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Tuesday, August 04, 2015

Fed Watch: Gearing Up For Employment Day

Tim Duy:

Gearing Up For Employment Day, by Tim Duy: The big event this week is the employment report. Fed watchers will eagerly dive into the data, looking for signs that the labor market made "some" further improvement. "Some" improvement appears to be an important hurdle to clear before the Fed will raise interest rates. How much "some" is necessary? I suspect it's like pornography - you will know it when you see it.
Incoming data continues a pattern general mediocrity. Today we received the June income and spending report, which one could have largely backed out of the second quarter GDP numbers. Real incomes edged up 0.2% while real spending was flat. Spending softened compared to last year, not unlike the pattern of 2004:

PCEa080315

Recall that it was in July of 2004 that the Fed initiated the previous tightening cycle. Note also that one aspect of consumer spending, auto sales, showed no signs of softening in July.
Inflation remains below target, but arguably not far below target: 

PCE080315

While on a year-over-year basis, core-PCE remains well below target, recent reading are more solid. On an annualized basis, core-PCE rose 1.79% in June, within the range that I suspect most policymakers believe is consistent with their mandate (you can't hit exactly 2% all the time). The Fed will see these numbers as supporting their view that the 2014 inflation drop was driven by largely temporary factors.  
Manufacturing numbers remain on the soft side:

ISM080315

Stronger dollar, lower commodity prices, and softer global demand took the wind out of that sector, to be sure. Note that a sharp decline in ISM numbers from mid-2004 through mid-2005 did not deter the Fed from continuing its rate hike campaign.
Coming on the heels of last week's disastrous employment cost report, Friday's measure of wages will be closely watched. The tentative signs of wage growth acceleration we had been seeing in the ECI were quickly wiped out in the second quarter:

ECI080315

How will the Fed view this data? Tough call at this point. Digging into the data may lead them to conclude that this report was more smoke than fire.  Millan Mulraine via across the curve:

...I wanted to make a few observations on the ECI report following our conversation with the BLS. The key findings reinforce our earlier view that this anomalous performance in both wages and benefits has been driven by one-off factors that should unwind. As such, we believe that this report does not reflect a germane deterioration in underlying inflation dynamics, and will have little bearing on the Fed’s deliberation on policy.

1. The sharp deceleration in the growth rate of the wages and salaries component (which accounts for about 70% of total compensation) was driven by a sharp falloff in incentive pay this quarter versus Q1. This accounted in the sharp drop in the growth rate of private industry wages (on an NSA basis) from 0.8% q/q in Q1 to 0.2% q/q in Q2. Excluding commission sale incentives, wages and salaries were unchanged at a solid 0.6% q/q pace in both quarters.

2. Benefits were also affected by special factors, and the key driver was the redefinition to retirement benefits in Q2, perhaps caused by the underfunding of some retirement pension plans. The 0.8% q/q drop in unionized workers benefits was a big part of this. Here is a link of various stories highlighting this fact earlier this year...

 The Fed may also find solace in the Atlanta Fed Wage Growth Tracker:

Atlanta-fed_individual-wage-growth-3

Of course, maybe they don't need faster wage growth at all, as Jon Hilsenrath at the Wall Street Journal reminds us:

Given her [Fed Chair Janet Yellen] stance, Friday’s employment cost report doesn’t look like a deal breaker for the Fed in its long-running debate about when to raise short-term interest rates. Wages appear to be stagnant but not clearly weakening, which is what she set out as her threshold for not acting. Still, it creates new doubts for officials and doesn’t help them build the confidence they’re hoping to build that the job market is nearing full employment and inflation rising toward 2%.

At least one Fed official is on record saying he couldn't care less about the ECI report. That is St. Louis Federal Reserve President James Bullard, via the Wall Street Journal:

“We are in good shape” for increasing the Fed’s currently near-zero short-term rate target at the Sept. 16-17 central bank gathering, Mr. Bullard said in an interview with The Wall Street Journal. He said officials needed to see how growth data released Thursday shaped up before clearing the way to act. 
Mr. Bullard shrugged off a report Friday showing surprising tepid wage gains, saying he isn’t that worried about that situation right now.

That said, I think that most Fed officials would be more comfortable ignoring the ECI report if they see some hard evidence in the next two labor reports that wage growth really is strengthening.

Bottom Line: My general sense is that the data is falling in line in such a way that the Fed can justify a rate hike in September. Not sure I would describe the situation as being in "good shape" as Bullard does, but I see where they can find room in the data, especially if their logic is to go early so they can go slower. A 200k+ nonfarm payroll gain, a tick down in unemployment, and some wage growth would support that case. September is a hard call, however, because I doubt that the next six weeks of data will give them a clear, consistent story free of any warts or boils. If they ultimately need perfect data to move forward, then they will again take a pass on September. Perfect data will simply be hard to come by, I suspect, in a world where 2% growth is the new 4%.

Saturday, August 01, 2015

'Lehman Brothers Once Again...'

Brad DeLong:

Lehman Brothers Once Again…: Ah. The debate continues:

David Zaring: Did The Fed Fail To Save Lehman Brothers Because It Legally Couldn’t?: “The Fed’s lawyers said, after the fact, that no, they didn’t have the legal power to bail out Lehman…

…Peter says yes they did, Philip says no, and I’m with Peter on this one...

I have two points to make here…

My first point is one that is obvious to an economic historian. But I do not see picked up by the lawyers. It is that central banks are government-chartered corporations rather than government agencies precisely to give them additional freedom of action. Corporations can and do do things that are ultra vires. Governments then either sanction them, or decide not to.

During British financial crises of the nineteenth century, the Bank of England repeatedly violated the terms of its 1844 charter restricting its powers to print bank notes. The Chancellor the Exchequer would then not take any steps in response to sanction it. Such a policy–of writing a charter for the central bank with the expectation that in an emergency the Bank would do whatever was needed to stabilize the economy in spite of the limitations placed on it by its charter, was clearly envisioned by the author of the 1844 charter, then Prime Minister Robert Peel, who expected to see the Governor of the Bank of England take responsibility for doing what was needed...

Peel saw a choice: either (i) give the Bank of England explicit powers (and so run the risk that financiers, expecting that those powers would be used, would exploit moral hazard and so produce irrational exuberance, extravagant overleverage, and repeated frequent financial crises), or (ii) forbid the Bank of England from acting and rely on financial statesmen in the future to take actions ultra vires under the principle that in the end salus populi suprema lex. Peel chose (ii). To him and his peers, the risks that granting explicit powers would enable moral hazard appeared greater than the risks that when a crisis should come the makers of monetary policy would not understand their proper role. And the Federal Reserve banks have inherited their non-agency but corporation legal structure from the Bank of England.

My second point is that Bernanke, Geithner, and their company at the head of the Federal Reserve in 2008 really, really, really want their decision not to have rescued Lehman in the fall of 2008 to have been a judgment call that went wrong.

They really do not want to have let a situation develop in which there is a systemically-important financial institution that they cannot support. Should any systemically-important financial institution ever approach a state in which the central bank could not support it in an emergency, the most elementary principles of central banking command that such an institution be resolved or shut down immediately.

To fail to do so is complete and total central banking malpractice.

Thursday, July 30, 2015

Fed Watch: GDP Report

Tim Duy:

GDP Report, by Tim Duy: The second quarter GDP report, while not a blockbuster by any measure, will nudge the Fed further in the direction of a September rate hike. At first blush this might seem preposterous - 2.3% growth is nothing to write home about in comparison to history. But history is deceiving in this case. It remains important to keep in mind that 2% is the new 4%.
Year-over-year growth rates continue to hover around 2.5%:

GDP073015

While the 2.3% quarterly rate of the second quarter was below consensus forecasts, the first quarter figure was revised up from -0.2% to 0.6%. That said, the annual revisions from 2012-2014 disappointed. Average annual growth from 2011 to 2014 dropped from a previsouly reported 2.3% to 2.0%. Sad, very sad.
That was still enough growth, however, to sustain fairly solid job growth and sharp declines in the unemployment rate, suggesting that potential output growth is indeed fairly anemic. The Fed staff appear to agree; see their very low potential growth numbers in the accidentally released forecasts (and for more on the implications of those forecasts, see Gavin Davies). Note also the low end of the range of potential growth estimates from FOMC meeting participants is 1.8%. Furthermore, San Francisco Federal Reserve President John Williams wants the Fed to guide the economy to a 2.0% growth rate in 2016. Hence 2.3% growth when the economy is operating near full-employment is sufficient for many policymakers to pull the trigger on the first rate hike.
A second implication of the revisions is that they provide no relief for those pondering low productivity growth. Indeed, it is quite the opposite, and they suggest downward revisions to productivity. Low productivity plus low labor force growth equals low potential output growth. 2% is the new 4%. And don't expect that all the data will fall into the same nice, consistent patterns we typically see in a business cycle. Some indicators will point up, others down, leading to many erroneous calls that a recession is soon upon us.  
As an aside, solid research and development spending gives hope that productivity growth will accelerate:

GDPa073015

We can only wait and see.
The inflation numbers also point to a September hike. Recall that the Fed is waiting until they are reasonably confident that inflation is heading back to target. Headline and core PCE rebounded to 2.15% and 1.81% annual growth rates in the first quarter, respectively, adding weight to the Fed's conviction that the inflation weakness of the first half was indeed transitory. To be sure, these gains have yet to translate into higher year-over-year numbers. But a forward looking Fed will expect they will head higher.
Separately, the forward-looking indicator of initial unemployment claims continues to hover at very low levels:

CLAIMS073015

A reminder that layoffs are few and far between as we head into next week's employment report for July.
Bottom Line: An unspectacular recovery, but sufficient to keep the Fed on track for raising rates this year. The case for September further strengthens.

Wednesday, July 29, 2015

Fed Watch: FOMC Recap

Tim Duy:

FOMC Recap, by Tim Duy: The July FOMC meeting yielded the widely expected outcome of no policy change. Very little change in the statement either - pulling out any useful information is about as easy as reading tea leaves or chicken bones. But that won't stop me from trying! On net, I would count it was somewhat more hawkish as the Fed gears up to hike rates later this year. By no means, however, did the statement make any definitive signal about September. The Fed continues to hold true to its promise to make the next move about the data. The era of handholding fades further into memory.
The first paragraph contained nearly all of the changes in the statement. Using the Wall Street Journal's handy-dandy Fed tracker:

FOMCa072915

In my opinion, this represents a not trivial upgrade of their thoughts on the labor market. Job growth is "solid," unemployment continues to decline, and a much more forceful conclusion on underemployment. No longer has underutilization diminished by a wishy-washy "somewhat." It now conclusively "has" diminished. Hence, it seems like the Fed is closer to declaring victory over one impediment to hiking rates - Fed Chair Janet Yellen's concerns about the high degree of underemployment.
I tend to regard the exclusion of the "energy prices appear to have stabilized" as the elimination of an artifact from the June statement. Energy prices are not in free-fall as the were at the end of last year, and have instead been tracking within a range since the beginning of the year. Hence the Fed can later repeat the inflation forecast as:
"...the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of earlier declines in energy and import prices dissipate."
Some may interpret it as a more dovish signal in light of the recent declines in oil prices. I am wary of that interpretation.
The only other change to the statement was in the third paragraph:

FOMCb072915

The addition of the determiner "some" fits nicely with the changes to the first paragraph. The labor market has now shown sufficient improvement such that the bar to a rate hike is actually quite low. Essentially, meeting participants believe the economy is closing in on full employment. And that in and of itself will raise their confidence on the inflation outlook.
There was some early chatter regarding the continued description of the risks to the outlook as "nearly" balanced. This was taken as dovish. Had they said the balance is weighted toward inflation, however, the Fed would have essentially been promising a rate hike in September, and they have been very clear they do not want to make such a promise. So the failure to change the balance of risks should not be that surprising. In that vein, I suspect that when they do hike, they will say something like "with today's action, the risks to the outlook remain balanced" such that they leave no signal regarding the timing or the magnitude of the next move.
Bottom Line:  All else equal, the next two labor reports will factor strongly into the Fed's decision in September. A continuation of recent labor trends is likely sufficient to induce them to pull the trigger. Further signs of stronger wage growth would make a September move a certainty.

FOMC Press Release

Not much to say about this, policy is unchanged, and not as much guidance on what to expect going forward as some expected (i.e., to get people ready for a rate increase in September):

Press Release, Release Date: July 29, 2015: Information received since the Federal Open Market Committee met in June indicates that economic activity has been expanding moderately in recent months. Growth in household spending has been moderate and the housing sector has shown additional improvement; however, business fixed investment and net exports stayed soft. The labor market continued to improve, with solid job gains and declining unemployment. On balance, a range of labor market indicators suggests that underutilization of labor resources has diminished since early this year. Inflation continued to run below the Committee's longer-run objective, partly reflecting earlier declines in energy prices and decreasing prices of non-energy imports. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations have remained stable.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate. The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of earlier declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.
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. This policy, by keeping the Committee's holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.

Tuesday, July 28, 2015

'Should Central Bankers Stick to Talking about Monetary Policy?'

Simon Wren-Lewis on whether "central bankers need to keep quiet about policy matters that are not within their remit":

Should central bankers stick to talking about monetary policy?: Few disagree that the recent remarks on corporate governance and investment made by Andy Haldane (Chief Economist at the Bank of England) are interesting, and that if they start a debate on short-termism that would be a good thing. As Will Hutton notes, Hillary Clinton has been saying similar things in the US. The problem Tony Yates has (and which Duncan Weldon, the interviewer, alluded to in his follow-up question) is that this is not obviously part of the monetary policy remit.
Haldane gave an answer to that, which Tony correctly points out is somewhat strained. ...
I have in the past said very similar things to Tony...
However I am beginning to have second thoughts about my own and Tony’s views on this. First, it all seems a bit British in tone. Tony worked at the Bank, and I have been involved with both the Bank and Treasury on and off, so we are both steeped in a British culture of secrecy. I do not think either of us are suggesting that senior Bank officials should never give advice to politicians, so what are the virtues of keeping this private? In trying to analyse how policy was made in 2010, it is useful to have a pretty good idea of what advice the Bank’s governor gave politicians because of what he said in public, rather than having to guess. ...
It is often said that central bankers need to keep quiet about policy matters that are not within their remit as part of an implicit quid pro quo with politicians, so that politicians will refrain from making public their views about monetary policy. Putting aside the fact that the ECB never got this memo, I wonder whether this is just a fiction so that politicians can inhibit central bankers from saying things politicians might find awkward (like fiscal austerity is making our life difficult). In a country like the UK with a well established independent central bank, it is not that clear what the central bank is getting out of this quid pro quo. And if it stops someone with the wide ranging vision of Haldane from raising issues just because they could be deemed political, you have to wonder whether this mutual public inhibition serves the social good.

The danger is that the Fed will become politicized as a result of taking sides on hotly debated political/policy questions. This is from a post in February of 2007:

...Should the Federal Reserve Chair talk only about matters directly related to monetary policy, or is it okay to discuss broader issues such as inequality, minimum wages, and Social Security without making the direct connection to monetary policy evident?...:

Willem Buiter: Martin's Column "Why America will need some elements of a welfare state", refers extensively to a recent speech by Ben Bernanke...

I believe it is a serious mistake for central bankers to express public views on politically contentious issues outside their mandates. The mistake is no less serious for being made so commonly by central bankers all over the world.

Central bank Governors have a lengthy and unfortunate track record of holding forth in public on matters that are outside the domains of their mandate (in the case of the Fed, monetary policy and financial stability)... With the exception of the Governors of the Bank of England and the Reserve Bank of New Zealand, every Governor on the block appears to want to share his or her views on necessary or desirable fiscal, structural and social reforms. Examples are social security reform and the minimum wage, subjects on which Alan Greenspan liked to pontificate when he was Chairman of the Board of Governors of the Federal Reserve System. Jean-Claude Trichet cannot open his mouth without some exhortation for fiscal restraint or structural reform rolling out. In the case of Chairman Bernanke's speech, equality of opportunity, income distribution, teenage pregnancy and welfare dependency are clearly not part of the (admittedly broad) three-headed mandate of the Fed: maximum employment, stable prices and moderate long-term interest rates. ...

When the Head of a central bank becomes a participant, often a partisan participant, in public policy debates on matters beyond the central bank's mandate..., the institution of the central bank itself is politicised and put at risk of becoming a partisan-political football. This puts at risk the central bank's operational independence in the management of monetary policy and in securing financial stability.

Central bankers, Mr. Bernanke included, should 'stick to their knitting' (if I may borrow Alan Blinder's phrase). Being the head of an institution with the national and global visibility of the Fed or the ECB gives one an unparalleled platform for addressing whatever one considers the great issues of the time. The temptation to climb that unique pulpit must be near-irresistible. Nevertheless, unless the text for the sermon concerns monetary policy or financial stability, that temptation is to be resisted in the interest of the institutional integrity and independence of the central bank.

As I've said before, I agree.

Fiscal policy has a clear connection to monetary policy through the government budget constraint, and there are also times -- e.g. recently -- when monetary policy needs the help of fiscal policy (if the Fed is forced to shoulder the entire burden, it can bring other risks). So I have no problem with the Fed chair raising fiscal policy issues (as Bernanke did, though not forcefully enough perhaps). I have a bit more trouble when the topic is inequality (e.g. Yellen's big speech on this -- and the subsequent reaction from the right). It's harder to see how that is connected to the Fed's policy mandate, and with Republicans already out to take away as much of the Fed's powers as they can, it was a bad time to tick them off.

Maybe this is too cautious. Perhaps Federal Reserve officials should feel free to address whatever topic they'd like. But the Fed's independence was instrumental during the Great Recession -- without it, monetary policy would have been as terrible as fiscal policy and things would have been much worse -- and I'd rather not take any risks.

Friday, July 17, 2015

Fed Watch: The Case For September

Tim Duy:

The Case For September, by Tim Duy: The Wall Street Journal reports that most economists still expect the Fed to raise rates in September:

BN-JK371_FEDSUR_G_20150715183208

Financial market participants tend to be less confident, with odds of a September hike running around 35%. Still, the consideration of any rate hike may seem odd given the lackluster nature of the US economy. Notably, inflation wallows below trend and anemic wage growth suggests significant remaining labor market slack. The Fed, however, looks at the progress towards its goals, which on the unemployment side has been substantial, as well as the perceived need to act ahead of actual inflation.
In short, the Fed believes the risks to the economy are shifting toward overheating, even if the economy is not yet overheating. And, as Greg Ip at the Wall Street Journal identifies, this has important consequences for monetary policy:
Risk management suggests they ought to start in September, because then they retain the option of tightening once or twice before the end of the year. But if they wait until December, they forgo that option. (This assumes they do not move at their meeting in October, which is not followed by a press conference.)
This is probably the best argument for a September rate hike. Federal Reserve Chair Janet Yellen made it fairly clear in her Congressional appearances this week that she would prefer to move earlier but more gradually than later and more rapidly. And even if you think she only anticipates a single rate hike this year, that outcome is not precluded by a hike in September. Yellen has also said we should not expect a clearly identified path similar to the last tightening cycle. They can hike in September and pass on December.
Paul Krugman thinks the Fed's logic is completely backwards. From his Bloomberg interview this week:
If the Fed waits too long to raise rates, then we get a little bit of inflation. If the Fed raises rates too soon, we risk getting caught in another lost decade. So the risks are hugely asymmetric. I really find it quite mysterious that the Fed is eager to raise rates given that, they're going to be wrong one way or the other, we just don't know which way. But the costs of being wrong in one direction are so much higher than the costs of being the other.
The Fed, I think, believes the risks are asymmetric in the other direction - that inflation expectations are very fragile to the upside, and hence waiting too long risks a costly rise in actual inflation.
If I had to bet who would be proven right, I would put my money with Krugman. Inflation and inflation expectations have proven substantially less fragile in the past twenty years than the Fed likes to admit. Consider first that inflation has tended to hover mostly below two percent since 1995:

PCE071515

Core inflation averaged 1.70% since 1995, headline inflation 1.86%, both comfortably below target. Note the particular rarity of periods where core inflation rises more than 25bp above target. What used to be one of the Fed's favorite indicators, the 5-year, 5-year forward breakeven rate, isn't pointing toward high inflation in the medium term:

BREAK071515

Although the Fed frets about unemployment, even at low levels of unemployment, inflation is more often than not below target:

PHILLIP071515

And neither faster wage growth nor low unemployment triggers higher inflation expectations. Inflation expectations are remarkably stable, with relatively few deviations from 3% which tend to be traced back to gasoline prices:

WAGEEXP071515

UNEMPEXP071515

The Fed would argue that their credibility explains stable inflation expectations. By acting ahead of inflation, the Fed ensures there is no above-target inflation, and that connection between policy and outcomes gives rise to that credibility. I would argue that two decades of generally below target inflation suggests an overly excessive pursuit of credibility at the cost of economic underperformance. We don't reach the target inflation consistently, but we do get recessions and slow job market recoveries.
Also, it seems that Yellen abandoned her enchantment with optimal control models. A recent version from the IMF indicates it would be still preferable to delay rate hikes in favor of a more aggressive normalization path later:

IMF

Under the optimal control approach, the Fed would accept the cost of temporarily higher inflation (still within a 25b range of target) in return for a faster return to potential output. Yellen now appears will to tolerate a return to the inflation target from below, rather than above, in order to avoid the possibility of a sharper rise in rates later.
Why the change of heart? Why the gradualist approach? It is reasonable to believe its about financial market instability. Back to Greg Ip:
... the effects of six years of zero rates on leverage and risk-taking are increasingly evident. As Ms. Yellen’s Monetary Policy Report noted, “Credit markets have been reflecting some signs of reach-for-yield behavior, as issuance of speculative grade bonds continues to be strong, yields are low, and credit spreads are somewhat narrow by historical standards.”
Fair enough, maybe it isn't about inflation, but financial markets. But that is kind of disconcerting as well - the gradualist approach didn't work so well last time around. Seems like if you were really worried about financial markets, you would want to follow the optimal control approach and move quickly when inflation warranted a policy shift. The error of the last cycle may not have been in waiting too long to hike, but hiking too slowly when the time came.
Bottom Line: Ultimately, as the crisis fades further into the rearview mirror, the Fed see the policy risks shifting. Many, including Yellen, will shift back toward the central banker's natural inclination to fight inflation, despite the lack of inflation for the past two decades. And that natural inclination keeps the September option alive. Given the Fed's penchant for tight policy on average, the risk is that while they don't trip the economy into recession in the near term, they instead lock the economy into a sub-par equilibrium.

Tuesday, July 14, 2015

Fed Watch: More Mediocrity

Tim Duy:

More Mediocrity, by Tim Duy: Federal Reserve Chair Janet Yellen will be playing a game of mixed messages with Congress tomorrow as she explains why she believes a rate hike approaches in spite of lackluster data. Today's data didn't help. The June retail sales report was a disappointment, slipping from May levels with generally soft internals in addition to downward revisions to previous months. Consequently, core spending growth is decelerating on a year-over-year basis to 2013 rates:

RETAIL071415

Maintaining the 2014 growth bump has been something of a challenge, to be sure.The report triggered downgrades to the second quarter growth forecast as it offset upward revisions attributable to last week's new estimates of federal spending and inventories:

Gdpnow-forecast-evolution-3

More mediocre growth - stuck in that 2.5 percent range which is a touch higher than the Fed's longer-run central tendency of 2.0-2.3 percent. And therein lies the key to understanding the Fed's repeated calls that 2015 is the year for the first rate hike. I think they are concluding 2014 was sufficient to largely close the output gap, as evidenced by falling unemployment and other measures of labor underutilization. San Francisco Federal Reserve President John Williams even believes that optimally, US growth needs to DECELERATE in 2016:
Looking towards next year, what we really want to see is an economy that’s growing at a steady pace of around 2 percent. If jobs and growth kept the same pace as last year, we would seriously overshoot our mark. I want to see continued improvement, but it’s not surprising, and it’s actually desirable, that the pace is slowing.

With the output gap closing, Fed policymakers believe they need to begin reducing financial accommodation. They are not sufficiently sure of that hypothesis to begin hiking at anything more than a modest pace, but are sufficiently sure to comfortably declare that the first rate hike is upon us. Hence, Boston Federal Reserve President Eric Rosengren can say things to Reuters like:

"If we do continue to get improvement in labor markets, if we do become reasonably confident that we're moving back to 2-percent inflation, it may be appropriate as early as September," he said of raising rates from near zero. "I don't think we have seen that evidence yet but we still have a couple months of data to see whether it's more strongly confirmed."
Rosengren has long advocated for more monetary accommodation than most of his colleagues at the central bank, which has kept interest rates at rock bottom to boost the recovery. With wages showing early signs of a pick-up and U.S. unemployment down to 5.3 percent, he set a high bar for delaying a hike.
Only if labor markets unexpectedly weaken, if core inflation starts to drop off, or if the wage gains dissipated, "those would be the things that would make me want to pause and wait and see whether there is further evidence," he said.
And Federal Reserve Chair Janet Yellen says:
My own outlook for the economy and inflation is broadly consistent with the central tendency of the projections submitted by FOMC participants at the time of our June meeting. Based on my outlook, I expect that it will be appropriate at some point later this year to take the first step to raise the federal funds rate and thus begin normalizing monetary policy.
Whereas Cleveland Federal Reserve President is somewhat more aggressive in an interview with the Financial Times:
Loretta Mester, president of the Federal Reserve Bank of Cleveland, said the case for “emergency” levels of interest rates was now gone given that the economy was “fundamentally sound”, as she signalled that she would support two increases in short-term rates this year.
To be sure, it is all data dependent. More solid wage growth would do the trick, I think, to draw the Fed to September. Without that wage growth acceleration, I suspect the more dovish side of the FOMC will pull the Fed toward December. No reason to rush given the lackluster numbers we are seeing. But one senses greater impatience on the more hawkish side of the FOMC. They will argue like Mester that the general consistency of underlying growth, steady improvement in labor utilization, and proximity to mandates signals it is time to leave behind the policies of the financial crisis.
Bottom Line: The basic theme is that the economy is that, in the Fed's eyes, the economy is sufficiently stable to justify a rate hike, but lacks any reason to rush that hike or the pace of subsequent hikes. That message I expect to hear tomorrow. In her appearance before the House Financial Services Committee, Yellen will reiterate the basic points of Friday's speech, maintaining faith that 2015 will be the year for the first rate hike since 2006. Heavy caveats, however, about data dependence. She may get asked directly about September. If so, she will not rule out September. She will instead say maybe September, maybe later. But more interesting might be the questioning surrounding the Fed's perceived intransigence; Congress is looking for more of that transparency the Fed is always bragging about.

Monday, July 13, 2015

'Janet Yellen’s Unusual Optimism'

Teresa Tritch of the NY Times editorial board:

Janet Yellen’s Unusual Optimism: ...To my ears, most of Ms. Yellen’s speech expertly laid out why the economy is not ready for interest rate increases anytime soon. Then, toward the end, she said that based on her views, she expected to begin raising rates “at some point later this year.” ...
Granted, it takes time for the effects of an interest-rate move to be felt in the economy. So if the Fed thinks the economy is going to start overheating, say, next year, it would choose to raise rates before that. But I didn’t hear any good reason in the speech to believe that a full-steam-ahead economy lies ahead. ...
And yet, Ms. Yellen’s take is that a gradual process of steady improvement is underway that, if continued, could justify the start of rate hikes this year.
That is guarded optimism. But six years into an economic recovery that has been consistently disappointing, I find it hard to share even guarded optimism. ...
Ms. Yellen stressed, as she always does, that actual economic developments in coming months would determine when to begin raising rates. The question is whether more of the same fitful, inconclusive growth will count as reason to act or reason to wait.

Thursday, July 09, 2015

'Fiscal Policy and the Long-Run Neutral Real Interest Rate'

Narayana Kocherlakota, President of the Federal Reserve Bank of Minneapolis, says more government debt would help the Fed:

Fiscal Policy and the Long-Run Neutral Real Interest Rate: Thanks for the introduction and the invitation to be here today.
In my remarks today, I will make three points about the U.S. economy.
First, there has been a significant decline in the long-run real interest rate, reflecting (in large part) a decline in what is sometimes called the long-run neutral real interest rate. (By the long-run neutral real interest rate, I mean the real interest rate that I expect to prevail when the economy is at maximum employment and inflation is at the central bank’s target.) Second, this decline in the long-run neutral real interest rate is likely to mean that monetary policymakers will be more constrained by the lower bound on the nominal interest rate in the future than they have been in the past. 
My third point concerns an important connection between monetary and fiscal policy. I consider a permanent increase in the market value of the public debt, financed by an increase in taxes or reduction in transfers. This policy change increases the supply of assets available to investors. I argue that, in a wide class of plausible economic models, such an increase in supply would push downward on debt prices, and so upward on the long-run neutral real interest rate. 
When I put these three points together, I reach my main conclusion. The decline in the long-run neutral real interest rate increases the likelihood that the economy will run into the lower bound on nominal interest rates. Accordingly, there is an enhanced risk that the Federal Open Market Committee (FOMC) will undershoot its maximum employment and 2 percent inflation objectives. Fiscal policymakers can mitigate this risk by choosing to maintain higher levels of public debt than markets currently anticipate.
I want to be clear at the outset that I am not saying that it is appropriate for fiscal policymakers to increase the long-run level of public debt. I am simply pointing to one benefit associated with such an increase: It allows the central bank to be more effective in mitigating the impact of adverse shocks to aggregate demand. I will point to other costs (and benefits) associated with increasing the level of public debt. Sorting through them is outside the scope of my remarks today, and really outside of my purview as a monetary policymaker. ...

Wednesday, July 08, 2015

'Policy Lessons From The Eurodebacle'

Paul Krugman:

Policy Lessons From The Eurodebacle: ...there’s a broader lesson from Greece that is relevant to all of us — and it’s not the usual one about mending our free-spending ways lest we become Greece, Greece I tell you. What we learn, instead, is that fiscal austerity plus hard money is a deeply toxic mix. The fiscal austerity depresses the economy, and pushes it toward deflation; if it’s accompanied by hard money (in Greece’s case the euro, but a fixed exchange rate, a gold standard, or any kind of obsessive fear of inflation would do the trick), the result is not just a depression and deflation, but quite likely a failure even to reduce the debt ratio. ...
So, how does this play into U.S. policy debates? Well, Republicans love to warn that America might turn into Greece any day now. But look at the policy mix that is now de facto GOP orthodoxy: sharp cuts in government spending (maybe offset by tax cuts for the rich, but these won’t provide much stimulus), combined with a monetary policy obsessed with fears of dollar “debasement”. That is, the conservative side of the US political spectrum, while holding up Greece as a cautionary tale, is actually demanding that we emulate the policy mix that turned Greek debt into a complete disaster.

Wednesday, July 01, 2015

Fed Watch: Ahead of the Employment Report

Tim Duy:

Ahead of the Employment Report, by Tim Duy: A rare Thursday release of the employment report is on tap for tomorrow, and all eyes will be watching to see if it falls in line with the other, more optimistic US data of late. Indeed, it increasingly looks like this year's growth scare was driven by temporary factors, not a fundamental downturn in the US economy. Consequently, anything reasonably close to expectations would bolster the case of those FOMC members looking for a first rate hike later this year, as early as September.
The ISM report for June was in-line with expectations, with fairly good internal components. Note in particular the bounce-back in the employment component:

NAPM070115

Other employment data also indicates the underlying trends in the labor market are holding. Initial unemployment claims - a leading indicator - give no cause for worry:

CLAIMS070115

And the ADP employment report came in slightly ahead of expectations at a private sector job gain of 237k for June. All of this suggests that the consensus for tomorrow's headline number of 230k is reasonable, although I am inclined to bet that the actual number will beat consensus.
The usual headline numbers, however, may not be the stars of the show. Attention will rightly be on the wage numbers. Further evidence that wage growth is accelerating would indicate that the labor market is finally closing in a full employment. Such data would point to a rate hike sooner than later as it would raise the Fed's confidence that inflation will be trending toward target. See Federal Reserve Governor Stanley Fischer today:
Regarding inflation, an important factor working to increase confidence in the inflation outlook will be continued improvement in the labor market. Theoretical and empirical evidence suggests that inflation will eventually begin to rise as resource utilization tightens. And while the link between wages and inflation can be tenuous, it is encouraging that we are seeing tentative indications of an acceleration in labor compensation.
Tantalizing evidence on wage growth comes from the Atlanta Federal Reserve Bank:

Atlanta-fed_individual-wage-growth

With fairly low inflation, this suggests that real wages growth is indeed accelerating, which helps account for the relatively solid consumer confidence numbers we are seeing. Demand for new cars and trucks also remains strong, although I sense that we are not likely to see higher numbers going forward.
Also from the Atlanta Fed is their GDP tracker, which continues to head back to consensus range:

Gdpnow-forecast-evolution

This is in-line with Fischer's assessment of the economy:
The U.S. economy slowed sharply in the first quarter of this year, with the most recent estimate being that real GDP declined 0.2 percent at an annual rate. Household spending slowed, while both business investment and net exports declined. Much of this slowdown seemed to reflect transitory factors, including harsh winter weather, labor disputes at West Coast ports, and probably statistical noise. Confirming that view, the latest monthly data on real consumption provide welcome evidence that consumer demand is rebounding, and that economic activity likely expanded at an annual rate of about 2.5 percent in the second quarter.
What about Greece? St. Louis Federal Reserve President James Bullard dismissed Greece as a reason for concern. Michael Derby at the Wall Street Journal reports:
What’s happening in Europe “would not change the timing of any rate hike. I would say September is still very much in play” for raising rates, Mr. Bullard told reporters after a speech in St. Louis. More broadly, he said “every meeting is in play depending on the data,” which he said had been “stronger” recently. He also described recent inflation data as being “more lively” and set to rise further over time.
I doubt other Federal Reserve officials are quite as confident, but they have plenty of time between now and September to assess the situation. As I said Monday, they will be looking for evidence of credit market spillovers. If they don't see it, the economic data will rule the day. Bullard also argued the case of a faster pace of rate hikes:
“The Fed should hedge against the possibility of a third major macroeconomic bubble in coming years by shading interest rates somewhat higher than otherwise” would be the case based on historical norms, Mr. Bullard said. “The benefit would be a longer, more stable economic expansion.”
Mr. Bullard warned “my view is that low interest rates tend to feed the bubble process.” He did not point to any major imbalances right now even as he flagged high stock market levels as something to watch, acknowledging the role of technology could be changing how the economy interacts with financial markets.
Derby correctly notes, however, that this places Bullard out of the Fed consensus:
Mr. Bullard’s suggesting that rates may need to be lifted more aggressively in the future puts him at odds with some of his central bank colleagues. Many key Fed officials are now gravitating to the view that changes in labor market demographics and other forces may mean the Fed could keep rates at a lower level relative to historic benchmarks. Most officials now expect that the long-term fed funds rate target, now at near zero levels, will likely stand at around 3.75%.
Fischer, for example, still argues for a gradual pace of normalization and is much more sanguine on the financial market excess:
Once we begin to remove policy accommodation, the Committee's assessment is that economic conditions will likely warrant raising the federal funds rate only gradually. Thus, we expect that the target federal funds rate will remain for some time below levels viewed as normal in the longer run. But that is only a forecast, and monetary policy will, in practice, be determined by the data--primarily data on inflation and unemployment.
What about financial stability? We are aware of the possibility that low interest rates maintained for a prolonged period could prompt an excessive buildup in leverage or cause underwriting standards to erode as investors take on risks they cannot measure or manage appropriately in a reach for yield. At this point, the evidence does not indicate that such vulnerabilities pose a significant threat, but we are carefully monitoring developments in this area.
Fischer is closer to the FOMC consensus than Bullard on these points.
Bottom Line: Incoming data continues to support the case that the underlying pace of activity is holding, alleviating concerns that kept the Fed on the sidelines in the first half of this year. I anticipate the employment report, or, more accurately, the sum of the next three reports, to say the same. Accelerating wage growth could very well be the trigger for a September rate hike, while Greece could push any rate hike beyond 2015. I myself, however, tend to be optimistic the Greece situation will not spiral out of control.

Monday, June 29, 2015

Fed Watch: Events Continue to Conspire Against the Fed

Tim Duy:

Events Continue to Conspire Against the Fed, by Tim Duy: Federal Reserve policymakers just can't catch a break lately. Riding on the back of strong data in the second half of last year, they were positioning themselves to declare victory and begin the process of policy normalization, AKA "raising interest rates." Then the bottom fell out. Data in the first half of the year turned sloppy. Although policymakers on average - and Federal Reserve Chair Janet Yellen in particular - could reasonably believe the underlying momentum of the economy had not changed, that the data reflected largely temporary factors, the case for a rate hike by mid-year evaporated all the same. The risk of being wrong was simply more than they were willing to bear in the absence of clear inflation pressures.

The story was clearly shifting by the end of June. Key data on jobs and the consumer firmed as expected, raising the possibility that September was in play. Salvation from ZIRP, finally. Federal Reserve Governor Jerome Powell called it a coin toss. Via Bloomberg:

Speaking at a Wall Street Journal event in Washington Tuesday, Powell said he forecast stronger growth than in the first half of 2015, growth in the labor market and a “greater basis for confidence” in inflation returning to 2 percent.

“If those things are realized, I feel that it is time, it will be time, potentially as soon as September,” he said. “I don’t think the odds are 100 percent. I think they’re probably in the 50-50 range that we will realize those conditions, but that’s my forecast.”

Earlier, San Francisco Federal Reserve President John Williams said he expected two rate hikes this year. Via Reuters:

"Definitely my own forecast would be having us raise rates two times this year, but that would depend on the data," San Francisco Fed President John Williams told reporters at the bank's headquarters.

Rate increases of a quarter percentage point each would be reasonable, he said, with little point in making rate increases any smaller.

Given that we have basically written off the possibility of a rate hike in October (Fed not positioning for a rate hike every meeting and no one expects October for a first hike in the absence of the press conference), that leaves September and December for hikes.

Over the weekend, New York Federal Reserve President William Dudley also raised the possibility of September in an interview with the Financial Times:

A Federal Reserve interest-rate hike will be “very much in play” at the central bank’s September meeting if the recent strengthening of the US economy continues, according to one of America’s top central bankers.

William Dudley, the president of the Federal Reserve Bank of New York, said recent evidence of accelerating wage gains, improving incomes, and growing household spending had alleviated some of his concerns about the sustainability of momentum in America’s jobs market.

Former Federal Reserve Governor Laurence Meyer expects Yellen to also be comfortable with two rate hikes in 2015 by the time September rolls around. Via Bloomberg:

"We expect the incoming data between now and the September meeting to help ease concerns about the growth outlook, prompting Chair Yellen and a majority of the FOMC to see two hikes this year as appropriate," Meyer said in a note to clients.

No, September was not a sure bet, but you could see how the data evolved to get you there. But then came Greece. Greece - will it never end? Financial markets were roiled as Greek Prime Minister Alexis Tsipras abandoned the latest round of bailout negotiations with the EU, IMF, and ECB and instead pursued a national referendum on the last version of the bailout proposal. Most of you know the story from that point on - run on Greek banks, the ECB ends further ELA extensions, a bank holiday is declared, likely missing a payment to the IMF etc., etc.

At this juncture, everything in Greece is now in flux. Greece will be holding a referendum on a deal that apparently no longer exists, so it is not clear what negotiations would happen even if it passes. Moreover, it seems likely that the economic damage that will occur in the next week or longer will almost certainly require an even bigger give on the part of Greece's creditors. Is that going to happen? There is no exit plan to force Greece out of the Euro. What if Greece refuses to leave? How does Europe respond to a growing humanitarian crisis Greece as the economy collapsed? This could drag on and on and on.

As would be reasonably expected, the jump in risk sank equities across the globe, in the process stripping away US stock gains for 2015. Not that there was much to give - it only took a little over 2% on the SP500. Yields on Treasuries sank in a safe-haven bid, and market participants pushed Federal Reserve rate hike expectations out beyond 2015.

At this moment, there is obviously little to confirm that 2015 is off the table. To be sure, we know the Fed is watching the situation closely. Back to the FT and Dudley:

That said, Mr Dudley warned that the financial market implications of a Greek exit from the euro could be graver than many investors seemed to believe, because it would set a “huge precedent” indicating that euro membership was reversible.

People “underestimate all the different channels in terms of how contagion works”, the central banker said. “We saw that in the financial crisis. People did not anticipate that the Lehman failure was going to affect the economy and financial markets to the degree that it did.”

At the risk of being guilty of underestimating contagion, I am optimistic that the ring fencing around Greece will hold. This will be a political disaster for Europe, and a humanitarian disaster for Greece, but I expect will ultimately prove to have limited impact beyond those borders.

Famous last words.

Of course, even if that is correct, we don't know it to be correct, and thus the Fed will again proceed cautiously, just like they did in the face of the weak first quarter. Hence, all else equal, pushing out the timing of the first hike is reasonable. September, though, is a long ways off, and plenty can happen between now and then. So what will the Fed be watching?

First is the data, as they have emphasized again and again. We have three labor reports between now and September, beginning this week. Strong monthly gains coupled with falling unemployment rates and further evidence of wage growth would go a long way to supporting a rate hike. All would give the Fed the faith that inflation will soon be heading toward target. This is especially the case if recent consumer spending and housing numbers hold and if business investment picks up. And it would be further helpful if the global economy did not sink under the weight of Greece. Essentially, the Fed wants to be confident that the first quarter was a fluke and thus the economy is in fact fairly resilient.

Second is the financial fallout from Greece. Mostly, they will be carefully watching to see if the Greece crisis impacts domestic credit markets and banking. Do interest rate spreads widen? Do lenders tighten underwriting conditions? Does interbank lending proceed without impediments? If they see conditions emerge like this, I would expect them to match market expectations and just stay out of the rate hike business until the fallout from Greece is clear. This likely holds even in the face of solid US data. There will (or at least should) recognize that periods of substantial unrest in credit markets are not the time to be raising rates.

Bottom Line: The Fed was already approaching the first rate hike cautiously, wary of even dipping their toes in the water. The crisis in Greece will make them even more cautious. Like their response to the first quarter data, until they see a clear path, they will be on the sidelines. That said, given the plethora of warnings not to underestimate the global impact of the crisis in Greece, one should be watching the opposite side of the story. Solid data and limited Greece impact would leave December at a minimum, and even September, in play.

Tuesday, June 23, 2015

Fed Watch: Dovish Fed

Tim Duy:

Dovish Fed, by Tim Duy: Coming on the heels of a dovish FOMC meeting and press conference, it might be surprising that San Francisco Federal Reserve President John Williams is still looking for two rate hikes this year. Via Bloomberg:

“We are getting closer and closer,” to raising rates, he told reporters on Friday after delivering a speech in San Francisco. Williams, a voter this year on the policy-setting Federal Open Market Committee, was head of research at the regional bank when it was led by now-Chair Janet Yellen.
“My own forecast would be having us raise rates two times this year,” he said. “But that would depend on the data.”
Why raise rates this year despite anemic inflation and moderate economic growth? He still expects the Fed will be moving closer to its stated goals in the second half of the year and moving sooner means moving slower:
Williams also said that raising rates earlier rather than later would allow the Fed to tighten gradually, which he favors because the U.S. economy still faces significant headwinds.
“If we raise rates sooner rather than later, then we can do it more gradually,” he said.
It is worth reiterating just how gradual the Fed is planning to raise rates. This I think remains more important than the timing of the first hike. Note that the midpoint forecasts from the Summary of Economic Projections imply a 0 percent equilibrium interest rate at the end of 2016, and just slightly higher than that in 2017:

RSTAR062215

And note that this is a somewhat more dovish projection than that made in March:

RSTAR0a62215

which was also more dovish than the prior SEP. Essentially, this Fed is jointly both hawkish and dovish - even as they warn they are moving ever closer to that first rate hike, they continue to push down the expected path of subsequent hikes. Persistently slow growth, low productivity, and low inflation are wearing on their outlook. Consequently, they continue to extend their expectations of a low interest rate environment. Policymakers are clearly moving toward market expectations in this regard.
Whether reality matches expectations remains an open question. Treasury rates have pulled up off their February lows, taking mortgages rates along for the ride. The Fed will be carefully monitoring this situation; they do not want mortgage rates in particular to climb ahead of the economy. The memories of the taper tantrum - and the subsequent stumble in the housing market - still sting. This time around, however, higher rates are being driven not by a shift in the expected Federal Reserve reaction function, but instead by an improved economic outlook. If housing markets can handle the higher rates (note the return of the first-time buyer), and there is reason to believe they will if wage growth continues to accelerate, then the Fed will feel more confident that they are getting across a message consistent with the evolution of activity. And they will thus be more willing to begin the normalization process in 2015 as they currently anticipate. 
Policymakers would like to orchestrate a smoother transition to more normal policy than that of the botched tapering signal. This time around they are more clearly signaling a transition in which interest rates are moving in line with an improvement in the broader equilibrium that includes stronger wage growth and inflation closer to target. They learned a lesson from the taper tantrum of 2013: Make sure the signals you send are consistent with the path of activity. Learning that lesson speaks well for the sustainability of the recovery. 
Bottom Line: Don't be surprised if you hear more Fed officials say they are still looking to rate hikes this year. Between being close to meeting their goals and the desire to move early to move slowly, the bar to hiking rates is probably not all that high. Watch instead for data that will either confirm or deny the Fed's near- and medium-term outlook. Seemingly paradoxically, that outlook has been increasingly dovish even as the countdown to the first rate hike ticks toward zero.

Thursday, June 18, 2015

'Wage Increases Do Not Signal Impending Inflation'

This note from Carola Binder was intended for the Fed meeting earlier this week, but it applies equally well to meetings yet to come:

Wage Increases Do Not Signal Impending Inflation: When the FOMC meets..., they will surely be looking for signs of impending inflation. Even though actual inflation is below target, any hint that pressure is building will be seized upon by more hawkish committee members as impetus for an earlier rate rise. The relatively strong May jobs report and uptick in nominal wage inflation are likely to draw attention in this respect.
Hopefully the FOMC members are aware of new research by two of the Fed's own economists, Ekaterina Peneva and Jeremy Rudd, on the passthrough (or lack thereof) of labor costs to price inflation. The research, which fails to find an important role for labor costs in driving inflation movements, casts doubts on wage-based explanations of inflation dynamics in recent years. They conclude that "price inflation now responds less persistently to changes in real activity or costs; at the same time, the joint dynamics of inflation and compensation no longer manifest the type of wage–price spiral that was evident in earlier decades." ...

Wednesday, June 17, 2015

Fed Watch: June FOMC Recap

Tim Duy:

June FOMC Recap, by Tim Duy: The FOMC meeting ended largely as expected with a nod toward recent data improvement but no change in policy. It is still reasonable to believe that lift-off will occur in September, but only if incoming data removes any residual concern about the sloppy data from earlier this year. Still, as Federal Reserve Chair Janet Yellen emphasized today, the lift-off itself is less important than the subsequent path of rates. That path remains subdued.
The FOMC statement itself was little changed - see the Wall Street Journal statement tracker here. Key is the opening line that validates the belief that the first quarter weakness was largely transitory:
Information received since the Federal Open Market Committee met in April suggests that economic activity has been expanding moderately after having changed little during the first quarter.
Otherwise, growth is expected to continue at a moderate pace that justifies an extended period of low interest rates. The updated forecasts saw reduced growth expectations this year as expected, while the near-term unemployment forecast was raised modestly (I had felt the Fed would be wary of doing this given their tendency to be overly pessimistic on this point). Longer term forecasts were essentially unchanged. The forecasts:

FEDFORE

The highest interest rate forecasts for 2015 were eliminated as was virtually required given the lack of any rate hike today. The median rate forecast suggests a rate hike this year, as did Yellen in her press conference. Still, she also said they are looking for decisive evidence to justify a rate hike, and I suspect that evidence will not arrive prior to the July meeting. Maybe September. Maybe not. It's all meeting by meeting now, you know.
Interestingly, although the inflation and unemployment forecasts for 2016 and 2017 were largely unchanged, the median interest rate projection fell along with the most hawkish forecasts. See this handy chart from Fulcrum Asset Management:

FULCRUM

No change in the inflation and unemployment forecasts combined with a slower and longer path to normal rates suggests a modest change in the reaction function. In effect, the Fed has turned more dovish as the timing of lift-off is delayed. Even with unemployment falling to current estimates of full employment next year, they do not believe the economy needs (or maybe could withstand) a rapid pace of hikes. Persistently low inflation and wage growth is taking its toll on policy expectations. And even the most hawkish participants are falling in line with this story.
Bottom Line: Fed policy unchanged as expected, door still open for a rate hike in September, but the lower rate path indicates a modestly more dovish Fed resigned to a persistent low interest rate environment. It's the rate path we need to be watching, not the timing of the first hike.

Tuesday, June 09, 2015

'Interest Rates: Natural or Artificial?'

Antonio Fatás:

Interest rates: natural or artificial?: The debate about who is responsible for the low level of interest rates that has prevailed in most economies over the last years heated up when Ben Bernanke wrote a series of blog posts on what determines interest rates. He argued, once again, that it is the global dynamics of saving and investment the one that created a downward trend in interest rates starting in the mid 90s and that it accelerated as a result of the crisis. In his story, central banks are simply reacting to economic conditions rather than driving the interest rate (always refreshing to see a former central banker explaining how powerless central banks are). What Bernanke described can be interpreted as a decrease in what economists called the natural real interest rate.
There are, however, those who have a very different interpretation of the persistent low levels of interest rates. They see central banks as the main drivers of this trend and they think about current levels of interest rates as being artificially low and forced on us by central banks. The popular press is full of references to artificially low interest rates causing bubbles, imbalances, hurting savers and being the seed of the future crisis (about 1 million results if you do a Google search).
From the academic world, John Taylor has been very vocal about the negative effects of artificially low interest rates. He stresses the fact that interest rates have been below what a Taylor rule indicates, a sign that there is a mispricing created by central banks. ...

After discussion, he concludes:

In summary, there are two very simple facts that provide strong support to the Bernanke hypothesis on why interest rates are (naturally) low:
1. Interest rates are low everywhere in the world.
2. Inflation remains low everywhere in the world.
These two facts are very difficult to square with a world where the US federal reserve is keeping interest rates artificially low for many years.

Saturday, June 06, 2015

'Crisis Chronicles: Railway Mania, the Hungry Forties, and the Commercial Crisis of 1847'

James Narron and Don Morgan

Crisis Chronicles: Railway Mania, the Hungry Forties, and the Commercial Crisis of 1847, by James Narron and Don Morgan, Liberty Street: Money was plentiful in the United Kingdom in 1842, and with low yields on government bonds and railway shares paying handsome dividends, the desire to speculate spread—as one observer put it, “the contagion passed to all, and from the clerk to the capitalist the fever reigned uncontrollable and uncontrolled” (Francis’s History of the Bank of England). And so began railway mania. Just as that bubble began to burst, a massive harvest failure in England and Ireland led to surging food imports, which drained gold reserves from the Bank of England. Constrained by the Bank Charter Act, the Bank responded by tightening policy. When food prices fell in the spring of 1847 on the prospects for a successful harvest, commodity speculators were caught short and a crisis, one of the worst in British history (Bordo), ensued. In this edition of Crisis Chronicles, we cover the Commercial Crisis of 1847.

Here's the part I want to highlight:

The Bank of England’s ability to contain the crisis as a lender of last resort was severely constrained by the Bank Charter Act of 1844 (Humphrey and Keleher). The Act gave the Bank of England a monopoly on new note (essentially money) issuance but required that all new notes be backed by gold or government debt. The intent, per Currency School doctrine, was to prevent financial crises and inflation by inhibiting currency creation. Adherents recognized that the Act might also limit the central bank’s discretion to manage crises, but they argued that limiting currency creation would prevent financial crises in the first place, thus obviating the need for a lender of last resort. But, of course, not all crises originate in the financial sector. In the case of the Commercial Crisis, the perverse effect of the Act was to cause the Bank to tighten monetary conditions in both April and October as gold reserves drained from the Bank (Dornbusch and Frenkel). In July, a coalition of merchants, bankers, and traders issued a letter against the Bank Charter Act, blaming it for “an extent of monetary pressure, such as is without precedent” (Gregory 1929, quoted in Dornbusch and Frenkel).
The panic culminated in a “Week of Terror,” October 17-23, with multiple banks failing or suspending payments to depositors in the midst of runs. The Royal Bank of Liverpool shuttered its doors on Tuesday, followed by three other banks, and by the end of the week the Bank of England held less than two million pounds in reserve, down from eight million in January. Systemic collapse seemed imminent. On Saturday of that week, London bankers petitioned Parliament to suspend the Bank Act, and by midday Monday it had done so, thus enabling the Bank to issue new notes without gold backing and to “enlarge the amount of their discounts and advances upon approved security” (J. Russell and Charles Wood, Bank of England). The ability to expand fiat note issuance increased liquidity and helped the Bank restore confidence, and the seven percent discount rate the Bank was charging attracted gold reserves back to its vaults (hence the maxim “seven percent will draw gold from the moon”). By December, interest rates were down substantially from their panic levels.

And the big question:

In contrast to the Bank of England in 1847, the Federal Reserve during the Panic of 2007-2008 was authorized to act as lender of last resort, and, in fact, the Fed acted aggressively to provide liquidity to the financial system in unprecedented ways. Through a variety of newly created facilities, the Fed expanded the types of institutions it would lend to, including nonbanks, and the types of collateral it would lend against, including asset-backed securities.
While some observers have praised the Fed’s actions, others, including some within the Fed, have been more critical. Partly in response to such criticism, the Dodd-Frank Act limits the Fed’s ability to lend to individual firms, as the Fed did during the panic, and a more recently proposed bill would further constrain the Fed’s emergency lending discretion. Will these reforms curb the moral hazard (excess risk-taking) that last-resort lending might invite? Might they aggravate future crises by curbing the Fed’s discretion as lender of last resort?

I have always believed that if another big financial crisis hits, the associated fear and panic would cause the Fed's emergency lending discretion to be restored.

Wednesday, June 03, 2015

Krugman vs. DeLong

Krugman vs. DeLong has an outcome that follows DeLong's rule:

Krugman: The Inflationista Puzzle: Martin Feldstein has a new column on what he calls the “inflation puzzle” — the failure of inflation to soar despite the Fed’s large asset purchases, which led to a very large rise in the monetary base. As Tony Yates points out, however, there’s nothing puzzling at all about what happened; it’s exactly what you should expect when interest rates are near zero.
And this isn’t an ex-post rationale, it’s what many of us were saying from the beginning. Traditional IS-LM analysis said that the Fed’s policies would have little effect on inflation; so did the translation of that analysis into a stripped-down New Keynesian framework that I did back in 1998, starting the modern liquidity-trap literature. ...
DeLong: New Economic Thinking, Hicks-Hansen-Wicksell Macro, and Blocking the Back Propagation Induction-Unraveling from the Long Run Omega Point: ... Whatever may be going on in the short run must thus be transitory in duration, moderate in their effects, and limited in the distance it can can push the economy away from its proper long run equilibrium. And it certainly cannot keep it there. Not for long.
This is the real critique of Paul Krugman’s “depression economics”. Paul can draw his Hicksian IS-LM diagrams of an economy stuck in a liquidity trap...
He can draw his Wicksellian I=S diagrams of how the zero lower bound forces the market interest rate above the natural interest rate at which planned investment balances savings that would be expected were the economy at full employment...
Paul can show, graphically, that conventional monetary policy is then completely ineffective–swapping two assets that are perfect substitutes for each other. Paul can show, graphically, that expansionary fiscal policy is then immensely powerful and has no downside: it does not generate higher interest rates; it does not crowd out productive private investment; and, because interest rates are zero, it entails no financing burden and thus no required increase in future tax wedges. But all this is constrained and limited by the inescapable and powerful logic of the induction-unraveling propagating itself back through the game tree from the Omega Point that is the long run equilibrium. In the IS-LM diagram, the fact that the long run is out there means that even the contemplation of permanent expansion of the monetary base is rapidly moving the IS curve up and to the right, and thus leading the economy to quickly exist the liquidity trap. In the Wicksellian I=S diagram, the fact that the long run is out there means that even the contemplation of permanent expansion of the monetary base is rapidly moving the I=S curve up so that the zero lower bound will soon no longer constrain the economy away from its full-employment equilibrium.
The “depression economics” equilibrium Paul plots on his graph is a matter for today–a month or two, or a quarter or two, or at most a year or two. ...
Krugman:Backward Induction and Brad DeLong (Wonkish): Brad DeLong is, unusually, unhappy with my analysis in a discussion of the inflationista puzzle — the mystery of why so many economists failed to grasp the implications of a liquidity trap, and still fail to grasp those implications despite 6 years of being wrong. Brad sorta-kinda defends the inflationistas on the basis of backward induction; I find myself somewhat baffled by that defense.

Actually, I find myself baffled both theoretically and empirically. ...

In the end, while the post-2008 slump has gone on much longer than even I expected (thanks in part to terrible fiscal policy), and the downward stickiness of wages and prices has been more marked than I imagined, overall the model those of us who paid attention to Japan deployed has done pretty well — and it’s kind of shocking how few of those who got everything wrong are willing to learn from their failure and our success.
DeLong: Paul Krugman Was Right. I, Ken Rogoff, Marty Feldstein, and Many, Many Others Were Wrong: The question is: Why were we wrong? We had, after all, read, learned, and taught the same Hicks-Hansen-Wicksell-Metzler-Tobin macro that was Paul Krugman’s foundation. ...

I want to highlight one of Brad's points. Theoretical models often act as if there is only one type of demand shock, and the short-run depends upon a single variable, e.g. the time period when inflation expectations are wrong. But the short-run depends upon the type of recession we experience, and the variable that signals the length of the recovery will not be the same in every case. A monetary induced recession will have a much shorter short-run than a balance sheet recession induced by a financial collapse, and an recession caused by an oil price shock will recover differently from both. Early in the Great Recession, policymakers, analysts, and most economists did not fully recognize that this recession truly was different, and hence required a different policy approach from the recessions in recent memory. Krugman, due to his work on Japan, did see this early on, but it took time for the notion of a balance sheet recession to take hold, and we never fully adopted fiscal policy to deal with this fact (e.g. sufficient help with rebuilding household balance sheets). To me this in one of the big lessons of the Great Recession -- we must figure out the type of recession we are experiencing, realize that the "short-run" will depend critically on the type of shock causing the recession, and adopt our policies accordingly. If we can do that, then maybe the short-run won't be a decade long the next time we have a balance sheet recession. And there will be a next time.

'Did The Fed Fail To Save Lehman Brothers Because It Legally Couldn't?'

David Zaring at The Conglomerate:

Did The Fed Fail To Save Lehman Brothers Because It Legally Couldn't?: My soon to be colleague Peter Conti-Brown and Brookings author (and future Glom guest) Philip Wallach are debating whether the Fed had the power to bail out Lehman Brothers in the middle of the financial crisis. The Fed's lawyers said, after the fact, that no, they didn't have the legal power to bail out Lehman. Peter says yes they did, Philip says no, and I'm with Peter on this one - the discretion that the Fed had to open up its discount window to anyone was massive. In fact, I'm not even sure that Dodd-Frank, which added some language to the section, really reduced Fed discretion much at all. It's a pretty interesting debate, though, and goes to how much you believe the law constrains financial regulators.

Here's Peter:

as I discuss at much greater length in my forthcoming book, The Power and Independence of the Federal Reserve, the idea that 13(3) presented any kind of a statutory barrier is pure spin..., so long as the Reserve Bank was “satisfied” by the security offered and there is “evidence”—some, any, of undefined quality—the loan could occur. 

Here's Philip:

I (and most observers) read the “satisfaction” requirement as meaning that the Fed can only lend against what it genuinely believes to be sound collateral—i.e., it must act as a (central) bank, and not as a stand-in fiscal authority. The Fed’s assessment of Lehman Brothers as deeply insolvent at the time of the crisis meant that it did not have the legal power to lend. ...

And the debate will be going on over at the Yale J on Reg for the rest of the week.  Do give it a look.

Friday, May 29, 2015

'It Would be a Mistake to Raise the Target Range for the Fed Funds Rate in 2015'

The conclusion of the most recent speech by Narayana Kocherlakota, President Federal Reserve Bank of Minneapolis

I am an economist, and economics is often, with good reason, called the “dismal” science. But my message to you today is one of hope and optimism.
From 2006 to 2009, we saw a marked deterioration in labor market performance. As recently as a year ago, it seemed like this loss of human resources might prove to be permanent. But the rapid growth in employment that we saw in 2014 shattered this hypothesis. The lesson of 2014 is clear: We can do better. The FOMC is charged with promoting maximum employment. In the wake of 2014, I see no reason why the Committee should not aim to facilitate continued improvement in labor market conditions. Indeed, I see no reason why we should not aim for the kind of strong labor market conditions that prevailed at the end of 2006.
But we will only get there if we make the right choices. The FOMC can only achieve its congressionally mandated price and employment goals by being extraordinarily patient in reducing the level of monetary accommodation. Under my current outlook, I continue to believe that it would be a mistake to raise the target range for the fed funds rate in 2015.

Hopefully today's GDP report will emphasize the need for the Fed to be patient (despite the White House's don't worry, be happy take on the report).

Wednesday, May 27, 2015

'Do Central Banks Need Capital?'

The start of a longer post from Cecchetti & Schoenholtz

Do central banks need capital?: If you ask monetary economists whether we should care if a central bank’s capital level falls below zero (even for an extended period of time), most will say no. Pose the same question to central bank governors, and the answer in nearly every case will be yes.
What accounts for this stark difference? How can something that seems not to matter in theory be so important in practice?
The economists correctly argue that central banks are fundamentally different from commercial banks, so they can go about their business even if they have negative net worth. However, central bankers know instinctively that the effectiveness of policy depends critically on their credibility. They worry that a shortfall of capital would threaten their independence, which is the foundation of that credibility.
The recent experience of the Swiss National Bank (SNB) can help us to explain what we mean. ...

Thursday, May 14, 2015

Fed Watch: Get Used To It

Tim Duy:

Get Used To It, by Tim Duy: As is well known, second quarter GDP growth is not off to a strong start, at least according to the Atlanta Federal Reserve staff:

Gdpnow-forecast-evolution

If this forecast holds, then the first half of 2015 will be very weak if not flat, slow enough that commentators might be tempted to refer to growth as at "stall speed". But quarterly GDP numbers are fairly volatile. Would two consecutive weak quarters be terribly unexpected, or even suggestive of a troubling undercurrent in the economy? It is somewhat difficult to panic about the GDP numbers just yet, especially in the context of the continuous slide in the forward-looking unemployment claims indicator:

CLAIMS051315

Moreover, should we be surprised by the occasionally GDP number in the context of lower estimate of potential growth? As Calculated Risk likes to say:
Right now, due to demographics, 2% GDP growth is the new 4%.
A simple way to think about this is to look at the confidence interval around the one-step ahead GDP forecast from an AR2 model:

GDP051315

Prior to the Great Depression, it would be very unusual for the confidence interval to include a negative read on GDP outside of a recession. Following the Great Depression, however, the confidence interval around the forecast almost always captures the possibility of a negative outcome. This is likely the consequence of two factors, the downshifting of GDP growth as described by Calculated Risk and an increased GDP growth volatility in the most recent sample.
Bottom Line: We probably need to get used to the occasional negative GDP growth numbers in the context of overall expansion for the US economy. The concept of "stall speed" will need to be revised accordingly.

Monday, May 11, 2015

'A Note on Nominal GDP Targeting and the Zero Lower Bound'

Roberto M. Billi, senior researcher at the Sveriges Riksbank, has a new paper on nominal GDP targeting:

”A Note on Nominal GDP Targeting and the Zero Lower Bound,” Sveriges Riksbank Working Paper Series No. 270, Revised May 2015: Abstract: I compare nominal GDP level targeting to strict price level targeting in a small New Keynesian model, with the central bank operating under optimal discretion and facing a zero lower bound on nominal interest rates. I show that, if the economy is only buffeted by purely temporary shocks to inflation, nominal GDP level targeting may be preferable because it requires the burden of the shocks to be shared by prices and output. But in the presence of persistent supply and demand shocks, strict price level targeting may be superior because it induces greater policy inertia and improves the tradeoffs faced by the central bank. During lower bound episodes, somewhat paradoxically, nominal GDP level targeting leads to larger falls in nominal GDP.

Tuesday, May 05, 2015

'Inflation Expectations and Recovery from the Depression in 1933'

Andrew Jalil and Gisela Rua:

Inflation Expectations and Recovery from the Depression in 1933: Evidence from the Narrative Record, by Andrew Jalil and Gisela Rua, April 2015: Abstract This paper uses the historical narrative record to determine whether inflation expectations shifted during the second quarter of 1933, precisely as the recovery from the Great Depression took hold. First, by examining the historical news record and the forecasts of contemporary business analysts, we show that inflation expectations increased dramatically. Second, using an event - studies approach, we identify the impact on financial markets of the key events that shifted inflation expectations. Third, we gather new evidence — both quantitative and narrative — that indicates that the shift in inflation expectations played a causal role in stimulating the recovery.

Monday, May 04, 2015

Ben Bernanke's Bad Example

At MoneyWatch:

Ben Bernanke's bad example, by Mark Thoma: The recent announcements that former Federal Reserve Chairman Ben Bernanke has accepted a position as a senior adviser at Pimco and a similar position at hedge fund Citadel have raised questions about whether the "revolving door" between government and private sector jobs ought to be restricted.
Perhaps, for example, Federal Reserve officials should be subject to a five-year waiting period before they can take jobs in the financial sector. The idea would be to reduce the chance that bank regulators could be influenced through formal and informal ties to previous Fed officials.
My concern is somewhat different: The incentive for Federal Reserve Board members to step down before their terms are up and accept lucrative private sector positions has the potential to damage the Fed as an independent institution...

Saturday, May 02, 2015

'Assessing the Effects of Monetary and Fiscal Policy'

From the NBER Reporter:

Assessing the Effects of Monetary and Fiscal Policy, by Emi Nakamura and Jón Steinsson, NBER Reporter 2015 Number 1: Research Summary: Monetary and fiscal policies are central tools of macroeconomic management. This has been particularly evident since the onset of the Great Recession in 2008. In response to the global financial crisis, U.S. short-term interest rates were lowered to zero, a large fiscal stimulus package was implemented, and the Federal Reserve engaged in a broad array of unconventional policies.
Despite their centrality, the question of how effective these policies are and therefore how the government should employ them is in dispute. Many economists have been highly critical of the government's aggressive use of monetary and fiscal policy during this period, in some cases arguing that the policies employed were ineffective and in other cases warning of serious negative consequences. On the other hand, others have argued that the aggressive employment of these policies has "walk[ed] the American economy back from the edge of a second Great Depression."1
In our view, the reason for this controversy is the absence of conclusive empirical evidence about the effectiveness of these policies. Scientific questions about how the world works are settled by conclusive empirical evidence. In the case of monetary and fiscal policy, unfortunately, it is very difficult to establish such evidence. The difficulty is a familiar one in economics, namely endogeneity. ..

After explaining the endogeneity problem, empirical evidence on price rigidity and its importance for assessing policy, structural modeling, natural experiments, and so on, they turn to their evidence:

Our identification approach is to study how real interest rates respond to monetary shocks in the 30-minute intervals around Federal Open Market Committee announcements. We find that in these short intervals, nominal and real interest rates for maturities as long as several years move roughly one-for-one with each other. Changes in nominal interest rates at the time of monetary announcements therefore translate almost entirely into changes in real interest rates, while expected inflation moves very little except at very long horizons.
We use this evidence to estimate the parameters of a conventional monetary business cycle model. ... This approach suggests that monetary non-neutrality is large. Intuitively, our evidence indicates that a monetary shock that yields a substantial response for real interest rates also yields a very small response for inflation. This suggests that prices respond quite sluggishly to changes in aggregate economic conditions and that monetary policy can have large effects on the economy.
Another area in which there has been rapid progress in using innovative identification schemes to estimate the impact of macroeconomic policy is that of fiscal stimulus.9 ... Much of the literature on fiscal stimulus that makes use of natural experiments focuses on the effects of war-time spending, since it is assumed that in some cases such spending is unrelated to the state of the economy. Fortunately - though unfortunately for empirical researchers - there are only so many large wars, so the number of data points available from this approach is limited.
In our work, we use cross-state variation in military spending to shed light on the fiscal multiplier.10 The basic idea is that when the U.S. experiences a military build-up, military spending will increase in states such as California - a major producer of military goods - relative to states, such as Illinois, where there is little military production. This approach uses a lot more data than the earlier literature on military spending but makes weaker assumptions, since we require only that the U.S. did not undertake a military build-up in response to the relative weakness of the economy in California vs. Illinois. We show that a $1 increase in military spending in California relative to Illinois yields a relative increase in output of $1.50. In other words, the "relative" multiplier is quite substantial.11
There is an important issue of interpretation here. We find evidence of a large "relative multiplier," but does this imply that the aggregate multiplier also will be large? The challenge that arises in interpreting these kinds of relative estimates is that there are general equilibrium effects that are expected to operate at an aggregate but not at a local level. In particular, if government spending is increased at the aggregate level, this will induce the Federal Reserve to tighten monetary policy, which will then counteract some of the stimulative effect of the increased government spending. This type of general equilibrium effect does not arise at the local level, since the Fed can't raise interest rates in California vs. Illinois in response to increased military spending in California relative to Illinois.
We show in our paper, however, that the relative multiplier does have a very interesting counterpart at the level of the aggregate economy. Even in the aggregate setting, the general equilibrium response of monetary policy to fiscal policy will be constrained when the risk-free nominal interest rate is constrained by its lower bound of zero. Our relative multiplier corresponds more closely to the aggregate multiplier in this case.12 Our estimates are, therefore, very useful in distinguishing between new Keynesian models, which generate large multipliers in these scenarios, and plain vanilla real business cycle models, which always generate small multipliers.
The evidence from our research on both fiscal and monetary policy suggests that demand shocks can have large effects on output. Models with price-adjustment frictions can explain such output effects, as well as (by design) the microeconomic evidence on price rigidity. Perhaps this evidence is still not conclusive, but it helps to narrow the field of plausible models. This new evidence will, we hope, help limit the scope of policy predictions of macroeconomic models that policymakers need to consider the next time they face a great challenge. ...

Thursday, April 30, 2015

Fed Watch: Data Note

Tim Duy:

Data Note, by Tim Duy: The Personal Income and Outlays report for March was released today. The pace of spending accelerated to 0.3% in real terms, the highest since last November and indication that the economy is perhaps shaking off some of its winter blues. On the other hand, inflation undershot the Fed's target for the 35th consecutive month, with core-inflation climbing just 1.3% over the past year. I would be a little wary that Fed officials won't find room for a somewhat more optimistic read on the data. Indeed, core-inflation on a monthly basis is also recovering from a winter stumble:

PCEa043015

The annualized monthly rate was for core-PCE inflation was 1.79% in March, arguably within spitting distance of the Fed's target. Definitely something policymakers will be watching. At least those not thinking that 2% is too low a target in any event. So although we should keep an eye on the year-over-year numbers, we should be listening for what policymakers say about the month-over-month trends. Right now, those trends argue in favor of the "transitory" hypothesis.
Monetary policymakers will also be watching, obviously, next week's employment report. Only two left before the June meeting, and they need to be reasonably good for the pendulum to swing back to the hawks by then. But would only "reasonably good" be "good" enough? One thing I am watching is how much longer Fed officials will be content to risk falling behind the curve. I think the Fed is concerned about the potential for a discontinuous jump in wage growth as the economy approaches 5% unemployment, illustrated as:

PHILLIPS043015

This is why Fed Chair Janet Yellen does not believe they need to see accelerating wage growth before hiking rates - she has faith it is coming and that the lower unemployment is when the dam breaks, the higher the odds of a jump in wage growth that signals an economy with rapidly diminishing labor slack. They want to be reacting slowing ahead of such a scenario, rather than quickly on the other side. 
Bottom Line: The Fed is in "wait-and-see" mode after the weak first quarter, and odds are against the Fed seeing a path to a June rate hike. But I that remain wary that the patience of the newly data-dependent Fed has worn thinner than commonly believed.

'Let Me Strongly Dissent from Ben Bernanke's Claim...'

Brad DeLong:

Let Me Strongly Dissent from Ben Bernanke's Claim That the Critical Objective of Recovery Viewed in the Proper Metrics Is Being Met: Ben Bernanke: WSJ Editorial Page Watch: The Slow-Growth Fed?: "The Wall Street Journal... argue[s] (again) for tighter monetary policy...

...It's generous of the WSJ writers to note... that 'economic forecasting isn't easy.' They should know, since the Journal has been forecasting a breakout in inflation and a collapse in the dollar at least since 2006, when the FOMC decided not to raise the federal funds rate above 5-1/4 percent.... They fail to note... unemployment, which has fallen more quickly than anticipated.... The relatively rapid decline in unemployment in recent years shows that the critical objective of putting people back to work is being met...

No, no, no, no, no, no, no, no, no. NO! NO!!!!

It is not the case that since 2000 three percent of our 25-54 year olds have decided that being at work is not what it is cracked up to be, and it is better to live in their parents' basement surfing the net.

It is the case that the low-pressure economies and resulting lousy labor markets since 2001 have degraded the social networks that Americans--especially young Americans--use to find jobs, and that an extra three percent of our 25-54 year olds are discouraged, largely rationally discouraged, from looking for jobs. And that other age groups are in the same situation.

You ... should not say that: "the critical objective of putting people back to work is being met..."? No, no, no, no, no.

You should say that it is being partially met. You should say that it is being left substantially unmet.

Wednesday, April 29, 2015

Fed Watch: FOMC Snoozer

Tim Duy:

FOMC Snoozer, by Tim Duy: The FOMC concluded their meeting today, and the result left Fed watchers struggling to find something interesting to say. The really offered no insight into the economy with the opening paragraph:
Information received since the Federal Open Market Committee met in March suggests that economic growth slowed during the winter months, in part reflecting transitory factors. The pace of job gains moderated, and the unemployment rate remained steady. A range of labor market indicators suggests that underutilization of labor resources was little changed. Growth in household spending declined; households' real incomes rose strongly, partly reflecting earlier declines in energy prices, and consumer sentiment remains high. Business fixed investment softened, the recovery in the housing sector remained slow, and exports declined. Inflation continued to run below the Committee's longer-run objective, partly reflecting earlier declines in energy prices and decreasing prices of non-energy imports. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations have remained stable.
Policy-wise, nothing changed other than the elimination of any date-based forward guidance, as expected.
In their defense, the repeated pattern of weakness in the first quarter over the past several years should leave one hesitant to draw much if any conclusions from recent data. I attribute the flat growth to a variety of factors, most of which are technical or transitory: seasonal adjustment problems, weather impacts, the West coast port slowdown, a greater initial impact of falling oil prices on investment than consumption (as predicted by the Atlanta Fed), and the stronger dollar. It was a mistake to get caught up in last year's first quarter GDP decline, and I think it would be a mistake to get caught up in this year's. Indeed, the underlying pace of growth remains stable to ever-so-gradually accelerating:

GDPa042815

That said, Bloomberg reports that market economists are sharply pulling back their Q2 GDP forecasts. I am always wary of over-reacting to the last data point; you need to be cautious that your "forecast" doesn't become a "backcast". This I think sets the stage for positive economic surprises in the months ahead.
I think it is also worth noting that while Wall St. engages in nonstop hand-wringing on the state of the economy, Main St. firms are pushing ahead with research and development spending at a pace not seen in years:

GDPb042815

This too bodes well for the strength and sustainability of underlying economic growth.
The FOMC statement provides little new information about the timing or pace of future rates hikes. Even if you believe, as I do, that the first quarter weakness will prove to be largely transitory, the Fed is not willing to take that chance. They will need better data to justify a rate hike, and that need is pushing the timing of a policy change ever-deeper into 2015. There just isn't that much data between now and June to move the needle on policy. You need the jobs and inflation data to turn sharply better to pull the Fed back to June. It could happen, but I am not confident it will happen.
Bottom Line: Wait and see - that's the message of this statement.

Tuesday, April 21, 2015

'An Overwhelming Argument for Draconian Bank Regulation'

Paul Krugman on John Taylor's claim that deviations from his Taylor Rule caused the financial crisis:

...if it’s really that easy for monetary errors to endanger financial stability — if a deviation from perfection so small that it leaves no mark on the inflation rate is nonetheless enough to produce the second-worst financial crisis in history — this is an overwhelming argument for draconian bank regulation. Modest monetary mistakes will happen, so if you believe that these mistakes caused the global financial crisis you must surely believe that we need to do whatever it takes to make the system less fragile. Strange to say, however, I don’t seem to be hearing that from Taylor or anyone else in that camp.

Monday, April 20, 2015

'Labor Market Slack and Monetary Policy'

Let's hope the Fed is listening:

Labor Market Slack and Monetary Policy, by David G. Blanchflower and Andrew T. Levin, NBER Working Paper No. 21094: In the wake of a severe recession and a sluggish recovery, labor market slack cannot be gauged solely in terms of the conventional measure of the unemployment rate (that is, the number of individuals who are not working at all and actively searching for a job). Rather, assessments of the employment gap should reflect the incidence of underemployment (that is, people working part time who want a full-time job) and the extent of hidden unemployment (that is, people who are not actively searching but who would rejoin the workforce if the job market were stronger). In this paper, we examine the evolution of U.S. labor market slack and show that underemployment and hidden unemployment currently account for the bulk of the U.S. employment gap. Next, using state-level data, we find strong statistical evidence that each of these forms of labor market slack exerts significant downward pressure on nominal wages. Finally, we consider the monetary policy implications of the employment gap in light of prescriptions from Taylor-style benchmark rules.

[Open link]

Tuesday, April 14, 2015

Sometimes, Boosting Supply Requires More Demand

I tried to make this point long ago (see below):

Sometimes, Boosting Supply Requires More Demand, by Greg Ip, WSJ: The Federal Reserve, everyone agrees, can boost growth in the short run. But can it do it over the long run? This once heretical concept is the latest argument in favor of the Fed taking its time about raising interest rates.
Traditionally, economists treated supply and demand as separate matters. ... The Fed, in this traditional view, can affect how demand fluctuates around the long-run trend, but it can’t affect the long-run trend itself.
But in real life, supply and demand are not so easily separated. The labor force is a function not just of the number of people of working age (a supply-side factor), but also how long they’ve been unemployed and thus how useful their skills are (a demand-side factor). Business investment in new equipment isn’t just a function of the state of technology (a supply side factor), but what they anticipate sales to be in coming years (a demand side factor).
This means that policies that affect demand in the short run can, conceivably, affect supply in the long run, as well. ...
Jay Powell, a Fed governor, makes the point in a speech last week. ... Mr. Powell suggests, the Fed should not assume capacity is written in stone and immune to monetary policy: “Should we think of this supply-side damage as permanent or temporary?” he said in his speech last week. “It seems plausible that at least part of the damage can be reversed. ...
This means, Mr. Powell says, the Fed should be more skeptical than usual when superficial evidence suggests the economy is approaching capacity. While he dances around the implications for monetary policy a bit, the conclusion is obvious: the Fed should stay easier, for longer, which should “not only help restore some of our economy’s potential,” but get inflation back up to 2% faster.
Mr.  Powell’s logic is quite compelling and provides an important reason why the Fed should err on the side of letting unemployment fall well below traditional measures of the “natural rate” of unemployment before tightening. ...

This post is from March, 2012 (see also David Beckworth's comments on endogenous labor supply):

The Gap In Monetary and Fiscal Policy, by Mark Thoma: One of the big questions for policymakers is how much of the current downturn represents of temporary cyclical fluctuation and how much of it is a permanent reduction in out productive capacity. If the downturn is mostly temporary, then we will eventually bounce back to the old output trend line. Something like this:

SR-LR-AS-1

But if it's mostly permanent, i.e. if the trend has fallen to a lower value and will stay there, then the picture is different:

SR-LR-AS-2

In the first case, highly stimulative policy is appropriate to help the economy get back to the long-run trend as soon as possible. There's still a lot of ground to cover, and policy can help. But in the second case the economy is already back to it's long-run trend at most points in time, or nearly so, and there is no need for policymakers to do much of anything at all. At least that's what we're told.
However, I think this misses part of the story. What it misses is that AS shocks themselves can be both permanent and temporary, and some people may be confusing one for the other. For example, when there as a large AD shock in the form of a change in preferences, say that people no longer like good A as it has gone out of fashion and have now decided B is the must have good, then there will be high unemployment in industry A and excess demand for labor and other resources in industry B. As workers and resources leave industry A, our productive capacity falls and it stays lower until the workers and other resources eventually find their way into industry B. When this process is complete, productive capacity returns to where it was before, or perhaps goes even higher. Thus, there is a short-run cycle in productive capacity that mirrors the business cycle.
A standard business cycle type AD shock will temporarily depress capacity and produce similar effects. Suppose that interest rates go up, taxes go up, government spending goes down, investment falls --pick your story -- causing aggregate demand to fall. When, as a result, businesses lay people off, idle equipment, etc., productive capacity will fall. It can be cranked up again, and will be when the economy recovers, but rehiring labor and taking equipment out of mothballs takes time. In the interim the natural rate of output falls and, just as with a change in the preference for good A versus good B, a negative aggregate demand shock can cause "frictions" on the supply side that temporarily increase the natural rate of unemployment. And there are many other ways this can happen as well.
The point is that there can be short-run cyclical AS effects, and failing to account for these can lead to policy errors. Consider the following diagram:

SR-LR-AS-3

Up until the point where the line splits into three pieces, assume the economy is in long-run equilibrium with output at the natural rate (we can discuss whether the natural rate actually exists another time, I want to work in the standard model for the moment since that is where the policy discussion is centered). Then, for some reason, aggregate demand falls leading the economy into a recession. As AD falls, people are laid off, equipment is stored, factories are shuttered, and so on and the economy's capacity to produce falls in the short-run as shown by the blue line on the diagram.
But this is a temporary, not a permanent situation. Eventually people will be put back to work, trucks in parking lots will be back on the road, factories will reopen -- you get the picture -- and productive capacity will grow as the economy recovers. I believe many people are treating what is ultimately a temporary fall in capacity as a permanent change, and they are making the wrong policy recommendations as a result.
In fact, there's no reason to think productive capacity can't return to its long-run trend just as fast or faster than output can recover. If so, then it would be a mistake to do as many are doing presently and treat the blue short-run y* line as a constraint for policy, conclude that the gap is small and hence there's nothing for policy to do. Capacity will recover, and policymakers must take this into account when looking at whether additional policy can help the economy. If capacity can grow fast as the economy recovers, then it poses little constraint and policymakers should try to return us to the long-run trend as soon as possible. That is, aggressive policy is still called for even if productive capacity is presently relatively low. ...
One last point about the diagram. I drew the long-run line so there is a long-run decline in the trend of our productive capacity after the recession (i.e. a permanent shock). However, it's hard to see because, consistent with my beliefs, I do not think the change in our long-run capacity to produce goods and services will be as negative as many others. So the effect is not large in the diagram (I acknowledge I'm more optimistic on this point than many others that I respect). But even if the long-run trend had fallen by more than shown in the diagram, say by 50%, the points above would still hold. If the capacity to produce recovers as the economy recovers, and does so relatively fast, then policymakers should not be constrained by the belief that the natural rate of output is relatively low at the present time. Aggressive policy is still the best course of action.

If I were to do this today -- several years later -- I would draw the last graph so that the permanent fall in productive capacity is larger (i.e. the Y*LR line would be lower). But, as explained in the last paragraph, the main point still holds.

Friday, April 03, 2015

Fed Watch: Air Pocket

Fed Watch:

Air Pocket, by Tim Duy: The employment data hit an air pocket in March, in line with a variety of softer economic news in the first quarter. That said, it likely will have little near term impact on Fed policy; I anticipate they will tend to dismiss the number as expected volatility in the overall upward path of job growth.
Job growth was paltry 126k in March and, in what might be a greater indication that US labor markets are hitting an inflection point, the January and February numbers were revised downward. The three-month moving average dipped sharply, while the 12-month moving average is leveling out:

NFPa040315

A clear slowdown in the good producing sector is contributing to the weaker numbers as the impact of lower oil prices works through mining. That factor, the stronger dollar, and the West coast port slowdown are also likely taking a toll on manufacturing. Flat construction numbers also contributed.
The unemployment rate was unchanged at 5.5% and wage growth remains tepid compared to last year. Payrolls in the context of indicators previously cited by Federal Reserve Chair Janet Yellen:

NFPc040315

NFPb040315

Broad yet still slow general improvement in underemployment indicators.

How does this impact the Fed's outlook? First, some recent quotes from policymakers, beginning with Federal Reserve Chair Janet Yellen:

...I anticipate that real gross domestic product is likely to expand somewhat faster than its potential in coming quarters, thereby promoting further gains in employment and declines in the unemployment rate.

And:

...a significant pickup in incoming readings on core inflation will not be a precondition for me to judge that an initial increase in the federal funds rate would be warranted...

...That said, I would be uncomfortable raising the federal funds rate if readings on wage growth, core consumer prices, and other indicators of underlying inflation pressures were to weaken, if market-based measures of inflation compensation were to fall appreciably further, or if survey-based measures were to begin to decline noticeably...

San Francisco Federal Reserve President John Williams, via the Wall Street Journal:

“Things are looking better–in fact, they’re looking downright good,” the official said in a speech to be delivered to an audience in Sydney and Melbourne via video.

Given how much the economy has improved and is likely to continue to gain ground, “I think that by mid-year it will be the time to have a discussion about starting to raise rates,” Mr. Williams said.

The strength of the U.S. dollar against a “broad index” of currencies is not an impediment to the U.S. economy reaching real GDP growth of 2.5% this year, he said.

“The U.S. economy has good momentum…even with what is a rather large appreciation of the U.S. dollar,” Mr. Williams said.

Atlanta Federal Reserve President Dennis Lockhart, via the New York Times:

The slowness in the first quarter obviously raises concerns that we’re going to see a continuing or persistent slowdown, but that’s not my base case view. My base case view is that we’ll see a rebound in the second and third quarter and beyond and that we’ll stay on the basic track that has been our story, our narrative here, for the last year or more. And that is a 2.5 percent to 3 percent growth rate with continuing improvement on the employment front, and gradual rise in inflation toward the 2 percent target. So to some extent I’m taking on a Wilbur Mills position: That’s my story and I’m sticking to it.

St. Louis Federal Reserve President James Bullard, via the Wall Street Journal:

Mr. Bullard said he expects the economy to recover in the second quarter following a soft start to the year as low gasoline prices fuel consumer spending. He added the European Central Bank’s decision to begin buying government bonds is driving down bond yields in the U.S., too, keeping a lid on corporate and household borrowing costs.

“These facts put us in a position for normalization of us monetary policy in 2015,” Mr. Bullard told the City Week conference.

You get the picture. Federal Reserve officials are clearly looking past the first quarter. Hence, while the number was clearly disappointing, I will stick with my thoughts from earlier this week:

Yellen intends to look through any first quarter weakness in GDP data, seeing it as largely an aberration (like arguably the first quarter of last year), as long as the employment data continues to hold up. And even there, I doubt any one weak report would do much to undermine her confidence in the recovery; we should be focusing on the story told by the next three employment reports in aggregate.

That said, I would also add that this strengthens the case that the Federal Reserve will need to move further in the direction of financial markets toward a slower and lower path of normalization than currently anticipated by the Summary of Economic Projections. It may be that if the March number was an outlier to the downside, the strong job growth in November and December of last year where outliers to the upside. On net, then job growth is solid, but still less robust than anticipated at the end of last year. Combined with lower estimates of the natural rate of unemployment, this would naturally push back and down the policy path.

Bottom Line: One jobs report is just that - one report. It needs to be placed in context of subsequent reports to confirm or deny the underlying trend, at least as far as policymakers are concerned. At the moment they seem content to believe the first quarter will be an aberration overall. If it looks like less of an aberration come June, they will be forced to push normalization plans back into the fourth quarter. This would make them less than happy.

Thursday, April 02, 2015

'Central Bank Solvency and Inflation'

Marco Del Negro and Christopher A. Sims:

Central Bank Solvency and Inflation, Liberty Street Economics: The monetary base in the United States, defined as currency plus bank reserves, grew from about $800 billion in 2008 to $2 trillion in 2012, and to roughly $4 trillion at the end of 2014 (see chart below). Some commentators have viewed this increase in the monetary base as a sure harbinger of inflation. For example, one economist wrote that this “unprecedented expansion of the money supply could make the '70s look benign.” These predictions of inflation rest on the monetarist argument that nominal income is proportional to the money supply. The fact that the money supply has expanded rapidly while real income has grown very modestly means that sooner or later prices will have to catch up. Most academic economists (from Cochrane to Krugman and Mankiw) disagree. The monetarist argument arguably applies only to non-interest-bearing central bank liabilities, but since October 2008 a large fraction of the monetary base has consisted of reserves that pay interest (the so-called IOER, or interest on excess reserves) and one linchpin of the Fed’s “policy normalization principles” consists precisely in raising the IOER along with the federal funds rate. Since reserves pay close to market interest rates, they are close substitutes for other short-term assets such as Treasury bills from a bank’s perspective. As long as the central bank can affect the return on these short-term assets by adjusting the IOER, controlling inflation with a large balance sheet seems no different than it was before the Great Recession.

U.S. Monetar Base

In fact, if we look at expansion of the central bank’s balance sheet (known as LSAP—large-scale asset purchases—within the Fed, and as QE—quantitative easing—to the rest of the world) from the perspective of the consolidated budget constraint of the U.S. government, we realize that the expansion shortened the maturity structure of the federal debt (at least for the part concerning the purchase of Treasuries), as explained in the LSE post “More Than Meets the Eye: Some Fiscal Implications of Monetary Policy.” When the Fed buys long-term Treasuries by issuing interest-bearing reserves, it effectively retires this long-term debt, at least temporarily, and replaces it with very short-term (overnight) debt reserves. Seen from this vantage point, the hyperinflation fears mentioned above appear misplaced: Why should a change in the maturity structure of the federal debt generate hyperinflation as long as the central bank continues to follow a Taylor-type rule for setting interest rates?
In our staff report “When Does a Central Bank’s Balance Sheet Require Fiscal Support?” we show that there is a potentially big difference between pre- and post-Great Recession central banking. We argue that a large, long-duration central bank balance sheet can, at least in principle, impair a central bank’s ability to control inflation if the fiscal authority (the Treasury) refuses to back under any circumstances the central bank’s balance sheet.
Our argument is very different from that dismissed at the beginning of this post. It rests on the observation that QE, almost by definition, resulted in a sizable maturity mismatch between the asset and the liability side of the central bank’s balance sheet. Many recent papers (for example, Hall and Reis; Carpenter et al.; Greenlaw, Hamilton, Hooper, and Mishkin; and Christensen, Lopez, and Rudebusch) have noted this mismatch, and have computed the implications of different interest rate renormalization paths for remittances from the central bank to the Treasury. Relative to these papers, we explicitly model the fact that seigniorage—revenues arising from currency creation—depends on the path of inflation and interest rates. We show that this endogeneity opens the door to the possibility of multiple equilibria in the absence of fiscal support.
Imagine that you are a Treasury investor and you know that the only resource the central bank can rely upon is seigniorage. You also know that the value of the central bank’s assets (long-term bonds) would fall below that of the bank’s interest-bearing liabilities (reserves, which are short-term) if high inflation and interest rates were to occur in the near future. Then you put two and two together and figure out that expectations of high inflation would actually force the central bank to rely on seigniorage, thereby validating such expectations. If you can convince your fellow investors that these expectations are to materialize, then your projection can become a self-fulfilling prophecy, reminiscent of second-generation currency crisis models.
Before we go any further, we should stress that this sort of self-fulfilling prophecy is unlikely to take hold in the United States for two reasons. First, we compute in our simulations that the expected present value of seigniorage for the central bank is very high, roughly the size of current U.S. GDP, under a most likely path for future interest rates. As a consequence, it would take very extreme expectations for interest rates to force the central bank to generate more seigniorage and validate the expectations. Moreover, there are reasons to believe that the assumption of no fiscal support under any circumstances is incorrect: if faced with the prospect of high inflation, the Treasury would eventually be willing to provide support to the central bank. Note that this support comes at no cost at all for the Treasury: simply being willing to provide it is enough to nip any hyperinflation in the bud.
What are the policy implications of all this? Certainly not that the central bank should not have engaged in QE. Much research has shown that QE successfully eased financial conditions, thereby promoting economic recovery. Rather, we argue that it would always be appropriate for a central bank to have access to, and be willing to ask for, support for its balance sheet by the fiscal authority. In other words, central bank independence does not mean that the central bank can control inflation regardless of the actions of the fiscal authority. As shown by history, it never has.
Disclaimer
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

'Liquidity Traps, Local and Global'

More on the secular stagnation debate from Paul Krugman:

Liquidity Traps, Local and Global: There’s been a really interesting back and forth between Ben Bernanke and Larry Summers over secular stagnation. I agree with most of what both have to say. But there’s a substantive difference in views, in which Bernanke correctly, I’d argue, criticizes Summers for insufficient attention to international capital flows – but then argues that once you do allow for international capital movement it obviates many of the secular stagnation concerns, which I believe is wrong.
As it happens, the role of capital flows in the logic of liquidity traps is an issue I tackled right at the beginning, back in 1998; and I’ve been trying to work out how it plays into the discussion of secular stagnation, which is basically the claim that countries can face very persistent, quasi-permanent liquidity traps. So I think I may have something useful to add here. ...

Wednesday, March 25, 2015

'Fed Should Push Unemployment Well Below 5%, Paper Says'

Larry Ball tells the Fed to be very patient when it comes to satisfying its mandate to pursue full employment:

Fed Should Push Unemployment Well Below 5%, Paper Says: The Federal Reserve should hold short-term interest rates near zero long enough to drive unemployment well below 5%, even if it means letting inflation exceed the central bank’s 2% target. That’s according to Laurence Ball, economics professor and monetary policy expert at Johns Hopkins University...
Mr. Ball says the Fed could create more jobs by letting the unemployment rate fall lower. It should seek to push the rate “well below 5%, at least temporarily,” he writes. That could help bring some discouraged workers to reenter the labor market, as well as help the long-term unemployed find work and involuntary part-time workers find full-time jobs, he said.
“A likely side effect would be a temporary rise in inflation above the Fed’s target, but that outcome is acceptable,” writes Mr. Ball... U.S. inflation has been undershooting the Fed’s target for nearly three years.
Mr. Ball’s view is not shared by many Fed officials...

The 'Audit' the Fed Crowd

Audit the Fed?:

The "Audit" the Fed Crowd, by David Andolfatto: Alex Pollock says that It's High Time to "Audit" the Federal Reserve. ...just the other day, Senator Rand Paul, a leader in "Audit-the-Fed" movement (a significant step down from his father's "End-the-Fed" movement) was making statements like this one:

“[An] audit of the Fed will finally allow the American people to know exactly how their money is being spent by Washington.”

Of course, the Fed does not control how money is being spent by Washington. The Fed prints money to buy government securities. It sometimes extends loans against high-grade collateral. Everything you want to know about these purchases and loans is publicly available. ...

Let's be honest here. There is nothing new to discover in further auditing. This movement is motivated by what they perceive to be bad monetary policy. It doesn't even make sense to say we want to "audit" the Fed's policy because the policy is already transparent (which is what permits critics to label it "bad").

There is, of course, nothing wrong with critiquing Fed policy. Indeed, there are many economists working inside the Fed that critique various aspects of Fed policy all the time. And, as we all know, members of the FOMC can hold very different opinions ("hawks" and "doves"). Thoughtful critiques of policy should be welcomed. Policymakers and researchers at the Fed do welcome them.

Moreover, I'm all for full accountability. The Fed should be accountable to the American people--it is, after all, a creation of the American people through their representatives in Congress. But as I have said, the issue here is not about accountability. It is about a group of individuals who want to see their preferred monetary policy adopted. That's fair enough. I just ask that they be honest about their motives. It has nothing to do with audits or accountability.

Tuesday, March 24, 2015

'The Assumptions Behind the Federal Reserve’s Choice of 2% per Year Were Erroneous'

Brad DeLong:

The Assumptions Behind the Federal Reserve’s Choice of 2% per Year Were Erroneous: Focus: ...The decision by the Federal Reserve in the mid-1990s to settle on a 2% per year target inflation rate depended on three facts — or, rather, on three things that were presumed to be facts back in the mid-1990s:

  1. That the long run Phillips curve was vertical even with an inflation rate averaging 2% per year, so that there was no production or employment cost of such a target.
  2. That the safe real interest rate would be positive and significant, so that a 2% per year inflation target would not entail disturbingly low levels of nominal interest rates that might lead to instabilities in velocity.
  3. That shocks to the economy would be small, so that the Federal Reserve would never seek to compensate with an interest-rate reduction in the range of 5% or more.

We now know that all three of these were and are false.

The easiest way to fix this problem would be to revise the Federal Reserve Act — perhaps to add “healthy rate of nominal wage growth” to the list of Federal Reserve monetary policy objectives.

Wednesday, March 18, 2015

Fed Watch: Yellen Strikes a Dovish Tone

Tim Duy:

Yellen Strikes a Dovish Tone, by Tim Duy: The FOMC concluded its two-day meeting today, and the results were largely as I had anticipated. The Fed took note of the recent data, downgrading the pace of activity from "solid" to "moderated." They continue to expect inflation weakness to be transitory. The risks to the outlook are balanced. And "patient" was dropped; April is still off the table for a rate hike, but data dependence rules from that point on.
Growth, inflation and unemployment forecasts all came down. Especially important was the decrease in longer-run unemployment projections. The Fed's estimates of NAIRU are falling, something almost impossible to avoid given the stickiness of wage growth in the face of falling unemployment. The forecast changes yielded a downward revision to the Fed's interest rate projections. In addition, the strong dollar was clearly on the Fed's mind. Federal Reserve Chair Janet Yellen often referred to the dollar and its impact on growth in the press conference, much more than I expected. I think they are probably happy the dollar took a hit today. On net, I think this from last week stood up well:
...assuming the Federal Reserve takes sufficient note of the rising dollar, and its impact on inflation, by lowering the expected path of short term interest rates. And perhaps this is exactly what is revealed in next week's Summary of Economic Projections. Look for the possibility next week that the Fed is both hawkish - by opening the door for a June hike - and dovish - by lowering the median rate projections in the dot plot.
Note that the Fed is capitulating here. The distance between the bond market and the Fed rate expectations has been something of a conundrum for policymakers. But it is now clear the bond market is not moving toward the Fed; the Fed is moving toward the bond market. Going forward, they still believe that their rate forecast is accommodative. Based on the new estimate of NAIRU and New York Federal Reserve President William Dudley's recent estimate of the equilibrium rate, they are correct:

FOMCa

But if you assume a lower equilibrium interest rate, the Fed's rate forecast has more downside to it if they wish to remain accommodative:

FOMCb

For what it's worth, this is what San Fransisco Federal Reserve President John Williams' research suggests about the current equilibrium rate:

FOMCc

Is June really on the table? Regarding the timing of the first rate hike, the FOMC had this to say:
The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.
Yellen was pushed to quantify "reasonably confident" during the press conference, but she declined to give a mechanical answer. Actual inflation, the path of the labor market, wage growth, and measures of inflation expectations were all fair game in the assessment. She did say wage growth was not a precondition for rate hike. I tend to think that unemployment dropping to 5% or an acceleration in wage growth is sufficient to prompt the first rate hike, either of which could still happen by the time of the June meeting. That said, at this point, the inflation and growth data point to a later lift-off, and weighting the expectations for a rate hike at a later date seems appropriate at this juncture.
Bottom Line: Yellen does it again - she moves the Fed both closer to and further from the first rate hike of this cycle. By moving toward the markets on the path of rate hikes, the Fed acknowledges that they are eager to let this recovery run on. Moreover, they proved that they are in fact data dependent by moving policy in the direction of the data. Overall, Yellen has managed the transition away from what the Fed came to see as excessive forward guidance just about as well as could be expected.

FOMC Press Release

The Fed has lost its patience (i.e. it dropped the word patience from its forward guidance even as it increases its estimate of the amount of slack in the economy by lowering its estimate of the natural rate of unemployment -- that gives it more reason to remain patient -- though the statement does say "This change in the forward guidance does not indicate that the Committee has decided on the timing of the initial increase in the target range"):

Press Release, Release Date: March 18, 2015, For immediate release, FOMC: Information received since the Federal Open Market Committee met in January suggests that economic growth has moderated somewhat. Labor market conditions have improved further, with strong job gains and a lower unemployment rate. A range of labor market indicators suggests that underutilization of labor resources continues to diminish. Household spending is rising moderately; declines in energy prices have boosted household purchasing power. Business fixed investment is advancing, while the recovery in the housing sector remains slow and export growth has weakened. Inflation has declined further below the Committee's longer-run objective, largely reflecting declines in energy prices. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations have remained stable.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate. The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of energy price declines and other factors dissipate. The Committee continues to monitor inflation developments closely.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress--both realized and expected--toward 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. Consistent with its previous statement, the Committee judges that an increase in the target range for the federal funds rate remains unlikely at the April FOMC meeting. The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term. This change in the forward guidance does not indicate that the Committee has decided on the timing of the initial increase in the target range.
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. This policy, by keeping the Committee's holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.

Monday, March 16, 2015

Fed Watch: The End of "Patient" and Questions for Yellen

Tim Duy:

The End of "Patient" and Questions for Yellen, by Tim Duy: FOMC meeting with week, with a subsequent press conference with Fed Chair Janet Yellen. Remember to clear your calendar for this Wednesday. It is widely expected that the Fed will drop the word “patient” from its statement. Too many FOMC participants want the opportunity to debate a rate hike in June, and thus “patient” needs to go. The Fed will not want this to imply that a rate hike is guaranteed at the June meeting, so look for language emphasizing the data-dependent nature of future policy. This will also be stressed in the press conference.

Of interest too will be the Fed’s assessment of economic conditions since the last FOMC meeting. On net, the data has been lackluster – expect for the employment data, of course. The latter, however, is of the highest importance to the Fed. I anticipate that they will view the rest of the data as largely noise against the steadily improving pace of underlying activity as indicated by employment data. That said, I would expect some mention of recent softness in the opening paragraph of the statement.

I don’t think the Fed will alter its general conviction that low readings on inflation are largely temporary. They may even cite improvement in market-based measures of inflation compensation to suggest they were right not to panic at the last FOMC meeting. I am also watching for how they describe the international environment. I would not expect explicit mention of the dollar, but maybe we will see a coded reference. Note that in her recent testimony, Yellen said:

But core PCE inflation has also slowed since last summer, in part reflecting declines in the prices of many imported items and perhaps also some pass-through of lower energy costs into core consumer prices.

Stronger dollar means lower prices of imported items.

The press conference will be the highlight of the meeting. Presumably, Yellen will continue to build the case for a rate hike. Since the foundation of that case rests on the improvement in labor markets and the subsequent impact on inflationary pressures, it is reasonable to ask:

On a scale of zero to ten, with ten being most confident, how confident is the Committee that inflation will rise toward target on the basis on low – and expected lower - unemployment?

Considering that low wage growth suggests it is too early to abandon Yellen’s previous conviction that unemployment is not the best measure of labor market tightness, we should consider:

Is faster wage growth a precondition to raising interest rates?

I expect the answer would be “no, wages are a lagging indicator.” The Federal Reserve seems to believe that policy will still remain very accommodative even after the first rate hike. We should ask for a metric to quantify the level of accommodation:

What is the current equilibrium level of interest rates? Where do you see the equilibrium level of interest rates in one year?

A related question regards the interpretation of the yield curve:

Do you consider low interest long-term interest rates to be indicative of loose monetary conditions, or a signal that the Federal Reserve needs to temper its expectations of the likely path of interest rates as indicated in the “dot plot”?

Relatedly, differential monetary policy is supporting capital inflows, depressing US interest rates and strengthening the dollar. This dynamic ignited a debate of what it means for the economy and how the Fed should or should not respond. Thus:

The dollar is appreciating at the fastest rate in many years. Is the appreciating dollar a drag on the US economy, or is any negative impact offset by the positive demand impact of looser monetary policy abroad? How much will the dollar need to appreciate before it impacts the direction of monetary policy?

Given that the Fed seems determined to raise interest rates, we should probably be considering some form of the following as a standard question:

Consider the next six months. Which is greater - the risk of moving too quickly to normalize policy, or the risk of delay? Please explain, with specific reference to both risks.

Finally, a couple of communications questions. First, the Fed is signaling that they do not intend to raise rates on a preset, clearly communicated path like the last hike cycle. Hence, we should not expect “patient” to be replaced with “measured.” But it seems like the FOMC is too contentious to expect them to shift from no hike one meeting to 25bp the next, then back to none – or maybe 50bp. So, let’s ask Yellen to explain the plan:

There appears to be an effort on the part of the FOMC to convince financial markets that rate hikes, when they begin, will not be on a pre-set path. Given the need for consensus building on the FOMC, how can you credibly commit to renegotiate the direction of monetary policy at each FOMC meeting? How do you communicate the likely direction of monetary policy between meetings?

Finally, as we move closer to policy normalization, the Fed should be rethinking the “dot plot,” which was initially conceived to show the Fed was committed to a sustained period of low rates. Given that the dot-plot appears to be fairly hawkish relative to market expectations, it may not be an appropriate signal in a period of rising interest rates. Time for a change? But is the Fed considering a change, and when will we see it? This leads me to:

Cleveland Federal Reserve President Loretta Mester has suggested revising the Summary of Economic Projections to explicitly link the forecasts of individual participants with their “dots” in the interest rate projections. Do you agree that this would be helpful in describing participants’ reaction functions? When will this or any other revisions to the Summary of Economic Projections be considered?

Bottom Line: By dropping "patient" the Fed will be taking another step toward the first rate hike of this cycle. But how long do we need to wait until that first hike? That depends on the data, and we will be listening for signals as to how, or how not, the Fed is being impacted by recent data aside from the positive readings on the labor market.

Friday, March 13, 2015

Paul Krugman: Strength Is Weakness

Is the rising value of the dollar good news?:

Strength Is Weakness, by Paul Krugman, Commentary, NY Times: We’ve been warned over and over that the Federal Reserve, in its effort to improve the economy, is “debasing” the dollar..., the Fed’s critics keep insisting that easy-money policies will lead to a plunging dollar. Reality, however, keeps declining to oblige. Far from heading downstairs to debasement, the dollar has soared through the roof. ... Hooray for the strong dollar!
Or not. ... Currency markets ... always grade countries on a curve. The United States isn’t exactly booming, but it looks great compared with Europe... Markets have responded to those poor prospects by pushing interest rates incredibly low. In fact, many European bonds are now offering negative interest rates.
This remarkable situation makes even those low, low U.S. returns look attractive by comparison. So capital is heading our way, driving the euro down and the dollar up.
Who wins from this market move? Europe: a weaker euro makes European industry more competitive against rivals, boosting both exports and firms that compete with imports, and the effect is to mitigate the euroslump. Who loses? We do, as our industry loses competitiveness, not just in European markets, but in countries where our exports compete with theirs. ...
In effect, then, Europe is managing to export some of its stagnation to the rest of us. ... And the effects may be quite large. ...
One thing that worries me is that I’m not at all sure that policy makers have fully taken the implications of a rising dollar into account. The Fed, still eager to raise interest rates despite low inflation and stagnant wages, seems to me to be too sanguine about the economic drag. ...
Oh, and one more thing: a lot of businesses around the world have borrowed heavily in dollars, which means that a rising dollar may create a whole new set of debt crises. Just what the global economy needed.
Is there a policy moral to all this? One thing is that it’s really important for all of us that Mario Draghi at the European Central Bank and associates succeed in steering Europe away from a deflationary trap; the euro is their currency, but it turns out to be our problem. Mainly, though, this is another reason for the Fed to fight the urge to pretend that the crisis is over. Don’t raise rates until you see the whites of inflation’s eyes!

Thursday, March 12, 2015

Fed Watch: Will the Dollar Impact US Growth?

Tim Duy:

Will the Dollar Impact US Growth?, by Tim Duy: A quick one while I wait for my flight at National. Scott Sumner argues that the strong dollar will not impact US growth. In response to a Washington Post story, he writes:

This is wrong, one should never reason from a price change. There are 4 primary reasons why the dollar might get stronger:

1. Tighter money in the US (falling NGDP growth expectations.)
2. Stronger economic growth in the US.
3. Weaker growth overseas.
4. Easier money overseas.

In my view the major factor at work today is easier money overseas. For instance, the ECB has recently raised its growth forecasts for 2015 and 2016, partly in response to the easier money policy adopted by the ECB (and perhaps partly due to lower oil prices—but again, that’s only bullish if the falling oil prices are due to more supply, not less demand–see below.) That sort of policy shift in Europe is probably expansionary for the US.

The initial point is correct - arguing from a price change is a risky proposition. Go to the underlying factors. But I think the next paragraph is a bit questionable. I think that the policy shift in Europe does reduce tail risk for the global economy, and is therefore a positive for the US economy (I suspect the Fed thinks so as well). But it reduces tail risk because ECB policy is supporting not one but two positive economic shocks - both falling oil and a rising falling Euro. And, all else equal, a rising falling euro means a stronger dollar, which means a negative for the US economy. Tail risk for Europe is reduced at a cost for the US economy (a cost that the Federal Reserve and US Treasury both seem willing to endure).

That said, all this means is that Sumner is right, you can't reason from a price change, but reasoning in a general equilibrium framework is very, very hard. Sumner gets closer here, but still I think falls short:

However NGDP growth forecasts in the Hypermind market have trended slightly lower in the past couple of months. Unfortunately, this market is still much too small and illiquid to draw any strong conclusions. Things will improve when the iPredict futures market is also up and running, and even more when the Fed creates and subsidizes a NGDP prediction market. But that’s still a few years away. Nonetheless, let’s assume Hypermind is correct. Then perhaps money in the US has gotten slightly tighter, and perhaps this will cause growth to slow a bit. But in that case the cause of the slower growth would be tighter money, not a stronger dollar.

So let's try to close the circle - not only can't you reason from a price change, but also you need to pay attention to the entire constellation of prices. If ECB policy - and, by extension, the falling euro - was a net positive for the US economy, shouldn't we expect higher long US interest rates? But long US rates continue to hover around 2%, which seems crazy given the Fed's stated intention to start raising rates. Consider, however, that the stronger dollar does in fact represent tighter monetary conditions, but long interest rates are falling, which acts as a counterbalance by loosening financial conditions. Essentially, markets are anticipating that the stronger dollar saps US growth, but the Fed will respond with a slower pace of policy normalization, which acts in the opposite direction. So the stronger dollar does negatively impact growth, but market participants expect a monetary offset.

Hence - and I think Sumner would agree with this - the ball is in the Federal Reserve's court. The stronger dollar is a negative for the US economy, while the expected impact on monetary policy is a positive. The net impact is neutral. You should anticipate a stronger domestic economy offset by a larger trade deficit.

That is, of course, assuming the Federal Reserve takes sufficient note of the rising dollar, and its impact on inflation, by lowering the expected path of short term interest rates. And perhaps this is exactly what is revealed in next week's Summary of Economic Projections. Look for the possibility next week that the Fed is both hawkish - by opening the door for a June hike - and dovish - by lowering the median rate projections in the dot plot.

Update: I see Paul Krugman is lamenting the possibility that some FOMC members interpret falling interest rates as reason to tighten policy more aggressively - a view primarily outlined by New York Federal Reserve President William Dudley. My read of the bond market implies that market participants expect the opposite - the Fed needs to accept additional financial accommodation. That said, Dudley's stance clearly opens the door to the possibility of the Fed running an excessively tight policy stance, which wouldn't happen if they took their inflation target seriously.

Monetary and Fiscal Policy in a Post-Inflation World

Alice Rivlin:

Thoughts about monetary and fiscal policy in a post-inflation world, Brookings: ... Why are we still so focused on fighting inflation? Why are so many people in this room devoting so much time and attention to guessing when the Federal Reserve will start raising short-term interest rates and get back to its “normal” job of protecting us from inflation? Is inflation an important threat to our economic well-being? Is when to raise interest rates the most urgent question facing the Fed at the moment? Or are we suffering from cultural lag?
Collecting linguistic evidence of cultural lags is a minor hobby of mine. I smile when I catch myself referring to the refrigerator as the “ice box,” because that was what my mother called it... I am amused when young people tell me their phones are “ringing off the hook.” Have they ever used a phone with a receiver on a hook? When bureaucrats say they are eager to break out of their silos, I wonder if they if they have ever lived on a farm or anywhere close to a silo. So when politicians and financial journalists ask me earnestly, as they do, whether the Federal Reserve isn’t risking devastating “run-away” inflation by buying all those bonds, I suspect cultural lag. What Inflation? We should be so lucky! Central banks have amply proved that they know how to stop inflation—Paul Volcker showed that. They have been much less successful in getting little inflation going.
A lecture in honor of Paul Volcker is the perfect occasion for raising the fundamental question: are the major advanced economies (US, Europe, Japan) facing a new normal for which current tools of monetary, fiscal, and regulatory policy need to be restructured? ...
Over-coming cultural lag in order to prosper in a post-inflation world will take significant shifts in the mind-set of economists, economic policy-makers, politicians and the public. I see four major challenges to current thinking:
  • We have to recognize that the main job of central banks is avoiding financial crisis.
  • We will have to get used to central banks operating at quite low interest rates much of the time and managing big balance sheets without apologies.
  • We have to rehabilitate budget policy to make it useable again and move to a sustainable debt track at the same time
  • We have to find constitutional ways of reducing the power of big money in politics and economic policy—or change the Constitution.

I will get back to these four challenges, but first a very quick tour through the macro-policy landscape of the last five or six decades. ...

And, later in the essay (it is relatively long, and I don't agree with every single point that is made, e.g. when she defends ‘Simpson-Bowlesism’ and discusses the need to rein in entitlement spending, and when she argues against selling the idea "that unspecified government spending would add to aggregate demand and accelerate the recovery without adverse consequences to the long-run debt... Unspecified spending and near-term debt increase are what the public and elected officials fear, and they are skeptical of fee lunches. Instead, we have to make the case for very specific public investments that can be shown to have positive impacts on productivity growth and future prosperity" -- deficit spending in a recession has a role to play in stimulating the economy in the short-run, we shouldn't focus only on the long-run growth potential of policy -- but I do agree with the the general thrust of her comments):

... Political polarization has led to angry confrontations over the budget for the last several years complete with threats to shut down the government or default on the national debt and bizarre budget decision processes, such as the Super Committee, the fiscal cliff, and sequestration. These shenanigans are unworthy of a mature democracy and horrendously destructive of confidence in rational economic governance. The result has been worse than gridlock. It has been insanely counterproductive budget policy at a time when the federal budget could have been contributing both to faster recovery and to longer run productivity growth.
I believe the Great Recession would have been longer and deeper without the stimulus package of 2009.[8] If the stimulus had been larger and lasted longer, recovery would have been more robust and the Fed might not have found it necessary to do so much quantitative easing. Indeed, it is pretty crazy economics for a country trying to climb out of a deep recession to put the burden of accelerating a recovery on the monetary authorities—a job they have never been great at—in the face of sharply declining federal deficits that made the task of stimulating recovery with monetary tools a lot more challenging. But that is what we did.
I also believe that the United States has been dangerously under-investing in public infrastructure, scientific research, and the skills of our future labor force. Doing everything we can to nudge productivity growth back up again is essential to future prosperity. With the private investment awaiting more demand and confidence, the public sector should be moving strongly into the breach with well-structured investment in everything from roads to technical training to basic research. Instead, our bizarre budget process has been squeezed the very budget accounts that contain most opportunity for public investment. Discretionary spending is at record lows in relation to the size of the economy and headed lower while the highway trust fund is running dry. How crazy is that?
Making budget policy useful again will take major shifts in political thinking, and here I think economists can help if they use arguments the public and politicians can relate to. First, I would recommend not pushing the argument that unspecified government spending would add to aggregate demand and accelerate the recovery without adverse consequences to the long-run debt. Ball, Summers and DeLong may well be right that hysteresis is so serious a consequence of recession that spending now would juice recovery enough to bring down long run debt.[9] But they are never going to sell that argument. Unspecified spending and near-term debt increase are what the public and elected officials fear, and they are skeptical of fee lunches.
Instead, we have to make the case for very specific public investments that can be shown to have positive impacts on productivity growth and future prosperity. This should not be an argument for larger government, but for shifting from less to more effective government spending and from consumption-oriented spending (including spending in the tax code) to growth oriented spending over time. And, oh yes, that means making the tax code more progressive, more pro-growth, and raising additional revenue, as well as restructuring entitlement programs. There is plenty is such an agenda for both liberals and conservatives to like—if only they could be persuaded to talk about it. ...

Wednesday, March 11, 2015

'Hard Money'

Brad DeLong:

Austerity, Gramscian Hegemony, and Hard Money: To the Re-Education Camp! Weblogging: ... Paul Krugman tries to untangle why so many center-right and right-wing economists are so resistant to the elementary logic of Hicks (1937) and the IS-LM model—even those who, like Marty Feldstein, teach the IS-LM model to their students, and teach it very well (after all: he taught it to me).

Back in 2009 ... Mark Thoma wrote a good piece giving what seemed to me to be the correct answer to the inflationistas: He wrote that there was some reason to fear an outburst of inflation when and if the long run came in which the government budget constraint bound and yet congress was continuing to refuse to either:

  • curb the growth of public health care costs, or
  • raise taxes to pay for them.

But, he went on, the IS-LM logic meant that that was not a risk in the short run. And the cost of the stimulus program and how much debt was "monetized" by QE had at best a second decimal-place effect on the vulnerability of the U.S. to long-run inflation driven by the fiscal theory of the price level. The big enchilada was health-care costs...[quotes my old post]...

That seemed and seems to me to be right, and that is driven by a coherent theoretical view: (i) an unemployment short-run until production returns to potential output, (ii) a medium run in which confidence and interest rates and full-employment growth rates depend on market assessments of how the long-run fiscal gap will be closed, and (iii) a long run in which, perhaps suddenly and unexpectedly, the fiscal theory of the price level binds.

The only thing wrong with Mark's analysis back in 2009 that I saw then and that I see now--other than the short run being a very long time indeed, the bending of the health care costs curve occurring much more sharply than I had imagined possible, and a configuration of interest rates which raises the strong possibility that the long-run in which the fiscal theory of the price level binds has been put off to infinity--was that it missed the easiest way of shrinking the velocity of money in a recovery: raising reserve requirements. So I always had a very hard time figuring out what Feldstein and company were fearing at all...

Indeed, it seemed to me not to be coherent:

 Martin Feldstein: "The unprecedented explosion of the US fiscal deficit raises the spectre of high future inflation. ... It is surprising that the long-term interest rates do not yet reflect the resulting risk of future inflation...

... As I looked back on the situation in 2009 and 2010--with a dead housing credit channel, and the increasing likelihood of a recovery characterized not as a V or as a U but as an L--I find myself thinking that Marty Feldstein and the others had turned all their smarts to trying to find reasons not to believe the IS-LM models that they (or at least Feldstein and Taylor) had taught, and not to believe that the marginal investor in financial markets was not-stupid. That fiscal and monetary ease would bring back the 1970s in short order was their conclusion. The task was to think of not-implausible reasons and mechanisms that would make this so.

The corollary, of course, is that for them the only good policies are hard-money austerity policies; and the only good portfolios are those that assume a departure from hard-money austerity will produce inflation.

So perhaps there is a deeper problem somewhere..., it really makes no sense for my contemporaries to be hard-money believers. Yet an astonishing share of the rich among them are.

A great and enduring puzzle...

So: To the re-education camp! I have a lot of rethinking to do--but not about IS-LM, hysteresis, or the fiscal theory of the price level; rather, about the connecting-belts between asset values, wealth levels, and people's ideal interests of what proper monetary and fiscal policy should be.

Monday, March 09, 2015

Paul Krugman: Partying Like It’s 1995

Patience!:

Partying Like It’s 1995, by Paul Krugman, Commentary, NY Times: Six years ago, Paul Ryan,... the G.O.P.’s leading voice on matters economic,... warned that the efforts of the Obama administration and the Federal Reserve to fight the effects of financial crisis would bring back the woes of the 1970s, with both inflation and unemployment high.
True, not all Republicans agreed with his assessment. Many asserted that we were heading for Weimar-style hyperinflation instead.
Needless to say, those warnings proved totally wrong. ... Far from seeing a rerun of that ’70s show, what we’re now looking at is an economy that in important respects resembles that of the 1990s. ... The Fed currently estimates the Nairu at between 5.2 percent and 5.5 percent, and the latest report puts the actual unemployment rate at 5.5 percent. So we’re there — time to raise interest rates!
Or maybe not. The Nairu is supposed to be the unemployment rate at which ... an inflationary spiral starts to kick in. But there is no sign of inflationary pressure. ...
The thing is, we’ve been here before. In the early-to-mid 1990s, the Fed generally estimated the Nairu as being between 5.5 percent and 6 percent, and by 1995, unemployment had already fallen to that level. But inflation wasn’t actually rising. So Fed officials ... held their fire... And it turned out that the ... economy was capable of generating millions more jobs, without inflation...
Are we in a similar situation now? Actually, I don’t know — but neither does the Fed. The question, then, is what to do in the face of that uncertainty...
To me, as to a number of economists ... the answer seems painfully obvious: Don’t ... pull that rate-hike trigger until you see the whites of inflation’s eyes. If it turns out that the Fed has waited a bit too long, inflation might overshoot 2 percent for a while, but that wouldn’t be a great tragedy. But if the Fed moves too soon, we might end up losing millions of jobs we could have had — and in the worst case, we might end up sliding into a Japanese-style deflationary trap...
What’s worrisome is that it’s not clear whether Fed officials see it that way. They need to heed the lessons of history — and the relevant history here is the 1990s, not the 1970s. Let’s party like it’s 1995; let the good, or at least better, times keep rolling, and hold off on those rate hikes.

Saturday, March 07, 2015

'Remembrance of NAIRUs Past'

Paul Krugman:

...the current situation looks quite a lot like the mid-90s, with unemployment basically at the Fed’s estimate of “full employment” but no sign of inflation — except that back then wages were rising much more vigorously than now. Now, as then, there is a very real possibility that we have lots more room to run, if the Fed lets us.

[Travel day today, will post more if and as I can.]

Friday, March 06, 2015

Fed Watch: 'Patient' is History

Tim Duy:

Patient' is History: The February employment report almost certainly means the Fed will no longer describe its policy intentions as "patient" at the conclusion of the March FOMC meeting. And it also keep a June rate hike in play. But for June to move from "in play" to "it's going to happen," I still feel the Fed needs a more on the inflation side. The key is the height of that inflation bar.

The headline NFP gain was a better-than-expected 295k with 18k upward adjustment for January. The 12-month moving average continues to trend higher:

NFPa030615

Unemployment fell to 5.5%, which is the top of the central range for the Fed's estimate of NAIRU. Still, wage growth remains elusive:

NFPb030615

Is wage growth sufficient to stay the Fed's hand?  I am not so sure. I recently wrote:

My take is this: To get a reasonably sized consensus to support a rate hike, two conditions need to be met. One is sufficient progress toward full-employment with the expectation of further progress. I think that condition has already been met. The second condition is confidence that inflation will indeed trend toward target. That condition has not been met. To meet that condition requires at least one of the following sub-conditions: Rising core-inflation, rising market-based measures of inflation compensation, or accelerating wage growth. If any were to occur before June, I suspect it would be the accelerating wage growth.

I am less confident that we will see accelerating wage growth by June, although I should keep in mind we still have three more employment reports before that meeting. Note, however, low wage growth does not preclude a rate hike. The Fed hiked rates in 1994 in a weak wage growth environment:

NFPg030615

And again in 2004 liftoff occurred on the (correct) forecast of accelerating wage growth:

NFPf030615

So wage growth might not be there in June to support a rate hike. And, as I noted earlier this weaker, I have my doubts on whether core-inflation would support a rate hike either. That leaves us with market-based measures of inflation compensation. And at this point, that just might be the key:

NFPe030615

If bond markets continue to reverse the oil-driven inflation compensation decline, the Fed may see a way clear to hiking rates in June. But the pace and timing of subsequent rate hikes would still be data dependent. I would anticipate a fairly slow, halting path of rate hikes in the absence of faster wage growth.

Bottom Line:  "Patient" is out. Tough to justify with unemployment at the top of the Fed's central estimates of NAIRU. Pressure to begin hiking rates will intensify as unemployment heads lower. The inflation bar will fall, and Fed officials will increasingly look for reasons to hike rates rather than reasons to delay. They may not want to admit it, but I suspect one of those reasons will be fear of financial instability in the absence of tighter policy. June is in play.

Tuesday, March 03, 2015

Fed Watch: Does The Fed Have a Currency Problem?

Tim Duy:

Does The Fed Have a Currency Problem?, by Tim Duy: The PCE inflation data was released today, and I have been seeing commentary on the relative strength of the core-inflation numbers. This, for example, from the Wall Street Journal:
A key gauge of U.S. consumer prices sank in January due partly to cheaper oil, undershooting the Federal Reserve’s goal of 2% annual inflation for the 33rd consecutive month. But a gauge of underlying price pressures remained resilient headed into 2015.
The picture:

PCEa030215

Core-PCE is hovering around 1.3%, and the stability relative to last month is supposedly supportive of Federal Reserve plans to hike interest rates later this year.  
I would caution against that interpretation just yet. While it is true that the year-over-year change is how the Fed measures its progress toward price stability, you should also be watching the near term changes to see the likely direction of the year-over-year message. And in recent months, near-term core inflation has been falling at a rapid pace:

PCEb030215

On a 3-month basis, core inflation is at its lowest since the plunge in 2008. Year-over-year inflation has been held up by a basis effect from a jump in early 2014, but unless we get another jump in the monthly data, you can guess where the year-over-year number will be heading in the next few months:

PCEc030215

Which means that unless the numbers turn soon, there is a fairly good chance the Fed's preferred inflation guide (I say guide because headline inflation is truly the target) drifts lower as the year progresses. Hence I am less eager to embrace that today's release is supportive of the Fed's plans.  
Why is core-inflation drifting lower?  Federal Reserve Chair Janet Yellen offered this in her testimony last week:
But core PCE inflation has also slowed since last summer, in part reflecting declines in the prices of many imported items and perhaps also some pass-through of lower energy costs into core consumer prices.
 While oil prices have stabilized, the dollar continues to gain ground, hitting an 11-year high today:

DOLLAR030215

If the dollar continues its upward gains - as might be expected given divergent monetary policy across the globe - further downward pressure on core-inflation is likely. This clearly throws a wrench into the Fed's plans. It would be hard to justify confidence in the inflation outlook if core-inflation trends lower in the months ahead.
The Fed could be headed for a very uncomfortable place. The dollar is rising, tightening financial conditions and placing downward pressure on inflation. At the same time, interest rates remain low while equities push higher, loosening financial conditions, arguably an equilibrating response to the rising dollar.  On net, then, the US economy keeps grinding upward, the labor market keeps improving, and the unemployment rate sinks lower. Yellen & Co. would want to resist tightening in the face of low inflation, but they would be increasingly tempted to react to low unemployment. Moreover, concerns of financial instability would mount if longer-term rates remained low and equities pushed higher. All in all, sounds like an increasingly hawkish FOMC coupled with a sluggish global economy and dovish central bankers elsewhere is raising the odds of a US policy error. 
Bottom Line: The rising dollar may be causing the Fed more headaches than they like to admit. To the extent that it is pushing inflation lower, the dollar should be delaying the time to the first rate hike as well as lowering the subsequent path of rates. The Fed may have to respond to the so-called "currency wars" whether they like it or not. That said, I can't rule out that they ignore the inflation numbers given the tightening labor market and what they perceive to be loose financial conditions. The Fed could fail to see the precarious nature of the current environment and move forward with plans to normalize policy. Increasingly likely to be a very interesting summer for monetary policy.