual amount of what economists call money illusion or lack of understanding of the difference between nominal and real interest rates. This confusion, in my view, is partly motivated by the communication strategy of central banks that seem to obsess with the asymmetric nature of their inflation targets (for both the ECB and US Fed, inflation targets are defined as close but below 2%) and are not clear enough on their final goal and its timing.
How do we want interest rates to react to aggressive monetary policy? The common answer is that we want interest rates to go down. This is correct if we think in real terms: given inflation expectations (or actual inflation), we want interest rates to move down relative to those inflation levels. But in some cases, in particular when inflation expectations are lower than what central banks would like them to be, the central bank by being aggressive is targeting higher inflation expectations and this can possibly lead to higher nominal (long-term) interest rates.
This is what happened in the three rounds of quantitative easing by the US Federal Reserve. 10-Year interest rates went up which was a signal of increasing inflation expectations (and even higher expectations of future real interest rates). This was seen as a success.

 

But the behavior of long-term interest rates or inflation expectations in response to recent communications by central banks has gone in the opposite direction. Long-term rates have come down (in particular in the Euro area). But don't we want lower interest rates? Isn't this the objective of massive purchases of long-term assets by central banks? Yes if we talk about real interest rates but not obvious if we talk about nominal ones. What we really want is inflation expectations (and inflation) to increase and this is likely to keep long-term interest rates from falling so much. 
And here is where I feel the central banks are not helping themselves. There are two mistakes they are doing: in their messages about interest rates they do not distinguish clearly between nominal and real interest rates. What I want to do is to send a message that real interest rates will remain low for an extended period of time to ensure higher inflation ahead and to ensure that nominal interest rates increase in the future so that we can escape the zero lower bound. By talking only about nominal interest rates central banks are sending a signal that we will be stuck at the zero lower bound for a long time, a message that seems to be an admission of defeat. They cannot get out of this trap.
And this leads me to the second mistake of central banks: their asymmetric view of their inflation target. In the US, inflation and core inflation is slowly moving towards the 2% target. This is seen by some as a proof that the zero lower bound or the deflation trap has been defeated. But this is the wrong reading. The fact that the federal funds rate remains so close to 0% means that we are still at the zero lower bound or close enough to it and we should not be complacent with what we achieved. The US Federal Reserve should only call it a success when the federal funds rate is back to 3% or higher, safe away from 0%. But to get there we need to shoot for higher inflation, at least temporarily. The same message or even stronger applies to the ECB. 
In summary, success in escaping the zero lower bound should be judged by how central bank interest rates manage to move away from 0% not by how long they stay at 0%. Central banks are not communicating this clearly because of the fear that this would be interpreted as a message of future tightening of monetary policy. But by doing so they are hurting their ability to escape the deflation/lowflation trap.

Tuesday, March 29, 2016

Yellen: The Outlook, Uncertainty, and Monetary Policy

The end of Janet Yellen's speech today:

...The FOMC left the target range for the federal funds rate unchanged in January and March, in large part reflecting the changes in baseline conditions that I noted earlier. In particular, developments abroad imply that meeting our objectives for employment and inflation will likely require a somewhat lower path for the federal funds rate than was anticipated in December.
Given the risks to the outlook, I consider it appropriate for the Committee to proceed cautiously in adjusting policy. This caution is especially warranted because, with the federal funds rate so low, the FOMC's ability to use conventional monetary policy to respond to economic disturbances is asymmetric. If economic conditions were to strengthen considerably more than currently expected, the FOMC could readily raise its target range for the federal funds rate to stabilize the economy. By contrast, if the expansion was to falter or if inflation was to remain stubbornly low, the FOMC would be able to provide only a modest degree of additional stimulus by cutting the federal funds rate back to near zero.9
One must be careful, however, not to overstate the asymmetries affecting monetary policy at the moment. Even if the federal funds rate were to return to near zero, the FOMC would still have considerable scope to provide additional accommodation. In particular, we could use the approaches that we and other central banks successfully employed in the wake of the financial crisis to put additional downward pressure on long-term interest rates and so support the economy--specifically, forward guidance about the future path of the federal funds rate and increases in the size or duration of our holdings of long-term securities.10 While these tools may entail some risks and costs that do not apply to the federal funds rate, we used them effectively to strengthen the recovery from the Great Recession, and we would do so again if needed.11
Of course, economic conditions may evolve quite differently than anticipated in the baseline outlook, both in the near term and over the longer run. If so, as I emphasized earlier, the FOMC will adjust monetary policy as warranted. As our March decision and the latest revisions to the Summary of Economic Projections demonstrate, the Committee has not embarked on a preset course of tightening. Rather, our actions are data dependent, and the FOMC will adjust policy as needed to achieve its dual objectives.
Financial market participants appear to recognize the FOMC's data-dependent approach because incoming data surprises typically induce changes in market expectations about the likely future path of policy, resulting in movements in bond yields that act to buffer the economy from shocks. This mechanism serves as an important "automatic stabilizer" for the economy. As I have already noted, the decline in market expectations since December for the future path of the federal funds rate and accompanying downward pressure on long-term interest rates have helped to offset the contractionary effects of somewhat less favorable financial conditions and slower foreign growth. In addition, the public's expectation that the Fed will respond to economic disturbances in a predictable manner to reduce or offset their potential harmful effects means that the public is apt to react less adversely to such shocks--a response which serves to stabilize the expectations underpinning hiring and spending decisions.12
Such a stabilizing effect is one consequence of effective communication by the FOMC about its outlook for the economy and how, based on that outlook, policy is expected to evolve to achieve our economic objectives. I continue to strongly believe that monetary policy is most effective when the FOMC is forthcoming in addressing economic and financial developments such as those I have discussed in these remarks, and when we speak clearly about how such developments may affect the outlook and the expected path of policy. I have done my best to do so today, in the time you have kindly granted me.

Monday, March 28, 2016

Fed Watch: Oil, Inflation Expectations, and Credibility

Tim Duy:

Oil, Inflation Expectations, and Credibility, by Tim Duy: In an IMF blog post, Maurice Obstfeld, Gian Maria Milesi-Ferretti, and Rabah Arezki offer a solution to the "puzzle" of the weak positive macroeconomic response to low oil prices. Specifically, they posit a sharp rise in real interest rates due to falling inflation expectations is the culprit:
Even though oil is a less important production input than it was three decades ago, that reasoning should work in reverse when oil prices fall, leading to lower production costs, more hiring, and reduced inflation. But this channel causes a problem when central banks cannot lower interest rates. Because the policy interest rate cannot fall further, the decline in inflation (actual and expected) owing to lower production costs raises the real rate of interest, compressing demand and very possibly stifling any increase in output and employment. Indeed, those aggregates may both actually fall. Something like this may be going on at the present time in some economies. Chart 3 is suggestive of a depressing effect of low expected oil prices on expected inflation: it shows the strong recent direct relationship between U.S. oil futures prices and a market-based measure of long-term inflation expectations.
Initially, I was a bit enamored with this idea. As I thought on it more, however, I came to see it as a cautionary tale of chart crime. But digging underneath the surface a bit uncovered some interesting questions about monetary policy and credibility. Specifically, how worried should we be that inflation expectations will soon become unanchored?
Obstfeld et al. rely on a version of this widely publicized chart to support their contention:

OBSa032816

The first and most obvious problem is that this chart really proves nothing. For example, I could just as easily presented this chart:

OBSb032816

Now I can tell a story that the rising dollar (note the inverted scale) is driving down inflation expectations and thus driving up the real interest rate. Oil, on the other hand, is having exactly the effect we might expect - just look at sales of light trucks and SUVs, not to mention vehicle miles traveled:

OBSE032816

Hence, there is no paradox of oil. Lower oil prices are triggering the expected positive impacts. It's about the dollar weighing on inflation expectations that is creating the offsetting impact. Obstfeld et al. apparently do not try to distinguish their story from this one.
(Warning: wonkishness ahead.)
This problem, however, just scratches the surface. Look at either of the first two charts above and two red flags should leap off the screen. The first is the different scales, often used to overemphasize the strength of a correlation. The second is the short time span, often used to disguise the lack of any real long term relationship (I hope I remember these two points the next time I am inclined to post such a chart).
Consider a time span that encompassed the entirety of the 5-year, 5-year forward inflation expectations:

OBSc032816

The correlation is less obvious to say the least (note too that changing the scale also suggests less correlation). Why does the correlation appear and disappear? Could any supposed correlation across selected time periods be spurious?
That gets to another issue. When you show me this chart

OBSa032816

and claim there is a meaningful relationship, I see two nonstationary variables you are claiming to be cointegrated. The trouble with that is that while oil is a nonstationary process - it is not mean reverting, nor is there reason to believe it should be a mean reverting series. Inflation expectations, however, should be a mean reverting series.
Or more specifically, it should be mean reverting if the central bank is credibly committed to their inflation target. If the central bank is credible, then we anticipate that policymakers will respond with policy that offsets inflation shocks to maintain their inflation target. Hence, inflation expectations should revert to that target and we would expect the series to be stationary.
If inflation expectations are a nonstationary series, then shocks build in the series and inflation expectations would drift persistently away from the central bank's inflation target. Inflation expectations would be unanchored. In other words, if inflation expectations are nonstationary, then we have a problem. More on that in a bit.
It appears that oil prices are nonstationary:
Dickey-Fuller Unit Root Test, Series DCOILBRENTEU
Regression Run From 1987:05:22 to 2016:03:21
Observations 7523
With intercept
With 1 lags chosen from 9 by AIC
Sig Level Crit Value
1%(**) -3.43430
5%(*) -2.86246
10% -2.56729
T-Statistic -1.47895
while, luckily, inflation expectations are stationary:
Dickey-Fuller Unit Root Test, Series T5YIFR
Regression Run From 2003:01:14 to 2016:03:24
Observations 3444
With intercept
With 7 lags chosen from 7 by AIC
Sig Level Crit Value
1%(**) -3.43524
5%(*) -2.86290
10% -2.56752
T-Statistic -4.63374**
Which leads me to conclude that the recent correlation between oil prices and 5-year, 5-year forward inflation expectations is not indicative of an underlying relationship and hence policymakers should be wary of accepting the Obstfeld at al. hypothesis. Of course, this should not be a surprise as the theoretical underpinnings for such a relationship are weak. A level shock to the price of oil should not change inflation expectations five years from now.
(The same is true for the dollar as well. And while both the dollar index and oil prices are nonstationary, they don't appear cointegrated, suggesting that instances of high correlation are more spurious than anything else.)
Digging a little deeper, note the University of Michigan Survey of Consumers has a longer series of 5-year inflation expectations which shows less variability than 5-year, 5-year forward inflation expectations:

OBSd032816

The UMich inflation series also appears to be stationary:
Dickey-Fuller Unit Root Test, Series UMICH5YEAREX
Regression Run From 1990:08 to 2016:03
Observations 309
With intercept
With 3 lags chosen from 4 by AIC
Sig Level Crit Value
1%(**) -3.45322
5%(*) -2.87105
10% -2.57180
T-Statistic -2.92456*
Consequently, I think we have evidence to support the claim that the Federal Reserve is a credible policymaker in the most important arena, that of maintaining stable inflation expectations.
I suspect the high variability of the 5-year, 5-year forward measure is attributable to financial market structural issues (depth of the market for TIPS, for example) rather than rapidly shifting inflation expectations. Hence, we would expect that should those structural issues lessen in importance, the measure will revert to its mean (assuming the Fed remains a credible policymaker). Nor should we read too much about inflation expectations in this measure. Federal Reserve Chair Janet Yellen has reached the same conclusion, which is why she is wary of claims that shifts in the 5-year, 5-year forward measure reflect inflation expectations - and why she refers to these measures as inflation "compensation" not "expectations." From the March 2016 press conference:
In addition, the Phillips curve theory suggests that inflation expectations are also an important driver of actual wage- and price-setting decisions and inflation behavior, and I believe there’s also solid empirical evidence for that. And it’s one of the reasons that I highlighted in my statement, and we continue to highlight in the FOMC statement, that we are tracking indicators of the inflation expectations that matter to wage and price setting.
Now, unfortunately, we don’t have perfect measures of these things. We have survey measures. We know that household measures, even when households are asked about longer- term inflation—at longer-term inflation, they tend to move in response to salient changes in prices that they see every day. In particular, when gas prices go down, which is very noticeable to most households, you tend to see a view—you tend to see responses about long-term inflation marked down. So that’s kind of an overresponse to something that’s transitory. So it’s difficult to get a clear read from those survey measures.
Inflation compensation as measured in financial markets also embodies a variety of risk premia and liquidity premia. And so, it’s also—we monitor those closely and discuss them in the statement in paragraph one, but, again, there’s not a straight read on what’s happening to the expectations that influence wage and price setting. But this model continues to at least influence my own thinking, and it certainly is a factor that I and at least some of my colleagues are incorporating in these projections.
Note too that she also questions the importance of the recent slight downward drift in survey-based measures. I would place more weight on those measures (I think others on the FOMC, such as Governor Lael Brainard, are similarly inclined). In any event, I think the Fed is moving in a credible way to either measure by moving more cautiously than anticipated in December. Hence, we should expect inflation expectation measures to remain stationary.
Of course, if expectations devolve into nonstationary processes (it is a long-period property of the data, hence we cannot definitely declare the answer in any finite time period), we should be very worried that policymakers have lost control of inflationary expectations. And at the present time, they would be unanchored to the downside, not the upside as often feared.
Bottom Line: Be wary of claims that oil prices are influencing inflation expectations; the recent correlation is likely spurious. Inflation expectations look to be following a mean reverting process, indicating that the Federal Reserve's has credibly committed to their inflation target. We should expect policymakers will maintain such credibility if they continue to react to inflation shocks with offsetting policy.

Friday, March 18, 2016

Bernanke: What Tools Does the Fed Have Left? Part 1: Negative Interest Rates

Ben Bernanke:

What tools does the Fed have left? Part 1: Negative interest rates: The U.S. economy is currently growing and creating jobs, a situation I hope and expect will continue. We can’t rule out the possibility, though, that at some point in the next few years our economy will slow, perhaps significantly. How would the Federal Reserve respond? What tools remain in the monetary toolbox? In this and a subsequent post I’ll discuss some policy options the Fed might consider, focusing first on negative interest rates. ...
To anticipate, I’ll conclude in these two posts that the Fed is not out of ammunition, and that monetary policy could help cushion a possible future slowdown. That said, there are signs that monetary policy in the United States and other industrial countries is reaching its limits, which makes it even more important that the collective response to a slowdown involve other policies—particularly fiscal policy. A balanced monetary-fiscal response would both be more effective and also reduce the need to use unconventional monetary tools. ...

Thursday, March 17, 2016

'The Fed and the Quest to Raise Rates'

This, from Dean Baker, is similar to what I was trying to say:

The Fed and the Quest to Raise Rates: The Federal Reserve Board’s Open Market Committee (FOMC) voted not to raise interest rates at today’s meeting, but their statement indicates that they are still very much looking toward further rate hikes this year. It is difficult to see reason for this urgency.
The justification for raising rates is to prevent inflation from getting out of control, but inflation has been running well below the Fed’s 2.0 percent target for years. ... In fact, since wages badly lagged productivity growth during the recession, the Fed should be prepared to allow for a period in which real wage growth slightly outpaces productivity growth in order to restore the pre-recession split between labor and capital. If preemptive steps are taken by the Fed in the near future that prevent workers from regaining their share of national income, that implies the use of the Fed’s power to make permanent the shift from wages to profits that took place in the recession.    
The most recent data provide much more reason for concern that the economy is slowing more than inflation is accelerating. Nominal retail sales declined in both January and February. Construction is at best mixed with residential construction being close to flat in recent months and private non-residential construction falling slightly in recent months. The continuing rise in the trade deficit is a further drag on growth. In the current environment, it is difficult to argue that the economy is growing too rapidly and that the Fed must slow growth.   

On the inflation side, there is little prospect that the core inflation rate will even reach 2.0 percent. ...

In addition to the lack of any noticeable price inflation, there is no clear upward trend in wage growth. In fact, the most recent data suggest a modest slowing of wage growth. ...

Furthermore, there are many other measures indicating that there continues to be considerable slack in the labor market despite the relatively low unemployment. There are no plausible explanations for the sharp drop in the employment rate of prime-age workers at all education levels from pre-recession levels, apart from the weakness of the labor market. The amount of involuntary part-time employment continues to be unusually high in spite of recent declines. And the duration measures of unemployment spells and the share of unemployment due to voluntary quits are both much closer to recession levels than business cycle peaks.

In short, there seems little justification for the Fed’s desire to raise interest rates. With no evidence of inflation posing a problem any time soon, the Fed should be looking to boost the economy rather than slow it.

The Fed Should Allow Wages to Rise

At MoneyWatch:

Why the Fed should allow wages to rise, by Mark Thoma: On Wednesday, the Federal Reserve's Open Market Committee announced its decision to leave its target interest rate unchanged. I believe that was a wise decision. However, the committee noted that labor market conditions will be a key part of its decisions about future rate increases:

A range of recent indicators, including strong job gains, points to additional strengthening of the labor market. ...
The Committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market indicators will continue to strengthen. ...
In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. ...

In assessing the need for future rate increases, it's important to take a closer look at one component of labor market conditions: how wage increases have been distributed. In 2015, wages increased by 2.2 percent, enough to outpace inflation over that period by a small margin, and wages have continued to rise at close to this rate, but how has that growth been distributed?

According to a recent analysis by the Economic Policy Institute, the growth in wages adjusted for inflation, or alternatively, wages and benefits adjusted for inflation, has been concentrated among those at the top of the income distribution since the onset of the Great Recession (chart below). ...

Wednesday, March 16, 2016

No Change in the Fed's Target Interest Rate

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

Press Release, Release Date: March 16, 2016: Information received since the Federal Open Market Committee met in January suggests that economic activity has been expanding at a moderate pace despite the global economic and financial developments of recent months. Household spending has been increasing at a moderate rate, and the housing sector has improved further; however, business fixed investment and net exports have been soft. A range of recent indicators, including strong job gains, points to additional strengthening of the labor market. Inflation picked up in recent months; however, it continued to run below the Committee's 2 percent longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market indicators will continue to strengthen. However, global economic and financial developments continue to pose risks. Inflation is expected to remain low in the near term, in part because of earlier declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further. The Committee continues to monitor inflation developments closely.
Against this backdrop, the Committee decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent. The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation. ...

I'll have more to say about this tomorrow at CBS MoneyWatch.

Monday, March 14, 2016

'The Real Reason to Worry About China'

Narayana Kocherlakota:

The Real Reason to Worry About China: The world's largest currency union contains about 1.7 billion people and accounts for more than a third of global economic output. It also may be headed for a breakup...
I’m talking, of course, about the U.S. and China. For more than 20 years, China has kept the yuan's value against the dollar in a very tight range. ... 
Over the past couple decades, China has been able to offset the effects of Fed policy by varying its relatively large level of public investment. It has always been clear, though, that China would no longer want to use fiscal policy in this way once its economy was sufficiently developed. The country's currency moves over the past few months suggest that it might have reached this point. ...
Any such breakup presents a big problem: Many businesses and financial institutions have entered into contracts that make sense only under the premise that the exchange rate is not going to vary much over time....
As far as I can tell, U.S. economic policymakers aren’t putting much emphasis on the potential repercussions of a break-up of the China-US currency union. ... There's a significant risk that if the Fed keeps tightening in 2016, it could force an abrupt break-up. The resultant disorder in the world economy would not serve Americans well.

Thursday, March 10, 2016

'China’s Trilemma—and a Possible Solution'

Just say no to monetary policy:

China’s trilemma—and a possible solution, by Ben Bernanke, Brookings Institution: China’s central banker, Zhou Xiaochuan of the People’s Bank of China (PBOC), and other top Chinese officials recently launched a communications offensive to persuade markets and foreign policymakers that no significant devaluation of the Chinese currency is planned.[1] Is the no-devaluation strategy a good one for China? If it is, what does China need to do to make its exchange-rate commitments credible? ...
China faces the classic policy trilemma of international economics, that a country cannot simultaneously have more than two of the following three: (1) a fixed exchange rate; (2) independent monetary policy; and (3) free international capital flows. Accordingly, China’s ability to manage its exchange rate may depend, among other factors, on its willingness and ability to adjust on other policy margins.

...[discussion of the costs and benefits of various options] ...
So what to do? An alternative worth exploring is targeted fiscal policy, by which I mean government spending and tax measures aimed specifically at aiding the transition in China’s growth model. (Spending on traditional infrastructure like roads and bridges is not what I have in mind; in the Chinese context, that’s part of the old growth model.) For example, as China observers have noted, the lack of a strong social safety net—the fact that Chinese citizens are mostly on their own when it comes to covering costs of health care, education, and retirement—is an important motivation for China’s extraordinarily high household saving rate. Fiscal policies aimed at increasing income security, such as strengthening the pension system, would help to promote consumer confidence and consumer spending. Likewise, tax cuts or credits could be used to enhance households’ disposable income, and government-financed training and relocation programs could help workers transition from slowing to expanding sectors. Whether subsidies to services industries are appropriate would need to be studied; but certainly, unwinding existing subsidies to heavy industry and state-owned enterprises, together with efforts to promote entrepreneurship and a more-level playing field, would be constructive.
There are recent indications China might be moving this direction. ...
Targeted fiscal action has a lot to recommend it, given China’s trilemma. Unlike monetary easing, which works by lowering domestic interest rates, fiscal policy can support aggregate demand and near-term growth without creating an incentive for capital to flow out of the country. At the same time, killing two birds with one stone, a targeted fiscal approach would also serve the goals of reform and rebalancing the economy in the longer term. Thus, in this way China could effectively pursue both its short-term and longer-term objectives without placing downward pressure on the currency and without new restrictions on capital flows. It’s an approach that China should consider.

Tuesday, March 08, 2016

The 'Strong Case' Against Central Bank Independence Critically Examined

Simon Wren-Lewis has a follow-up to his recent post on central bank independence:

The 'strong case' critically examined: Perhaps it was too unconventional setting out an argument (against independent central banks, ICBs) that I did not agree with, even though I made it abundantly clear that was what I was doing. It was too much for one blogger, who reacted by deciding that I did agree with the argument, and sent a series of tweets that are best forgotten. But my reason for doing it was also clear enough from the final paragraph. The problem it addresses is real enough, and the problem appears to be linked to the creation of ICBs.

The deficit obsession that governments have shown since 2010 has helped produce a recovery that has been far too slow, even in the US. It would be nice if we could treat that obsession as some kind of aberration, never to be repeated, but unfortunately that looks way too optimistic. The Zero Lower Bound (ZLB) raises an acute problem for what I call the consensus assignment (leaving macroeconomic stabilisation to an independent, inflation targeting central bank), but add in austerity and you get major macroeconomic costs. ICBs appear to rule out the one policy (money financed fiscal expansion) that could combat both the ZLB and deficit obsession. I wanted to put that point as strongly as I could. Miles Kimball does something similar here, although without the fiscal policy perspective ...

Skipping ahead (and omitting quite a bit of the argument):

... The basic flaw with my strong argument against ICBs is that the ultimate problem (in terms of not ending recessions quickly) lies with governments. There would be no problem if governments could only wait until the recession was over (and interest rates were safely above the ZLB) before tackling their deficit, but the recession was not over in 2010. Given this failure by governments, it seems odd to then suggest that the solution to this problem is to give governments back some of the power they have lost. Or to put the same point another way, imagine the Republican Congress in charge of US monetary policy.

But if abolishing ICBs is not the answer to the very real problem I set out, does that mean we have to be satisfied with the workarounds? One possibility that a few economists like Miles Kimball have argued for is to effectively abolish paper money as we know it, so central banks can set negative interest rates. Another possibility is that the government (in its saner moments) gives ICBs the power to undertake helicopter money. Both are complete solutions to the ZLB problem rather than workarounds. Both can be accused of endangering the value of money. But note also that both proposals gain strength from the existence of ICBs: governments are highly unlikely to ever have the courage to set negative rates, and ICBs stop the flight times of helicopters being linked to elections.       
These are big (important and complex) issues. There should be no taboos that mean certain issues cannot be raised in polite company. I still think blog posts are the best medium we have to discuss these issues, hopefully free from distractions like partisan politics.

Monday, March 07, 2016

Fed Watch: State of Play

Tim Duy:

State of Play: We are heading into the March FOMC meeting next week. The recessionistas are on the sidelines, waiting for data to turn in their favor. I suspect they have a long wait. In the meantime, FOMC participants will hone their arguments as they prepare for what is likely to be a contentious meeting. At stake is not a decision of rates; they will hold steady. At stake is a decision on the balance of risks. Do they want to send a dovish, neutral, or hawkish signal for the April and June meetings? I expect them to default to the neutral/dovish side. I don’t think there is sufficient weight on the hawkish side of the FOMC to drive an aggressive rate signal at this juncture. 
Labor markets shook off the January “slowdown” with nonfarm payrolls rising an above-consensus 242k. The twelve-month trend is slowing, but ever-so-gradually:

NFP030416

The unemployment rate held constant near the Fed’s estimate of the natural rate:

UN030416

This is actually good news, as it reflects a faster pace of labor force growth:

LF030416

The labor force participation rate is now 0.5 percentage points above its September low. Assuming this trend will continue, the US economy can sustain fairly strong job growth while unemployment rates drift lower very gradual, in line with the Fed’s expectations. It would also give the Fed a bit more breathing room with regards to raising rates. And it would help boost potential GDP growth as it helps offset weakness in productivity growth. 
Incoming data, including the inflation uptick, will solidify the positions of those FOMC participants opposed to an extended pause. A fairly clear split emerged in recent weeks. David Harrison at the Wall Street Journal:
The report likely will accentuate a growing split among Fed officials. On one side are regional Fed bank presidents such as San Francisco’s John Williams, Richmond’s Jeffrey Lacker and Kansas City’s Esther George who continue to press for rate increases this year. In the other camp are policy makers who prefer to take a more cautious approach and wait until the effects of the global financial turmoil and the fall in oil prices have played themselves out. Count the Dallas Fed’s Robert Steven Kaplan, Boston’s Eric Rosengren and Philadelphia’s Patrick Harker among them.
And to be sure, the Fed will have its external critics as well. Drew Matus, chief US economist at UBS, told Bloomberg Surveillance that the Fed will “take the cowards way out” by not raising interest rates in the first half of this year. 
I don’t find this a compelling interpretation. If you are a “coward” by definition you are not “brave.” And one should remember there is a fine line between “brave” and “foolhardy.” I suspect that Federal Reserve Chair Janet Yellen will wisely follow Falstaff’s advice and recognize that discretion is the better part of valor. True, one can argue that some financial indicators have stabilized since the January FOMC meeting:

FIN030416

To be sure stocks and oil are off their lows, while the dollar is off its highs. Even market-based inflation expectations are heading back up. Panic has subsided. On the surface, that may add weight to the argument that the Fed should “just follow the data.” But corporate bond spreads, although narrowing, still indicate fairly tight credit conditions:

BAML030416

This is on top of a very cold IPO market. So while incoming data points toward solid growth in Q1, the Fed still needs to stand down while the lagged impacts of this winter’s financial tightening pass through to the real economy. Discretion. Yes, this does put the Fed at risk of falling behind the curve. A dovish Fed now on the back of an improving economy suggests that the yield curve will steepen in the near term. If necessary, the Fed can chase that with a higher fed funds rate in the back half of the year. 
Also suggesting caution on the part of the Fed is a renewed awareness of the sensitivity of global financial flows to the Fed’s policy stance. Federal Reserve Governor Lael Brainard:
Financial tightening associated with cross-border spillovers may be limiting the extent to which U.S. policy diverges from major economies. As policy adjusts to the evolution of the data, the combination of heightened spillovers from weaker foreign economies, along with a lower neutral rate, could result in a lower policy path in the United States relative to what many had predicted…
And New York Federal Reserve President William Dudley:
Our monetary policy actions, however, often have global consequences that, in turn, influence the U.S. economy and financial markets. At the same time, external factors can impact the monetary policy transmission mechanism in the U.S. and influence the effectiveness of our monetary policy in achieving our objectives. We cannot appropriately calibrate policy without keeping these spillover and feedback effects in mind.
The degree to which the Federal Reserve can tighten short-term rates is limited by the extent of global feedback effects. In short, the Fed has limited capacity to defy the pattern of zero (or negative) rates abroad. 
Overall, I don’t believe a Federal Reserve pause is inconsistent with the data. All it takes is the realization that financial market outcomes are in fact data. Ultimately just prices and quantities of bonds and stocks and other assets – data just like any other data that measure prices and quantities of labor or goods. Data that provides insight into the direction of the economy. Or, as Dudley explained:
The federal funds rate is only one element of the broader set of financial conditions affecting the U.S. growth and inflation outlook. Tighter financial conditions abroad do spill back into the U.S. economy, and policymakers must take this into account in their assessment of appropriate monetary policy. Of course, this does not mean that we will let market volatility dictate our policy stance. There is no such a thing as a “Fed put.” What we care about is the country’s growth and inflation prospects, and we take financial market developments into consideration only to the extent that they affect the economic outlook.
Still, I am sympathetic to complaints of communication confusion. Harrison concludes his article:
Fed officials, chief among them Ms. Yellen, have repeated for months that their interest-rate decisions will depend on the economic data. It could be harder to make that case if it appears the central bank is acting contrary to increasingly strong data.
The Summary of Economic Projections is a woefully incomplete description of the Fed’s reaction function. It attempts to distill the Fed’s reaction function into a simple Taylor rule that abstracts away from financial sector. In other words, it does not capture the role of the financial sector in the Fed’s reaction function. And I think it fails to do so because of complex endogeneities involved (the Fed is in integral part of the financial sector) and, as a consequence, a lack of consensus about the implications for the Fed’s reaction function. 
Indeed, Cleveland Federal Reserve President Loretta Mester, Kansas City Federal Reserve President Esther George, San Francisco Federal Reserve President John Williams, and Board of Governors Vice Chair Stanley Fischer all appear to discount the importance of the Fed’s financial reaction function (see here and here for example). Brainard and Dudley clearly see a more complex relationship. 
Where does Yellen stand? My sense is that six month ago Yellen’s position would align close to Fischer. But I think she would now find Brainard’s position more persuasive, especially with Dudley’s support. That suggests that the Yellen will work to pull the Fed toward a neutral/dovish statement.
Bottom Line: Fed will hold steady next week. Key FOMC participants are shifting in a dovish direction. The financial market volatility, which induced clear tightening in financial conditions, bolstered the Brainard’s arguments. Despite solid incoming data, the Fed will find it necessary to tread cautiously in the months ahead.

Wednesday, March 02, 2016

'Four Common-Sense Ideas for Economic Growth'

Larry Summers:

Four common-sense ideas for economic growth: Let me begin with two facts that I think should be cause for concern. First, since the summer of 2009, the US economy has grown at about 2 percent. Two percent isn't a very good growth rate. Second, the 10-year interest rate at the end of trading today ... was just a bit below 1.8 percent. ...
What’s the way to think about these two facts together? I believe that we are dealing with a situation that goes beyond the usual cyclical issues associated with recession—and for many years the policy debate has been confounded by that. The Fed has been substantially too optimistic in its one-year-ahead forecast every year for the last six, and its forecasts are pretty close to the consensus forecasts. The prevailing expectation in markets has always been that significant tightening will take place in nine months. That’s been true for the last six years. It has not happened yet.
If you accept all of this, what should be done? I would suggest four things at a minimum. First, there is an overwhelming case in the United States for expanded public infrastructure investment. ... It’s hard to imagine a better time for expanded infrastructure investment, yet the rate of infrastructure investment is lower now than it’s been anytime since 1947. ...
Second, we should increase support for private investment in infrastructure. ...
Third, we should grow our effective labor force. ...
Fourth, our financial system requires continuing attention. ...
I would say to you that whatever you care about, if all you care about is that we’ve got an excessive federal debt, the most important determinant of the debt-to-GDP ratio in 2030 is how rapidly the economy grows between now and then. If what you care about is American national security, the most important determinant of how much we are respected and how much influence we have in the world is how well our economy performs. If what you care about is inequality and poverty, the most important determinant of the employment prospects of the poor is how rapidly the economy is growing.
I would suggest to you that there is no more important question for the American prospect than accelerating the rate of economic growth. It seems to me, whether you’re a demand sider or a supply sider, a Democrat or a Republican, there’s a great deal of common sense that should lead you to support increased economic growth.

[There is quite a bit of discussion of each point in the full post.]

Fed Watch: Dudley the Dove

Tim Duy:

Dudley the Dove, by Tim Duy: The beleaguered manufacturing sector saw an uptick in February, at least according to the ISM report: 

This information builds on the stronger consumer spending and inflation numbers we saw last week. Not to mention solid auto sales for February. The news is sufficiently good that Torsten Sløk of Deutsche Bank argues (via Business Insider) that the Fed should raise rates:
Today we got more confirmation that the negative effects of dollar appreciation on the US economy are starting to fade, see the first chart below. Specifically, we have in recent months seen a solid turnaround in the employment data for the manufacturing sector and in the manufacturing ISM. Combined with the acceleration we are seeing in consumer spending and inflation I would argue that if the Fed is truly data dependent then they should be raising rates at their next meeting...
I don't think the Fed will raise in March, nor do I think they should raise in March. I think the financial markets signaled fairly clear that further tightening now would be a mistake. The Fed would be wise to heed that call.
And, if New York Federal Reserve President William Dudley is any indication, they will heed that call. Indeed, he goes even further than me. Whereas yesterday I raised the possibility of a "hawkish pause" at the March meeting where the Fed revives the balance of risks with an upside bias, he opens the door to the opposite.
First, note that Dudley appears unmoved by the uptick in core inflation:
Turning to the outlook for inflation, headline inflation on a year-over-year basis has begun to rise as the sharp falls in energy prices in late 2014 and early 2015 are removed from the calculations. However, inflation still remains well below the Federal Reserve’s 2 percent objective. As the FOMC has noted in its statements, this continued low inflation is partly due to recent further declines in energy prices and ongoing impacts of a stronger dollar on non-energy import prices. Although energy prices will eventually stop falling and the dollar will stop appreciating, these factors appear to have had a more persistent depressing influence on inflation than previously anticipated.
This is actually quite dovish. If core inflation is a good signal for the direction of overall inflation, then the latter will leap sharply when the "transitory" impacts fades. This suggests to me that the forecast of a gradual return to target is almost certainly wrong. When (and if) inflation turns, it will turn quickly. Dudley is discounting that possibility.  
I suspect he is discounting inflation concerns because he is focussed on inflation expectations:
This continued period of low headline inflation is a concern, in part, because it could lead to significantly lower inflation expectations. If this drop in inflation expectations were to occur, it would, in turn, tend to depress future inflation. Evidence on the inflation expectations front suggests some cause for concern...
...With respect to the market-based measures, there are some reasons to discount the decline...Still, given the extent to which inflation compensation has fallen since mid-2014, I believe that it is prudent to consider the possibility that longer-term inflation expectations of market participants may have declined somewhat.
What I find more concerning is the decline in some household survey measures of longer-term inflation expectations....To date, these declines have not been sufficiently large for me to conclude that inflation expectations have become unanchored. However, these developments merit close scrutiny, as past experience shows that it is difficult to push inflation back up to the central bank’s objective if inflation expectations fall meaningfully below that objective. Japan’s experience is cautionary in this regard.
Asymmetric risk surrounds inflation expectations. Difficult to raise up, but easy to push down. Hence, it is important to guard against falling expectations. This is especially the case as he sees risks to the outlook as now tilted to the downside:
Now, putting these inputs and my judgment together, I see the uncertainties around my forecast to be greater than the typical levels of the past. This assessment reflects the divergent economic signals I highlighted earlier, and is consistent with the turbulence we have seen in global financial markets. At this moment, I judge that the balance of risks to my growth and inflation outlooks may be starting to tilt slightly to the downside. The recent tightening of financial market conditions could have a greater negative impact on the U.S. economy should this tightening prove persistent and the continuing decline in energy and commodity prices may signal greater and more persistent disinflationary pressures in the global economy than I currently anticipate. I am closely monitoring global economic and financial market developments to assess their implications for my outlook and the balance of risks.
Hence Dudley is likely to stand as a bulwark against FOMC participants who think the Fed should hike in March and those who would like a more optimistic balance of risks. Moreover, this is a pretty clear signal of his expectations for March:
The federal funds rate is only one element of the broader set of financial conditions affecting the U.S. growth and inflation outlook. Tighter financial conditions abroad do spill back into the U.S. economy, and policymakers must take this into account in their assessment of appropriate monetary policy. Of course, this does not mean that we will let market volatility dictate our policy stance. There is no such a thing as a “Fed put.” What we care about is the country’s growth and inflation prospects, and we take financial market developments into consideration only to the extent that they affect the economic outlook.
In other words, when we don't hike in March, it's not because of a Fed "put" on the stock market. It is more accurately a Fed "put" on the economy. Financial market weakness signals tighter financial conditions, and to prevent those conditions from spilling into the rest of the economy, the Fed needs to respond with a more accommodative policy stance. The Fed then is not saving Wall Street. It is saving Main Street from Wall Street.
The upshot is that if the economy remains on firm ground (the "no recession" camp), inflation is heating up, and the Fed goes solidly dovish, we should see the yield curve steepen in the near term, at least until the Fed turns hawkish again. If we are really lucky, the secular stagnation story is wrong and the entire yield curve lifts up as the Fed chases higher rates. Then we could really imagine the "short treasuries" bet to be a no-brainer.  If secular stagnation remains the order of the day, then the long end quits rising soon after the Fed sends out hawksh signals, setting the stage for a renewed flattening. 
An interesting possibility is that in the back half of 2016, inflation pops above trend and one of the Fed's fears is realized. That fear is that they fall behind the curve and need to raise rates quickly to counteract rising inflation. They seem to think that they have no choice at that point but to murder the expansion. I disagree with that conclusion. I think they tend to forget about the long and variable lags of policy at the end of the cycle and consequently rush raising rates needlessly. In any event, how they respond to (potentially) higher inflation later this year will shape the 2017 and 2018 economic environment. So, obviously it is something to keep an eye on.
Bottom Line: The Fed will take a pass on the March meeting. Whether the statement is dovish, neutral, hawkish is the key question. Dudley opens up the possibility of a not just a neutral statement, but a dovish one. My sense is that this is shaping up to be a very contentious meeting as participants struggle with the question of exactly which data are they dependent upon.

Tuesday, March 01, 2016

'How Low Can They Go?'

Cecchetti & Schoenholtz:

How Low Can They Go?: Not long ago, nearly everyone thought that nominal interest rates could not go below zero. Now, we have negative policy rates in the euro area and Japan, while in Sweden and Switzerland, the lowest controlled rate is below -1%. And government securities worth trillions of dollars bear negative rates, too. ...

Skipping past the detailed explanation:

... The bottom line: international experience suggests that negative interest rates, at least as low as we are seeing today and (in some places) significantly lower, will become a permanent part of the monetary policy toolkit. If that’s right, we need not worry quite so much whether a 2% inflation target is too low.

Monday, February 29, 2016

Fed Watch: Fed Doves Still Have The Upper Hand For March

Tim Duy:

Fed Doves Still Have The Upper Hand For March, by Tim Duy: The Personal Income and Outlays report for January delivered a surprise for the Fed doves. It does not, however, derail their push for a March pause. I believe policymakers will still take a pass on the March meeting as they assess the impact of recent market unpleasantness. But if markets calm further ahead of the March meeting and data remains solid, beware that they may choose to re-instate the balance of risks into the FOMC statement. Furthermore, sufficiently supportive data may induce them to shift the risks to the upside to signal the hope of a June hike.
Real personal consumption expenditures rose 0.4% in January and stands a respectable 2.9% higher than last year. The death of the consumer has been greatly exaggerated (although the death of the department store has not). Fairly firm consumer spending should be expected given the broad-based support from the labor market. Equally if not more important is that the report rewarded the defenders of the Phillips curve as core-PCE inflation spiked higher during the month:

PRICES22916

Core inflation was up 1.7 percent from a year ago, actually bringing the FOMC's target into view. Note that as of the December meeting, the Fed did not expect to see 1.6 percent until the end of the year. It is easy to see unemployment close to their year-end target of 4.7 percent by the next meeting. It is already at 4.9 percent. In other words, it is easy to see economic projections updated to reveal a faster than expected return to both mandates.

It seems then like the Fed should consider picking up the pace of rate hikes rather than pausing. Indeed, there is some commentary that the current level of interest rates is inconsistent with the expected path of growth and inflation. This is sometimes described as Treasury market participants "underestimating" the Fed. Fed Governor Lael Brainard, however, continues to reconcile this apparent disconnect between the bond market and the economy with her focus on the international side of the equation. In yet another compelling speech, Brainard argues that the decline in the neutral rate of interest is a common shock that prevents policy diversion:

To the extent that we are observing limited divergence in inflation outcomes and less divergence in realized policy paths than many anticipated, this could be attributable to common shocks or trends that cause economic conditions to be synchronized across economies. The sharp repeated declines in the price of oil have been a major common factor depressing headline inflation...Even so, most observers expect this source of convergence in inflationary outcomes to eventually fade and thereafter not affect monetary policy paths over the medium term...In contrast, a more persistent source of convergence may be found in an apparent decline in the neutral rate of interest.

The persistent of this shock has significant implications for policy:

The very low levels of the shorter run neutral rate reflect in part headwinds from the crisis that are likely to dissipate over time. However, if many of the common forces holding down neutral rates prove persistent, then neutral rates may remain low through the medium term, implying a shallower path for policy trajectories.

It seems reasonable to equate the "persistent" common shock weighing on the natural rate of interest with the concept of secular stagnation. She reiterates estimates of the degree of tightening already impacting the US economy:

...although the U.S. real economy has traditionally been seen as more insulated from foreign trade shocks than many smaller economies, the combination of the highly global role of the dollar and U.S. financial markets and the proximity to the zero lower bound may be amplifying spillovers from foreign financial conditions. By one rough estimate, accounting for the net effect of exchange rate appreciation and changes in equity valuations and long term yields, over the past year and a half, the United States has experienced a tightening of financial conditions that is the equivalent of an additional increase of over 75 basis points in the federal funds rate...

...Financial channels can powerfully propagate negative shocks in one market by catalyzing a broader reassessment of risks and increases in risk spreads across many financial markets...Recent events suggest the transmission of foreign shocks can take place extremely quickly such that financial markets anticipate and indeed may thereby front-run the expected monetary policy reactions to these developments.

In other word, market participants are correctly assessing the Fed's response to recent turmoil by anticipating a slower path of rate hikes. Or, as I have said, the Fed has to be easier because everything else is tighter. Brainard draws special attention to the exchange rate (emphasis added):

It also appears that the exchange rate channel may have played a particularly important role recently in transmitting economic and financial developments across national borders. Indeed, recent research suggests that financial transmission is likely to be amplified in economies with near-zero interest rates, such that anticipated monetary policy adjustments in one economy may contribute more to a shifting of demand across borders than a boost to overall demand. This finding could explain why the sensitivity of exchange rate movements to economic news and to changes in foreign monetary policy appear to have been relatively elevated recently.

Read that carefully. She is saying that at the zero bound, the domestic impact of monetary policy is limited, leaving external demand as the primary policy channel. Hence exchange rates shift rapidly to induce that shifting of demand.

Or, in other words, Brainard is saying that at the zero bound monetary policy degrades to currency wars. Chew on that admission for awhile.

The implication for US policy:

Financial tightening associated with cross-border spillovers may be limiting the extent to which U.S. policy diverges from major economies. As policy adjusts to the evolution of the data, the combination of heightened spillovers from weaker foreign economies, along with a lower neutral rate, could result in a lower policy path in the United States relative to what many had predicted.

Pulling away from the zero bound is easier said than done. The Fed cannot lift the rest of the world from the zero bound; the rest of the world drags the Fed to the zero bound.

How does this relate to the idea that market participants are underestimating the Fed? I see two paths. One is that Brainard's "common shock" lowering the neutral rate of output is very persistent. Hence small changes to short-term rates have substantial economic impacts and the Fed needs to be very cautious in their response to inflation. In this scenario, the yield curve continues to flatten just as in any other tightening cycle. There is little movement in the long-end because market participants anticipate that the Fed has little room to maneuver.

Alternatively, the common shock dissipates, the long-end of the yield curve rises, and the Fed chases it with a faster than expected pace of rate hikes. I do not view this as a best on the markets underestimating the Fed. I view this as a bet against secular stagnation (the common shock).

It is worth pointing out at this juncture that shorting the long end (once thought a no brainer) has been something of a widowmaker trade. Just like it has been for Japanese government bonds.

If you accept the secular stagnation hypothesis and that the Fed will need to tighten in response to higher inflation, then expect long rates to hold flat or more likely decline as short rates rise. In other words, the yield curve would flatten further. Note that the yield curve has flattened per usual after the Fed began tightening.

So how I do interpret the incoming information of recent weeks as it regards at least near term policy? As follows:

  1. The rise in wage growth and now inflation is consistent with an economy near full-employment. In this dimension, the world is not much different than it has always been. Push unemployment low enough and resource constraints start to bite.
  2. Fed hawks will argue vociferously that they will soon fall behind the curve, if they have not already. Even some moderates will push for higher rates sooner than later. Here I am thinking of Fed Vice Chair Stanley Fischer.
  3. Federal Reserve Chair Janet Yellen will be swayed by Brainard to a dovish position in the near term. Brainard correctly called the importance of the external transmission channels last year. Those channels are forcing the Fed to lower the path of rate hikes in response by skipping at least the March meeting. And incoming data is largely backward looking; the Fed needs time to assess the impact of recent tightening in financial markets.
  4. I don't expect Fed hawks to go quietly into the night on this. I think they will want something in return for pausing, and that solid incoming data with a whiff of inflation will prompt them to revive the balance of risks.
  5. Unless growth does slow down dramatically, delaying rate hikes now means, as the Fed sees it, falling behind the curve later this year (remember that the push for raising rates in 2015 was premised on the need to be able to raise slowly ahead of inflation). The Fed will then have a choice between accepting a greater risk of above target inflation or accelerating the pace of rate hikes. I don't know which way that debate will fall yet.

Bottom Line: Inflation concerns are not likely to prompt a the Fed to hike rates in March. Financial market issues will dominate; like it or not, the Fed cannot separate the financial system from the real economy. The former is signaling it requires a looser policy stance to compensate for the stronger dollar. It would be tempting fate to ignore that signal. Be wary, however, of a hawkish message sent through the statement.

Thursday, February 25, 2016

Fed Watch: Lacker, Kaplan, Fischer

Tim Duy:

Lacker, Kaplan, Fischer, by Tim Duy: Today Richmond Federal Reserve President Jeffrey Lacker argued that the case for rate hikes remains intact, arguing that monetary policy remains quite accommodative:
So at this point, estimates of the natural real rate of interest do not suggest that the zero lower bound is impeding the Fed’s ability to attain its 2 percent inflation objective. In fact, this perspective would bolster the case for raising the federal funds rate target.
And in he is quoted by Reuters adding:
Ongoing strength in the U.S. job market could give the Federal Reserve justification for multiple interest rate increases this year, Richmond Fed President Jeffrey Lacker said on Wednesday...
.."I still think prospects for rate increases this year is the logical" view, Lacker said in a presentation to a business school in Baltimore, adding that economic data did not indicate that a recession was imminent in the United States.
If Lacker were still voting this year, he would likely be a serial dissenter. On the opposite side of the table sits Dallas Federal Reserve President Robert Kaplan. In an interview with the Financial Times, Kaplan leans very dovish:
Now was a time for patience as the Federal Reserve seeks to understand the impact of financial market turbulence and slowing growth in other economies, said Mr Kaplan, who does not vote on Fed rates this year but takes part in the debate.
“In order to reach our inflation objective we may need to be more patient than we previously might have thought,” he said. “If that means we take an extended period of time where we stop and don’t move, that may also be necessary. I am not prejudging that.”
Pure wait-and-see, risk management mode, and the most likely direction the Fed will take in March and April. Federal Reserve Vice Chair Stanley Fischer remains less-moved by recent developments. Instead, low unemployment rates capture his attention (emphasis added):
..most estimates of the full employment rate of unemployment are close to 5 percent. The actual rate of unemployment is now slightly below 5 percent, and the median view of the members of the FOMC is that it will decline further, perhaps even to the vicinity of 4.7 percent. The question is, should we be concerned about that possibility? In my view, a modest overshoot of this sort would be appropriate in current circumstances for two reasons. The first reason is that other measures of labor market conditions--such as the fraction of workers with part-time employment who would prefer to work full time and the number of people not actively looking for work who would like to work--indicate that more slack may remain in the labor market than the unemployment rate alone would suggest. And the second reason is that with inflation currently well below 2 percent, a modest overshoot could actually be helpful in moving inflation back to 2 percent more rapidly. Nonetheless, a persistent large overshoot of our employment mandate would risk an undesirable rise in inflation that might require a relatively abrupt policy tightening, which could inadvertently push the economy into recession. Monetary policy should aim to avoid such risks and keep the expansion on a sustainable track.
Unemployment is currently at 4.9 percent. It doesn't take much imagination to see it falling to 4.7 percent in short order. Fischer sounds very uncomfortable with the prospect of the unemployment rate falling much below 4.7%. He is getting an itchy trigger finger.
I remain unmoved by this logic:
If the recent financial market developments lead to a sustained tightening of financial conditions, they could signal a slowing in the global economy that could affect growth and inflation in the United States. But we have seen similar periods of volatility in recent years--including in the second half of 2011--that have left little visible imprint on the economy, and it is still early to judge the ramifications of the increased market volatility of the first seven weeks of 2016. As Chair Yellen said in her testimony to the Congress two weeks ago, while "global financial developments could produce a slowing in the economy, I think we want to be careful not to jump to a premature conclusion about what is in store for the U.S. economy."
This echoes the comments of San Francisco Federal Reserve President John Williams, and again misses the Fed's response to financial turmoil. In 2011, it was Operation Twist. One would think they would keep a chart like this on hand:

SP22316

I really do not understand how Fed officials can continue to dismiss market turmoil using comparisons to past episodes when those episodes triggered a monetary policy response. They don't quite seem to understand the endogeneity in the system.
My sense is that there remains a nontrivial contingent within the Fed that really, truly believes they need to hike sooner than later for fear that overshooting the employment mandate will result in overshooting the inflation target. This contingent is attempting to look at the financial system as separate from the "real" economy. That will not work. No matter how good the underlying fundamentals, if you let the financial system implode, it will take the economy down with it. I don't know that the Fed needs to cut rates, or that they needed to cut rates as deeply as they did during the Asian Financial crisis, but I do know this: The monetary authority should not tighten into financial turmoil. Wait until you are out of the woods. That's Central Banking 101. And I suspect that is ultimately the direction the Fed will take.
Bottom Line: Despite some hawkish talk, the Fed will find themselves in risk management mode at the March meeting. Some will not like it. There will remain a contingent that fears standing still risks excessive overshooting of the inflation target.

Wednesday, February 24, 2016

Fed Watch: Not All Fed Presidents On Board With March Pause

Tim Duy:

Not All Fed Presidents On Board With March Pause: The Fed will almost certainly pause in March. But not all Fed presidents are leaning that way. And at least one seems to be shifting closer to March than further away. At the end of January, San Francisco Federal Reserve President John Williams had this to say, via Reuters:
San Francisco Federal Reserve Bank President John Williams told reporters he now sees slightly slower growth, slightly higher unemployment, and about a tenth of a percent lower inflation this year than he had expected in December, when the Fed raised rates for the first time in nearly a decade...
..."Standard monetary policy strategy says a little less inflation, maybe a little less growth ... argue for just a smidgen slower process of normalizing rates," Williams said. 
"We got a little stronger dollar, some mixed data on the economy, some weakness in (fourth-quarter U.S. GDP growth), all of those coming together kind of tell me that we probably need a little bit more monetary accommodation this year than I was thinking in the middle of December."
But yesterday, the LA Times reported:
And unlike some of his colleagues at the Fed, who have suggested that the central bank hold off on raising interest rates next month, Williams says no such thing. The Fed lifted its benchmark rate in December after keeping it at near zero for seven years, but officials made no change at their last meeting in late January, amid tumbling stock and oil prices, and rising fears about China’s slowdown.
Williams, in an interview with the Los Angeles Times, said the recent global developments certainly need to be closely monitored. But he said the “big picture for me hasn’t changed,” and his view on U.S. employment and inflation — the two key areas determining the Fed’s monetary policy — remains sanguine.
Sounds like Williams is backing down from his "smidgen" slower pace of rate hikes. Of course, really the only way to have just a "smidgen" slower pace is to skip the March meeting and acquiesce to at most three rate hike this year. So if Williams is backing down, he is saying that March remains an open question. 
What would have changed his position? Data would be my guess. Since Williams spoke with reporters in January, the data has been fairly supportive. As he notes in his most recent speech, unemployment has fallen below 5%, his estimate of the natural rate of unemployment, and wage growth is starting to accelerate. Moreover, he still expects inflation will accelerate. I would add that initial unemployment claims turned back down:

CLAIMS021816

Quits rates rose in December, indicating more, not less, confidence among workers:

QUITS21816

Industrial production ticked up and weakness remains fairly concentrated:

IP021816

Retail sales were stronger than expected, knocking a hole in the "consumer is dying" story:

RETAIL21816

In addition, housing remains solid - and housing generally does not strengthen into a recession. Indeed, Toll Brothers is not exactly worried about the economy in 2016. And, to top it off, last week we saw more evidence of rising inflation in the CPI report:

PRICES21816

Hence I am not surprised to hear more optimism among Fed presidents than at the end of January. To be sure, some never wavered in their confidence. Kansas City Federal Reserve President Esther George today, via Bloomberg:
Federal Reserve policy makers should be prepared to consider raising interest rates in March despite recent financial market volatility, said Kansas City Fed President Esther George, whose outlook for solid growth this year remains intact.
“It absolutely should be on the table” at the next meeting, George told Pimm Fox and Kathleen Hays in a Bloomberg Radio interview Tuesday from the bank. “At this point I would not say that the data have suggested there has been a fundamental shift in the outlook.”
She even suggests that the Fed could surprise markets:
“It is clear the markets have taken that off the table,” said George, a voting member of the FOMC in 2016. “Policy makers have to look at what are the fundamentals of the economy.” Investors currently view the probability of a single rate rise in 2016 at around 45 percent, according to trading in federal funds futures contracts. The FOMC next meets on March 15-16.
That's not going to happen; the Fed will pause in March because ultimately they have to. The events since December have only bolstered the position of Federal Reserve Governor Lael Brainard, the strongest voice on the Board arguing for a cautious approach. That said, not all will see it this way. Back to Williams:
Of course, I am aware of, and closely monitoring, potential risks. But I want to be clear what that means. It’s often said that the economy isn’t the stock market and the stock market isn’t the economy. That’s very true. Short-term fluctuations or even daily dives aren’t accurate reflections of the state of the vast, intricate, multilayered U.S. economy. And they shouldn’t be viewed as the four horsemen of the apocalypse. Remember, the expansion of the 1980s wasn’t derailed by the crash of ’87, and we sailed through the Asian financial crisis a decade later. I say “remember”—some of you here will actually remember and others will remember it from your high school history class.
This paragraph was almost painful to read. Revisionist history. It is as if Williams completely forgets the role of monetary policy in both instances. What did the Fed do in November of 1987? Did they continue hiking rates? What did the Fed do in 1998? Did they continue hiking rates? No, in both instances they actually cut rates. And it was that monetary response that helped the economy "sail through" these episodes. 
The Fed will reach the same conclusion this time as well: Even if the economic data is solid and the recovery remains intact, there is reason to believe that tightening financial conditions alone give sufficient reason for the Fed to pause. The Fed knows this. From the January minutes:
Almost all participants cited a number of recent events as indicative of tighter financial conditions in the United States; these events included declines in equity prices, a widening in credit spreads, a further rise in the exchange value of the dollar, and an increase in financial market volatility. Some participants also pointed to significantly tighter financing conditions for speculative-grade firms and small businesses, and to reports of tighter standards at banks for C&I and CRE loans. The effects of these financial developments, if they were to persist, may be roughly equivalent to those from further firming in monetary policy.
These issues are not going away by March. Hence, risk management mode remains the order of the day.
Moreover, consider the situation from the perspective of Federal Reserve Chair Janet Yellen. You have no doubt that your actions at this point define your legacy. On one side is the risk that your policy traps the US economy at the zero bound. You are just another in a long line of failed central bankers who tried to normalize too soon. This risk has been brought into sharp relief in the past two months (Brainard warned you, you think). On the other side is the risk that inflation drifts above your 2% target but you raise the odds of pulling off the zero bound. And you know that if push comes to shove, you can always argue that a period of above-2% inflation only makes up for a extended period of sub-2% inflation. And that you need somewhat higher inflation to firm up faltering inflation expectations. Which risk do you want to embrace? I am guessing the second. That's what Yellen will choose.
Bottom Line: The Fed is on hold. No clear end to the pause. But be wary that some Presidents might want something in return for that pause. What I am watching for are signs that Fed officials will lean toward re-instating the balance of risks assessment to the post-FOMC statement. And which way would that assessment lean? That, I think, is the question I would like to see financial journalists asking of Fed officials.

Monday, February 22, 2016

FRBSF: Economic Outlook

The economic outlook from Kevin Lansing of the SF Fed:

FRBSF FedViews: Kevin J. Lansing, research advisor at the Federal Reserve Bank of San Francisco, stated his views on the current economy and the outlook as of February 11, 2016.

Moderate growth likely to continue

  • Real GDP growth slowed in the fourth quarter of 2015 to less than 1% at an annual rate. Declines in business investment, inventories, and net exports were offset by solid increases in personal consumption expenditures and residential investment. For 2015 as a whole, real GDP growth was 1.8%, slightly below the average annual growth rate of 2.1% observed since the Great Recession ended. 
  • We expect real GDP growth to pick up in 2016 and then ease to trend by the end of 2017. Downside risks to the U.S. growth outlook include possible spillovers from economic slowdowns in foreign markets and a continued strengthening of the U.S. dollar which would pose a headwind for net exports.

Solid employment growth continues

Unemployment dips below natural rate

  • Payroll employment increased by 151,000 jobs in January, signaling continued improvements in the labor market. The six-month moving average remains above 200,000 new jobs per month. The unemployment rate dipped to 4.9% in January, which is slightly below the level that we judge to be the natural rate of unemployment.

Inflation expected to increase gradually

  • Inflation as measured by the four-quarter change in the personal consumption expenditures (PCE) price index has remained below the Federal Open Market Committee’s (FOMC) 2% target since mid-2012. Absent further declines in energy prices or a further strengthening of the U.S. dollar, we would expect PCE inflation to rise gradually towards 2% as economic slack continues to dissipate.

Credit spreads have widened

  • Treasury yields have declined recently reflecting a “flight-to-safety” in response to investor concerns about economic slowdowns in foreign economies and the prospect that such events could have negative spillovers for U.S. growth. Since May 2015, the yield spread between Baa-rated corporate bonds and 10-year Treasury bonds has widened by nearly 100 basis points, indicating that corporate bondholders are demanding more compensation for exposure to credit risk.

Equity and oil prices signal slowdown

  • Recent declines in the Standard & Poor’s (S&P) 500 have caused the index to dip below levels that prevailed one year ago. Over the same time frame, oil prices have dropped precipitously to levels last observed in 2002. Historically, U.S. recessions have often been associated with oil price spikes, but not sharp declines. The recent contemporaneous drop in stock prices suggests that equity market investors are interpreting lower oil prices as a signal of slowing global growth—a development that would have negative consequences for future corporate profits.

Industrial production slipping

  • The Federal Reserve Board’s index of industrial production has recorded three consecutive monthly declines, mainly reflecting production slowdowns in the energy sector. Still, the December 2015 reading is only about 1% below the prior peak recorded in September 2015.

Recent data indicate below trend growth

  • The Chicago Fed National Activity Index (CFNAI) has proved useful as an early indicator of recessions. It is distilled from 85 monthly series drawn from four broad data categories: consumption and housing; employment, unemployment, and hours worked; sales, orders, and inventories; and production and income. The index is constructed to have an average value of zero, with a positive reading indicating growth above trend and a negative reading indicating growth below trend. The three-month moving average CFNAI is currently at –0.24, well above the threshold of –0.7 that has typically signaled the onset of a recession. But as a caveat, it should be noted that the index has often dropped quickly in the months leading up to past downturns. For example, the index stood at –0.2 in July 2007, only five months before the start of the Great Recession.
  • Few, if any, past recessions have been successfully predicted by professional forecasters. Forecasting recessions is difficult because each one tends to differ in important ways from previous episodes. Past recessions have been triggered by upward spiking oil prices, increases in policy interest rates designed to bring down high inflation, and bursting asset price bubbles. None of these scenarios would seem to fit the present circumstances.

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

Friday, February 19, 2016

'Quantitative Easing: Walking the Walk without Talking the Talk?'

Brad DeLong:

Quantitative Easing: Walking the Walk without Talking the Talk?: The extremely-sharp Joe Gagnon is approaching the edge of shrillness: he seeks to praise the Bank of Japan for what it has done, and yet stress and stress again that what it has done is far too little than it should and needs to do ...

Those of us who are, like me, broadly in Joe Gagnon's camp are now having to grapple with an unexpected intellectual shock. When 2010 came around and when the "Recovery Summers" and "V-Shaped Recoveries" that had been confidently predicted by others refused to arrive, we once again reached back to the 1930s. We remembered the reflationary policies of Neville Chamberlain, Franklin Delano Roosevelt, Takahashi Korekiyo, and Hjalmar Horace Greeley Schacht gave us considerable confidence that quantitative easing supported by promises that reflation was the goal of policy would be effective. They had been effective in the major catastrophe of the Great Depression. They should, we thought, also be effective in the less-major catastrophe that we started by calling the "Great Recession", but should now have shifted to calling the "Lesser Depression", and in all likelihood will soon be calling the "Longer Depression".

Narayana Kocherlakota's view, if I grasp it correctly, is that in the United States the Federal Reserve has walked the quantitative-easing walk but not talked the quantitative-easing talk. Increases in interest rates to start the normalization process have always been promised a couple of years in the future. Federal Reserve policymakers have avoided even casual flirtation with the ideas of seeking a reversal of any of the fall of nominal GDP or the price level vis-a-vis its pre-2008 trend. Federal Reserve policymakers have consistently adopted a rhetorical posture that tells observers that an overshoot of inflation above 2%/year on the PCE would be cause for action, while an undershoot is... well, as often as not, cause for wait-and-see because the situation will probably normalize to 2%/year on its own.

By contrast, Neville Chamberlain was very clear that it was the policy of H.M. Government to raise the price level in order to raise the nominal tax take in order to support the burden of amortizing Britain's WWI debt. Franklin Delano Roosevelt was not at all clear about what he was doing in total, but he was very clear that raising commodity prices so that American producers could earn more money was a key piece of it. Takahashi Korekiyo. And all had supportive rather than austere and oppositional fiscal authorities behind them.

But, we thought, monetary policy has really powerful tools expectations-management and asset-supply management tools at its disposal. They should be able to make not just a difference but a big difference. And yet…

There are three possible positions for us to take now:

  1. In a liquidity trap, monetary policy is not or will rarely be sufficient to have any substantial effect—active fiscal expansionary support on a large scale is essential for good macroeconomic policy.
  2. In a liquidity trap, monetary policy can have substantial effects, but only if the central bank and government are willing to talk the talk by aggressive and consistent promises of inflation—backed up, if necessary, by régime change.
  3. We are barking up the wrong tree: there is something we have missed, and the models that we think are good first-order approximations to reality are not, in fact, so.

I still favor a mixture of (2) and (1), with (2) still having the heavier weight in it. Larry Summers is, I think, all the way at (1) now. But the failure of the Abenomics situation to have developed fully to Japan’s advantage as I had expected makes me wonder: under what circumstances should I being opening my mind to and placing positive probability on (3)?