Category Archive for: Monetary Policy [Return to Main]

Wednesday, January 28, 2015

Fed Watch: FOMC Decision

Tim Duy:

FOMC Decision, by Tim Duy: If you were looking for fireworks from today's FOMC statement, you were disappointed. Indeed, you need to work pretty hard to pull a story out of this statement. It provided little reason to believe that the Fed has shifted its view since December. A June rate hike remains the base case.

The Fed's assessment of the current statement is arguably the best in years:

Information received since the Federal Open Market Committee met in December suggests that economic activity has been expanding at a solid pace. Labor market conditions have improved further, with strong job gains and a lower unemployment rate. On balance, a range of labor market indicators suggests that underutilization of labor resources continues to diminish. Household spending is rising moderately; recent declines in energy prices have boosted household purchasing power. Business fixed investment is advancing, while the recovery in the housing sector remains slow.

The Fed is simply not seeing any warning signs in recent data. Regarding inflation:

Inflation has declined further below the Committee’s longer-run objective, largely reflecting declines in energy prices. Market-based measures of inflation compensation have declined substantially in recent months; survey-based measures of longer-term inflation expectations have remained stable.

They continue to dismiss headline inflation, and I think they will continue to do so. And if you continue to insist that the Fed is paralyzed with fear over market based measures of inflation expectations, note that they do not refer to these as "expectations" measures. It is inflation "compensation." From Fed Chair Janet Yellen's most recent press conference:

There are a number of different factors that are bearing on the path of market interest rates, I think, including global economic developments. It is often the case that when oil prices move down and the dollar appreciates, that that tends to put downward pressure on inflation compensation and on longer-term rates. We also have safe-haven flows that may be affecting longer-term Treasury yields. So I can’t tell you exactly what is driving market developments. But what I can say is that we are trying to communicate our thoughts as clearly as we can.

And:

Oh, and longer-dated expectations. Well, what I would say, we refer to this in the statement as “inflation compensation” rather than “inflation expectations.” The gap between the nominal yields on 10-year Treasuries, for example, and TIPS have declined—that’s inflation compensation. And five-year, five-year-forwards, as you’ve said, have also declined. That could reflect a change in inflation expectations, but it could also reflect changes in assessment of inflation risks. The risk premium that’s necessary to compensate for inflation, that might especially have fallen if the probabilities attached to very high inflation have come down. And it can also reflect liquidity effects in markets. And, for example, it’s sometimes the case that— when there is a flight to safety, that flight tends to be concentrated in nominal Treasuries and could also serve to compress that spread. So I think the jury is out about exactly how to interpret that downward move in inflation compensation. And we indicated that we are monitoring inflation developments carefully.

They are trying to tell us very clearly that TIPS are not giving a measure of pure inflation expectations. They do not want those measures by themselves to affect market expectations of the path of monetary policy.

Growth risks are balances and low inflation is transitory:

The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to decline further 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 lower energy prices and other factors dissipate. The Committee continues to monitor inflation developments closely.

They make a small nod to international concerns when considering future policy actions:

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 Fed remains patient and policy is data dependent:

Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy. However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.

June remains on the table. Within the context of the current forecast, I think that June will be difficult to justify in the absence of wage acceleration. A sharp decline in the forecast, or the balance of risks to the forecast, would also prompt a delay. Importantly, at this point they see the current forecast as still the most likely outcome.

Bottom Line: At this point, the Fed does not see market turbulence as an impediment to raising rates. They are willing to hike rates even if stocks are moving sideways (which they probably think is reasonable in the context of expectations for less monetary accommodation). They do not see any data that threatens their baseline forecast. Maybe market participants have written off June, but for the Fed, June remains very much on the table.

'Somebody Is Inside an Echo Chamber. But Who?'

Brad DeLong:

Somebody Is Inside an Echo Chamber. But Who?: Paul Krugman fears that somebody is trapped inside an echo chamber, hearing only things that confirm what they already believe...

But how can we tell which side has lost contact with the reality out there? ...

I do not think we have to decide. I think that even if we are uncertain whether the optimistic “insiders” or the pessimistic “outsiders” are correct, elementary prudent optimal-control theory tells us that we should act as if the “outsiders” are right.

But I have gotten ahead of myself:...

So how would we tell whether, right now, it is the outsiders are overstating the dangers to premature tightening, or it is the insiders who are understating the dangers to premature tightening here in the United States?

To answer this question, I think we need to consider five points–the first about our decision procedure, the second about the level of spending consistent with full employment, the third about the degree of uncertainty and variability, the fourth about the vulnerabilities of the economy to spending deviations above and below the projected current-policy path, and the fifth about the effectiveness of our optimal-control levers in different scenarios.

The first point is that if it turns out that we cannot tell–that we have to split the difference–then the considerations that rule are the asymmetries in the situation.

The second point is that no one right now has a good and convincing read on what, exactly, the level of spending consistent with full employment at the currently-projected price level is. Uncertainty is rife: if there was ever a time for considering not just the central tendency of the forecast but the risks on either side and taking optimal control appropriately valuing these risks seriously, it is right now.

The third point is that we are not just uncertain about what the proper full-employment path for demand is, we have much more than the usual amount of uncertainty about nearly all other dimensions of the structure of the economy. To suppose that any of the emergent properties that are policy multipliers can be estimated from data collected during “normal” times is to make an enormous leap of faith.

The fourth point is that downside risks to the forecast greatly exceed upside opportunities. ...

And the fifth point is that, while the Federal Reserve has powerful levers to restrict demand if spending shoots above the desired policy path, its levers to expand demand if spending falls below have been demonstrated over the past six years to be relatively weak.

Thus, if it turns out that we cannot tell–and we cannot tell–then it is not correct that we should split the difference. The considerations that rule are then the asymmetries in the situation. It is, right now, much worse to undershoot than to overshoot full-employment demand...

These asymmetries mean that, as far as policy is concerned, the “outsiders” win any tie and win any near-tie: the “insiders” should govern what policy should be only if there is not just a preponderance of the but clear and convincing evidence on their side.

Yet the Federal Reserve appears to have decided:

  • that those who think that the economy is near full employment and is in a durable recovery have by far the better of the argument as to what the central tendency projected current-policy demand path is.
  • that it is appropriate to make policy via certainty-equivalance.

Given the inability of the Federal Reserve to attain traction at the ZLB, its current frame of mind–which appears to be doing certainty-equivalence policy–makes no sense to me. Certainty-equivalence is appropriate only with a symmetric loss function and a symmetric ability to compensate for deviations on either side of the target. We do not have either of those.

Has there been an explanation of why the Federal Reserve’s policy is appropriate, given the uncertainties, given the asymmetry of the loss function, and given the asymmetry of the control levers, that I have missed? If so, where is it?

Fed watch: While We Wait For Yet Another FOMC Statement...

Tim Duy:

While We Wait For Yet Another FOMC Statement...: The FOMC will reveal the outcome of this week's meeting later today. I think Calculated Risk hits the high points - "patient" is in, "considerable time" is completely out. Beyond this, we will be looking for clues on how the Fed is interpreting the current economic environment. I suspect little change in the overall tenor of the statement as they will want to leave June open as an option. I reiterate my position: The Fed needs to see an acceleration in wage growth to be confident that inflation will return to trend if they intend to raise rates in June. 

Why is the Fed focused on normalizing policy? This is one explanation I see tossed around, from Jeffrey Gunlock via Reuters:

"The Fed seems to want to raise interest rates simply because they don't want to be at zero when the next recession occurs," he said.

A similar statement from the Economic Cycle Research Institute:

In this context, ECRI explains the reasons for the declines in both measures, but also why they may ultimately not be that important to the timing of rates hikes. Above all, the Fed wants to remain relevant in case the economy is hit by recessionary shocks that require interest rates to return to the zero-lower-bound (ZLB). By definition, once on the ZLB, they need to rise before they can fall again.

I don't think these are accurate representations of Fed thinking. The Fed recognizes that hiking rates prematurely to "give them room" in the next recession is of course self-defeating. They are not going to invite a recession simply to prove they have the tools to deal with another recession.  

The reasons the Fed wants to normalize policy are, I fear, a bit more mundane:

  1. They believe the economy is approaching a more normal environment with solid GDP growth and near-NAIRU unemployment. They do not believe such an environment is consistent with zero rates.
  2. They believe that monetary policy operates with long and variable lags. Consequently, they need to act before inflation hits 2% if they do not want to overshoot their target. And they in fact have no intention of overshooting their target.
  3. They do not believe in the secular stagnation story. They do not believe that the estimate of the neutral Fed Funds rate should be revised sharply downward. Hence 25bp, or 50bp, or even 100bp still represents loose monetary policy by their definition.

I am currently of the opinion that there is a reasonable chance the Fed is wrong on the third point, and that they have less room to maneuver than they believe. If so, they will find themselves back at the zero bound in the next recession, very quickly I might add. This is not their expectation. They expect to remain relevant in the next recession and do not believe they need to quickly raise rates to achieve relevance. Again, they know this is self-defeating.

Whether or not they can maintain their mid-year target is of course the topic du jour. But the logic of those who believe the Fed will not have what it needs in June and thus expect the first hike much later is more convincing than those who argue that they will raise rates due to some pressing need to prepare for the next recession.

Saturday, January 24, 2015

'Did the Keynesians Get It Wrong in Predicting a Recession in 2013?'

Dean Baker:

Did the Keynesians Get It Wrong in Predicting a Recession in 2013?:  I have had several readers send me a blogpost from Scott Sumner saying that the Keynesians have been dishonest in not owning up to the fact that they were wrong in predicting a recession in 2013. The argument is that supposedly us Keynesian types all said that the budget cuts and the ending of the payroll tax cut at the start of 2013 would throw the economy back into recession. (Jeffrey Sachs has made similar claims.)
That isn't my memory of what I said at the time, but hey we can check these things. I looked at a few of my columns from the fall of 2012 and they mostly ran in the opposite direction. The Washington insider types were hyping the threat of the "fiscal cliff" in the hope of pressuring President Obama and the Democrats to make big concessions on Social Security and Medicare. They were saying that even the risk of falling off the cliff could have a big impact on growth in the third and fourth quarter of 2012.
My columns and blogposts (e.g. here, here, here, here, and here) were largely devoted to saying this was crap. I certainly agreed that budget cutbacks and the end of the payroll tax cuts would dampen growth, but the number was between 0.5-0.8 percentage points. This left us far from recession. (All my columns and blogposts from this time are at the CEPR website, so folks can verify that I didn't do any cherry picking here.)
I know Paul Krugman is the real target here, not me, but we've been seeing the economy pretty much the same way since the beginning of the recession. If he had a different story at the time I think I would remember it. But his columns and blogposts are archived too. I really don't think anyone will find him predicting a recession in 2013, although I'm sure he also said that budget cuts and tax increases would dampen growth. 
Anyhow, I'm generally happy to stand behind the things I've said, and when they are proven wrong I hope I own up to it. But I don't see any apologies in order. No recession happened in 2013 and none was predicted here.

I don't recall predicting a recession either (the "they" intended to tar all Keynesians refers to just a few people), just that it would be a drag on growth (the CBO predicted 0.6%). In any case, not much can be said unless one takes the time to estimate a model, use it as a baseline, and then ask the model how the economy would have done in an alternative world where policy was different. Just because we still had growth after the budget cuts does not prove or disprove anything. Even if growth rises under austerity, you can't say it would not have risen a bit more more without austerity (all else is far from equal) unless you have done the hard work of estimating a defensible model and then asking it these questions. Similarly, you can't say much about the degree of monetary offset unless you have taken the time to do the econometrics to support it. But with changes this small -- the impact was predicted to be much less than one percent of growth by most models -- it is very hard to get statistically significant differences in any case.

The problem is that there is no model that all economists agree is "best" for these purposes, and the answer one gets depends upon the particular choice of models. Choose a model that delivers small fiscal multipliers and you get one answer, use a model with bigger multipliers and the answer changes. But even the models with the largest multipliers did not predict a recession, only a drag on growth (generally less than one percent) so the fact that we still had growth says nothing about the impact of the policy, or the degree of monetary offset.

Friday, January 23, 2015

Paul Krugman: Much Too Responsible

Europe’s self-indulgent "archons of austerity" and "doyens of deflation":

Much Too Responsible, by Paul Krugman, Commentary, NY Times: The United States and Europe have a lot in common. Both are multicultural and democratic; both are immensely wealthy; both possess currencies with global reach. Both, unfortunately, experienced giant housing and credit bubbles between 2000 and 2007, and suffered painful slumps when the bubbles burst.
Since then, however, policy on the two sides of the Atlantic has diverged. In one great economy, officials have shown a stern commitment to fiscal and monetary virtue, making strenuous efforts to balance budgets while remaining vigilant against inflation. In the other, not so much.
And the difference in attitudes is the main reason the two economies are now on such different paths. ... No, it’s not morning in America... Recovery could and should have come much faster, and family incomes remain well below their pre-crisis level. Although you’d never know it from the public discussion, there’s overwhelming agreement among economists that the Obama stimulus of 2009-10 helped limit the damage..., but it was too small and faded away far too fast. ...
Europe, on the other hand ... did almost everything wrong. On the fiscal side, Europe never did much stimulus, and quickly turned to austerity ... despite high unemployment. On the monetary side, officials fought the imaginary menace of inflation, and took years to acknowledge that the real threat is deflation. ...
Monetary policy got much better after Mario Draghi became president of the European Central Bank in late 2011. ... But it’s not at all clear that he has the tools to fight off the broader deflationary forces set in motion by years of wrongheaded policy. ...
The terrible thing is that Europe’s economy was wrecked in the name of responsibility. ... In a depressed economy..., a balanced-budget fetish and a hard-money obsession are deeply irresponsible. Not only do they hurt the economy in the short run, they can — and in Europe, have — inflict long-run harm, damaging the economy’s potential and driving it into a deflationary trap that’s very hard to escape.
Nor was this an innocent mistake. The thing that strikes me about Europe’s archons of austerity, its doyens of deflation, is their self-indulgence. They felt comfortable, emotionally and politically, demanding sacrifice (from other people) at a time when the world needed more spending. They were all too eager to ignore the evidence that they were wrong.
And Europe will be paying the price for their self-indulgence for years, perhaps decades, to come.

Thursday, January 22, 2015

Fed Watch: Policy Divergence

Tim Duy:

Policy Divergence, by Tim Duy: Increasingly, the Federal Reserve stands in stark contrast with its global counterparts. While the ECB readys its own foray into quantitative easing, the Bank of England shifted to a more dovish internal position, the central bank of Denmark joined the Swiss in cutting rates, and the Bank of Canada unexpectedly cut rates 25bp this morning. The latter move I found somewhat unsurprising given the likely impact of oil prices on the Canadian economy. The rest of the world is diverging from US monetary policy. How long can the Fed continue to stand against this tide?

Late last week, Reuters reported that the Fed's resolve was stiffening. This week, the Wall Street Journal reported the Fed was staying the course. This morning, Bloomberg says the Fed is getting weak in the knees:

Federal Reserve officials are starting to reassess their outlook for the economy as global weakness and disappointing data on American consumer spending test their resolve to raise interest rates this year.

San Francisco Fed President John Williams last week said he will trim his U.S. estimate because of slower growth abroad. Atlanta’s Dennis Lockhart said Jan. 12 that he advocates a “cautious” approach to rate increases and inflation readings “may be pivotal.” Both are voters on the Federal Open Market Committee in 2015 and repeated that rates could be raised in the middle of the year.

I doubt the Fed will place too much weight on the December retail sales report. It is fairly noisy data and there is no indication that the fundamental upward trend has been broken:

RETAIL012115

Moreover, I think they would be wary of reading too much into one data point given the upswing in consumer confidence in recent months. That, of course, only builds upon the upswing in employment data. And housing starts finished the year on a strong note - see Calculated Risk for more on that topic.

All that said, the Fed should of course be cautious about the impact of global weakness. But how does the Fed communicate such caution? The challenge I see for the Fed is that they will want to hold the statement fairly steady, with falling oil prices and global weakness as offsetting risks while holding the line on the "low inflation is transitory" story. They want to keep June alive. After all, it's still five months out - a lifetime at the speed of today's financial world. They don't want expectations to fall too far to the back of the year while they are still looking at a June hike.

Such a steady hand, however, may be viewed as hawkish, which is also a message the Fed does not want to send. My expectation is that they highlight the improving US economy, particularly the acceleration in job growth, while offering concerns about the global economy. Remember that the condition of the US job market is very different than during previous bouts of financial instability; the momentum looks more self-sustaining than it has in a long time. They may even point to policy action on the part of foreign central banks to help assuage some global weakness concerns.

Separately, St. Louis Federal Reserve President James Bullard gives no quarter in his argument for rate hike in the first quarter of this year in this Wall Street Journal interview:

I still think we should get off zero (interest rates). The kinds of things we’re observing now, it is not the constellation of data that would be consistent with a zero policy rate. I think it is important to get started and to start normalizing policy. Even once we start to normalize, interest rates would still be extremely low. We’re talking about levels of 50 basis points or 75 basis points. That is still extremely low and that would still be putting upward pressure on inflation even if we did that. So I’d like to get going. I don’t think we can any longer rationalize a zero interest rate policy.

Bullard thinks the data is not consistent with a zero rate policy, while I fear that the data is where it is at because of the zero rate policy. Moreover, I would tend to proceed more cautiously then Bullard given the current flattening of the yield curve. But Bullard is an outlier; the FOMC consensus is in favor of caution, which is why there is no rate hike on the table next week or in March. And it is why June is in no way guaranteed; they need something from wage growth that they just aren't getting. If they want to set up for a June rate hike without wage growth, they need to start telling a compelling alternative story soon.

Somewhat disappointing is that Bullard is flip-flopping. To date he has been a fairly reliable inflation-hawk - his opinions shift consistently with the inflation outlook. Not this week:

I do worry about TIPS-based inflation compensation and it has been down a lot recently and it does concern me. What I want to do with that is wait and see what happens in global oil markets, wait and see what equilibrium turns out to be and then see what happens with breakeven inflation at that point. I want to let the dust settle on the oil market and then go back and check breakeven inflation rates and see what’s happened.

Basically, Bullard wants to ignore the market-based inflation metrics that would have in the past told him to hold off on any tightening. He really, really wants to liftoff from the zero bound, the sooner the better. I don't think this level of immediacy is felt by other FOMC members, but I do think they are hoping and praying the data gives them enough to move by mid-year.

Bottom Line: The Fed finds itself in a familiar place - wanting to change policy but not quite getting the data they need while at the same time global stress in on the rise. Luckily for them, they weren't going to move off the zero-bound next week anyways; they still have months of data to sift through between now and then. And unlike past times of turbulence, the US is coming from a position of strength, eliminating the need for any panicky moves. Next week is mostly then just about communicating how and how not they are responding to overseas developments.

Monday, January 19, 2015

Fed Watch: Seconded

Tim Duy:

Seconded, by Tim Duy: I see Jon Hilsenrath at the Wall Street Journal seconds my take from this morning:

Federal Reserve officials are on track to start raising short-term interest rates later this year, even though long-term rates are going in the other direction amid new investor worries about weak global growth, falling oil prices and slowing consumer price inflation.

This is generally consistent with my view. The Fed is likely reacting more slowly than market participants. Hilsenrath adds something I forgot to mention:

Central to their internal deliberations ahead of the March meeting is a debate about how low the jobless rate can fall before it stirs wage and inflation pressure. Fed officials estimate the “natural rate” of unemployment—meaning the rate below which wage pressures increase—is between 5.2% and 5.5%.

Mr. Rosengren said he was considering revising this estimate down because the jobless rate has fallen to near the 5.2%-5.5% range without triggering any sign of wage pressure. He said he suspected some of his Fed colleagues also were considering moving this estimate down. The lower the estimate goes, the more patient they might be before raising rates.

Just as I think it will be hard for the Fed to raise rates if the unemployment rate continues to fall while wage growth remains subdued, it will also be difficult to justify current estimates of the natural rate of unemployment under those circumstances. Still, I would caution that lowering the estimate of the natural rate would be, I think, an implicit rejection of the "underemployment hypothesis." It would be easier to adjust estimates of the natural rate downward if measures of underemployment were more consistent with their traditional relationships with unemployment. In other words, the natural rate may be consistent with subdued wage growth due to the existence of high levels of underemployment.

My opinion is that the global disinflationary environment would support low inflation at levels of unemployment below the Fed's current estimate of the natural rate, similar to the situation of the late 1990s.

Fed Watch: Will The Fed Take a Dovish Turn Next Week?

Tim Duy:

Will The Fed Take a Dovish Turn Next Week?, by Tim Duy: As it stands now, we are heading into the next FOMC meeting with the growing expectation that the Fed will take a dovish turn. Is it not obvious that global economic turmoil, collapsing oil prices, weak inflation, and a stronger dollar are clearly pointing to rapidly rising downside risks to the US economy? For financial market participants, they answer is a clear "yes." Expectations of the first rate hike have been pushed out to the end of this year, seemingly in complete defiance of Fed plans for policy normalization. The Fed may get there as well and abandon their carefully crafted mid-year plan, but I suspect they will not move quite as rapidly as financial market participants desire.
As a general rule, the Fed tends to act in a more deliberate fashion. To be sure, this was not evident during the crisis. Indeed, "panicky" might be a better adjective during that period. But note that in comparison to past bouts of tumolt on global markets, the US economy is in a much better place, with accelerating job growth when unemployment is already near traditional mandate-levels. From their point of view, this is a whole different world compared to that of the last round of Euro-induced crisis.
This take from Jonathan Spicer and Ann Saphir at Reuters probably saw less play than it deserved:
Tumbling oil prices have strengthened rather than weakened the Federal Reserve's resolve to start raising interest rates around midyear even as volatile markets and a softening U.S. inflation outlook made investors push back the timing of the "liftoff."
Kind of a "Fed is from Mars, markets are from Venus" situation. It is important to recognize that the Fed sees falling oil prices as a significant, unexpected development that represents the realization of an upside risk to their forecast. They are thinking of an outcome not unlike that revealed in the most recent Bloomberg/UMich read on consumer sentiment:

CONSEN011815

Through the roof, one might say. So at this point the Fed will view the external threats to the economy as just risks, but the very real move in oil is at a minimum adding upside risk to their forecasts or already pushing their forecasts to the upside. With regards to external threats, they probably think that more aggressive ECB action is in the wings to put their immediate fears to rest. And the downward push on inflation is, from their perspective, a transitory issue and therefore a non-issue.
Consider this also from the Reuters article:
Interviews with senior Fed officials and advisors suggest they remain confident the U.S. economy will be ready for a modest policy tightening in the June-September period, while any subsequent rate hikes will probably be slow and depend on how markets will behave.
in light of this from St. Louis Federal Reserve President James Bullard:
“The level of inflation is not so low that it can alone justify a policy rate of zero,” Mr. Bullard said in material prepared for a speech in Chicago.
and this from San Fransisco Federal Reserve President John Williams:
Placing heavy emphasis on the date of liftoff “suggests that you don’t have any other decisions to make,” Williams said. “We want to be very confident that we’re on the right path, that the data support that first move, but that first move on tightening is only one of many, many policy actions we’ll need to do during the normalization. It’s not the critical component.”
and this from Federal Reserve Chair Janet Yellen:
So, I think you raise a very important point because, although there is a great deal of market focus on the timing of liftoff, what to matter in thinking about the stance of policy is what the entire path of interest rates will look like. And I really don’t have much for you other than to say that they will be data dependent—that, over time, the stance of policy will be adjusted to try to keep the economy on a track where we see continuing progress toward achieving our goals of maximum employment and price stability.
My takeway is that the Fed sees the timing of the first rate hike as less important than everything that comes after that hike. This will leave them less eager to delay the hike. Given where the economy currently stands, I suspect they see little chance of damage from that first hike alone.
This is also interesting:
Some of those interviewed stressed that in the light of last year's strong jobs gains waiting until mid-year represented a cautious approach rather than an aggressive one, allowing the Fed to delay the rate liftoff if needed, particularly if inflation expectations turned sharply down.
The suggestion here is that at least some Fed officials view signaling a mid-year rate hike as the cautious approach because the data increasingly suggests to them that they should be moving sooner than later.
Bottom Line: I reiterate my view that despite the generally positive data flow, and the upward boost from oil, I don't see how they can justify raising rates without some reasonable acceleration in wage growth. That said, perhaps by my own argument above they can justify it on the basis of 25bp won't hurt anyone anyways. But my broader point is this: During normal times the Fed moves methodically if not ponderously. The current state of the economy gives them room to move as such. So I would not be surpised to see a fairly steady hand revealed in the next FOMC statement.

Friday, January 09, 2015

Fed Watch: Wage Growth - or Lack of - Continues to Surprise

Tim Duy:

Wage Growth - or Lack of - Continues to Surprise, by Tim Duy: The December employment report, with its surprising combination of solid job gains and decelerating wage growth, leaves Fed policy up the air.
Headline nonfarm payrolls gained by 252k, while previous months were revised up a net 50k. Job growth continues to accelerate:

NFPa010915

Note the acceleration in aggregate hours worked:

NFPd010915

Such gains suggest the recent acceleration in GDP growth is real and likely to be sustained. From the household survey, we see that the unemployment rate continues to decline. Fed forecasts will once again soon be in jeopardy:

NFPc010915

In the context of indicators previously identified by Federal Reserve Chair Janet Yellen:

YELLENa010915

YELLENb010915

Overall, the story is one of ongoing improvement in labor markets, including metrics of underemployment. Wage growth, however, nosedived during the month:

NFPb010915

I would be wary of this read on wages - strikes me as an aberration that is likely to be violently reversed, but I also stick to what I wrote yesterday:
I believe that an acceleration of wage growth would do the trick, which is why this remains the data to watch in the employment report. If June rolls around with no inflation and no greater wage growth, the Fed will find it challenging to begin normalization. In that case, they would need to focus on the employment mandate or pivot to some financial stability story to justify a rate hike.
Bottom Line: Generally a very solid report. But the wage numbers present a dilemma for the Fed. Simply put, no wage growth means the Fed can't be particularly confident that inflation will trend toward target. Not that a rate hike was imminent in any event; Fed is still looking at June, but they need some more help from the data. Of course, June is still a long way off - we have five more employment reports before that meeting. Time enough for these numbers to turn around. Note that if the wage trend does reverse quickly, policy expectations would shift just as quickly.

Thursday, January 08, 2015

Fed Watch: Volatile Week Ahead of Employment Report

Tim Duy:

Volatile Week Ahead of Employment Report, by Tim Duy: At the moment, there are many different competing threads in the tapestry of monetary policy, with another thread entering the pattern with tomorrow's employment report. In short, the Fed is balancing clear evidence of accelerating US activity in the back half of 2014 against the implications of declining oil prices and a host of international weaknesses that are roiling financial markets. The reality of volatility in asset prices was on full display this week. The Fed desire to begin normalizing policy with a rate hike in the middle of this year certainly appears in jeopardy. They very much need continued solid data on the US side of the equation to push forward with their plans.
Early 2015 US data in the form of ISM reports provides little new guidance. While the measures slipped from recent high, I would be hard-pressed to say that the underlying trend has changed after considering the volatility of this data:

NAPMa010814

NAPMb010814

Likewise, initial unemployment claims continue to hover below pre-recession lows, signaling solid labor demand:

CLAIMS010815

Plunging gasoline prices will almost certainly bolster consumer confidence:

GAS010814

The Fed anticipates that declining energy prices will have a net positive impact on the economy. Via the minutes of the most recent FOMC meeting:
In their discussion of the foreign economic outlook, participants noted that the implications of the drop in crude oil prices would differ across regions, especially if the price declines affected inflation expectations and financial markets; a few participants said that the effect on overseas employment and output as a whole was likely to be positive. While some participants had lowered their assessments of the prospects for global economic growth, several noted that the likelihood of further responses by policymakers abroad had increased. Several participants indicated that they expected slower economic growth abroad to negatively affect the U.S. economy, principally through lower net exports, but the net effect of lower oil prices on U.S. economic activity was anticipated to be positive.
I tend agree that the net impact will be positive, but note that the negative impacts will be fairly concentrated and easy for the media to sensationalize, while the positive impacts will be fairly dispersed. We all know what is going to happen to rig counts, high-yield energy debt, and the economies of North Dakota and at least parts of Texas. "Kablooey," I think, is the technical term. Easy media fodder. Much more difficult to see the positive impact spread across the real incomes of millions of households, with particularly solid gains at the lower ends of the income distribution. This will be most likely revealed in the aggregate data and be much less newsworthy.
The decline in energy prices, combined with the stronger dollar, confounds the Fed's inflation outlook, but for now they seem content to assume the impacts are transitory:
Participants generally anticipated that inflation was likely to decline further in the near term, reflecting the reduction in oil prices and the effects of the rise in the foreign exchange value of the dollar on import prices.Most participants saw these influences as temporary and thus continued to expect inflation to move back gradually to the Committee's 2 percent longer-run objective as the labor market improved further in an environment of well-anchored inflation expectations.
The Fed also, at least for now, is choosing to heavily discount market-based measures of inflation expectations:
Survey-based measures of longer-term inflation expectations remained stable, although market-based measures of inflation compensation over the next five years, as well as over the five-year period beginning five years ahead, moved down further over the intermeeting period.Participants discussed various explanations for the decline in market-based measures, including a fall in expected future inflation, reductions in inflation risk premiums, and higher liquidity and other premiums that might be influencing the prices of Treasury Inflation-Protected Securities and inflation derivatives.Model-based decompositions of inflation compensation seemed to support the message from surveys that longer-term inflation expectations had remained stable, although it was observed that these results were sensitive to the assumptions underlying the particular models used. It was noted that even if the declines in inflation compensation reflected lower inflation risk premiums rather than a reduction in expected inflation, policymakers might still want to take them into account because such changes could reflect increased concerns on the part of investors about adverse outcomes in which low inflation was accompanied by weak economic activity. In the end, participants generally agreed that it would take more time and analysis to draw definitive conclusions regarding the recent behavior of inflation compensation.
For example, the Cleveland Federal Reserve measure of inflation expectations over the next ten years was 1.83% in December, within spitting distance of the Fed's target. This kind of analysis, combined with survey-based measures, provides the Fed with a great deal of comfort regarding the inflation situation.
That said, inflation remains below target and, importantly, was decelerating before the impact of lower energy prices worked its way through the economy:

PCE33122314

Shouldn't this alone keep any talk of rate hikes at bay? You might think so, but the Fed already believed there was a good chance that they would raise interest rates while core-inflation was below target:
With lower energy prices and the stronger dollar likely to keep inflation below target for some time, it was noted that the Committee might begin normalization at a time when core inflation was near current levels, although in that circumstance participants would want to be reasonably confident that inflation will move back toward 2 percent over time.
So what is the bar for "reasonably confident"? I believe that an acceleration of wage growth would do the trick, which is why this remains the data to watch in the employment report. If June rolls around with no inflation and no greater wage growth, the Fed will find it challenging to begin normalization. In that case, they would need to focus on the employment mandate or pivot to some financial stability story to justify a rate hike.
Jon Hilsenrath offers a potential interpretation of the implications of the rally at the long end of the Treasury yield curve:
If falling yields are a reflection of diminishing inflation prospects, as is typically the case, it ought to prompt the Fed to hold off on raising short-term interest rates in the months ahead. If, on the other hand, lower long-term rates are a reflection of investors pouring money into U.S. dollar assets, flows that could spark a U.S. asset price boom, it might prompt the Fed to push rates higher sooner or more aggressively than planned.
The latter interpretation is less conventional, but it is one that New York Fed President William Dudley made at length in a speech in December. He argued the Fed had the wrong reaction to lower long rates in the 2000s, a mistake that might have contributed to the housing boom that ended disastrously.
I wrote about this last month, coming to the conclusion:
A second point is that Dudley is not taking seriously the possibility that the flattening yields curve suggests the Fed has less room to move than policymakers think they do. This is something I worry about - if the Fed leans on the short end too much, they risk taking an expansion that should last another fours years to one that has just two more years left. But that might be a story for next December.
I think the late-90's is a better comparator to the current envrionment, but that will take another post to deal with. For the moment, I will add that San Francisco Federal Reserve President John Williams hinted that current action in the bond market is in fact telling a less hawkish story. Via Greg Robb at MarketWatch:
Williams said he thinks a rate hike this year will be appropriate, but added he is in "no rush" to tighten. He said that mid-2015 is a reasonable guess of when the Fed will first ask "should we do it now or wait a little longer."
I have interpreted Williams remarks in the past as pointing at a June rate hike. Arguably, here he hedges and says June is when they should start considering the rate hike. Perhaps falling Treasury yields are having the traditional impact on Fed thinking after all.
Bottom Line: Fed wants to begin normalizing policy, but sees a murkier path compared to even just last month. They need hard US data to overwhelm the oil/international driven fears. An acceleration of wage growth would help put some light on the path they want to follow.

'Trying to Understand Current FedThink'

Brad DeLong:

Today’s Essay at Trying to Understand Current FedThink: Daily Focus, by Brad DeLong: The “more thoughts about this” I promised earlier below…

Jon Hilsenrath: Could Lower 10-Year Yields Spark A More Aggressive Fed?:
“Falling long-term interest rates pose a quandary for Federal Reserve officials….

…If falling yields are a reflection of diminishing inflation prospects… it ought to prompt the Fed to hold off on raising short-term interest rates…. If… lower long-term rates are a reflection of investors pouring money into U.S. dollar assets, flows that could spark a U.S. asset price boom, it might prompt the Fed to push rates higher sooner…. The latter interpretation is less conventional, but it is one that New York Fed President William Dudley made….

The Fed’s next policy meeting is three weeks away. It is clear officials will spend a considerable time debating the correct response to a perplexing lurch down in long-term rates. ...

Our current remarkably-low long-term interest rates has three possible interpretations:

  1. Ms. Market expects currently-planned near-term Fed policy to produce a very weak economy for a long time to come, and hence very low interest rates in the out years. Ms. Market is correct. In this case, low long-term interest rates are a signal that the Federal Reserve’s current liftoff plans are a mistake and should be revisited.

  2. Ms. Market expects currently-planned near-term Fed policy to produce a very weak economy for a long time to come, and hence very low interest rates in the out years. Ms. Market is wrong. In this case, low long-term interest rates are not a signal that the Federal Reserve’s current liftoff plans are a mistake and should be revisited. Rather, the Federal Reserve should act as in (3).

  3. Ms. Market expects currently-planned near-term Fed policy to produce a normal economy in the out-years, but the U.S. Treasury market has an unusually small or negative term premium because of the large number of foreign investors seeking U.S.-based political and economic risk insurance via holdings of U.S. Treasuries. In this case, low long-term interest rates are inappropriately stimulative and run the risk of generating an overheating economy, and the proper response by the Federal Reserve is to announce that it will raise interest rates sooner and faster in order to push long-term rates to where they need to be for a sustainable Goldilocks continued recovery.

The Federal Reserve strongly believes that Ms. Market has no information about the future course of the macroeconomy that the Federal Reserve does not have–that (1) is simply unthinkable. That leaves (2)–Ms. Market thinks the Federal Reserve’s currently-planned near-term policy path is risking another lost decade, but Ms. Market is wrong–or (3)–long-term rates have an anomalously-low term premium because of foreign-investor demand.

A glance at the graph above would seem to rule out (3): 10-Yr breakeven inflation has fallen from 2.5%/year just before the taper tantrum to 1.6%/year today, while the TIPS has risen from -0.7%/year to +0.4%/year today. If it were (3), the surge of foreign demand ought to have put downward pressure on both nominal Treasuries and TIPS, leaving the breakeven largely unchanged. That is not what has happened. If the Federal Reserve wants to hold to (3), therefore, it needs to add to it:

3′. Something else weird and unrelated has happened in the market for TIPS.

While that is possible, it is disfavored by Occam’s Razor.

Thus Dudley seems to be chasing down a red herring. The interpretation he wants to put forward ought to be this:

Today Ms. Market expects inflation over the next ten years to be 0.9%/year less than it expected it to be back in June 2013. But we know better: the economy is actually much stronger than Ms. Market thinks.

Coming from a Federal Reserve that has overestimated the future strength of the economy in every single quarter since the start of 2007, that is not a terribly reassuring posture for it to take.

Saturday, January 03, 2015

'In Defense of NGDP Targets'

Simon Wren-Lewis:

In defence of NGDP targets: Tony Yates had recently written a couple of posts (here, and here, but see also the discussion with Andy Harless on the second) slamming the idea of NGDP targets. (From now on I assume this refers to targeting the level of NGDP.) Now you might think that NGDP targets do not need any support from lukewarm advocates like me, given all the supporters in the econ blogging world. That would be wrong, because - as Tony rightly says - most advocates of NGDP targets tend to argue in a model free way. Both he and I want to stay close to the academic literature, at least as a starting point.
I think Tony is wrong when he says that “the case for levels based targets – including NGDP levels targets – is, both practically and analytically, extremely weak”. In making such a claim, Tony should be very worried that one of the supporters of NGDP targets is Michael Woodford, who literally wrote the book on modern monetary theory. ...

After explaining, he concludes with:

Having said all this, it is great that Tony is opening up the discussion on the correct level, so we can get away from what often seems like faith based arguments for NGDP targets. I think the framework that he seems to have in mind is also the correct one: the ultimate policy target would be inflation (and the output gap: I would want a dual mandate), and NGDP would be an intermediate target to achieving welfare maximising paths. So I hope this discussion continues. My one last plea is that arguments make clear whether a NGDP targeting regime is being compared to some form of optimal policy, or policy as currently practiced: as I suggest here these are (unfortunately) different things. 

Yates replies here.

Wednesday, December 31, 2014

'On the Stupidity of Demand Deficient Stagnation'

Simon Wren-Lewis:

On the Stupidity of Demand Deficient Stagnation: In my last post I wrote about “why recessions caused by demand deficiency when inflation is below target are such a scandalous waste. It is a problem that can be easily solved, with lots of winners and no losers. The only reason that this is not obvious to more people is that we have created an institutional divorce between monetary and fiscal policy that obscures that truth.” I suspect I often write stuff that is meaningful to me as a write it but appears obtuse to readers. So this post spells out what I meant. ...

Tuesday, December 30, 2014

'Asymmetric Credibility at the Fed and Price-Level Targeting'

Jared Bernstein:

Asymmetric Credibility at the Fed and Price-Level Targeting: While we in the US don’t have the disinflation (positive but declining rates of inflation) problem facing the Eurozone, our benchmark inflation rate has consistently undershot its mark. The Federal Reserve target for the core PCE deflator is 2%, year-over-year, and yet it hasn’t hit that growth rate even once since April of 2012. Since then, the average rate of PCE core inflation is 1.5% (Euro area core inflation was last seen growing at 0.6%).
Note also that the 2% is a target, not a ceiling (though there’s often ambiguity around this), meaning if you’ve been below for a while, it’s consistent with hitting your target rate on average to be above it for a while as well.
And yet, the question of whether the Fed is adequately meeting the “stable prices” part of its dual mandate (the other part is, of course, full employment) seems almost uniformly to be whether it’s keeping inflation from going above 2%. In other words, the Fed’s inflation credibility is asymmetric: they only lose credibility points for going above 2%.
As a policy matter for a healthy economy, this is wrong...

Monday, December 22, 2014

Fed Watch: Looking Backward to See the Future

Tim Duy:

Looking Backward to See the Future, by Tim Duy: Is this our future, brought back from the past? A contact referenced the last hike cycle via the FOMC statements from 2003-04 (emphasis added):

October 28, 2003:

The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. In contrast, the probability, though minor, of an unwelcome fall in inflation exceeds that of a rise in inflation from its already low level. The Committee judges that, on balance, the risk of inflation becoming undesirably low remains the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.

December 9, 2003:

The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. The probability of an unwelcome fall in inflation has diminished in recent months and now appears almost equal to that of a rise in inflation. However, with inflation quite low and resource use slack, the Committee believes that policy accommodation can be maintained for a considerable period.

January 28, 2004:

The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. The probability of an unwelcome fall in inflation has diminished in recent months and now appears almost equal to that of a rise in inflation. With inflation quite low and resource use slack, the Committee believes that it can be patient in removing its policy accommodation.

March 16, 2004:

The Committee perceives the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. The probability of an unwelcome fall in inflation has diminished in recent months and now appears almost equal to that of a rise in inflation. With inflation quite low and resource use slack, the Committee believes that it can be patient in removing its policy accommodation.

May 4, 2004:

The Committee perceives the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. Similarly, the risks to the goal of price stability have moved into balance. At this juncture, with inflation low and resource use slack, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured.

June 30, 2004:

The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 1-1/4 percent.

"Patient" lasted for two meetings before being replaced by "measured." This is fairly consistent with my expectations. My baseline scenario is that the Fed drops "considerable" entirely in January, retains "patient" in March, drops "patient" in April, and raise rates in June. In her press conference, Federal Reserve Chair Janet Yellen said:

There certainly has been no decision, you know, decision on the part of the Committee to move at a measured pace or to use language like that. I think quite a few people looking back on the use of that language in the--I can't remember if it was 12 or 16 meetings, where there were 25 basis point moves. We'd probably not like to repeat a sequence in which there was a measured pace and 25 basis point moves at every meeting. So I certainly don't want to encourage you to think that there will be a repeat of that.

If she really believes this, Yellen will not push to replace "patient" with "measured," but instead some more vague data-dependent type language.

Bottom Line: Assuming the data holds, maybe history will repeat itself. If it really is this easy, I have no idea what I will be writing about for the next six months.

Fed Watch: Asked and Answered. Mostly.

Tim Duy:

Asked and Answered. Mostly, by Tim Duy: Last week I had six questions for Federal Reserve Chair Janet Yellen. Here is my attempt to piece together the answers from her post-FOMC press conference:

Question 1: If you want to know what the Fed is thinking at this point, a journalist needs to push Yellen on the secular stagnation issue at next week's press conference. Does she or the committee agree with Fischer? And does she see any inconsistency with the SEP implied equilibrium Federal Funds rates and the current level of long bonds?

Yellen, in answer to Peter Coke of Bloomberg Television: "(The Committee) are optimistic that those conditions will lift. They see the longer-run normal level of interest rates as around 3-3/4 percent. So there's no view in the Committee that there is secular stagnation in the sense we won't eventually get back to pretty historically normal levels of interest rates."

Yellen, in answer to Robin Harding of the Financial Times: "There are a number of different factors that are bearing on the path of market interest rates. I think including global economic developments. It is often the case that when oil prices move down, and the dollar appreciates, that tends to put downward pressure on inflation compensation and on longer-term rates. We also have safe haven flows that may be affecting longer-term Treasury yields. So I can't tell you exactly what is driving market developments. But what I can say is that we are trying to communicate our thoughts as clearly as we can."

The Federal Reserve believes that the current level of long rates is an artifact of safe-haven flows, not an indication of secular stagnation. They must anticipate that the yield curve will not flatten further or invert when they begin raising rates.

Question 2: I would like a journalist to press Yellen on her interpretation of the 5-year, 5-year forward breakeven measure of inflation expectations. Does she see this measure as important or too noisy to be used as a policy metric? What is her preferred metric?

Yellen, in answer to Greg Ip of the Economist: "Oh, and longer-dated expectations. Well I would say we refer to this in the statement as inflation compensation, rather than inflation expectations. The gap between the nominal yields on 10-year Treasuries for example. And TIPS have declined -- that's inflation compensation, and five-year, five-year forwards, as you've said, have also declined. That could reflect a change in inflation expectations. But it could also reflect changes in assessment of inflation risks. The risk premium that's necessary to compensate for inflation. That might especially have fallen if the probabilities attached to very high inflation have come down. And it can also reflect liquidity effects in markets and for example, it's sometimes the case that -- when there is a flight to safety, that flight tends to be concentrated in nominal Treasuries, and can also serve to compress that spread. So I think the jury is out about exactly how to interpret that downward move in inflation compensation. And we indicated that we are monitoring inflation developments carefully."

The Federal Reserve does not believe market-based measures of inflation expectations as indicative of actual inflation expectations. Watch surveys, Cleveland Fed-type measures, and actual inflation instead.

Question 3: Considering that recent updates of your optimal control framework now suggest that the normalization process should already be underway, how useful do you believe such a framework is for the conduct of monetary policy? What specific framework are you now using to dismiss the results of your previously preferred framework?

Yellen, in answer to Greg Ip of the Economist: "So you -- your first question is why is it that the committee sees unemployment as declining slightly below its estimate of the longer-run, natural rate? And I think in part, the reason for that is that inflation is running below our objective, and the committee wants to see inflation move back toward our objective over time. And a short period of a very slight under shoot of unemployment below the natural rate will facilitate slightly faster return of inflation to our objective. It is, I should say, a very small undershoot in a situation where there is great uncertainty about exactly what constitutes maximum employment, or a longer-run, normal rate of unemployment."

This is the general story of optimal control - hold unemployment below the natural rate to accelerate return to target inflation. Ignore any overshooting of inflation in such an analysis; Yellen was never really serious about that. Only thing preventing Fed from raising rates now is tweeking the optimal control results to account for still-high unemployment.

Question 4: St. Louis Federal Reserve President James Bullard has defined a specific metric to assess the Fed's current distance from its goals. What is your specific metric and by that metric how far is the Fed from it's goals? What does this metric tell you about the likely timing of the first rate hike of this cycle?

Yellen, in answer to Binyamin Appelbaum of the New York Times: "And with respect to inflation -- and our forecast for inflation, and inflation expectations, let me start by saying I think it's important that monetary policy be forward-looking. The lags in monetary policy are long. And therefore the committee has to base its decisions on how to set the federal funds rate looking into the future. Theory is important, and theories that are consistent with historical evidence will be something that governs the thinking of many people around the table. Typically we have seen that as long as inflation expectations are well-anchored, that as the labor market recovers, we'll gradually see upward pressure on both wages and prices. And that inflation will tend to move back toward 2 percent. I think historically we have seen, as the economy strengthens and slack diminishes, that inflation does tend to gradually rise over time. And as long -- you know, I just -- speaking for myself, that I will be looking for evidence that I think strengthens my confidence in that view, and you know, looking at the full range of data that bears on, whether or not that's a reasonable view of how events will unfold. But it's likely to be a decision that's based on forecasts and confidence in the forecast."

No firm metrics. Raising rates is like pornography - we know it is time when we see it.

Question 5: Why is the Fed setting the stage for raising interest rates next year while inflation measures remain below target? What is the risk, exactly, of explicitly committing to a zero interest rate policy until inflation reaches at least your target?

Yellen, in answer to Greg Ip of the Economist: "But it's important to point out that the committee is not anticipating an over-shoot of its 2 percent inflation objective."

From the Fed's perspective, not an interesting question. Theory says monetary policymakers need to move ahead of seeing inflation at target. If inflation was actually at target, they would be behind the curve in this economic environment. Also refer to San Francisco Federal Reserve President John Williams, via the Wall Street Journal:

“There’s no question that core inflation will likely be below 2% when liftoff is appropriate,” Mr. Williams said.

You have to love that statement - only an economist could piece together a sentence with "no question" and "likely" in this context. In short, they have no intention of allowing inflation to drift above 2%. The 2% goal is a ceiling, not a target. They are perfectly happy tolerating modestly below-target inflation as long as unemployment is below 6%. If you thought that any mention of above-target inflation was anything more than an acknowledgement of potential forecast errors, you were wrong. As far as the Fed is concerned, 2% inflation was handed down by God. It's in the Bible. Look it up.

Question 6: High yield debt markets are currently under pressure from the decline in oil prices. Are you confident that macroprudential tools are sufficient to contain the damage to energy-related debt? If the damage cannot be contained and contagion to other markets spreads, what does this tell you about the ability to use low interest rate policy without engendering dangerous financial instabilities?

Yellen, in answer to Greg Robb of MarketWatch: "So I mean there is some--you're talking about in the United States exposure? I mean we have seen some impacts of lower oil prices on the spreads for high-yield bonds, where there's exposure to oil companies that may see distress or a decline in their earnings, and we have seen some increase in spreads on high-yield bonds more generally. I think for the banking system as a whole the exposure to oil, I'm not aware of significant issues there. This is the kind of thing that is part of risk management for banking organizations and the kind of thing they look at in stress tests. But the movements in oil prices have been very large, and undoubtedly unexpected.

We--in terms of leverage, and whether or not levered entities could be badly effected by movements in oil prices, leverage in the financial system in general is way down from the levels before the crisis. So it's not a major concern that there are levered entities that would be badly affected by this, but we'll have to watch carefully. There have been large and unexpected movements in oil prices."

I honestly think that Yellen was surprised the rest of us were worried about this. Don't worry, be happy -high yield energy debt problems are contained.

Bottom Line: Final result is data dependent, but nothing at the moment is dissuading the Fed from their intention to hike rates in the middle of 2015.

Wednesday, December 17, 2014

Fed Watch: Quick FOMC Recap

Tim Duy:

Quick FOMC Recap, by Tim Duy: Running short on time today....

Today's FOMC statement was a reminder that in normal times the Federal Reserve moves slowly and methodically. Policymakers were apparently concerned that removal of "considerable time" by itself would prove to be disruptive. Instead, they opted to both remove it and retain it:

Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy. The Committee sees this guidance as consistent with its previous statement that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program in October, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.

If you thought they would drop "considerable time," they did. If you thought they would retain "considerable time," they did. Everyone's a winner with this statement.

Federal Reserve Chair Janet Yellen explained the change in language as necessary to shift away from the increasingly dated reference to the end of quantitative easing. In addition to the lower inflation and interest rate expectations in the Summary of Economic Projections, the statement was initially regarded as dovish. The press conference, however, was in my opinion anything but dovish.

During the presser, Yellen explained that "patience" was only likely guaranteed through the next "couple" of meetings, later clarified to be two. Hence, the April meeting is still on the table, although I still suspect that is too early. Yellen also said that a press conference was not required to raise rates; if necessary, they could always opt to have a presser even if one not scheduled. She dismissed falling market-based inflation expectations as reflecting inflation "compensation" rather than expectations. She dismissed the disinflationary impulse from oil, calling it transitory and drawing attention to the expected positive implications for US growth (much as she corrected described "noisy" inflation indicators earlier this year). She indicated that inflation did not need to return to target prior to raising rates, only that the Fed needed to be confident it would continue to trend toward target. She was very obviously unconcerned about the risk of contagion either via Russia or high yield energy debt - I think she almost seemed surprised anyone was worried about the latter.

In short, Yellen dismissed virtually all of the reasons to expect the Federal Reserve to delay rate hikes past its expectation of mid-2015. They have their eyes set firmly on June. My sense is that they see the accelerating economy and combine that with, as Yellen mentioned, the long lags of monetary policy, and worry that it will not be long before they are behind the curve.

To be sure, it is easy to outline a scenario that derails the Fed's plans. The impact of the oil shock on core inflation may be more than expected. Or rising labor force participation stabilizes the unemployment rate and wage growth continues to move sideways. My guess is that if they see an acceleration in wage growth between now and June, a June hike is pretty much in the bag.

Bottom Line: Like it or not, believe it or not, the Fed is seriously looking at mid-2015 to begin the normalization process. And there is no guarantee that it will be a predictable series of modest rate hikes. As much as you think of the possibility that the hike is delayed, think also of the possibility of 1994.

Tuesday, December 16, 2014

How Fiscal Policy Failed During the Great Recession

I have a new column:

How Fiscal Policy Failed During the Great Recession: Fiscal policy failed us during the Great Recession. We did get a fiscal stimulus package shortly after Obama took office, and it helped. But it wasn’t big enough and did not last long enough to make the kind of difference that was needed. Fear of deficits stood in the way, though all the dire predictions that were made about the debt associated with the stimulus package did not come to pass. We could have done so much more. ...

Fed Watch: IP, Russia

Tim Duy:

IP, Russia, by Tim Duy: The string of solid US economic news continued with industrial production advancing 1.3% in November. Year-over-year growth (5.2%) is now comparable to the late-90's:

IP121514

Meanwhile, the international fallout from the oil price drop continues. Russia is a classic emerging market crisis story. The decline in energy prices reveals a currency mismatch between assets and liabilities. The decline in oil dries up the dollars needed to support those liabilities, so the value of the ruble is bid down as market participants scramble for dollars. One suspects that capital flight from Russia only aggravates the problem; those oligarchs are seeing their fortunes whither. Currency plummets, aggravating the cycle. The sanctions were the beginning of this crisis, the oil price shock the culmination.
The Central Bank of Russia is forced into defending its currency via either depleting reserves or hiking interest rates. Both are losing games in a full blown crisis. The Central Bank of Russia has tried both, upping the ante by jacking up rates to 17% this afternoon, a hike of 650bp. That, however, is no guarantee of stability. Tight policy will crush the financial sector and the economy with it, triggering further net capital outflows that my guess will swamp the net inflows the rate hike was intended to create. Everything heads into free-fall until a new, lower equilibrium is established.
It is all appears really quite textbook. At this point, an IMF program would be on the horizon. But that's where the textbook changes. Hard to see the IMF just handing out a lifeline to an economy probably viewed by most as currently invading its neighbor (that's the point of the sanctions after all). And I am guessing that Russian Premier Vladimir Putin is not going to easily acquiesce to an IMF program in any event. At the moment, looks like Russia is toast. (Update: Arguably I am being a little pessimistic here. Joseph Cotterill points out that the rate hike falls well short of 1998.)
Venezuela is heading down the tubes as well, but that was always a given. Just a matter of time on that one.
Back at the Federal Reserve ranch, a fascinating experiment is underway. Have policymakers been successful in insulating the financial sector from these kinds of shocks? There will be losses, but will those losses cascade throughout the financial sector and into the real economy, or will they be contained? If the answer is containment, then interestingly Russia will lose a bargaining chip and the Fed's willingness to counter the potential risks of low interest rates with macroprudential policy will look like a sustainable policy mix.
If, however, contagion takes hold, we will once again be revisiting regulatory policy. And if the proximate cause of the contagion is deemed high-yield energy sector debt, and the excessively low rates in high-yield in general is deemed a consequence of ZIRP, then the Fed will be pushed to rethink its faith in macroprudential policy. The Austrians would have plenty of grist to chew on.
Bottom Line: All of this will be on the table at tomorrow's two-day FOMC meeting. The Fed will be forced to balance the US picture against the global shock. The primary argument to pull "considerable time" is the current US economic momentum. Furthermore, changing the language is not a policy change in any event; arguably, the language itself is already meaningless if the Fed is truly data dependent. In addition, policymakers may be wary to appear overly sensitive to financial markets. They may also be concerned that not eliminating the language will make the Fed appear less hawkish and more pessimistic than it is, thus risking disrupting financial markets at a later time if data suggests a rate hike is appropriate. The issue of "considerable time" however, is in my opinion, no longer of much interest. The macroprudential/regulatory experiment is far more important now.

Monday, December 15, 2014

Fed Watch: More Questions for Yellen

Tim Duy:

More Questions for Yellen, by Tim Duy: FOMC meeting this week. We all pretty much know the lay of the land. "Considerable time" is on the table, and whether it stays or goes is a close call. The existence of the press conference this week argues for the change over just waiting until January. Stupid reason, I know, but we are just playing the Fed's game here. No real reason not to wait until January other than to keep a March rate hike in play, but only a few policymakers are seriously looking at March anyway. Uncertainty regarding the financial market impact of the oil price drop and its subsequent impact on credit markets seems sufficient to stay the Fed's hand - but they may be hesitant to appear reactive to every dip in financial markets. If the statement is changed, they will probably replace "considerable time" with the intention to be "patient" when considering the timing of the first rate hike.
They will be navigating some tricky currents when constructing the rest of the statement. The opening paragraph will need to acknowledge the improved data - the US economy clearly has some momentum. They will also acknowledge again the expected impact of energy prices on headline inflation, but emphasize the temporary nature of the impact and fairly stable survey-based expectations. This suggest another dismissal of market-based measures.
The Fed could argue that improving domestic indicators at a time of softening in the global economy leaves the risks to the outlook as nearly balanced. They can't both suggest that risks are weighted to the downside and pull the "considerable time" language. That would, I think, be just silly. If they want to suggest there is a preponderance of downside risks, then they will leave in "considerable time." It will be interesting to see if they mention the external environment at all - we know from the minutes of the previous meeting that they were concerned about appearing overly pessimistic.
I have previously suggested two questions for Federal Reserve Chair Janet Yellen at the post-FOMC press conference:
If you want to know what the Fed is thinking at this point, a journalist needs to push Yellen on the secular stagnation issue at next week's press conference. Does she or the committee agree with Fischer? And does she see any inconsistency with the SEP implied equilibrium Federal Funds rates and the current level of long bonds?
and
I would like a journalist to press Yellen on her interpretation of the 5-year, 5-year forward breakeven measure of inflation expectations. Does she see this measure as important or too noisy to be used as a policy metric? What is her preferred metric?
Now I have four additional questions. The first refers to Yellen's previous endorsement of optimal control theory, which as stated in 2012 suggests the extension of zero rate policy well into 2015. Recent research from the Federal Reserve indicates that the same framework is now signaling that liftoff should occur in late 2014, suggesting that the Federal Reserve is now behind the curve. Did Yellen embrace this methodology only until it began to give results she did not like? The obvious question is thus:
Considering that recent updates of your optimal control framework now suggest that the normalization process should already be underway, how useful do you believe such a framework is for the conduct of monetary policy? What specific framework are you now using to dismiss the results of your previously preferred framework?
The second, arguably related, question refers to St. Louis Federal Reserve President James Bullard's argument that the Fed is very close to reaching its monetary policy goals:

Bullard121214

Thus another question is:
St. Louis Federal Reserve President James Bullard has defined a specific metric to assess the Fed's current distance from its goals. What is your specific metric and by that metric how far is the Fed from it's goals? What does this metric tell you about the likely timing of the first rate hike of this cycle?
A third question is obvious. Given current readings on inflation:
Why is the Fed setting the stage for raising interest rates next year while inflation measures remain below target? What is the risk, exactly, of explicitly committing to a zero interest rate policy until inflation reaches at least your target?
The fourth question addresses the potential financial instability related to oil price shock. Note that critics of Fed policy have posited that the low interest rate policy would encourage excessive risk taking in the reach for yield. High yield debt markets have come under particular scrutiny. The Fed has responded that they need to address any financial market instabilities first with macroprudential policy rather than tighter monetary policy. That approach is going to come under sharp criticism if the oil-related debt defaults cascade destructively throughout US financial markets. A natural question is thus:
High yield debt markets are currently under pressure from the decline in oil prices. Are you confident that macroprudential tools are sufficient to contain the damage to energy-related debt? If the damage cannot be contained and contagion to other markets spreads, what does this tell you about the ability to use low interest rate policy without engendering dangerous financial instabilities?
If anyone uses these questions or variations thereof, feel free to give me some credit. Or at least when you speak of me, speak well.
Bottom Line: Odds are high that the Fed alters the statement to increase their policy flexibility next year. But even if they drop "considerable time," Yellen will emphasize via the press conference that this change does not mean a rate hike is imminent. She will emphasize that the timing and pace of rate hikes remains firmly data dependent. The current oil-related disruptions in financial markets loom like a dark cloud over a both the FOMC meeting and the generally improving US outlook.

Friday, December 12, 2014

Fed Watch: Data Supportive of Fed Plans

Tim Duy:

Data Supportive of Fed Plans, by Tim Duy: Incoming data in the second half of this week continues to support the Federal Reserve's plans to begin normalizing policy in the middle of next year, with the removal of "considerable time" language next week a likely first step.
Retail sales for November were unquestionably strong and reveal an acceleration in the pace of core sales:

CORERETAIL121214

You were right if you dismissed the early earnings on the holiday shopping season as useless noise. Similarly, consumer confidence is pushing to pre-recession levels:

MICHSENT121214

And note this from Reuters:
"Expected wage gains rose to their highest level since 2008, and consumers voiced the most favorable buying attitudes in several decades," survey director Richard Curtin said in a statement.
As I have said before, nothing interesting happens until we get unemployment below 6%. Be prepared for a better equilibrium.
Even as the economic data improve, however, Wall Street remains on edge. Lower oil prices and the resulting impact on high yield bonds are resonating throughout credits markets while equity prices struggle. Despite warnings from Fed officials about the likely path of policy, long-dated US Treasury yields continue to remain under pressure. It is difficult to assess the impact on policy-making at this point. Fed officials will be torn between the market turmoil and expectations that lower energy prices will boost an already accelerating economy. And note that New York Federal Reserve President William Dudley was very dismissive of the idea that the Fed would respond to every financial market disruption as policy moved toward normalization:
Because financial market conditions affect economic activity only slowly over time, this suggests that we should look through short-term volatility and movements in financial markets. We should not respond until we become convinced that the movements will likely, without action on our part, prove sufficiently persistent to conflict with achievement of our objectives. Often, financial markets can be quite volatile and move a lot without disturbing underlying economic performance.
Similarly, he has been dismissive of market-based measures of inflation expectations.
In assessing inflation expectations, I currently put more weight on survey-based measures of inflation expectations as opposed to market-based measures. Survey-based measures have been generally stable, consistent with inflation expectations remaining well-anchored. However, market-based measures, such as those based on breakeven inflation derived from the difference between yields on nominal versus Treasury Inflation-Protected Securities (TIPS), have registered declines over the past few months, even on a 5-years forward basis. Research done by my staff suggests that much of this decline in market-based measures of inflation compensation reflects a fall in the inflation risk premium—that is, what investors are willing to pay to protect themselves against inflation risk. Adjusting for the fall in the inflation risk premium, inflation expectations appear to have declined much less than implied by TIPS inflation breakeven measures.
Market participants believe the Fed leans heavily on the 5-year, 5-year forward inflation metric. That measure is heading toward lows last seen on the eve of operation twist:

5Y5Y121214

The Fed dares not defy this chart. Or do they? Jim O'Sullivan at HFE accurately notes that the 5-year, 5-year forward breakeven has been inordinately driven by oil prices:
Why Fed prefers "survey based:" 5y5yf TIPS swing with oil even tho current infl irrelevant for pic.twitter.com/StxfsvubNh
— Jim O'Sullivan (@osullivanEcon) December 12, 2014
The Fed may be losing faith in these measures. As Dudley suggests, they may feel that such metrics are too simplistic, and find themselves favoring metrics like that offered by the Cleveland Fed that shows a firming of inflation expectations in recent months:

Image1

Note also that the resilience of survey-based metrics of inflation expectations. Back to Reuters and the confidence report:
The survey's one-year inflation expectation rose to 2.9 percent from 2.8 percent, while its five-year inflation outlook also rose to 2.9 percent from 2.6 percent last month.
And that leads me to my bottom line - another question for Federal Reserve Chair Janet Yellen at next week's post-FOMC press conference.
Bottom Line: I would like a journalist to press Yellen on her interpretation of the 5-year, 5-year forward breakeven measure of inflation expectations. Does she see this measure as important or too noisy to be used as a policy metric? What is her preferred metric?

Thursday, December 11, 2014

Fed Watch: Challenging the Fed

Tim Duy:

Challenging the Fed, by Tim Duy: Both Paul Krugman and Ryan Avent are pushing back on the Federal Reserve's apparent intent to raise rates in the middle of next year. Why is the Fed heading in this direction? Krugman offers this explanation:

My guess — and it’s only that — is that they have, maybe without knowing it, been bludgeoned into submission by the constant attacks on easy money. Every day the financial press, many of the blogs, cable financial news, etc, are full of people warning that the Fed’s low-rate policy is distorting markets, building up inflationary pressure, endangering financials stability. Hard-money arguments, no matter how ludicrous, get respectful attention; condemnations of the Fed are constant. If I were a Fed official, I suspect that I would often find myself wishing that the bludgeoning would just stop, at least for a while — and perhaps begin looking for an opportunity to prove that I’m not an inflationary money-printer, that I can take away punchbowls too.

I don't think that the Fed is reacting to external criticism. What I think is that there are two basic views of the world. In one view, the post-2007 malaise is simply the hangover from a severe financial crisis. Time heals all wounds, including this one, and the recent data suggests such healing is underway. The alternative view is that the economy is suffering from secular secular stagnation similar although not to the same extreme as Japan. The latter view suggests the need for a very low or negative real interest rates to maintain full employment, the former view suggests a fairly significant normalization of monetary policy.

I believe that the consensus view on the Fed is the former, that the malaise is simply temporary ("a temporary inconvenience") and now ending. I think this is evident from the Summary of Economic Projections - the implied equilibrium Federal Funds rate is around 3.75%. Perhaps this is below what might have been perceived as normal ten years ago, but the difference could be attributed to slower potential growth rather than secluar stagnation.

If you don't like that argument, then take the more explicit route. Gavin Davies did the intellectual legwork here so we don't have to, and catches Vice Chair Stanley Fischer saying that he doesn't believe the situation calls for protracted negative interest rates. In other words, he rejects the main monetary policy implication of the secular stagnation hypothesis.

And, I don't know if Krugman agrees, but I find it hard to believe that Fischer carries anything but extreme intellectual weight within the Fed. So I would hardly be surprised that the Fed would be moving in a direction he defined. One wonders where Fed Chair Janet Yellen's leadership is on this point? That was always a risk of adding Fischer to the Board - that what might have seemed to be a dream team turned into a power struggle.

This is not to say that I do not share Krugman's and Avent's concerns. I most certainly do. Fischer claims that markets do not believe the secular stagnation story either, but in my mind the flattening of the yield curve is a red flag that the Fed has less room to maneuver than implied by the SEP. But maybe once the Fed actually starts hiking rates, market participants get the clue and the yield curve shifts up. I am not sure I am interested in taking that risk at this point, but no one is asking me to serve on the Federal Reserve Board.

One quibble with Krugman regarding his interpretation of the Phillips Curve:

Suppose the Fed waits too long. Well, inflation ticks up — probably not much, since the short-run Phillips curve looks very flat. And the Fed has the tools to rein the economy in. It would be annoying, unpleasant, and no doubt there would be Congressional hearings berating the Fed for debasing the dollar etc.. But not a really big problem.

Maybe two quibbles. First is that if you asked policymakers why the Phillips Curve was flat, I think they would say that nominal wages rigidities hold up the back end, while tighter policy holds down the front. In other words, the reason inflation does not accelerate at low unemployment rates is that the Fed tightens policy accordingly. Second, I think they equate "reigning the economy in" as triggering a recession. I think they find this more than unpleasant.

Bottom Line: If you want to know what the Fed is thinking at this point, a journalist needs to push Yellen on the secular stagnation issue at next week's press conference. Does she or the committee agree with Fischer? And does she see any inconsistency with the SEP implied equilibrium Federal Funds rates and the current level of long bonds?

Tuesday, December 09, 2014

'Profiles in Coreage'

Paul Krugman follows up on one of Tim Duy's posts:

Profiles in Coreage: Tim Duy, in the course of a discussion of the outlook for Fed policy, reminds us of the spring of 2011, when headline inflation had risen a lot mainly due to oil prices. He portrays Ben Bernanke as being all alone in insisting that the inflation bump was a blip, and would soon fade away. Actually, that’s not quite right; as far as I recall, most saltwater economists agreed. I was writing about it often. And the Fed, after all, routinely focuses on core inflation rather than headline numbers. Still, Bernanke was definitely under pressure.
What Duy doesn’t say is that the inflation fight of 2011 was about more than inflation; it was another aspect of the fight over how the economy works – and another big victory for the Keynesian view. The concept of core inflation arises out of the notion that most prices are “sticky” ... Standard measures of core inflation are imperfect ways of getting at this distinction, but they ... have been hugely vindicated by the experience of recent years. So I’m glad to see all the people who issued dire warnings about inflation in 2011 acknowledging that they had the wrong model. Hahahahaha.
And yes, this means that you should discount the effects of falling oil prices in the same way you discount the effects of rising oil prices. I would nonetheless urge the Fed to hold off on rate hikes, but for different reasons – the asymmetry in risks between raising rates early and raising them late. And I worry that the Fed may be losing the thread here (hi Stan!). But that’s another topic.

Fed Watch: Fed Updates Ahead of FOMC Meeting

Tim Duy:

Fed Updates Ahead of FOMC Meeting: I have tended to think that there is a tendency to underestimate the potential for a more hawkish Fed. From last week:

Dudley appears to be increasingly concerned that the evolution of financial conditions this year suggests the Fed needs to pursue a more aggressive policy stance or else risk a repeat of 04-07. If this concern is being felt more generally within the Fed, it clearly puts a more hawkish bias to the Fed's reaction function. And, in my opinion, I think the risk of a more hawkish Federal Reserve is under-appreciated. Few are expecting a hawkish Federal Reserve, reasonably so given the path of policy since 2008. But I don't think the data are that far from a tipping point for the Federal Reserve. Of course, take that in the context of my general optimism.

I think policymakers have been falling in line with the idea of a mid-2015 rate hike, somewhat earlier than market expectations. In a great piece, Gavyn Davies concurs:

One of the most successful rules for investors in the past few years has been never to underestimate the innate dovishness of the Federal Reserve. Whenever there has been a scare that the Fed might move in a hawkish direction, this has quickly proven to be a mistake. Forward curves for short term interest rates have consistently moved “lower for longer”, and incoming economic data have always ensured that the Federal Open Market Committee (FOMC) has remained comfortable with this tendency.

In recent months, however, the markets may have become over confident about the Fed’s dovishness in the face of a large and persistent decline in the US unemployment rate...

...The controlling group may be shifting towards the median dot, rather than the dovish end of the spectrum. This may even include Ms Yellen herself, if the Stanley Fischer interview is any guide. Mr Fischer is universally regarded as an intellectual heavyweight, but he has said very little about his personal views on monetary policy since taking office last May. He is unlikely to have broken this silence without the knowledge and support of the Chair.

Davies summarizes Federal Reserve Vice Chair Stanley Fischer's recent interview and concludes that "Mr Fischer is building a high hurdle to any delay in lift-off beyond mid 2015." Many policymakers are ready and eager to normalize policy, and they see economic improvements as consistent with normalization. Just like they wanted out of the asset purchase business, they want out of the zero rate business, and they see fewer and fewer reasons why this isn't possible.

A small step to that rate hike is the removal of the "considerable time" language in the FOMC policy statement on the basis that too much improvement in labor markets has occurred to justify a certain position on zero interest rates. If the Fed is looking for flexibility and does not want to surprise market participants with an unexpectedly hawkish position next year, they will soon need to loosen up the language. Hence sometime soon "considerable time" will be replaced, perhaps with the term "patience."

Jon Hilsenrath at the Wall Street Journal puts us on alert that next week may be just that time:

Federal Reserve officials are seriously considering an important shift in tone at their policy meeting next week: dropping an assurance that short-term interest rates will stay near zero for a “considerable time” as they look more confidently toward rate increases around the middle of next year.

Senior officials have hinted lately that they’re looking at dropping this closely watched interest-rate signal, which many market participants take as a sign rates won’t go up for at least six months.

“It’s clearer that we’re closer to getting rid of that than we were a few months ago,” FedVice Chairman Stanley Fischer said in an interview with The Wall Street Journal last week. New York Fed President William Dudleyhas avoided using the “considerable time” phrase in recent speeches and instead said the Fed should be “patient” before raising rates.

I find this piece of logic, however, to be irritating:

Fed officials have several tactical issues to consider that could prompt them to shift their rate assurance now, while they’re still taking measure of the economy’s strength. Ms. Yellen has a news conference after the policy meeting ends Dec. 17 to explain the central bank’s decision. The Fed doesn’t have another news conference scheduled until March. If officials wait to change the words until then, the market could take it as a signal officials are pushing off planned rate increases until the second half of next year.

It is not Hilsenrath I am irritated with, it is the Fed. It is fairly clear that the Fed has set expectations such that major policy moves can only be made in meetings with press conferences. It's the reason that June 2015 comes into focus for a rate hike - given the repeated warnings about the "middle of next year," March seems too early, and September too late. April and July are deemed not real policy meetings because they don't have press conferences. This really needs to end. The Fed needs to move to a press conference with every meeting.

If they feel they need a press conference to announce the end of the "considerable time" language, supporters of such a change will argue strongly for next week and probably win. It also opens up the possibility of a March hike, something the hawks would be keen on. Delaying the removal of "considerable time" to March would likely close off a June hike, but the moderates want to retain that option. I think both moderates and doves would be willing to wait until the January meeting, but that meeting has no press conference. So at this point I would be expecting that a change in the language next week is likely, and by the end of January is certain.

But make no mistake that I think that having to set policy by the timing of press conferences rather than the meetings is just stupid.

Finally, another line from Hilsenrath leaves me cautious:

At the same time, a stronger dollar and falling commodities prices—including the sharp decline in oil prices—are putting downward pressure on inflation.

I can certainly imagine that the stronger dollar is a consequence of stronger economic growth, which supports consumer prices. On the declining oil prices, I tend to view those as primarily supply side related and almost certainly a net positive for the US economy. Over the weekend Matt Busigin reminded us of this:

In April of 2011, Ben Bernanke was universally lambasted and lampooned for claiming that inflation, which was accelerating and running above 3%, was “transitory”. He used this view to justify loosening monetary policy. The next few months of CPI were not favourable to the Fed chairman’s views: it peaked at 3.8% (nearly double the implicit target at that point) in September of 2011, sparking a feverishly pitched cacophony of criticism that the Fed chair was out of touch, and tone-deaf in his theoretical ivory tower to the practical realities on the ground.

This, however, proved to be Bernanke’s finest hour. Yes, even more so than the extraordinary measures taken during the height of the credit crisis. His detractors then, of which there were still many, included people and institutions on the brink that needed the Fed to extend them a hand. In September of 2011, the chairman stood very much alone in his call for moderated inflation now that the acute disaster removed influential institutions and people from needing the Fed to act in order to survive....

...This is why Ben Bernanke’s 2011 triumph is relevant today. The same framework for understanding inflation through commodity prices and wages that successfully predicted the deceleration of inflation against the tidal wave of popular belief now finds itself in the inverse position: the expectations of inflation are very low, and despite low commodity prices, it expects inflation will accelerate...

You can read this for my similar take back in 2011. Rather than preventing inflation from returning to target, the oil price decline is likely to have the opposite impact and push inflation back to target. Hence the low-inflation argument for holding rates near zero will look weaker by June if not March.

Bottom Line: Fed is still positioning to begin normalizing rates in the middle of 2015. The data is less of an impediment with each passing day. The time to eliminate the "considerable period" language is fast approach. The press conference calendar argues for next week. Honestly, I hope they will skip this meeting in favor of the January meeting just to prove that every FOMC meeting is a live meeting. Alas, I think they believe they need the press conference to temper any adverse reactions from market participants. Finally, I am wary with the consensus view that the oil price decline in disinflationary. Open up to the possibility of the opposite. Look back to what you believed in 2011.

Friday, December 05, 2014

Fed Watch: Economy Clearly Gaining Momentum

Tim Duy:

Economy Clearly Gaining Momentum, by Tim Duy: The November employment report came in ahead of expectations, with a monthly nfp gain of 321k and 44k of upward revisions to previous months. Job gains were spread throughout the major sectors of the economy. The 2014 acceleration in job growth is clearly evident:

NFPa120514

The employment report in the context of indicators previously identified by Federal Reserve Chair Janet Yellen as important to watch:

NFPb120514

NFPc120514

Measures of underemployment are generally moving in the right direction. To be sure, the labor force participation rate remains in a general downward trend, but on this point I think you have to accept that demographic forces are driving the train. Year-over-year wage growth remains anemic although average wages gained 0.37% on the month. While this indicates that wage gains are not dead and gone forever, I would find it more impressive if these kinds of gains repeated themselves in the next few months. As I have said before, I think that will happen as unemployment rates fall further. I read nothing of importance into the unchanged unemployment rate for the month.
The tenor of this report harmonizes well with the song sung by recent data. Of course, data are inherently variable, and not every report will be as bright (or as dark) as the last. Nor would we expect a string of 300k+ gains in employment just yet. But I think any reasonable single extraction effort tells you that activity is on a firmer footing than it has been in years, and there is little reason to expect the improvements will reverse quickly. The US economy has momentum. Do not discount the value of that momentum.
Fixed income markets quickly discerned what this report means for the Fed - the risk is that rate hikes will come sooner than expected. At time of writing, the yield on the two-year bond gained 11bp, while the ten-year yield rose 9bp. The Fed will be pleased by the upward though controlled gains at the longer end of the yield curve as they will associate those gains with modestly less financial accommodation. They may be less pleased that stocks keeps hitting record highs as it suggests that financial conditions are easing somewhat, thus perhaps necessitating a faster pace of rate hikes. Over the longer run, I remain wary of the flattening yield curve.
My guess is that the Fed will soon begin to believe that they stayed pessimistic on the recovery the year the recovery began to show significant signs of life. More on the Fed next week.
Bottom Line: A solid employment report. The risk that the first rate hike comes sooner than June continues to rise.

Thursday, December 04, 2014

Fed Watch: Ahead of the November Employment Report

Tim Duy:

Ahead of the November Employment Report, by Tim Duy: Data in the first week of December has told a generally bullish story for the US economy. The week began with an upbeat number from the ISM manufacturing index with solid underlying data:

ISM1120214

While this was seemingly at odds with the Markit manufacturing index, I would say that both of these series (like consumer confidence) exhibit far too much variability to place too much weight on any one month of data. If I look at the ISM measure in context with other US manufacturing data, the overall view is one of steadily improving activity in the sector (note the estimated 17.1 million auto sales rate for November):

IND120214

This also seems consistent with the anecdotal story told by the Beige Book:
Manufacturing activity generally advanced during the reporting period. The automotive and aerospace industries continued to be sources of strength. Steel production increased in Cleveland, Chicago, and San Francisco. Fabricated metal manufacturers in the Chicago and Dallas Districts noted widespread growth in orders. Dallas reported that domestic sales for plastics were strong, while demand for plastics was steady in Richmond and declined in Kansas City. Chemical manufacturers in the Boston District indicated that the falling price of oil relative to natural gas had made U.S. producers less competitive, because foreign chemical producers rely more heavily on oil for feedstock and production. St. Louis, Minneapolis, and Dallas reported that food production was little changed on balance, but production in Kansas City continued to decline. Chicago and Dallas indicated that shipments of construction materials increased. Manufacturers of heavy machinery in the Chicago District cited improvements in sales of construction machinery, but reported ongoing weak demand for agricultural and mining equipment. High-tech manufacturers in Boston, Dallas, and San Francisco noted steady growth in demand. Biotech revenue increased in the San Francisco District.
I would also add that the Beige Book had a decidedly optimistic tenor:
Reports from the twelve Federal Reserve Districts suggest that national economic activity continued to expand in October and November. A number of Districts also noted that contacts remained optimistic about the outlook for future economic activity.
The ISM's service sector report was equally upbeat:

ISM2120214

The ADP report fell somewhat short of expectations, but again this number is far too volatile to place much if any weight on a small miss. Or even a large miss, for that matter. Calculated Risk places the ADP number in context of other labor market indicators, concluding that:
There is always some randomness to the employment report. The consensus forecast is pretty strong, but I'll take the over again (above 230,000).
I don't have much to add here. As I have said before, predicting the monthly nonfarm payroll change is a fool's errand, yet an errand we all undertake. I would pick 235k with an upside risk. More important is what happens to wage growth. I expect that to pick up over the next six months, but would be surprised to see any large gain this month.
Jon Hilsenrath at the Wall Street Journal reports that top Federal Reserve policymakers are not deterred in their plans for policy normalization:
In public appearances this week, Janet Yellen’s two top lieutenants sounded like individuals who want to start raising short-term interest rates in the months ahead, despite mounting uncertainties about growth abroad and associated downward pressure on commodities prices...
...“It is clear we are getting closer” to dropping an assurance that rates will stay low for a considerable time, he said. Mr. Fischer repeatedly emphasized his desire to get back to normal. “We almost got used to thinking that zero is the natural place for the interest rate. It is far from it,” he said.
In case there is any doubt about where top Fed officials are going with this, New York Fed president Bill Dudley said bluntly: “Market expectations that lift-off will occur around mid-2015 seem reasonable to me.” Like Mr. Fischer, Mr. Dudley sees the recent decline in oil prices as a net positive for the U.S., a net importer of energy which benefits from a lower cost of imported oil.
I think the speech my New York Federal Reserve President William Dudley is a must read. I have been repeatedly drawn to this paragraph (emphasis added):
First, when lift-off occurs, the pace of monetary policy normalization will depend, in part, on how financial market conditions react to the initial and subsequent tightening moves. If the reaction is relatively large—think of the response of financial market conditions during the so-called “taper tantrum” during the spring and summer of 2013—then this would likely prompt a slower and more cautious approach. In contrast, if the reaction were relatively small or even in the wrong direction, with financial market conditions easing—think of the response of long-term bond yields and the equity market as the asset purchase program was gradually phased out over the past year—then this would imply a more aggressive approach. The key point is this: We will pursue the monetary policy stance that best generates the set of financial market conditions most consistent with achievement of the FOMC’s dual mandate objectives. This depends both on how financial market conditions respond to the Fed’s policy actions and on how the real economy responds to the changes in financial conditions.
Long term yields have been drifting down since the "taper tantrum," flattening the yield curve significantly:

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Dudley seems to be saying that he does not think that financial conditions should be easing, especially since he thinks he has been clear that the time to begin policy normalization is fast approaching. Robin Harding at the Financial Times sees the implications:
Although Mr Dudley does not say it, this argument could apply to the timing of rate rises as well as their pace. Markets have not reacted much to the prospect of Fed rate rises: the ten-year yield at 2.22 per cent is no higher than it was before the taper tantrum in summer 2013; the S&P 500 is up by 15 per cent on a year ago. Mr Dudley explicitly cites the low level of 10-year Treasury yields, saying they are presumably due, “in part, to the fact that long-term interest rates in Europe and Japan are much lower”.
If markets are not reacting to potential Fed rate rises then, by Mr Dudley’s logic, rate rises could need to come earlier as well as faster. The initial rate rise, in particular, could help the Fed to learn about the financial market response. That may help to explain why Mr Dudley is still in June 2015 for rate lift-off despite his dovish views.
Take this all in context of an earlier passage from the Dudley speech:
...during the 2004-07 period, the FOMC tightened monetary policy nearly continuously, raising the federal funds rate from 1 percent to 5.25 percent in 17 steps. However, during this period, 10-year Treasury note yields did not rise much, credit spreads generally narrowed and U.S. equity price indices moved higher. Moreover, the availability of mortgage credit eased, rather than tightened. As a result, financial market conditions did not tighten.
As a result, financial conditions remained quite loose, despite the large increase in the federal funds rate. With the benefit of hindsight, it seems that either monetary policy should have been tightened more aggressively or macroprudential measures should have been implemented in order to tighten credit conditions in the overheated housing sector...
Dudley appears to be increasingly concerned that the evolution of financial conditions this year suggests the Fed needs to pursue a more aggressive policy stance or else risk a repeat of 04-07. If this concern is being felt more generally within the Fed, it clearly puts a more hawkish bias to the Fed's reaction function. And, in my opinion, I think the risk of a more hawkish Federal Reserve is under-appreciated. Few are expecting a hawkish Federal Reserve, reasonably so given the path of policy since 2008. But I don't think the data are that far from a tipping point for the Federal Reserve. Of course, take that in the context of my general optimism.
A second point is that Dudley is not taking seriously the possibility that the flattening yields curve suggests the Fed has less room to move than policymakers think they do. This is something I worry about - if the Fed leans on the short end too much, they risk taking an expansion that should last another fours years to one that has just two more years left. But that might be a story for next December.
Bottom Line: Generally positive US data leave the Fed on track for a rate hike in the middle of next year. I am inclined to believe that the risk is that rate hikes come sooner and faster than anticipated outweigh the risk of later and slower.

Wednesday, December 03, 2014

'Charles Evans: Low Inflation Is the Primary Concern'

I hope the Fed listens to Charlie Evans (as opposed to Charles Plosser):

Q. and A. With Charles Evans of the Fed: Low Inflation Is the Primary Concern: Charles Evans, president of the Federal Reserve Bank of Chicago, is nervous about inflation. His worry, however, is not the old Fed fear that prices are rising too quickly, but the new Fed fear that prices are not rising fast enough.
Mr. Evans said in an interview Tuesday that he now saw the sluggish pace of inflation as the primary reason the Fed should keep short-term interest rates near zero, a view shared by a growing number of Fed officials.
Mr. Evans, one of the 10 Fed officials who will vote on monetary policy decisions next year, has emerged since the financial crisis as one of the most forceful advocates for the Fed’s stimulus campaign. He pressed successfully in 2012 for more forceful action to reduce unemployment. Now he is warning that the Fed must be careful to avoid raising rates prematurely. ...

Tuesday, December 02, 2014

'Why so Glum?'

Ryan Avent responds to Tim Duy:

Why so glum?: Tim Duy, one of the best writers on macro policy issues, is optimistic about America's economy and wonders why more people aren't...
Have we all been too pessimistic about the American economy? What attitude should we have?
One metric might be a cross-country comparison. On that score one might suppose optimism is clearly warranted. America's recovery is the envy of the rich world. On the other hand, that is not saying much. Being the best of the bunch when the bunch has done so miserably is not exactly reason for cheer. ...
An historical comparison, by contrast, leads to a much bleaker assessment of the current recovery. ...
That brings us to another case for pessimism... GDP is growing, but ... Real GDP per capita is only a shade above its level of seven years ago... At the median the performance has been much worse...
Sentiment is an important economic variable; if you want people to buy things and invest, rather than grasp fearfully to their incomes, then you need them to be confident: indeed, optimistic. Optimism is self-fulfilling. But it is not detached from reality. ... I don't find it remotely surprising that people are glum. That is an indictment of the Fed, whose job it is to coordinate our expectations so that we all anticipate, and therefore cause to occur, maximum employment and an average inflation rate of 2%. ...
Being down so long things look like up is not optimism. ... I will turn optimistic when the Fed convinces me such a turn is warranted.

I don't think the Fed performed perfectly, but to me this places too much of the blame in their hands.

Monday, December 01, 2014

Fed Watch: Sometimes I Wonder

Tim Duy:

Sometimes I Wonder, by Tim Duy: Sometimes I wonder if the Fed every actually looks at the data. This, from Ann Saphir and Jonathon Spicer at Reuters:
With the U.S. economy humming along at its fastest clip in more than a decade, the Federal Reserve should be confident about its ability to weather a global slowdown and start lifting interest rates around the middle of next year.
But then there is inflation.
Interviews with Fed officials and those familiar with its thinking show the mood inside is more somber than the central bank's reassuring statements and evidence of robust economic health would suggest. The reason is the central bank's failure to nudge price growth up to its 2 percent target and, more importantly, signs that investors and consumers are losing faith it can get there any time soon...
..."The primary concern at the moment is whether you can get back to 2 percent in a way that keeps expectations anchored, and maintains the credibility of the Fed as an institution that can achieve its goal," said Jeffrey Fuhrer, the Boston Fed's senior policy advisor...
...One Fed official, who declined to be named, told Reuters policymakers must resist the urge to lift rates at the first opportunity because they might be forced to backtrack if inflation failed to pick up...
One would think that central bank officials would recognize that low inflation is not a new phenomenon. It has been a persistent phenomenon for the past twenty years:

PCE120114

Note the long periods of below trend core inflation. Has this trend really gone unnoticed on Constitution Avenue? Moreover, the periods of elevated inflation have been more persistent when unemployment is below 5%, compared to the current 5.8%. At current rates, I would say you are more likely to be below than about 2% inflation:

PHIL1

And even focusing on 5% you have to ignore the low inflation of the late 1990's as an outlier. It seems clear that the economy is only now moving into a range where upward pressure on inflation is more likely to occur. So why should the Fed be surprised at the inflation numbers?
Bottom Line: Sometimes I think the Fed's underlying pessimism stems from some belief that inflation and wage pressures were about to occur when there was absolutely no reason to hold such a belief. The economy is only just beginning to move into a zone where more interesting things could happen. Honestly, it would be much more interesting if the economy moved to 4% unemployment with no wage or price pressures.

Fed Watch: Yes, I am Optimistic

Tim Duy:

Yes, I am Optimistic, by Tim Duy: I stood relieved when Federal Reserve policymakers recognized the tendency toward pessimism during this recovery when no such pessimism was warranted:
Finally, a couple of members suggested including language in the statement indicating that recent foreign economic developments had increased uncertainty or had boosted downside risks to the U.S. economic outlook, but participants generally judged that such wording would suggest greater pessimism about the economic outlook than they thought appropriate.
This stands in contrast to fairly consistent efforts to find the dark cloud in every silver lining. This, from the Wall Street Journal:
Economic prospects are flagging across Europe, Japan and big emerging markets such as India, a turn that presents fresh challenges to the relatively robust U.S. economy at a time when the world needs a dependable growth engine.
At least they mentioned the "robust" part. And the perennial activity of agonizing over holiday sales is in full swing, despite the reality that holiday sales tell you little if anything about the overall economy.
The lesson no one wants to draw from this recovery is that the US economy is both stronger and more resilient than commonly believed. Everyone, it would seem, is in the pessimism business - and such pessimism seems endemic throughout the US public. Perhaps only pessimism scores political points. Or perhaps that is only human nature. As Deirdre McCloskey recently remarked in her review of Piketty:
…pessimism sells. For reasons I have never understood, people like to hear that the world is going to hell, and become huffy and scornful when some idiotic optimist intrudes on their pleasure. Yet pessimism has consistently been a poor guide to the modern economic world. We are gigantically richer in body and spirit than we were two centuries ago…
Overall, I find the pessimism (from the right and the left) inconsistent with the fact that despite the ups and downs of the quarterly data, throughout the recovery, GDP has grown at a fairly consistent rate:

GPD112914

And even that might hide the strength of the recovery this year. GDP growth has exceeded 3% in four of the last five quarters. In two of those quarters, growth was in excess of 4%. It is simply reasonable to believe that the first quarter GDP report was largely an aberration. Do not dismiss the real improvement in the economy since 2009. It is not unimportant that 2014 is likely to be the biggest year for private sector employment since 1999 and that auto sales will reach a level not seen since 2001. It is not unimportant, in contrast to the conventional wisdom, that "in the post-Great Recession era, the growth in full-employment is, without a doubt, way out ahead." These are just three of many genuine signals of economic strength. It seems to me that in the effort to find what is wrong with the economy, everyone misses what is right.
The US economy is far more resilient than it is given credit for. None of the downside risks of recent years have been sufficient to derail the recovery, nor will the supposed downside risks of next year. They are mostly external, while the primary engine of US growth is internal and flexible. The decline in energy prices (another purported reason to fear the new year) will prove to be no exception. I believe we are witnessing a supply driven dynamic, not collapsing global demand. The US economy will adjust as the balance shifts from energy producers to energy consumers. While this will have some concentrated, negative implications for a handful of sectors and geographies (I would hope but find it unlikely that state and municipal leaders in North Dakota recognized the boom-bust nature of the commodity cycle well in advance of the bust part), I expect that the net impact will be modestly positive.
Indeed, the resiliency of the economy was almost certainly on display in the years preceding the Great Recession. Brad DeLong likes to note that the economy was adjusting to the housing collapse (a much deeper and widespread sector of the economy than energy production) fairly well until the financial crisis:
…you also have a strong argument that it was the financial crisis and not the collapse of the housing bubble that was the lead violin in this catastrophe. Construction reached its housing-bubble peak in the third quarter of 2005. From then until the third quarter of 2008, through the business cycle peak and out the other side, the market economy adjusted as smoothly to the recognition of a sectoral disequilibrium as the most optimistic of macroeconomists could have hoped: interest rates fell as demand for loans to finance construction eased off, and exports and business investment took up the slack resources released by the shrinking construction sector. The NBER's Business-Cycle Dating Committee did not conclude that the U.S. economy was in a full-blown recession until more than halfway through the fourth quarter of 2008.
As long as people have babies, capital depreciates, technology evolves, and tastes and preferences change, there is a powerful underlying (and under-appreciated) impetus for growth that is almost certain to reveal itself in any reasonably well-managed economy. This ultimately is the reason that despite the seemingly persistent belief that the recessionary bogeyman is just around the corner, recessions are remarkably rare events.
Since 1983, the US economy has been in expansion for 350 months. Recessions account for just 34 months, less than 10% of the time. In any given month, the probability of recession is certainly less than 10%. Recessions are concentrated in a handful of periods. If you are not in a recession this month, it is almost certain that you will not be in a recession next month. Consider that only three times since 1983 has a recession occurred in a month preceded by an expansion.
But this makes it seem as if recessions simply spring out of thin air, which they do not. Even if you thought the conditions for a recession were currently brewing, it is highly unlikely that the momentum of the US economy will turn in twelve months or less. Even if you thought, for example that the financial sector could not absorb any losses that stem from a decline in energy prices and thus be faced once again with crisis (unlikely, in my opinion, especially in the wake of regulatory enhancements since the last crisis), it would still take months for that shock to propagate throughout the economy.
Moreover, this ignores the other relevant feature of US recessions – they are preceded by long periods of sustained monetary tightening. And the Fed has not yet initiated even its first rate hike. Even if you accept that tapering is tightening, we are still on the front end of the cycle rather than the back end.
Hence my probability of recession in the next twelve months: 0%. I would place similar odds on the following twelve months as well.
To be sure, improvements were not as quick as many had hoped, but the shortfalls can largely be traced to two sectors – housing, in which the financing mechanism was damaged, and the failure of the fiscal authorities to adequately plug the hole. But the resilient economy continued to march higher nonetheless. And now fiscal policy is no longer a drag; the bottom in government jobs has likely been reached. Moreover, there is one silver lining in the relatively low pace of new housing activity – such activity has room to run. I expect that over the next two years housing will become an increasingly strong force in the US economy. Nor will the economy likely be impeded by monetary policy, which even if tighter than expected is likely to remain more accommodative than traditional metrics of appropriate monetary conditions would suggest.
Bottom Line: Perhaps, just perhaps, the US economic expansion has been consistently undersold, and continues to be undersold. It is worth considering that maybe it is time to just accept the good news without the desperate search for every dark cloud.

Wednesday, November 26, 2014

'Keynes Is Slowly Winning'

[Travel day, so no more until later.]

Paul Krugman:

Keynes Is Slowly Winning: Back in 2010, I had a revelation about just how bad economic policy was about to get; I read the OECD Economic Outlook, which called not just for fiscal austerity but for interest rate hikes — 350 basis points on the Fed funds rate by the end of 2011! — because, well, because.
Now, the OECD is calling for fiscal and monetary stimulus in Europe. ....
It has taken a while. ... But the hawks seem in retreat at the Fed; Mario Draghi ... sounds an awful lot like Janet Yellen; the whole way we’re discussing Japan is very much on Keynesian turf. Three and a half years ago Businessweek was declaring that expansionary austerian Alberto Alesina was the new Keynes; now it tells us that Keynes is the new Keynes. And we have people like Paul Singer complaining about the “Krugmanization” of the debate.
Why does the tide finally seem to be turning? Partly, I think, it’s just a matter of time; after six years it’s becoming hard not to notice that the anti-Keynesians have been wrong about everything. Europe’s slide toward deflation makes it even harder to deny the realities of liquidity-trap economics. And the refusal of almost everyone on the anti-Keynesian side to admit any kind of error has gradually made them look ridiculous.
All of this may be coming too little and too late to avoid policy disaster, especially in Europe. But it’s something to cheer, faintly.

Monday, November 24, 2014

Paul Krugman: Rock Bottom Economics

The era of "rock-bottom economics" is far from over:

Rock Bottom Economics, by Paul Krugman, Commentary, NY Times: Six years ago the Federal Reserve hit rock bottom. It had been cutting the federal funds rate ... more or less frantically in an unsuccessful attempt to get ahead of the recession and financial crisis. But it eventually reached the point where it could cut no more...
Everything changes when the economy is at rock bottom... But for the longest time, nobody with the power to shape policy would believe it.
What do I mean by saying that everything changes? As I wrote..., in a rock-bottom economy “the usual rules of economic policy no longer apply...” Government spending doesn’t compete with private investment — it actually promotes business spending. Central bankers, who normally cultivate an image as stern inflation-fighters, need to do the exact opposite, convincing markets ... that they will push inflation up. “Structural reform,” which usually means making it easier to cut wages, is more likely to destroy jobs than create them.
This may all sound wild and radical, but ... it’s what mainstream economic analysis says will happen once interest rates hit zero. And it’s also what history tells us. ...
But as I said, nobody would believe it. By and large, policymakers and Very Serious People ... went with gut feelings rather than careful economic analysis. ...
Thus we were told ... that budget deficits were our most pressing economic problem, that interest rates would soar ... unless we imposed harsh fiscal austerity... —... demands that we cut government spending now, now, now have cost millions of jobs and deeply damaged our infrastructure.
We were also told repeatedly that printing money ... would lead to “currency debasement and inflation.” The Fed ... stood up to this pressure, but other central banks didn’t. ...
 But... Isn’t the era of rock-bottom economics just about over? Don’t count on it..., the counterintuitive realities of economic policy at the zero lower bound are likely to remain relevant for a long time..., which makes it crucial that influential people understand those realities. Unfortunately, too many still don’t; one of the most striking aspects of economic debate in recent years has been the extent to which those whose economic doctrines have failed the reality test refuse to admit error, let alone learn from it. ...
This bodes ill for the future. What people in power don’t know, or worse what they think they know but isn’t so, can very definitely hurt us.

Thursday, November 13, 2014

Fed Watch: Dudley, Plosser, JOLTS, Potential Output

Tim Duy:

Dudley, Plosser, JOLTS, Potential Output, by Tim Duy: Not enough time to do any of these topics justice, but some quick takeaways for the last two days.
First, read today's speech by Federal Reserve President William Dudley in which he discusses the global implications of US monetary policy. Some keys points:
1. Still dismissing the recent drop in inflation expectations. Dudley says:
In assessing inflation expectations, I currently put more weight on survey-based measures of inflation expectations as opposed to market-based measures. Survey-based measures have been generally stable, consistent with inflation expectations remaining well-anchored. However, market-based measures, such as those based on breakeven inflation derived from the difference between yields on nominal versus Treasury Inflation-Protected Securities (TIPS), have registered declines over the past few months, even on a 5-years forward basis. Research done by my staff suggests that much of this decline in market-based measures of inflation compensation reflects a fall in the inflation risk premium—that is, what investors are willing to pay to protect themselves against inflation risk. Adjusting for the fall in the inflation risk premium, inflation expectations appear to have declined much less than implied by TIPS inflation breakeven measures.
The Fed is not taking the market-based measured of inflation expectations at face value, especially now that the Fed is closer to its employment objectives and they are increasingly confident that the recovery is more likely than not to strengthen further.
2. Cautious about prematurely raising rates. Dudley on the implications of his outlook for monetary policy:
In considering the appropriate timing of lift-off, there are three important reasons to be patient. First, the Committee is still undershooting both its employment and inflation objectives...Second, when interest rates are at the zero lower bound, the risks of tightening a bit too early seem considerably greater than the risks of tightening a bit too late. A premature tightening might lead to financial conditions that are too tight, resulting in a weaker economy and an aborted lift-off...Finally, given the still high level of long-term unemployment, there could be a significant benefit to allowing the economy to run “slightly hot” for a while in order to get these people employed again. If they are not employed relatively soon, their job skills will erode further, reducing their long-term prospects for employment and, therefore, the productive capacity of the U.S. economy.
Hence, no need for a rate hike now. But...
3. Rate hikes are coming. Dudley continues:
All that said, I hope the economic outlook evolves so that it will be appropriate to begin to raise interest rates sometime next year. While raising interest rates is often portrayed as a difficult task for central bankers, in fact, given the events since the onset of the financial crisis, it would be a development to be truly excited about. Raising interest rates would signal that the U.S. economy is finally getting healthier, and that the Fed is getting closer to achieving its dual mandate objectives of maximum employment and price stability. That would be very good news, even if it were to cause a bump or two in financial markets.
The economy is improving, hence normalization is coming. And note he does not specify any time frame other than next year. Based on previous comments we might reasonably conclude that he thinks mid-year, but it is a data-dependent decision. I think his is "patient" in the sense that it is not going to happen this year (which really isn't a question to begin with). But I doubt he has ruled out the end of the first quarter of next year. And again, don't expect the Fed to change course on the basis of some market turbulence. They expect it as part of the policy transition.
Outgoing Philadelphia Federal Reserve President Charles Plosser, in contrast, is looking for action sooner than later. While Dudley sees the risks of premature tightening, Plosser thinks the risk of wanting too long before normalization are higher:
First, we do not know how to confidently determine whether the labor market is fully healed or when we have reached full employment...Second, if we wait until we are certain that the labor market has fully recovered before beginning to raise rates, policy will be far behind the curve. One risk of waiting is that the Committee may be forced to raise rates very quickly to prevent an increase in inflation...This would represent a return of the so-called "go-stop" policies of the past...A third risk to waiting is that the zero interest rate policy has generated a very aggressive reach for yield as investors take on either credit or duration risk to earn higher returns...For these reasons, I would prefer that we start to raise rates sooner rather than later. This may allow us to increase rates more gradually as the data improve rather than face the prospect of a more abrupt increase in rates to catch up with market forces, which could be the outcome of a prolonged delay in our willingness to act. Of course, financial markets are not always patient, so some volatility will be unavoidable.
Still a minority position on the FOMC, but eventually hawks (or those that remain, see below) and doves will converge. I still think that convergence will happen in the middle of next year with the risks weighted more on the second than the third quarter. Indeed, the JOLTS report for September suggests the labor market improvement is accelerating as we head into the final months of the year. Notably, the quits rates spiked:

JOLTS111314

I suspect that a faster quit rate will force employers to step up the pace of higher out of necessity. Moreover, unemployment below 6% and heading south and quit rates heading north to pre-recession levels suggests that wage growth is coming. And that wage growth will push FOMC moderates toward the "hike sooner than later" side of the debate. Call me an optimist on the near-term outlook.
Finally, via Mark Thoma, researchers at the Federal Reserve are questioning the ability of the economy to regain anything like what we thought was potential output prior to the recession:
The economic collapse in the wake of the global financial crises (GFC) and the weaker-than-expected recovery in many countries have led to questions about the impact of severe downturns on economic potential. Indeed, for several major economies, the level of output is nowhere near returning to pre-crisis trend (figure 1). Such developments have resulted in repeated downward revisions to estimates of potential output by private- and public-sector forecasters. In addition, this disappointment in post-recession growth has contributed to concerns that the U.S. economy, among others, is entering an era of secular stagnation. However, the historical experience of advanced economies around recessions indicates that the current experience is less unusual than one might think. First, output typically does not return to pre-crisis trend following recessions, especially deep ones. Second, in response, forecasters repeatedly revise down measures of trend...
...Although these calculations are simple, they raise deeper questions about the impact of recessions on trend output. The finding that recessions tend to depress the long-run level of output may imply that demand shocks have permanent effects. The sustained deviation of the level of output from pre-crisis trend points to flaws in the way the economics profession models the recovery of output to economic shocks and raises further doubts about the reliance on measures of output gaps to determine economic slack. For policymakers, the results also point to the cost of recessions, especially deep and long ones, and provide a rationale for strong and rapid policy responses to economic downturns.
Those of us concerned by the risk that the lengthy cyclical downturn would yield structural damage would not be surprised by this conclusion. Note that the more the Fed believes output is close to potential, the less patient they will be in holding rates low. And note that the have already pretty much given up on the CBO potential output numbers:

POT111314

If he don't get back to that estimate of potential output by 2017, that estimate just isn't going to hold. Call me a pessimist on this point. I think it more likely than not that the CBO estimate of potential is revised downward again. I suspect the Fed has already done so.
And in a late-breaking development, Dallas Federal Reserve President Richard Fisher announced his retirement today, effective March 19, 2015. Another hawk down.
Bottom Line: Watch the data. In my opinion, the pessimistic focus from both the left and the right risks underestimating the degree of economic improvement. The Fed's patience will wane in the face of further improvement in the pace of activity.

'The Mysterious Fed'

Dear Fed hawks. Please listen:

The Mysterious Fed, by Paul Krugman: As usual, my inbox is full of speculations about when the Fed will raise interest rates. June 2015? Earlier? Has it already waited too long?
And as usual, I wonder why anyone is talking about this at all. Yes, unemployment has fallen. But there is huge ambiguity about what level of unemployment is sustainable given changing demography, the uncertain degree to which people might return to the work force given better job availability, and so on. There’s also a huge asymmetry in risks between raising rates too soon — which can leave us stuck in a low inflation or deflation trap for a very long time — and raising rates a bit too late, which at worst means temporarily overshooting an inflation target that’s arguably too low anyway.
Meanwhile, both the Fed’s preferred measure of inflation and wages are showing no hint of an overheating economy...
So what the heck is going on? Maybe it’s just pluralistic ignorance?

Dallas Fed president Richard Fisher said recently that the failure to raise interest rates soon enough could cause the economy to go into a recession. Because inflation. He wants interest rates to go up sooner rather than later, which I think would be a mistake.

[See also Dan Alpert: Why the Fed is Flummoxed by the U.S. Labor Market.]

Update: "Federal Reserve Bank of Dallas President and CEO Richard W. Fisher today announced that he will retire from his position on March 19, 2015."

Saturday, November 08, 2014

'How Severe Has The Zero Lower Bound Constraint Been?'

Eric Swanson:

How severe has the zero lower bound constraint been?: Summary In December 2008, the Fed lowered the federal funds rate to essentially zero and has kept it there since then. This column argues that, contrary to traditional macroeconomic thinking, monetary policy has not been severely constrained by the zero bound until mid-2011. The results imply that the Fed could have done more to ease monetary policy between 2009 and 2011. These findings could also help explain why the fiscal stimulus package adopted in 2009 did not bring the expected success.

Friday, November 07, 2014

Fed Watch: Employment Report, Yellen Speech

Tim Duy:

Employment Report, Yellen Speech, by Tim Duy: The October employment report was another solid albeit not spectacular read on the labor market. Job growth remained above the 200k mark, extending the ever-so-slight acceleration over the past year:

NFPa110714

Upward revisions to the previous two months added another 31k jobs. The acceleration is a bit more evident in the year-over-year picture, albeit still modest:

NFPc110714

The unemployment rate fell to 5.8% while the labor force participation rate ticked up. The labor market picture in the context of indicators previously cited by Federal Reserve Chair Janet Yellen looks like this:

YELLENa110714

YELLENb110714

Looks like steady, ongoing progress to meeting the Federal Reserve's goals that remains fairly consistent with expectations for a mid-year rate hike. Wage growth remains anemic, but as regular readers know I believe we are just entering the zone where we might expect upward pressure on wage growth:

NFPb110714

I am wondering what the Fed will do if the unemployment rate touches 5% and wage growth and inflation remain anemic? Not my baseline scenario, but I am wondering how patient they will be before moving further along the normalization process. I suppose this is what Chicago Federal Reserve President Charles Evans wonders about as well. Via Reuters:
The Federal Reserve should be "extraordinarily patient" when it comes to raising interest rates, because doing so too soon could choke off recovery and force the U.S. central bank to cut rates back to zero again, a top Fed official said on Friday...
...But the biggest risk, he said, is raising rates prematurely, which could consign the United States to the kind of stagnation that affected it in the 1930s and that dogs Japan today.
Speaking of policy normalization, Yellen made some interesting remarks this morning:
As employment, economic activity, and inflation rates return to normal, monetary policy will eventually need to normalize too, although the speed and timing of this normalization will likely differ across countries based on differences in the pace of recovery in domestic conditions. This normalization could lead to some heightened financial volatility. But as I have noted on other occasions, for our part, the Federal Reserve will strive to clearly and transparently communicate its monetary policy strategy in order to minimize the likelihood of surprises that could disrupt financial markets, both at home and around the world. More importantly, the normalization of monetary policy will be an important sign that economic conditions more generally are finally emerging from the shadow of the Great Recession.
Take note of the specific emphasis on financial volatility. The message is that market participants should not expect the Fed to react to every twist and turn in equity markets. More to the point, they expect volatility as they progress toward policy normalization. Consequently, while they will keep an eye on the financial markets, they are primarily concerned with watching overall economic indicators as they consider the timing and pace of their next steps. In short, they are signalling that market participants misread the likely path of the Federal Reserve when 2 year yields collapsed last month:

RATES110714

That said, I am fairly concerned that the Fed is not taking the flattening of the yield curve seriously enough. I see that as a signal that they have less room for normalization than they might think they have.
Bottom Line: Steady as she goes.

Fed Watch: Nonsense

Tim Duy:

Nonsense, by Tim Duy: I stumbled across this piece in The America Spectator in which the authors argue against the prospect of the Federal Reserve pursuing a "triple mandate" by adding inequality to the current mandate of price stability and maximum employment. They claim the current mandate itself is unworkable:
...Replace the Fed’s current dual mandate with a single mandate—keep the price system as honest and stable as possible.
The dual mandate creates a contradictory tension that makes it practically impossible for the Fed to function effectively...
...The Fed currently finds itself unable to pursue that kind of price stability, because its unemployment mandate gets in the way. The Fed can induce a temporary boom by unexpectedly boosting inflation...
...If the Fed tinkers with interest rates and the money supply in an effort to reduce inequality, it puts further obstacles in the path of entrepreneurs, and hurts the very people it intends to help...If the Fed’s seeks to maintain a stable, predictable, and honest price system as its sole monetary policy objective, it will do more to lift people out of poverty than any double or triple mandate.
The implication is that the Fed is currently creating unexpected inflation to lower unemployment. The implication is that the Fed is not meeting its price stability mandate. The first thing that makes this such nonsense is the absolute absence of inflationary pressures for going on 30 years now:

PCE110714

There have been NO episodes of "unexpectedly boosting inflation." In fact, for all intents and purposes, the Phillips Curve has become nonexistent:

PHILLIPS110714

There is no "contradictory tension." The Fed can obviously meet both mandates concurrently. See Minneapolis Federal Reserve President Narayana Kocherlakota. It is pretty straightforward. And even if the Fed wanted to boost inflation beyond its current target, they would not want unexpected inflation. They would only do so because they needed more room to cushion against the zero bound. They would want higher expected inflation. It would be anything but unexpected. They would scream it from sea to sea.
Of course, inflation truthers will argue that the Fed's chosen price measure does not measure "real" inflation. Only "real" people, not economists, know what "real" inflation is. Well, if you ask "real" people, once again you get a flat Phillips Curve:

PHILLIPS2110714

Sure, the public tends to overreact to gas prices (both up and down), but I have always thought the overall consistency of median inflation expectations among the public is pretty remarkable and under-appreciated. To be sure that is arguably because the Fed has generally made reality consistent with expectations. But perhaps not so much lately. Consider inflation expectations and acutal year ahead inflation:

EXPECT110714

Note that I used headline CPI inflation as it is arguably the best known price index. Interestingly, since 1983, average expected inflation was 3.1%, compared to an actual 2.9%. Remarkably close. And note that since 2007, actual inflation over the next twelve months has remained well below expectations. In other words, the US economy is experiencing unexpected disinflation. By the author's argument, shouldn't that mean that unemployment is now artificially high? (Note too that concerns about the Fed's credibility may be premature.)
The second thing that makes this such nonsense is that the authors seem to believe that if the Fed dumped its dual mandate in favor of a single price mandate, monetary policy would be tighter (because the current need to maintain low unemployment requires unexpected inflation, or loose policy). This is exactly opposite of reality. The reality is that if the Fed focused only on its price mandate, it would not be so eager to normalize policy. The Federal Reserve currently can neither hit its target nor anticipates hitting its target over the next two years. So what is driving the push for normalizing policy? They fear that falling unemployment falling toward their estimate of the natural rate (5.2-5.5%) will trigger an inflationary outbreak if not caught early with tighter policy! They want to arrest the decline in unemployment before it slides much below 5.2%.
Truth be told, oftentimes I would prefer the Fed abandon its dual mandate as well. I wish they would focus more on prices than unemployment at this point. But that's because I understand the implications for monetary policy. It would be looser, not tighter. Monetary policymakers would have one less excuse to justify normalizing policy when they still can't hit their inflation targets.
I would also add that the Fed isn't doing itself any favors when they argue that they need to keep policy loose to meet their employment mandate or give the impression that they intend to keep policy loose to address inequality. They could just point out they need to keep policy loose to meet their inflation target and by meeting their inflation target they foster conditions amenable to sustained maximum employment and by extension reducing inequality. Do themselves a favor and keep the price stability mandate front and center. Read Minneapolis Federal Reserve President Narayana Kocherlakota's statement on his dissent:
I felt that the FOMC needed to reduce possible downside risk to the credibility of its 2 percent inflation target by taking more purposeful steps to move inflation back up to 2 percent.
The arch-dove on the FOMC is a dove because his colleagues can't meet or are unwilling to meet their inflation target.
Bottom Line: The Fed is not using unexpected inflation to lower unemployment. Just isn't happening now. Not tomorrow. Or the day after that either. And if the Fed wants to reduce inequality, they don't need unexpected inflation in any event. What they need is to actually generate the inflation they promised.

Wednesday, November 05, 2014

'Neo-Fisherites and the Scandinavian Flick'

Nick Rowe:

Neo-Fisherites and the Scandinavian Flick: Noah Smith wonders if "reality might topple a beloved economic theory". Well, if you look at Sweden, reality just confirmed that beloved economic theory. The Riksbank raised interest rates because it was scared that low interest rates would cause financial instability. Lars Svensson resigned in protest. Then inflation fell, and the Riksbank needed to cut interest rates even lower than before.
That's only one data point. But there are loads more.

If you don't know how to drive a car, and you don't even have a clue whether you turn the steering wheel clockwise or counter-clockwise if you want to turn right, one good strategy is to borrow a car, and a wide open field, and experiment. Make a random turn of the wheel, and see what happens. The recent data point in Sweden was a natural experiment like that. But Sweden is not a wide open field, and it's hard to borrow a car to experiment like that on regular roads.

An alternative strategy is to ask an experienced driver which way to turn the wheel. Preferably a driver who has managed to keep his car out of the ditch for the last 20 years. Like the Bank of Canada. And if the Bank of Canada says that it cuts interest rates when inflation is falling below target, and it wants to bring inflation back up to target, you listen. They are either right, or wrong and very very lucky.

Never ignore the advice of experienced practitioners, who have had their hands on the steering wheel for a very long time. Unless you have a very good theory about why they might be deluded.

Theory says, and the data confirm, and the advice of experienced practitioners confirms, that if it wants to raise inflation the central bank should first lower interest rates. Then, when inflation and expected inflation starts to rise, it can raise interest rates, higher than they were before. Then, and only then, does the Fisher effect kick in, and we see a positive correlation between inflation and nominal interest rates. That is the Scandinavian flick we saw recently in Sweden. ...

There's more.

Tuesday, November 04, 2014

What’s Next for the Fed?

I have a new column:

What’s Next for the Fed?: Last week, the Federal Reserve announced an end to its quantitative easing program. This brings up the obvious question, what is next for the Fed? Before getting to that, here are a few notes on quantitative easing and what the Fed’s announcement means for the economy. ...

'Why Don’t We See More Macroeconomic Populism?'

Paul Krugman has a question:

Why Don’t We See More Macroeconomic Populism?: As I’ve been noting recently, there’s a lot of opposition within Japan to the Bank of Japan’s policy of printing more money; there’s also a lot of pressure on the government to raise taxes. And that’s not really very different from what has been happening in the rest of the advanced world: central banks that have pursued quantitative easing have done so despite political pressure, not because of it, and fiscal austerity has been imposed almost everywhere.
The funny thing is that when you ask for justifications for pursuing hard money and tight budgets in a depressed, low-inflation economy, the answers you get often start from the presumption that money-printing and deficit finance are immensely tempting to politicians, so that you don’t dare let them get even a slight taste of these addictive drugs. This is often said in a tone of great wisdom, and presented as the lesson history teaches us.
Now, as Simon Wren-Lewis points out — and as I’ve pointed out in the past — history actually teaches us no such thing. ...
But ... populist politicians should love it when people tell them that printing money and running big deficits is OK — seems plausible. And things like this have happened in Latin America — indeed are happening again today in Venezuela and Argentina. So why don’t they ever happen in America, Europe, or Japan? Why, in a time of deflationary pressure, have calls for belt-tightening dominated the political scene?
I actually don’t know, although I continue to think about it. But it is a puzzle worth pondering.

Sunday, November 02, 2014

Fighting the Last (Macroeconomic) War

Simon Wren-Lewis:

Fighting the last war: It is often said that generals fight the last war that they have won, even when those tactics are no longer appropriate to the war they are fighting today. The same point has been made about macroeconomic policy: policymakers cannot avoid thinking about the dangers of rising inflation, and in doing so they handicap efforts to fully recover from the Great Recession.
Another military idea is the benefit of using overwhelming force. In the case of inflation we have two legacies of the last war that are designed to prevent inflation reaching the heights of the late 1970s: inflation targets and in many countries independent central banks. Do we need both, or is just one sufficient? I think this question is relevant to the debate over helicopter money (financing deficits by printing money rather than selling debt).
Why are helicopter drops taboo in policy circles? Why is it illegal in the Eurozone? The answer is a fear that if you allow governments access to the printing presses, high inflation will surely follow at some point. ...
I think...: yes, in the grand scheme of things we should worry about inflation and debt, but right now we are worrying about them too much and therefore failing to deal with more pressing concerns.

'The Impact of the Maturity of US Government Debt on Forward Rates and the Term Premium'

At Vox EU:

The impact of the maturity of US government debt on forward rates and the term premium: New results from old data, by Jagjit Chadha: Summary The impact of the stock and maturity of government debt on longer-term bond yields matters for monetary policy. This column assesses the magnitude and relative importance of overall bond supply and maturity effects on longer-term US Treasury interest rates using data from 1976 to 2008. Both factors have a significant impact on both forwards and term premia, but maturity of public debt appears to matter more. The results have implications for exit from unconventional policies, and also for the links between monetary and fiscal policy and debt management.

Saturday, November 01, 2014

'Keynes Was Right'

Anatole Kaletsky:

... It ... seems appropriate to consider what we can learn from all the policy experiments conducted around the world since the 2008 crisis.
The main lesson is that government decisions on taxes and public spending have turned out to be more important as drivers of economic activity than the monetary experiments with zero interest rates and quantitative easing that have dominated media and market attention. ... While every major economy in the world has followed essentially the same monetary policy since 2008, their fiscal policies have been very different and the divergence in outcomes, especially when we compare the United States and Europe, has been exactly the opposite to what was implied by the rhetoric of most politicians and central banks. ...

Thus the six years since 2008 have provided strong empirical support for the supposedly outmoded Keynesian view that government borrowing is more powerful than monetary policy in stimulating severely depressed economies...

More here.

Friday, October 31, 2014

Fed Watch: Another Kocherlakota Dissent

Tim Duy:

Another Kocherlakota Dissent, by Tim Duy: Minneapolis Federal Reserve President Narayana Kocherlakota released a statement regarding his dissenting vote at this week's FOMC meeting. He does not share his colleagues faith that inflation will return to target anytime soon:
...In my assessment, the medium-term outlook for inflation has shown no overall improvement since last December and, indeed, is arguably worse. Failing to act in response to this subdued inflation outlook increases the downside risk to the credibility of our 2 percent inflation target. Market-based measures of longer-term inflation expectations have fallen recently to unusually low levels, a decline that I believe reflects that kind of increased downside risk...
Today's reading on inflation is supportive of Kocherlakota's concerns:

PCE103114b
PCE103114a

He reiterated his preferred policy outcomes:
There are a number of possible actions that I would have seen as responsive to the evolution of the data. Let me describe two in particular. First, the Committee could have continued to buy $15 billion of longer-term assets per month. Second, it could have committed to keeping the target range for the federal funds rate at its current level at least until the one- to two-year-ahead inflation outlook has risen back to 2 percent, as long as risks to financial stability remain well-contained.
I find this interesting compared to his preferred language after his dissent in March:
For example, the Committee could have adopted language of the following form: “the Committee anticipates keeping the fed funds rate in its current range at least until the unemployment rate has fallen below 5.5 percent, as long as the one-to-two-year-ahead outlook for PCE inflation remains below 2 1/4 percent, longer-term inflation expectations remain well-anchored, and possible risks to financial stability remain well-contained.”
Notice that earlier this year the best he thought he could get from his colleagues was an allowance for 2.25% inflation. Now the best he could hope for has been downgraded to a 2%, suggesting - you guessed it - that the rest of the FOMC considers 2% a ceiling.
I think the inflation downgrade in Kocherlakota's suggested policy language suggests that low inflation is less of a concern for FOMC members now that unemployment is below 6% and measures of underemployment are improving. I believe that Kocherlakota is hearing from his colleagues that 1.) inflation will almost certainly move toward target as the unemployment rate falls further and that 2.) even if inflation remains below 2%, declining slack in the labor market suggests that less financial accommodation is necessary and failure to reduce accommodation will result in undesirable financial instability.
Bottom Line: Kocherlakota's dissent raises the possibility that labor data will trump inflation data in policy considerations. It also suggests that given the pace of labor market improvement, they are not writing off the possibility of a March rate hike (although that is not my baseline).

Thursday, October 30, 2014

Fed Watch: FOMC Recap

Tim Duy:

FOMC Recap, by Tim Duy: In broad terms, the FOMC meeting concluded as I had expected. To the extent there were any surprises, they were on the hawkish side. Or, I would say, hawkish mostly if you believed the events of the last few weeks justified a radical revision of the Fed's anticipated policy path. I didn't, but was too busy those same past few weeks to scream into the wind.

As I anticipated, the Fed dismissed the decline in market-based inflation expectations. They clearly believe financial markets over-reacted to the decline in oil prices, and that that decline would ultimately prove to be a one-time price shock rather than the beginning of a sustained disinflationary process.

This is why we watch core-inflation.

And note that the Fed sent a pretty big signal along the way. In contrast to conventional wisdom, they do not hold market-based measures of inflation expectations as the Holy Grail. Especially with unemployment below 6%, pay more attention to survey-based measures. And recognize they will discount even those if they feel they are unduly affected by energy prices in either direction.

Somewhat more hawkish than I anticipated, they did not explicitly hold out the hope of future asset purchases. The statement shifts directly to the issue of rate hikes. On that point, they did as I had expected, emphasize the data-dependent nature of future policy:

However, if incoming information indicates faster progress toward the Committee's employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.

In my opinion, this suggests that they want to retain the baseline expectation of a mid-2014 rate hike with the option for an earlier hike. I don't think they see recent data or market action as by itself justifying the shift to the latter part of 2015. If anything, remember that recent data is pointing to accelerating growth and a rapid decline in unemployment.

And that rapid decline in unemployment is important, as I have trouble imagining a scenario in which the Fed is content to watch unemployment fall below 5.5% without at least beginning the rate hike cycle. Remember that they think that even as they increase rates, they believe that policy will continue to be accommodative. In other words, they do not fear raising rates as necessarily a tightening of policy. They will view it as a necessary adjustment in financial accommodation in response to a decline in labor market slack. Hence the line:

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.

I anticipated at least one dissent. In all honesty, this would have been a more impressive call if I had also indicated the direction of the dissent. I expected a hawk to reject the retention of the considerable time language. No such luck - quite the opposite, with noted-dove Minneapolis Federal Reserve President Narayana Kocherlakota protesting both the considerable time language (wanting a more firm commitment to ZIRP) and the decision to end QE. The hawks, in contrast, were generally comfortable with the direction of the discussion. Expect Dallas Federal Reserve President Richard Fisher to say as much soon.

The acceptance of the hawks with the general tone of the meeting is also important. Clearly hawkish in contrast with the shift in market expectations. Time will tell.

Bottom Line: Despite the market turbulence of recent weeks, the general outlook of monetary policymakers remain generally unchanged. In general, they continue to see the direction of activity pointing to a mid-year rate hike. The actual date is of course data dependent, but they have not seen sufficient data in either direction to change that baseline outlook.

Wednesday, October 29, 2014

'Riksbank and ECB: Reverse Asymmetry'

Antonio Fatás:

Riksbank and ECB: reverse asymmetry: The Swedish central bank just lowered interest rates to zero because of deflation risks. This action comes after ignoring repeated warnings from Lars Svensson who had joined the bank in 2007 and later resigned because of disagreements with monetary policy decisions. What it is interesting is the parallel between Riksbank decisions and ECB decisions. In both cases, these central banks went through a period of optimism that make them raise interest rates to deal with inflationary pressures. In the case of Sweden interest rates were raised from almost zero to 2% in 2012. In the case of the ECB interest rates were raised from 1% to 1.5% during 2011. Also, in both cases, after a significant expansion in their balance sheets following the 2008 crisis, there was a sharp reduction in the years that followed. ... Their policies stand in contrast with those of the US Federal Reserve and the Bank of England...
The consequences of the policies of the ECB and Riksbank are clear: a continuous fall in their inflation rates that has raised the risk of either a deflationary period or a period of too-low inflation. What is more surprising about their policy actions is their low speed of reaction as the data was clearly signaling that their monetary policy stance was too tight for months or years. ...
What we learned from these two examples is that central banks are much less accountable than what we thought about inflation targets. And they ... use ... a policy that is clearly asymmetric in nature. Taking some time to go from 0% inflation to 2% inflation is ok but if inflation was 4% I am sure that their actions will be much more desperate. In the case of the ECB their argument is that the inflation target is defined as an asymmetric target ("close to but below 2%"). But this asymmetry, which was never an issue before the current crisis, has very clear consequences on the ability of central banks to react to deep crisis with deflationary risks.
What we have learned during the current crisis is that an asymmetric 2% inflation target is too low. Raising the target might be the right thing to do but in the absence of a higher target, at a minimum we should reverse the asymmetry implied by the ECB mandate. Inflation should be close to but above 2% and this should lead to very strong reaction when inflation is persistently below the 2% target.

Tuesday, October 28, 2014

Fed Watch: FOMC Meeting

Tim Duy:

Fed Watch: FOMC Meeting, by Tim Duy: I have been buried the past few weeks. So blogging has been, and will be, at least for a little longer, light. That said, I have trouble letting an FOMC meeting pass without at least few words before and after - even if there already exist broad agreement on the outcome.

The general expectation is that the Fed ends its bond buying program at the conclusion of the meeting tomorrow. That alone promises to knock down the FOMC statement to a more manageable size. While St. Louis Federal Reserve President James Bullard offered up the possibility of retaining the program for another meeting, there is little indication that other FOMC members are similarly inclined. They have long wanted to get out of asset purchase business, and see no shift in activity sufficient to delay that objective. Moreover, as Boston Federal Reserve President Eric Rosengren has noted, the remaining $15 billion is effectively a rounding error. If the Fed really wants to do something, they need to go bigger. But that is not on the table.

Regarding the statement, here is what I anticipate:

1. The general description of the economy will remain essentially unchanged, expanding at a "moderate pace." This would be consistent with expectations that the economy is currently on track to post 3%+ growth in the third quarter.

2. That said, they will mention they remain watchful of foreign growth.

3. They will acknowledge the further decline in unemployment rates yet retain the view that labor market indicators still suggest underutilization of resources. I would not be surprised by specific mention of low wage growth as evidence of underutilization.

4. I expect the Fed will acknowledge the decline in market-based measures of inflation expectations, but ultimately dismiss those measures for now in favor of stable of survey based measures. In general, I think they will take the approach of Rosengren in this Washington Post interview:

"Inflation breakevens," Rosengren explained, "are based on the pricing of Treasury securities and Treasury Inflation-Protected Securities (TIPS). So if you think about what the implication of significant financial market turbulence is, particularly about Europe, it's for foreign investors to buy Treasury securities. They disproportionately buy regular Treasury securities, so the flight to safety is going to start changing the relative prices of Treasury securities" and make it look like markets expect less inflation. But "if you look at inflation expectations based more on surveys, there's been a little bit of softening, but certainly nothing consistent with the kind of movements we've seen in the [Treasury] breakevens. So I wouldn't overreact to one or two weeks of sharp movements, because I think there are plenty of other reasons to explain" them.

5. I expect the risks to growth and employment will remain balanced, and the risk of persistently low inflation will continue to be "somewhat diminished."

6. They will announce the end of the asset purchase program, but emphasize continued reinvestment of principle and that the sizable asset holdings will continue to provide support for the recovery.

7. They will note that despite the end of asset purchases, such purchases remain in the monetary toolbox and could be revived if conditions warranted.

8. The "considerable time" language will remain. I don't anticipate any tweaks to the interest rate guidance, but I would expect if there are any such tweaks, they would be to emphasize the data-dependent nature of future policy decisions.

9. I expect at least one dissent.

Bottom Line: I am anticipating a pretty straightforward result from this FOMC meeting.

Has Fed Policy Made Inequality Worse?

At MoneyWatch:

Has Fed policy made inequality worse?: What effect did Federal Reserve policy during the Great Recession have on inequality? Did quantitative easing and the Fed’s low interest rate policy benefit those at the top of the income distribution the most?

Many people seem to be convinced that is the case. According to this view, the Fed has been captured by the interests of wealthy bankers and its policies therefore benefit this group the most. But what does the evidence actually say about this question? Are Ron Paul and the Austrian economists, among many others on both sides of the political fence, correct to claim that loosening monetary policy to combat recessions makes inequality worse? ...

[The editors changed the intro, this is the original.]

Thursday, October 23, 2014

''A Few Comments on QE''

After A Few Comments on QE, Bill McBride ends with:

...My view is QE was not a panacea, but overall QE was a success.  I was a frequent critic of the Fed prior to the financial crisis - I think the Fed was almost anti-regulation during the housing bubble, and initially the Fed was behind the curve when the crisis was looming - however once Bernanke became aware of the severity of the crisis, the Fed was aggressive and effective. Perhaps they were a little slow in implementing QE3 - and with low inflation an argument could be made now to extend QE - but overall I think QE was a success.

Wednesday, October 22, 2014

'Helicopter Money'

Everything you ever wanted to know about helicopter money:

Helicopter money, by Simon Wren-Lewis, Mainly Macro: Periodically articles appear advocating, or discussing, helicopter money. Here is a simple guide to this strange sounding concept. I go in descending order of importance, covering the essential ground in points 1-7, and dealing with more esoteric matters after that. ...