Category Archive for: Monetary Policy [Return to Main]

Wednesday, September 30, 2015

Overly Optimistic Forecast's Have Caused Poor Fed Communication

I think I buried the main point on this one for MoneyWatch. There has been quite a bit of criticism of the Fed's messaging on the timing of a rate liftoff. But while the messaging has been far from perfect, the bigger problem is the Fed's overly rosy forecasts. The Fed's forecasting models generally impose what is known as a stationarity assumption in response to demand-side shocks -- that is, the models have a relatively fast return to full employment baked into them. The rosy forecasts lead the Fed to adopt a relatively hawkish stance that has to be adjusted as more sobering data arrive. Thus, observers see the Fed continually revising its message, putting itself on a different "data dependent" path each time, and the succession of revisions causes observers to conclude that the Fed's messaging is off-base. But if the forecasts had been better, messaging wouldn't be so much of a problem:

Is communication the Fed's big problem?, Commentary: The Federal Reserve has gotten plenty of criticism for its recent communications about its monetary policy intentions. For example, Mark Gilbert at Bloomberg complained that "...the forward guidance policy adopted in recent years by many central banks is in tatters, and is probably doing more harm than good in telling companies and consumers when borrowing costs are likely to rise and at how fast."
Edward Luce at the Financial Times had similar sentiments, concluding that "Ms Yellen has juggled with different types of communication. They call this learning by doing. As the next countdown begins, her goal must be to share her thinking more clearly."
Is the Fed guilty as charged, and why is this important? ...

Tuesday, September 29, 2015

'Trump World and the Fed'

Magic plans meet the reality called the Fed:

Trump World and the Fed, by Dean Baker: ...Suppose that Donald Trump's tax cut really is the magic elixir that would get the economy to 6.0 percent annual growth. But what if the people at the Fed's Open Market Committee (FOMC) don't recognize this fact? Suppose the FOMC thinks the economy is still bound by the pre-Trump tax cut rules and believes that inflation will start to accelerate out of control if the unemployment rate falls much below its current 5.1 percent level.
In this case, we would expect to see the Fed raise interest rates sharply as they saw the Trump tax cuts boosting growth. ... If the Fed raises interest rates high enough, it could fully offset the boost that Trump's tax cut is giving to the economy. In this case, even though the Trump tax cuts might have been the best thing for the economy since the Internet (okay, better than the Internet), we wouldn't see any dividend because the Fed would not allow it.
For this reason, the Fed's likely response to a tax cut is a fundamental question that reporters should be asking. If the Fed is likely to simply slam on the brakes to offset any possible stimulus, then a tax plan will have little prospect of providing a growth dividend.

Maybe they aren't asking because they know in their heart of hearts that the plan will be lucky to boost growth at all.

Thursday, September 24, 2015

'Inflation Dynamics and Monetary Policy'

Federal Reserve Chair Janet L. Yellen:

Inflation Dynamics and Monetary Policy, by Chair Janet L. Yellen: ... In my remarks today, I will discuss inflation and its role in the Federal Reserve's conduct of monetary policy. I will begin by reviewing the history of inflation in the United States since the 1960s, highlighting two key points: that inflation is now much more stable than it used to be, and that it is currently running at a very low level. I will then consider the costs associated with inflation, and why these costs suggest that the Federal Reserve should try to keep inflation close to 2 percent. After briefly reviewing our policy actions since the financial crisis, I will discuss the dynamics of inflation and their implications for the outlook and monetary policy. ...

It's a relatively long speech. Skipping ahead:

Policy Implications
Assuming that my reading of the data is correct and long-run inflation expectations are in fact anchored near their pre-recession levels, what implications does the preceding description of inflation dynamics have for the inflation outlook and for monetary policy?
This framework suggests, first, that much of the recent shortfall of inflation from our 2 percent objective is attributable to special factors whose effects are likely to prove transitory. ...
To be reasonably confident that inflation will return to 2 percent over the next few years, we need, in turn, to be reasonably confident that we will see continued solid economic growth and further gains in resource utilization, with longer-term inflation expectations remaining near their pre-recession level. Fortunately, prospects for the U.S. economy generally appear solid. ... My colleagues and I, based on our most recent forecasts, anticipate that this pattern will continue and that labor market conditions will improve further as we head into 2016.
The labor market has achieved considerable progress over the past several years. Even so, further improvement in labor market conditions would be welcome because we are probably not yet all the way back to full employment ... which most FOMC participants now estimate is around 4.9 percent...  
Reducing slack ... may involve a temporary decline in the unemployment rate somewhat below the level that is estimated to be consistent, in the longer run, with inflation stabilizing at 2 percent. For example, attracting discouraged workers back into the labor force may require a period of especially plentiful employment opportunities and strong hiring. Similarly, firms may be unwilling to restructure their operations to use more full-time workers until they encounter greater difficulty filling part-time positions. Beyond these considerations, a modest decline in the unemployment rate below its long-run level for a time would, by increasing resource utilization, also have the benefit of speeding the return to 2 percent inflation. Finally, albeit more speculatively, such an environment might help reverse some of the significant supply-side damage that appears to have occurred in recent years, thereby improving Americans' standard of living.33
Consistent with the inflation framework I have outlined, the medians of the projections provided by FOMC participants at our recent meeting show inflation gradually moving back to 2 percent, accompanied by a temporary decline in unemployment slightly below the median estimate of the rate expected to prevail in the longer run. ... This expectation, coupled with inherent lags in the response of real activity and inflation to changes in monetary policy, are the key reasons that most of my colleagues and I anticipate that it will likely be appropriate to raise the target range for the federal funds rate sometime later this year and to continue boosting short-term rates at a gradual pace thereafter as the labor market improves further and inflation moves back to our 2 percent objective.
By itself, the precise timing of the first increase in our target for the federal funds rate should have only minor implications for financial conditions and the general economy. What matters for overall financial conditions is the entire trajectory of short-term interest rates that is anticipated by markets and the public. As I noted, most of my colleagues and I anticipate that economic conditions are likely to warrant raising short-term interest rates at a quite gradual pace over the next few years....
The economic outlook, of course, is highly uncertain... Given the highly uncertain nature of the outlook, one might ask: Why not hold off raising the federal funds rate until the economy has reached full employment and inflation is actually back at 2 percent? The difficulty with this strategy is that monetary policy affects real activity and inflation with a substantial lag. If the FOMC were to delay the start of the policy normalization process for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession. In addition, continuing to hold short-term interest rates near zero well after real activity has returned to normal and headwinds have faded could encourage excessive leverage and other forms of inappropriate risk-taking that might undermine financial stability. For these reasons, the more prudent strategy is to begin tightening in a timely fashion and at a gradual pace, adjusting policy as needed in light of incoming data.
To conclude, let me emphasize that, following the dual mandate established by the Congress, the Federal Reserve is committed to the achievement of maximum employment and price stability. To this end, we have maintained a highly accommodative monetary policy since the financial crisis; that policy has fostered a marked improvement in labor market conditions and helped check undesirable disinflationary pressures. However, we have not yet fully attained our objectives under the dual mandate: Some slack remains in labor markets, and the effects of this slack and the influence of lower energy prices and past dollar appreciation have been significant factors keeping inflation below our goal. But I expect that inflation will return to 2 percent over the next few years as the temporary factors that are currently weighing on inflation wane, provided that economic growth continues to be strong enough to complete the return to maximum employment and long-run inflation expectations remain well anchored. Most FOMC participants, including myself, currently anticipate that achieving these conditions will likely entail an initial increase in the federal funds rate later this year, followed by a gradual pace of tightening thereafter. But if the economy surprises us, our judgments about appropriate monetary policy will change.

Tuesday, September 22, 2015

'Central Banks Have Made the Rich Richer'

Paul Marshall, chairman of London-based hedge fund Marshall Wace, in the FT:

Central banks have made the rich richer: Labour’s new shadow chancellor has got at least one thing right. ... Quantitative easing ... has bailed out bonus-happy banks and made the rich richer. ...
It is no surprise that the left is angry about this, nor that they are looking for other versions of QE that do not so directly benefit bankers and the rich. Instead of increasing the money supply by buying sovereign bonds from banks, central banks could spread the love evenly by depositing extra money in every person’s bank account..., it might have been fairer.
Mr McDonnell and Jeremy Corbyn, the new Labour leader, advocate a second approach: targeting QE at infrastructure projects. The central bank would buy bonds direct from the Treasury on the understanding that the funds would be used to improve housing and transport infrastructure. ...
QE had clear wealth effects, which could have been offset by fiscal measures. All political parties should acknowledge this. So should those of us who want free markets to retain their legitimacy.

Monday, September 21, 2015

'Can We Rely on Market-Based Inflation Forecasts?'

Michael Bauer and Erin McCarthy of the SF Fed:

Can We Rely on Market-Based Inflation Forecasts?, Michael D. Bauer and Erin McCarthy, Economic Letter, FRBSF: The Federal Reserve’s dual mandate requires monetary policy to aim for both maximum employment and price stability. Although employment has recovered since the recession, inflation has consistently remained below the Fed’s 2% longer-run objective. Because expectations of future inflation play an important role in determining current inflation, decreases in measures of inflation expectations based on market prices have raised some concerns. For example, between June 2014 and January 2015, one-year inflation swap rates, which measure market-based expectations of inflation in the consumer price index (CPI) one year ahead, dropped over 2.5 percentage points. Large decreases were also observed in breakeven inflation rates, the difference between yields on nominal and inflation-indexed Treasury securities, known as TIPS.
Market-based measures of inflation expectations are calculated from the prices of financial securities. Their advantage is that they are readily available at high frequency and therefore are widely monitored. However, they reflect not only the public’s inflation expectations but also other idiosyncratic factors that affect market prices, which are difficult to quantify. For example, they include a risk premium to compensate investors for inflation uncertainty and are affected by changes in liquidity, unusual demand flows, and, more broadly, “animal spirits” that change prices but are unrelated to expectations (see Bauer and Rudebusch 2015). Hence it is unclear how much useful information they provide, and how much one should pay attention to these rates when forecasting inflation.
If market-based inflation expectations provided accurate inflation forecasts, then one surely would want to pay close attention to their evolution. In this Economic Letter, we evaluate their performance in comparison with a variety of alternative forecasts for CPI inflation. ...
Conclusions We find that market-based measures of inflation are poor predictors of future inflation. In particular, they perform much worse than forecasts constructed from survey expectations of future inflation, which incorporate all the information used by professional forecasters. Interestingly, a simple constant inflation rate corresponding to the Federal Reserve’s 2% inflation target consistently performs best. While our analysis is based on a short sample that displays a lot of volatility during the Great Recession, our results appear quite robust as they are consistent across two subsamples.
Our results add to the discussion about how much attention policymakers and professional forecasters should pay to market-based inflation forecasts. These measures mostly reflect current and past inflation movements, and do not contain a lot of useful forward-looking information. Idiosyncratic market forces and inflation risk premiums appear to be important drivers of market-based inflation expectations. Overall, it is important to keep this caveat in mind when interpreting market-based inflation expectations.

Paul Krugman: The Rage of the Bankers

Why are bankers so angry about the Fed's decision not to raise interest rates?:

The Rage of the Bankers, by Paul Krugman, Commentary, NY Times: Last week the Federal Reserve chose not to raise interest rates. It was the right decision. In fact, I’m among the economists wondering why we’re even thinking about raising rates right now. ... Yet the Fed has faced constant criticism for its low-rate policy. Why?
The ... story keeps changing. In 2010-2011 the Fed’s critics issued dire warnings about looming inflation. You might have expected some change in tune when inflation failed to materialize. Instead, however, those who used to demand higher rates to head off inflation are still demanding higher rates, but for different reasons. The justification du jour is “financial stability,” the claim that low interest rates breed bubbles and crashes. ... Why does anyone take this stuff seriously?
Well, when you see ever-changing rationales for never-changing policy demands, it’s a good bet that there’s an ulterior motive. And the rate rage of the bankers — combined with the plunge in bank stocks that followed the Fed’s decision not to hike — offers a powerful clue... It’s the bank profits, stupid. ...
For banks make their profits by taking in deposits and lending the funds out at a higher rate of interest. And this business gets squeezed in a low-interest environment... The ... difference between the interest rate banks receive on loans and the rate they pay on deposits ... has fallen sharply over the past five years.
The appropriate response of policy makers ... should be, “So?” There’s no reason to believe that what’s good for bankers is good for America. But bankers are different from you and me: they have a lot more influence. Monetary officials meet with them all the time, and in many cases expect to join their ranks when they come out on the other side of the revolving door. ...
So we shouldn’t be surprised to see institutions that cater to bankers, not to mention much of the financial press, spinning elaborate justifications for a rate hike that makes no sense in terms of basic economics. And the debate of the past few months, in which the Fed has seemed weirdly eager to raise rates..., suggests that even U.S. monetary officials aren’t immune.
But the Fed did the right thing last week: nothing. And the howling of the bankers should be taken not as a reason to reconsider, but as a demonstration that the clamor for higher rates has nothing to do with the public interest.

Saturday, September 19, 2015

'Less Worried about a Hard Landing for China'

SF Fed President John Williams on China:

China, Rates, and the Outlook: May the (Economic) Force Be with You: ...China has garnered almost as much editorial ink in the past month as U.S. presidential candidates—which may or may not be a complimentary comparison. I don’t want to sound pejorative by calling some of the commentary “hand-wringing”—though to be fair, some of it has been downright apocalyptic—but I don’t see the situation as dire. I’ve said publicly over the past few months that after going to China, and after talking to academics and officials there, I came away a lot less concerned than when I arrived. And I have to say that recent events have not changed my thinking to any serious extent.
This is where I’ll reuse one of the more helpful quotes for forecasting: “It’s difficult to make predictions, especially about the future.” With the dangers of prognostication acknowledged, I’ll tread into that territory anyway.
The China story is remarkable, and its growth over the past 30 years has been unprecedented.5 But now China’s at something of a crossroads, facing tradeoffs in their goals, dealing with a new normal for growth expectations, and pivoting to a new source of economic momentum.
It’s important to see the situation not through the filters of our own paradigms, but from the perspective of China’s unique position. China is not the U.S. Or the U.K. Or Japan. Its goals, structure, government, and place on its growth trajectory are very different, and looking to impose foreign expectations on China’s markets or actions can lead one astray.
Growth versus reform
In a nutshell, China is facing a tradeoff between its short-term growth goals and its longer-term reform agenda.
China’s government has made it abundantly clear that it is willing to intervene when necessary, ensuring that growth stays on its target path, even if that means extending the timeline on reform. That willingness to do “whatever it takes” to keep growth on target is what made me less worried about a hard landing for China.
Of course, that very disposition for intervention is the source of much hue and cry on this side of the globe. China has made important incremental steps on the road to liberalization, and from the perspective of a fully open, free-market, Western-oriented paradigm or advocacy, the recent stock market interventions seem anathema to that goal. But that’s a view through a narrow lens that may obscure the bigger picture.
For all its moves towards liberalization, China’s markets are not the same as ours. Yes, they have a reform agenda, but it’s a mistake to think that in the foreseeable future China will have fully open capital and financial markets in the way that we in the U.S. and other countries think about them. They are relaxing their grip on the exchange rate—allowing the renminbi to respond to economic news, letting its value be more market-determined—and as a policy approach, this is a positive; it’s something we as economists wanted to see happen. But it’s very clear that China is not going to let its exchange rate float completely freely. They’ll continue to have buffers to ensure that, should some dramatic event unfold, they can step in again and stop that interfering with their other goals. To some extent, we can see these moves as something akin to beta-testing liberalization. It is happening, which is a remarkable shift. But completely free, open markets are not in the cards, and the government has made clear that those are not their intention.
This, incidentally, is why talk about the renminbi replacing the dollar as an international reserve currency is unrealistic. The role of a reserve currency is to be a harbor during a storm; it’s where people flock when the unexpected happens. As we saw in the financial crisis, as we’ve seen in other crises, the market’s instinct is, when in doubt, go to the dollar. As long as China has controls in place to mediate the free flow of money, the dollar will be the refuge, not the renminbi.
In the context of China’s dual—oftentimes conflicting—goals, the recent stock market intervention by the government should be seen as what I believe it was: A move to keep growth on pace. It’s a pattern we’ve seen before. When the Chinese authorities see growth struggling, or other economic warning lights, they take steps, including reversing or postponing reforms, to keep growth at pace. Fiscal and economic policymakers can pull a number of levers and the Chinese government has proved again and again its willingness to do just that.
China’s growth rate
In balancing these objectives, the Chinese government has realistically moderated its expectations for growth. For decades we all marveled at China’s double-digit growth, and there was, perhaps, some expectation that it would persist in perpetuity. But growth like that is unsustainable. If you look at the progression of Japan, for instance, from the 1960s to the 1980s, or South Korea from the 1980s to the 2000s, you see the pattern China will likely follow.6 At low income levels, growth can be rapid, because low domestic wages make exports very competitive and there is so much untapped potential in moving workers to more productive pursuits.
But as income or GDP per capita rise, these advantages begin to ebb, and growth naturally slows. The pattern is clear, with a rapid decline in the growth rate and eventual leveling out as domestic income and wages rise. This is the natural progression of economies moving into maturity. The further they have to go, the faster they can grow; but once they’ve come to a place like Japan or Korea—that is, around 80 or 90 percent of U.S. per capita GDP—their growth expectations will be lower because they’re closer to the finish line. China obviously isn’t close yet, but it’s a good indicator of how much further it can go. What China’s accomplished has been amazing—but we also called Japan a growth miracle and Korea’s success was remarkable as well. There were challenges along the way for both countries, but ultimately, what slowed growth was entering the middle-income bracket and the inevitability of slower growth for wealthier countries.   
The officials and economists I spoke to in China know that not only are the days of 10 percent growth behind them, but that it will move below the current 7 percent target. Seven will likely become 6, which will become 5, and so on as their economy moves into a middle-income economy and progresses to a high-income one.
Shift in focus
Of course, China faces challenges in continuing that advance. One is a refocus of its economic engine. Given the global environment, how do they successfully pivot their economy to more domestic consumption, moving the emphasis more toward services and away from manufacturing? That’s clearly a challenge, but also a central objective of the government.
For people who have concerns about China, one of the red flags they point to is that industrial production has slowed a lot, more so than the economy overall. I fall on the side of commentators who’ve pointed out that this isn’t surprising.7 China’s been talking for years about switching from industry to services. They’re moving from making steel and concrete to making consumer goods. One of the interesting things I heard this summer was the plan to build more tourism in China for China. That’s something that’s virtually nonexistent at the moment. They don’t have the abundance of recreational resources we do; in California alone, you can go skiing or surfing, to wine country or Disneyland. As high- or low-brow as you want it, we as Americans have become incredibly used to spending our leisure dollars domestically. That’s something China’s looking to do for itself.
When you look at where China’s priorities lie—in switching to services, in expanding tourism—it makes absolute sense that industrial production is slowing.
Liberalization and the impact of risks from abroad
I’ve mentioned that China is seen by some as a risk; but conversely, what effect does U.S. policy have on them? Right now, China is more susceptible to the shifts in U.S. monetary policy. But as they liberalize their exchange rate, it will automatically adjust to changes in situations around the world. This is a huge advantage and an automatic stabilizer. When China pegs to the dollar, they’re too linked to U.S. policy, so that when the U.S. tightens or loosens, they effectively follow suit. By allowing market-based influence, China will have a buffer when the U.S. economy is moving in a different direction than theirs. And that’s going to make it easier in the end for China to manage its economy.
An outside observer might ask why they haven’t done this already. I think that China was wary that unpegging would’ve interrupted the double-digit growth. When a country’s exchange rate and capital flows suddenly start shifting around dramatically, it can interfere with the ability to deliver on growth targets. As China’s growth targets have come down, and as they begin to shift away from an export-reliant economy, instead fueling itself via domestic consumption, they can start allowing their exchange rate to move—though again, it won’t be the free floating exchange rate that we have.
This is all just one economist’s take. ...

'Is the Fed Pulling or Pushing?'

John Cochrane:

Is the Fed Pulling or Pushing?: ... Is the Fed in fact "holding down" interest rates? Is there some sort of natural market equilibrium that features higher rates now, but the Fed is pushing down rates? That's the conventional view...
Well, let's think about that. If a central bank were holding down rates, what would it do? Answer, it would lend a lot of money at low rates. Money would be flowing out the discount window (that's where the Fed lends to banks), to banks, and through banks to the rest of the economy, flooding the place with low-rate loans. The interest rate the Fed pays on reserves and banks pay to borrow from the Fed would be low compared to market rates; credit and term spreads would be large, as the Fed would be trying to drag down those market rates.
That is, of course, the exact opposite of what's happening now. Banks are lending the Fed about $3 trillion worth of reserves, reserves the banks could go out and lend elsewhere if the market were producing great opportunities. Spreads of other rates over the rates banks lend to or borrow from the Fed are very low, not very high. Deposits are flooding in to banks, not loans out of banks.
If you just look out the window, our economy looks a lot more like one in which the Fed is keeping rates high, by sucking deposits out of the economy and paying banks more than they can get elsewhere; not pushing rates down, by lending a lot to banks at rates lower than they can get elsewhere.

Thursday, September 17, 2015

No Rate Hike

Tim Duy called it. No rate hike (and only one dissent, lacker). Here's the statement:

Press Release, Release Date: September 17, 2015: Information received since the Federal Open Market Committee met in July suggests that economic activity is expanding at a moderate pace. Household spending and business fixed investment have been increasing moderately, and the housing sector has improved further; however, net exports have been soft. The labor market continued to improve, with solid job gains and declining unemployment. On balance, labor market indicators show that underutilization of labor resources has diminished since early this year. Inflation has continued to run below the Committee's longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports. Market-based measures of inflation compensation moved lower; survey-based measures of longer-term inflation expectations have remained stable.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term. Nonetheless, the Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate. The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced but is monitoring developments abroad. Inflation is anticipated to remain near its recent low level in the near term but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee's holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams. Voting against the action was Jeffrey M. Lacker, who preferred to raise the target range for the federal funds rate by 25 basis points at this meeting.

Fed Watch: Final Thoughts On September

Tim Duy:

Final Thoughts On September, by Tim Duy: Everyone's bets are placed for the outcome of tomorrow's FOMC statement and subsequent press conference. Final thoughts heading into the meeting:
I expect the Fed will pass on raising rates this meeting. This is a highly contentious issue, and reasonable arguments can be made for either case. Economists appear to be roughly split, while financial market participants taking the under with a roughly 25% probability of a rate hike. Whatever the outcome, roughly half of the economists on Wall Street will be wrong. Good thing, as misery loves company.
I believe FOMC participants will arrive at a consensus for the timing and direction of policy for subsequent meetings. The FOMC has had something of a luxury in that economic conditions have not forced them to choose a defined policy path. I believe they no longer have that luxury. They will need to commit policy to one side of the mandate or the other. At this meeting they will decide if their Phillips curve view of the world in concert with their estimate of the natural rate of unemployment dominates the fact that inflation continues to drift away from their target.
I expect the Fed will ultimately pledge allegiance to the Phillips curve. I think they believe that stable inflation is incompatible with sub-5% unemployment if short term interest rates remain at zero. Hence, they will signal that the first rate hike is imminent.
Fed Chair Janet Yellen has the opportunity to prove her mettle. Assuming that I am correct that the Fed needs to forge a consensus, Yellen will be the guiding influence on that consensus. The best outcome for her is a consensus with no dissenting votes. That said, it may be that only an immediate rate hike would be acceptable to Richmond Federal Reserve President Jeffrey Lacker.
I expect Yellen will make a strong attempt to open the door for October. The Fed has established expectations that, outside of obvious exigent circumstances, they can only make major decisions when there is a scheduled press conference. Yellen will push back hard. Indeed, I think there is a possibility that this becomes the "rate hike" press conference in spirit, with the actual hike in October. Something to think about.
The Fed will try to take the sting out of any hawkish signals with a dovish message. I expect the terminal rate forecasts in the dot plot to drift lower. In addition, I expect Yellen will emphasize that low inflation provides room for a slow and halting pace of rate increases. (My expectation, however, is that assuming the first hike goes smoothly, subsequent hikes will come at regular intervals.) Finally, the estimate of the natural rate of unemployment may drift down further. 
If I am wrong...two potential alternatives. First is that everything above remains the same, but they pull the trigger today. They tend not to surprise, but maybe this time is different. Maybe they don't need to built a consensus, although I think that unlikely.  Second is that Yellen pushes the FOMC into a dramatically more dovish direction that re-emphasizes the issue of underemployment and shifts expectations to 2016. I don't think that is likely as I think she is fairly entrenched in the 5% NAIRU camp, but we will see tomorrow.
Enjoy the day's excitement!

Tuesday, September 15, 2015

'Why the Fed Is Likely to Stand Pat This Week'

Tim Duy at Bloomberg:

Why the Fed Is Likely to Stand Pat This Week: What a week it might have been?

Speeches and interviews have made it fairly clear that Federal Reserve officials were building a case to begin normalizing interest rate policy as soon as this month, but they are increasingly wary that a misstep could derail the economy at a time when they perceive a lack of tools to address renewed weakness.

From the policy discussion of the June Federal Open Market Committee meeting:

Another concern related to the risk of premature policy tightening was the limited ability of monetary policy to offset downside shocks to inflation and economic activity when the federal funds rate was near its effective lower bound.

This concern will weigh heavily on the policy discussion as the Fed begins what promises to be a tumultuous two-day meeting this week. While the central bank was likely prepared to raise interest rates this month at the conclusion of the last FOMC meeting, deteriorating global economic conditions and market volatility will likely derail those plans.

Nor is the inflation picture particularly supportive at this juncture. ...[continue]...

Wednesday, September 09, 2015

The Fed Must Act Soon? Why?

I tried to argue against the points Richard Fisher is making in my column yesterday.

First, he tells us to ignore the headline inflation rate since it is subject to lots of short-run variation from factors such as food and commodity prices, and instead focus on the Dallas Fed's trimmed mean measure. Here it is:

12-month PCE inflation
  Feb-15 Mar-15 Apr-15 May-15 Jun-15 Jul-15
PCE excluding food & energy
Trimmed Mean PCE

See the problem? The Fed's target rte of inflation is 2.0 percent, but trimmed mean inflation, which is intended to isolate long-run inflation trends and ignore short-run variation, is holding steady at 1.6 percent.

Actually, Fisher is a bit loose with the numbers. He says:

conventional core PCE inflation has averaged 1.65 per cent, nearly 30 basis points below headline inflation’s 1.94 per cent average.

But, his preferred measure of inflation, the trimmed mean, shows inflation:

coming in at 1.83 per cent over the past decade, 10 basis points below the headline rate.

But for policy, who cares about 10 years ago? Recently, as shown above, the measure has been close to 1.6 percent, and that's a big miss on the downward side. He does acknowledge this, but still acts as though it is only a near miss:

the Dallas Fed trimmed mean rate has been running steadily at 1.6 per cent over the past year, lower than policymakers are shooting for, but less discouraging than the most watched measures suggest.

Yes, 1.6 versus 1.2 percent for July (see above) is a bit better, but let's not pretend it's close to target. Maybe it is "less discouraging," but it is still discouraging.

In any case, if you are a hawk and want rates up, what do you argue at this point? First, that labor markets are tightening (he ignores the secular stagnation point others use to argue labor markets are tighter than they seem), and inflation is just around the corner (as it always is if you are Richard Fisher, go back and look at what he has been saying throughout the crisis -- inflation has always been just ahead):

History tells us that wage growth initially picks up slowly when unemployment starts to fall but, as it approaches more fulsome levels, wage rises accelerate.
That is the territory we are approaching now. Unemployment has reached 5.1 per cent sooner than the Fed’s rate setters expected. Wage-inflation pressures are not yet nettlesome but they have been rising, smack dab in line with past experience.

But as I explained in my column, recent research says much of that history can be ignored since the relationship between wage inflation and price inflation has changed considerably over the years (pass-through has diminished quite a bit since 1980, i.e. wage increases no longer translate into price increases as they once did, for example in the 1970s Fisher remembers so well). And as the WSJ recently explained, where is the wage inflation the hawks are so worried about?:

U.S. employers aren’t yet being squeezed by workers demanding higher wages. The employment-cost index, a broad gauge of wage and benefit expenditures, rose a seasonally adjusted 0.6% in the fourth quarter last year, the Labor Department said Friday. That’s down from 0.7% in the two earlier quarters and jibes with other data showing only limited wage pressure across the U.S. 

But inflation is coming. It's always coming, right?

Okay, price inflation is below target, wage inflation is really hard to find, and there are many reasons to suspect that labor markets are not as robust as the unemployment rate suggests (not to mention uncertainties in the world economy). But if you are a hawk, you don't give up merely because the data is stacked against you. Instead, you fall back on the "long lags" argument:

Monetary policy ... operates with a lag. If the Fed waits for full employment and then has to throttle back sharply, there will be a nasty shock. The upcoming Fed meetings present a timely opportunity to start slowing down the engines

The question I raised yesterday is whether, with advances in digital technology, we should expect these lags to be as long as they were in the past, e.g. in the 1970s. It seems to me that they have likely shortened, perhaps quite a bit, and that gives the Fed more room for patience than it had in the past. Couldn't it at least wait for clear signs of a problem before acting?

Finally, why the huge fear over a little bit of inflation rather than huge fear over higher than necessary unemployment? Why not reserve the same level of fear for those who struggle with unemployment and all the troubles that come with it? Which is the greater problem to avoid? If we make a mistake, should it be to allow a bit of inflation, which the Fed can quickly reverse, or allow a higher level of unemployment, a problem that is much more costly and much harder to deal with? Why does inflation get so much more attention from some people? Why the hurry to raise rates?

Tuesday, September 08, 2015

The Fed Must Banish the 1970’s Inflation Devil

I have a new column:

The Fed Must Banish the 1970’s Inflation Devil: Will the Fed raise rates when it meets later this month? Inflation remains below the Fed’s two percent target, and that argues against a rate increase. But labor markets appear to be tightening and that is raising worries that higher inflation is just ahead. Should the Fed launch a preemptive strike against the possibility of wage-fueled inflationary pressure? ...

Hopefully there's at least one argument against raising rates that you have not heard before.

Fed Watch: Flying Mostly Blind Heading Into the September FOMC Meeting

Tim Duy:

Flying Mostly Blind Heading Into the September FOMC Meeting, by Tim Duy: Last year, I would have said you were crazy if you told me that short-term rates would still be hugging zero even as unemployment fell to 5.1 percent. Yet here we are, gearing up for a FOMC meeting that promises to be the most contentious in years. The era of data dependence yielded substantially less clarity on the direction of policy than one would hope for, leaving expectations for the meeting’s outcome all over the place. That means this meeting is not just about 25 basis points – it’s about defining the parameters of the Fed’s reaction function. We will learn what data dependence means not just in theory, but in practice.
The argument for a move next week is straightforward. Actual and underlying economic activity remains sufficient to sustain further improvement in the labor market. Indeed, dramatic progress has been made when viewed through the eyes of Federal Reserve Chair Janet Yellen as she scoped out the economic landscape in 2013:


With unemployment at the Fed’s estimate of the natural rate, inflationary pressures will soon emerge. To be sure, wage growth remains flat, but even Yellen leans toward writing that off as an expected outcome of low productivity growth:
The growth rate of output per hour worked in the business sector has averaged about 1-1/4 percent per year since the recession began in late 2007 and has been essentially flat over the past year. In contrast, annual productivity gains averaged 2-3/4 percent over the decade preceding the Great Recession. I mentioned earlier the sluggish pace of wage gains in recent years, and while I do think that this is evidence of some persisting labor market slack, it also may reflect, at least in part, fairly weak productivity growth.
When combined with stable inflation expectations, policymakers have good reason to be confident that actual inflation will soon reverse course and trend toward the Fed’s target. In such an environment, financial accommodation needs to be withdrawn pre-emptively to avoid overshooting the targets. As policymakers prefer to raise rates gradually, they are impelled to raise them early to avoid the risk of more rapid increases in the future.
The counterargument, however, is also straightforward. Labor markets remain far from healed if viewed through the eyes of Yellen in 2014: 


Low wage growth is thus consistent with the hypothesis that underemployment indicators are important measures of labor market health. The persistence of weak wage growth should leads to revised estimates of the natural rate of unemployment. After all, targeting 5 percent unemployment when the natural rate is 4 percent means denying jobs to roughly 1.5 million people. That’s no small responsibility.
Moreover, inflation continues to trend away from target. If you are uncertain of your estimate of the natural rate and inflation is moving away from target, why rush to hike rates? Even though Fed officials believe that inflation has been unduly influenced by the temporary factors of falling oil prices and a rising dollar, those factors reasserted themselves since the last FOMC meeting. And market-based measures of inflation expectations do not signal a revival of inflation anytime soon.
Recent financial turbulence also calls into doubt the wisdom of raising rates next week. To be sure, the Federal Reserve is not responsible for maintaining the value of everyone’s portfolio. But they are responsible for maintaining the financial stability necessary to sustain economic growth. Recent market activity, including a stronger dollar, wider credit spreads, and falling stocks, points toward already tighter financial conditions in the absence of a rate hike. A forward-looking central bank should be cautious of further tightening. Indeed, a forward-looking central bank would be expected to react to current signals with a delayed and shallower path of rate hikes.
Ultimately, the Fed will need to choose between one of these two arguments, and by doing so they will define a direction for policy. This will be important new information. Ultimately, we will learn who rules the roost at the FOMC – the Janet Yellen of 2013, or the Janet Yellen of 2014. Will it be the hawkish or dovish Janet Yellen that appears in the subsequent press conference? I tend to think the later will appear, but the case for the former is strong as well. In any event, the signaling information we receive next week is far more important than any 25 basis points could be.

Saturday, September 05, 2015

Fed Watch: If You Ever Wondered Whose Side The Federal Reserve Is On...

Tim Duy:

If You Ever Wondered Whose Side The Federal Reserve Is On..., by Tim Duy: Catching up with Richmond Federal Reserve Jeffrey Lacker's speech. His dismissal of low wage growth numbers:
Some argue there must be excessive slack in labor markets if wage rates are not accelerating. But real wages are tied to productivity growth, and productivity growth has been slow for several years now. Wage growth in real terms has at least kept pace with productivity increases over that time period, which is perfectly consistent with an economy from which labor market slack has largely dissipated. 
Real wage growth is consistent with productivity, thus there is no excess slack in the labor market. If you think this is some crazy hawk-talk, think again. Fed Chair Janet Yellen in July:
The growth rate of output per hour worked in the business sector has averaged about 1‑1/4 percent per year since the recession began in late 2007 and has been essentially flat over the past year. In contrast, annual productivity gains averaged 2-3/4 percent over the decade preceding the Great Recession. I mentioned earlier the sluggish pace of wage gains in recent years, and while I do think that this is evidence of some persisting labor market slack, it also may reflect, at least in part, fairly weak productivity growth.
For more than three decades, the pace of productivity growth has exceed that of real compensation:


Another view from real median weekly earnings:


Real median weekly earnings have grown 8.6% since 1985. Nonfarm output per hour is up 79% over that time. Yet the instant that there is even a glimmer of hope that labor might get an upper hand, the Federal Reserve looks to hold the line on wage growth. It still appears that the Fed's top priority is making sure the cards remain stacked against wage and salary earners.

Deflation and Money

The summary "Deflation and money" by Hiroshi Yoshikawa, Hideaki Aoyama, Yoshi Fujiwara, and Hiroshi Iyetomiof says:

Deflation and money, Vox EU: Deflation is a threat to the macroeconomy. Japan had suffered from deflation for more than a decade, and now, Europe is facing it. To combat deflation under the zero interest bound, the Bank of Japan and the European Central Bank have resorted to quantitative easing, or increasing the money supply. This column explores its effectiveness, through the application of novel methods to distinguish signals from noises.

The conclusion:

...all in all, the results we obtained have confirmed that aggregate prices significantly change, either upward or downward, as the level of real output changes. The correlation between aggregate prices and money, on the other hand, is not significant. The major factors affecting aggregate prices other than the level of real economic activity are the exchange rate and the prices of raw materials represented by the price of oil. Japan suffered from deflation for more than a decade beginning at the end of the last century. More recently, Europe faces a threat of deflation. Our analysis suggests that it is difficult to combat deflation only by expanding the money supply.

Thursday, September 03, 2015


Carlos Garriga, Finn Kydland, and Roman Sustek, say (based upon their work "The Costs of Interest Rate Liftoff for Homeowners":

If the purpose of the liftoff is to “normalize” nominal interest rates without derailing the recovery, the Federal Reserve Bank and the Bank of England should wait until the economies show convincingly signs of inflation taking off.

Wednesday, September 02, 2015

'QE and Financial Interests'

Simon Wren-Lewis says:

Corbyn, QE and financial interests: ... I want to talk about Quantitative Easing (QE). The basic idea behind QE is that by buying long term assets at a time when their price is high (interest rates are low) to make their price even higher (interest rates even lower) in the short term, and selling them back later when asset prices are lower (and interest rates higher), you could stimulate additional demand. At first sight it seems not too dissimilar to a central bank’s normal activities in changing short rates. There are however two major differences....

After discussing the differences, and some of the problems with QE, he continues with:

That should mean that everyone is looking around for a better way of doing things when short rates hit their lower bound. Fiscal stimulus is the obvious candidate, but we know the political problems there. ...
In the absence of an appropriate government fiscal policy, I find the logic for helicopter money compelling and the arguments against it pretty weak. But just as with fiscal policy, just because something makes good macroeconomic sense does not mean it will happen. I have always been reluctant to pay too much attention to the distributional impact of monetary policy, because it seemed like one of those occasions when even well meaning attention to distribution can mess up good policy. Yet in terms of the political economy of replacing QE, perhaps we should.
It is more likely than not that QE will lead to central bank losses. ... After all, they are buying high, and selling low. That is integral to the policy. Who gains from these losses. Where does the money permanently created because of these losses go? To the financial sector, and the owners of financial assets (who are selling to the central bank high, and buying back low). In that sense, likely losses on QE will involve a transfer from the public to the financial sector.
If QE was the only means of stabilizing the economy in a liquidity trap, because fiscal policy was out of bounds for political reasons, then so be it. The social benefits would far outweigh any distributional costs, even if the latter could not be undone elsewhere. But if QE is a highly ineffective instrument, and there are better instruments available, you have to ask in whose interest is it that we stick with QE?

Tuesday, September 01, 2015

The U.S. Economy Has Become Less Interest Rate Sensitive

This is from "Has the U.S. Economy Become Less Interest Rate Sensitive?," by Jonathan L. Willis and Guangye Cao of the KC Fed:

... IV. Conclusion Although monetary policy is an important tool for promoting price and economic stability, its efficacy can change over time. This article investigates the interest rate channel of monetary policy and, more specifically, the response of employment to changes in the federal funds rate. Analytical results suggest the interest sensitivity of employment has declined in recent decades for nearly all industries and for the overall economy. The article tests three possible explanations for the observed change in interest sensitivity. First, changes in the conduct of monetary policy do not appear to be responsible for the shift in interest sensitivity. Second, linkages between the short end and the long end of the yield curve along with linkages between financial markets and the overall economy have become protracted. Third, structural shifts have altered how employment changes at the industry level feed back to the aggregate economy. Overall, the findings suggest that the decline in the interest sensitivity of the economy is not due to changes in the conduct of monetary policy, but rather to structural changes in industries and financial markets. Future research should investigate whether and how monetary policy should adapt in response to these changes.

Syllabus for Monetary Theory and Policy

Everyone seems to be posting the syllabus for the graduate courses they are teaching this fall. Mine is simple. In my Monetary Theory and Policy course we are going to go through this book by Jordi Gali (don't tell anyone I actually know this stuff):

Front Cover

Blurb: This revised second edition of Monetary Policy, Inflation, and the Business Cycle provides a rigorous graduate-level introduction to the New Keynesian framework and its applications to monetary policy. The New Keynesian framework is the workhorse for the analysis of monetary policy and its implications for inflation, economic fluctuations, and welfare. A backbone of the new generation of medium-scale models under development at major central banks and international policy institutions, the framework provides the theoretical underpinnings for the price stability–oriented strategies adopted by most central banks in the industrialized world.

Using a canonical version of the New Keynesian model as a reference, Jordi Galí explores various issues pertaining to monetary policy’s design, including optimal monetary policy and the desirability of simple policy rules. He analyzes several extensions of the baseline model, allowing for cost-push shocks, nominal wage rigidities, and open economy factors. In each case, the effects on monetary policy are addressed, with emphasis on the desirability of inflation-targeting policies. New material includes the zero lower bound on nominal interest rates and an analysis of unemployment’s significance for monetary policy.

  • The most up-to-date introduction to the New Keynesian framework available
  • A single benchmark model used throughout
  • New materials and exercises included
  • An ideal resource for graduate students, researchers, and market analysts

I'm looking forward to it. The revised version has lots of new, up to date material, and I really like the fact that he uses variations on a core model throughout the text (it makes the math and intuition a bit easier since you don't have to redo everything with each new topic). I'm a bit torn to move away from Carl Walsh's book, both books have their advantages and I'll still draw quite from the Walsh text. But my focus this quarter is Gali.

Monday, August 31, 2015

Fed Watch: Does 25bp Make A Difference?

Tim Duy:

Does 25bp Make A Difference?, by Tim Duy: I am often asked if 25bp really makes any difference? If not, why does it matter when the Fed makes its first move? The Fed would like you to believe that 25bp really isn't all that important. Indeed, they don't want us focused on the timing of the first move at all, reiterating that the path of rates is most important. Yet I have come to believe that the timing of the first rate hike is important for two reasons. First, it will help clarify the Fed's reaction function. Second, if the experience of Japan and others who have tried to hike rates in the current global macroeconomic environment is any example, the Fed will only get one shot at pulling the economy off the zero bound. They better get it right.
On the first point, consider that there is no widespread agreement on the timing of the Fed's first move. Odds for September have been bouncing around 50%, lower after a couple of weeks of market turmoil, but bolstered by the Fed's "stay the course" message from Jackson Hole. I think you can contribute the lack of consensus to the conflicting signals send by the Fed's dual mandate. On one hand, labor markets are improving unequivocally. The economy is adding jobs and measures of both unemployment and underemployment continue to improve. The Fed has said that only "some" further progress is necessary to meet the employment portion of the dual mandate. I would argue the Fed Vice-Chair Stanley Fischer even was kind enough to define "some" while in Jackson Hole:
In addition, the July announcement set a condition of requiring "some further improvement in the labor market." From May through July, non-farm payroll employment gains have averaged 235,000 per month. We now await the results of the August employment survey, which are due to be published on September 4.
Nonfarm payroll growth was the only labor market indicator he put a number to. He clearly intended to tie that number to the Fed statement. Basically, he said "some" further improvement is simply another month of the same pattern.
While the Fed is moving closer to the employment mandate, however, the price stability mandate is moving further from view:


On a year-over-year basis, core-CPI is at four year lows, and the collapse in the monthly change suggests that year-over-year trends will not soon turn in the Fed's favor. One can argue that the net effect on policy should be zero. After all, the Fed has long argued that inflation will revert to target, yet inflation has only drifted away from target. What kind of central bank tightens policy when they are moving farther from their inflation target?
Fischer, however is undeterred:
Can the Committee be "reasonably confident that inflation will move back to its 2 percent objective over the medium term"? As I have discussed, given the apparent stability of inflation expectations, there is good reason to believe that inflation will move higher as the forces holding down inflation dissipate further. While some effects of the rise in the dollar may be spread over time, some of the effects on inflation are likely already starting to fade. The same is true for last year's sharp fall in oil prices, though the further declines we have seen this summer have yet to fully show through to the consumer level. And slack in the labor market has continued to diminish, so the downward pressure on inflation from that channel should be diminishing as well.
So back to the question: What kind of central bank tightens policy when they are moving further from their inflation target? Answer: The Federal Reserve. Why? Faith in their estimate of the natural rate of unemployment. Inflation expectations hold the baseline steady, shocks cause deviations from that baseline. The shocks will all dissipate over time, including labor market shocks. The economy is approaching full employment, therefore the downward pressure from labor market slack will soon diminish and turn into upward pressure in the absence of tighter monetary policy.
Now note that, aside from the equilibrium real rate, of the four variables in a Taylor-type reaction function, only one of those variables is unobserved. The target inflation rate is defined, and unemployment and inflation are measured. The natural rate of unemployment is unobserved and needs to be estimated. How confident are policymaker's in their estimate (5.0-5.2 percent) of the natural rate of unemployment?
I would argue that the Fed will reveal a high degree of confidence in that estimate if they hike rates in the face of inflation drifting away from trend. That would be new information in defining their reaction function. I think it would be a signal that Federal Reserve Chair Janet Yellen has largely abandoned here concerns about underemployment, which remains unacceptably high.
The clarification of the Fed's reaction function by narrowing the confidence interval around the Fed's estimate of the natural rate of unemployment would, I think, be an important new piece of information. Moreover, I think it would be a fairly hawkish signal - remember that financial market participants, as well as the Federal Reserve staff, tend to have a more dovish outlook that FOMC participants. The sooner the Fed hikes rate, the more hawkish the signal relative to expectations.
That signal, I suspect, is more important than the actual 25bp. The latter might not mean much, but at the zero bound, the former probably means a lot.
The timing of the first hike is also important because the Fed will only get one bite at the apple. That at least is what we saw with the rush to tighten in Japan, Europe, and Sweden. The downside risks of tightening too early are thus enormous, amounting to essentially locking your economy into a subpar equilibrium. This was the Fed's staff's warning in the last set of minutes:
The risks to the forecast for real GDP and inflation were seen as tilted to the downside, reflecting the staff's assessment that neither monetary nor fiscal policy was well positioned to help the economy withstand substantial adverse shocks.
Again, Fischer seems to fear the opposite risk more. Via the New York Times:
And Mr. Fischer emphasized that Fed officials could not afford to wait until all of their questions were answered and all of their doubts resolved. “When the case is overwhelming,” he said, “if you wait that long, then you’ve waited too long.”
I am not looking for an overwhelming case, just inflation that is trending toward target instead of away. Yet even that is apparently too much for Fischer as unemployment bears down on their estimate of the full employment.
You can take the central banker out of the 1970's, but you can't take the 1970's out of the central banker.
Bottom Line: I am coming around to the belief that the timing of the first rate hike is more important than Fed officials would like us to believe. The lack of consensus regarding the timing of the first hike tells me that we don't fully understand the Fed's reaction function and, importantly, their confidence in their estimates of the natural rate of unemployment. The timing of the first hike will thus define that reaction function and thus send an important signal about the Fed's overall policy intentions.

Saturday, August 29, 2015

'U.S. Inflation Developments'

[A speech by Stanley Fischer at Jackson Hole turned into a pretend interview]

Hello, and thank you for talking with us.

 Let me start by asking if you feel like it gives the Fed a bad image to have a conference in an elite place like Jackson Hole. Why not have the conference in, say, a disadvantaged area to send the signal that you care about these problems, to provide some stimulus to the area, etc.?

I am delighted to be here in Jackson Hole in the company of such distinguished panelists and such a distinguished group of participants.

Okay then. Let me start be asking about your view of the economy. How close are we to a full recovery?:

Although the economy has continued to recover and the labor market is approaching our maximum employment objective, inflation has been persistently below 2 percent. That has been especially true recently, as the drop in oil prices over the past year, on the order of about 60 percent, has led directly to lower inflation as it feeds through to lower prices of gasoline and other energy items. As a result, 12-month changes in the overall personal consumption expenditure (PCE) price index have recently been only a little above zero (chart 1).

Why are you telling us about headline inflation? What about core inflation? Isn't that what the Fed watches?

...measures of core inflation, which are intended to help us look through such transitory price movements, have also been relatively low (return to chart 1). The PCE index excluding food and energy is up 1.2 percent over the past year. The Dallas Fed's trimmed mean measure of the PCE price index is higher, at 1.6 percent, but still somewhat below our 2 percent objective. Moreover, these measures of core inflation have been persistently below 2 percent throughout the economic recovery. That said, as with total inflation, core inflation can be somewhat variable, especially at frequencies higher than 12-month changes. Moreover, note that core inflation does not entirely "exclude" food and energy, because changes in energy prices affect firms' costs and so can pass into prices of non-energy items.

So are you saying you don't believe the numbers? Why bring up that core inflation is highly variable unless you are trying to de-emphasize this evidence? In any case, isn't there reason to believe these numbers are true, i.e. doesn't the slack in the labor market imply low inflation?

Of course, ongoing economic slack is one reason core inflation has been low. Although the economy has made great progress, we started seven years ago from an unemployment rate of 10 percent, which guaranteed a lengthy period of high unemployment. Even so, with inflation expectations apparently stable, we would have expected the gradual reduction of slack to be associated with less downward price pressure. All else equal, we might therefore have expected both headline and core inflation to be moving up more noticeably toward our 2 percent objective. Yet, we have seen no clear evidence of core inflation moving higher over the past few years. This fact helps drive home an important point: While much evidence points to at least some ongoing role for slack in helping to explain movements in inflation, this influence is typically estimated to be modest in magnitude, and can easily be masked by other factors.

If that's true, if the decline in the slack in the labor market does not translate into a notable change in inflation, why is the Fed so anxious to raise rates based upon the notion that the labor market has almost normalized? Is there more to it than just the labor market?

...core inflation can to some extent be influenced by oil prices. However, a larger effect comes from changes in the exchange value of the dollar, and the rise in the dollar over the past year is an important reason inflation has remained low (chart 4). A higher value of the dollar passes through to lower import prices, which hold down U.S. inflation both because imports make up part of final consumption, and because lower prices for imported components hold down business costs more generally. In addition, a rise in the dollar restrains the growth of aggregate demand and overall economic activity, and so has some effect on inflation through that more indirect channel.

That argues against a rate increase, not for it. Anyway, I interrupted, please continue.

Commodity prices other than oil are also of relevance for inflation in the United States. Prices of metals and other industrial commodities, and agricultural products, are affected to a considerable extent by developments outside the United States, and the softness we've seen in these commodity prices, has in part reflected a slowing of demand from China and elsewhere. These prices likely have also been a factor in holding down inflation in the United States.

So you must believe that all of these forces holding down inflation (many of which are stripped out by core inflation measures, which are also low) that these factors are easing, and hence a spike in inflation is ahead?

The dynamics with which all these factors affect inflation depend crucially on the behavior of inflation expectations. One striking feature of the economic environment is that longer-term inflation expectations in the United States appear to have remained generally stable since the late 1990s (chart 6). ... Expectations that are not stable, but instead follow actual inflation up or down, would allow inflation to drift persistently. In the recent period, movements in inflation have tended to be transitory.

Let's see, lots of factors holding down inflation, longer-term inflation expectations have been stable throughout the recession and recovery, remarkably so, yet the Fed still thinks a rate raise ought to come fairly soon?

We should however be cautious in our assessment that inflation expectations are remaining stable. One reason is that measures of inflation compensation in the market for Treasury securities have moved down somewhat since last summer (chart 7). But these movements can be hard to interpret, as at times they may reflect factors other than inflation expectations, such as changes in demand for the unparalleled liquidity of nominal Treasury securities.

I have to be honest. That sounds like the Fed is really reaching to find a reason to justify worries about inflation and a rate increase. Let me ask this a different way. In the Press Release for the July meeting of the FOMC, the committee said it can be " reasonably confident that inflation will move back to its 2 percent objective over the medium term." Can you explain this please? Why are you "reasonably confident" in light of recent history?

Can the Committee be "reasonably confident that inflation will move back to its 2 percent objective over the medium term"? As I have discussed, given the apparent stability of inflation expectations, there is good reason to believe that inflation will move higher as the forces holding down inflation dissipate further. While some effects of the rise in the dollar may be spread over time, some of the effects on inflation are likely already starting to fade. The same is true for last year's sharp fall in oil prices, though the further declines we have seen this summer have yet to fully show through to the consumer level. And slack in the labor market has continued to diminish, so the downward pressure on inflation from that channel should be diminishing as well.

Yet when these forces were absent -- they weren't there throughout the crisis -- inflation was still stable. But this time will be different? I guess falling slack in the labor market will make all the difference? More on labor markets in a moment, but let me ask if you have more to say about inflation expectations first.

...with regard to expectations of inflation, it is possible to consult the results of the SEP, the Survey of Economic Projections, which FOMC participants complete shortly before the March, June, September, and December meetings. In the June SEP, the central tendency of FOMC participants' projections for core PCE inflation was 1.3 percent to 1.4 percent this year, 1.6 percent to 1.9 percent next year, and 1.9 percent to 2.0 percent in 2017. There will be a new SEP for the forthcoming September meeting of the FOMC.
Reflecting all these factors, the Committee has indicated in its post-meeting statements that it expects inflation to return to 2 percent. With regard to our degree of confidence in this expectation, we will need to consider all the available information and assess its implications for the economic outlook before coming to a judgment.

You will need to consider all the available information, I agree wholeheartedly with that. I just hope that information includes how poor forecasts like those just cited have been in the past, and the Fed's own eagerness to see "green shoots" again and again, far before it was time for such declarations.

What might deter the Fed from it's intention to raise rates sooner rather than later?

Of course, the FOMC's monetary policy decision is not a mechanical one, based purely on the set of numbers reported in the payroll survey and in our judgment on the degree of confidence members of the committee have about future inflation. We are interested also in aspects of the labor market beyond the simple U-3 measure of unemployment, including for example the rates of unemployment of older workers and of those working part-time for economic reasons; we are interested also in the participation rate. And in the case of the inflation rate we look beyond the rate of increase of PCE prices and define the concept of the core rate of inflation.

I find these kinds of statement difficult to square with the statement that labor markets are almost back to normal. Anyway, what, in particular, will you look at?

While thinking of different aspects of unemployment, we are concerned mainly with trying to find the right measure of the difficulties caused to current and potential participants in the labor force by their unemployment. In the case of the core rate of inflation, we are mainly looking for a good indicator of future inflation, and for better indicators than we have at present.

How do recent events in China change the outlook for policy?

In making our monetary policy decisions, we are interested more in where the U.S. economy is heading than in knowing whence it has come. That is why we need to consider the overall state of the U.S. economy as well as the influence of foreign economies on the U.S. economy as we reach our judgment on whether and how to change monetary policy. That is why we follow economic developments in the rest of the world as well as the United States in reaching our interest rate decisions. At this moment, we are following developments in the Chinese economy and their actual and potential effects on other economies even more closely than usual.

I know you won't answer this directly, but let me try anyway. When will rates go up?

The Fed has, appropriately, responded to the weak economy and low inflation in recent years by taking a highly accommodative policy stance. By committing to foster the movement of inflation toward our 2 percent objective, we are enhancing the credibility of monetary policy and supporting the continued stability of inflation expectations. To do what monetary policy can do towards meeting our goals of maximum employment and price stability, and to ensure that these goals will continue to be met as we move ahead, we will most likely need to proceed cautiously in normalizing the stance of monetary policy. For the purpose of meeting our goals, the entire path of interest rates matters more than the particular timing of the first increase.

As expected, that was pretty boilerplate. When rates do go up, how fast will they rise?

With inflation low, we can probably remove accommodation at a gradual pace. Yet, because monetary policy influences real activity with a substantial lag, we should not wait until inflation is back to 2 percent to begin tightening. Should we judge at some point in time that the economy is threatening to overheat, we will have to move appropriately rapidly to deal with that threat. The same is true should the economy unexpectedly weaken.

The Fed has said again and again that it's 2 percent inflation target is symmetric with respect to errors, i.e. it will get no more worried or upset about, say, a .5 percent overshoot of the target than it will an undershoot of the same magnitude (2.5 percent versus 1.5 percent). However, many of us suspect that the 2 percent target is actually a ceiling, not a central tendency, or that at the very least the errors are not treated symmetrically, and statements such as this do nothing to change that view.

I have quite a few more questions, and I wish we had time to hear your response to the charge that the 2 percent target is functionally a ceiling, but I know you are out of time and need to go, so let me just thank you for talking with us today. Thank you.

Friday, August 28, 2015

Fed Watch: Hawkish Rumblings

Tim Duy:

Hawkish Rumblings, by Tim Duy: Fedspeak from the Jackson Hole conference suggests that the more hawkish FOMC participants are sticking to their guns. Cleveland Federal Reserve Bank President Loretta Mester, via the Wall Street Journal:
“I want to take the time I have between now and the September meeting to evaluate all the economic information that’s come in, including recent volatility in markets and the reasons behind that,” Ms. Mester said. “But it hasn’t so far changed my basic outlook that the U.S. economy is solid and it could support an increase in interest rates.”
Then there is St. Louis Federal Reserve President James Bullard, via Bloomberg:
“The key question for the committee is -- how much would you want to change the outlook based on the volatility that we’ve seen over the last 10 days, and I think the answer to that is going to be: not very much,” Bullard told Bloomberg Television in an interview Friday at the Kansas City Fed’s annual conference in Jackson Hole, Wyoming.
“You’ve really got the same trajectory that the committee will be looking at that we were looking at before, so why would we change strategy, which was basically to lift off at some point,” said Bullard, who votes on the FOMC next year...
...“The committee does not like to move when there’s volatility,” he said. “If we had the meeting this week, people would probably say let’s wait.”...
...He added, “but the meeting is not this week, it’s Sept. 16 and 17.”
Bullard does not want financial market turmoil to derail his long-supported rate hike. He is hoping all this noise just fades away over the next few weeks. And he wants to open up the October option:
Bullard also said he would support scheduling a press conference following the Oct. 27-28 FOMC meeting if the committee doesn’t raise rates next month. That would make it easier for the Fed to explain a liftoff in October.
Bullard has repeatedly sought a press conference for every meeting, to no avail. I agree with him. The Fed has reinforced the view that major policy shifts are limited to only four of the eight meetings a year. Ridiculous and unnecessary. There should be a press conference at every meeting. That said, they can't now announce a press conference for October because it will be taken as a clear signal of a rate hike on that date. After they get the first hike out of the way, then they should switch to a press conference with every meeting.
Here Bullard disappoints:
“I actually think we’re OK on the inflation front,” Bullard said. “I’ve been arguing that we should get going, because interest rates -- it’s not that we’re a little bit below normal, we’re all the way down at zero, so you’ve got to think about: How is this going to play out over the next two to three years.”
I can remember when Bullard had a reliable view on inflation. When inflation deviates from trend, you act. But the inflation picture is not friendly for hawks and even less so after this morning:


Core-PCE inflation decelerated to a meager 0.87 percent annualized rate in July. The uptick in near-term inflation had provided strong support for a September rate hike as it was consistent with the view that last year's disinflation was temporary. That no longer looks to be the case, pulling apart the argument that the Fed can be confident that inflation will trend back to target. If anything, all the monthly data looks like noise as inflation slowly drifts further and further away from target.
Moreover, I would have thought that Bullard would give more weight to market-based measures:
BreakI believe Bullard is increasingly held by the siren-song of the Neo-Fisherians, thinking the only way to raise inflation is to hike rates. Good luck with that.
I like this from Greg Robb at MarketWatch:
Fischer just trying to show the Fed is as cool as the underside of your pillow
— Greg Robb (@grobb2000) August 28, 2015
Fischer went into this interview with the goal of leaving September open. Via CNBC:
"I think it's early to tell: The change in the circumstances which began with the Chinese devaluation is relatively new and we're still watching how it unfolds, so I wouldn't want to go ahead and decide right now what the case is—more compelling, less compelling, etc.," he said.
Fischer was trying not to tip his hat as much as New York Federal Reserve President William Dudley did on Tuesday. Or even arguably trying to pull back Dudley's comments as they had seemed to close off September. Perhaps more telling, when asked about the PCE numbers, Fischer reiterated his confidence that inflation will trend to target, citing the transitory nature of the oil shock. This is somewhat disappointing given the data and his dovish comments on inflation just two weeks ago. But then again, he couldn't take a dovish stance if his intent was to keep September on that table.
Where does Fischer get his confidence on inflation? A basic Phillips curve story. It is the story that makes a September liftoff compelling. He believes the labor market is near full employment and that you need to move ahead of the inflation curve:
Still, he added that he has not seen "much evidence" of increasing risks to staying at near-zero rates for longer, but he also said he didn't want to wait too long.
"When the case is overwhelming, if you wait that long, you'll be waiting too long," he said. "There's always uncertainty."
The Fed very much wants to ignore the inflation data and follow the labor markets. And even as inflation drifts further away from their target, they keep doubling down on their bets. It's what the Phillips curve is telling them they should do.
Bottom Line: The Fed doesn't want to take September off the table. Many officials had what they believed was a solid case for hiking rates at the next meeting, and they don't want market turmoil to undermine that case. And that case is not complicated. It's the Phillip curve combined with an estimate of full employment (an estimate of full employment that remains sticky despite the persistent downtrend in inflation). If they move in September, that's the story they will run with. They don't have another paradigm.

Thursday, August 27, 2015

'Q2 GDP Revised up to 3.7%'

Are you as convinced as Tim is that rate hikes are off the table at the Fed's next meeting?:

Q2 GDP Revised up to 3.7%, by Bill McBride, Calculated Risk: From the BEA: Gross Domestic Product: First Quarter 2015 (Third Estimate)

Real gross domestic product -- the value of the goods and services produced by the nation's economy less the value of the goods and services used up in production, adjusted for price changes -- increased at an annual rate of 3.7 percent in the second quarter of 2015, according to the "second" estimate released by the Bureau of Economic Analysis. In the first quarter, real GDP increased 0.6 percent.

The GDP estimate released today is based on more complete source data than were available for the "advance" estimate issued last month. In the advance estimate, the increase in real GDP was 2.3 percent. With the second estimate for the second quarter, nonresidential fixed investment and private inventory investment increased. ... [emphasis added]

Here is a Comparison of Advance and Second Estimates. PCE growth was revised up from 2.9% to 3.1%. Residential investment was revised up from 6.6% to 7.8%.

Solid growth. And above the consensus of 3.2%.

'Mind the Gap: Assessing Labor Market Slack'

Joseph Tracy, Robert Rich, Samuel Kapon, and Ellen Fu say "that roughly 90 percent of the labor gap that opened up following the recession has been closed":

Mind the Gap: Assessing Labor Market Slack, Liberty Street Economics, NY Fed: Indicators of labor market slack enable economists to judge pressures on wages and prices. Direct measures of slack, however, are not available and must be constructed. Here, we build on our previous work using the employment-to-population (E/P) ratio and develop an updated measure of labor market slack based on the behavior of labor compensation. Our measure indicates that roughly 90 percent of the labor gap that opened up following the recession has been closed.
An earlier post, “A Mis-Leading Labor Market Indicator,” argued that the gap between the E/P ratio and a demographically adjusted version of the same ratio is a useful measure of labor market slack. A challenge in constructing this measure is that it requires a normalization (a level shift) to “re-center” the demographically adjusted E/P ratio. In this earlier post, we normalized by assuming that the average labor gap should be zero over a long period of time. Although this approach was easy to implement, it had the disadvantage of not being linked to wage behavior.
To better motivate an E/P-based approach, we turn to Phillips curve models that relate wage growth to labor market slack. The specification we consider relates nominal wage growth to an E/P gap variable (defined as the difference between a demographically adjusted E/P ratio and the actual E/P ratio), as well as expected inflation and trend productivity growth. Expected inflation is subtracted from nominal wage growth to derive an expected real wage growth series, which is then regressed on a constant, the E/P gap, and trend productivity growth. The E/P gap is normalized so that the estimated intercept of the Phillips curve model is set to zero. This approach implies that when the resulting normalized E/P gap is zero, expected real wage growth adjusted for the return to labor productivity is, on average, zero. That is, a labor market with no slack will have nominal wage growth, on average, equal to expected inflation plus a return to labor productivity.
We estimate Phillips curve models for three wage measures: compensation per hour, average hourly earnings, and the employment cost index. We construct four-quarter-ahead growth rates starting in the first quarter of 1982, the earliest start date for which all three measures are available, and ending in the second quarter of 2015. Expected inflation is measured using survey data on ten-year CPI inflation expectations, and trend productivity growth is a twelve-quarter moving average of (annualized) productivity growth rates. Adopting the same approach we took in another post—“U.S. Potential Economic Growth: Is it Improving with Age?”—we have extended the data sample used to estimate the demographically adjusted E/P ratio back to the early 1960s. This provides us with roughly thirteen million observations on individuals that we divide into 280 cohorts based on decade of birth, sex, race/ethnicity, and educational attainment. For each cohort, we estimate a cohort-specific profile for average employment rates by age that abstracts from cyclical effects. Aggregating these predicted employment rates across individuals produces a demographically adjusted E/P ratio, with the quarterly series derived as an average of the three monthly values.
The three Phillips curve models yield similar normalizations, so we average them instead of selecting one. The chart below shows the actual E/P ratio along with the demographically adjusted E/P ratio based on this new normalization.

E/P: Actual and Adjusted

The next chart plots the estimated E/P gap (the difference between the two series in the chart above) along with the three expected real wage growth measures adjusted for trend productivity growth. By our definition, a positive E/P gap indicates slack in the labor market. The periods in which the estimated E/P gap is zero line up well with the periods in which our adjusted real wage growth measures are also close to zero. Moreover, periods in which the adjusted wage measures have exceeded zero generally correspond to episodes of tight labor markets (negative E/P gaps), while periods in which the measures are below zero are typically associated with slack in the labor market (positive E/P gaps).

E/P Gap and Wage Measures

The current normalized E/P gap is estimated to be 32 basis points, which represents an 89 percent reduction from the 283-basis-point gap in November 2010. This finding suggests that the labor market has made considerable progress in its recovery, but is still not yet back to neutral. To gain additional perspective on this finding, we can compare the current gap with those that existed in two earlier tightening episodes. At the time the FOMC began to raise rates in February 1994, the gap was 92 basis points; at the end of that tightening cycle, it was 14 basis points. And when the Committee began to raise rates in June 2004, the gap was -38 basis points; at the end of that tightening cycle, the gap was -125 basis points. To assess labor market slack and understand the behavior of labor compensation in the quarters ahead, it will be particularly important to mind the gap.

Wednesday, August 26, 2015

Fed Watch: Dudley Puts The Kibosh On September

Tim Duy:

Dudley Puts The Kibosh On September, by Tim Duy: Monday's action on Wall Street was too much for the Fed. That day, Atlanta Federal Reserve President Dennis Lockhart pulled back his previous dedication to a September rate hike earlier, reverting to only an expectation that rates rise sometimes this year. But today New York Federal Reserve President William Dudley explicitly called September into question. Via the Wall Street Journal:

In light of market volatility and foreign developments, “at this moment, the decision to begin the normalization process at the September [Federal Open Market Committee] meeting seems less compelling to me than it did several weeks ago. But normalization could become more compelling by the time of the meeting as we get additional information” about the state of the economy, he told reporters.

While this comment was sufficiently nuanced to leave open the possibility of September, in reality Dudley pretty much ended the debate. He only reinforced expectations that September was off the table, and time is running out to pull back expectations. Incoming data, what little there is at this point, would need to come in well above expectations to bring September back into play. And that is just mostly like not going to happen.

What about October or December? I tend to think that October is off the table due to a lack of a press conference. Yes, I know the Fed claims every meeting is live, but the reality is that they have reinforced the perception that major policy shifts occur only on meetings with scheduled press conferences. If the Fed  wants eight live meetings a year, they need eight press conferences. December remains open with sufficiently strong data, but does the Fed really want to attempt the first rate hike when financial markets are already tight seasonally?

Fundamentally, the problem for the Federal Reserve is that US financial conditions have tightened since the end of the quantitative easing, and will most likely continue to tighten as the rest of the world, notably now China, eases further. In effect, easier policy in the rest of the world requires, all else equal, easier policy in the US as well. Hence this from the FT:

Interest rate futures indicate that investors now see just a 24 per cent chance of a rate increase in September, down from more than 50 per cent earlier this month. The probable path of rate rises in 2016 has also moderated markedly, according to Bloomberg futures data.

The path of rates necessary to maintain stable growth in the US will be lower in response to easing conditions elsewhere. This is something known to bond market participants who as a group have long been more dovish than FOMC participants. But it was the equity market participants that shocked the Fed into the same realization.

To be sure, critics will loudly proclaim that the Fed must hike in September if only to prove they are not governed by the equity markets. That call will be heard in the next FOMC meeting as well, but it will be a minority view. A thousand point drop in the Dow will not be ignored by the majority of the FOMC. Dismissing what are obviously fragile financial market conditions would be a hawkish signal the FOMC does not want to send. Hiking rates is not going to send a calming message of confidence. That never works. If the history of financial crises has taught us anything, it is that failure to respond with easier policy only adds to the turmoil.

Bottom Line: The Fed has long argued that the timing of the first rate hike does not matter. I had thought so as well, but that is clearly no longer the case. A rate hike during a period of substantial financial market turmoil would matter a great deal. It looks like the Fed's plans to raise rate will once again be overtaken by events.

'It’s Getting Tighter'

Paul Krugman has advice for the Fed:

It’s Getting Tighter: When thinking about the market madness and its possible real effects, here’s something you — where by “you” I mean the Fed in particular — really, really need to keep in mind: the markets have already, in effect, tightened monetary conditions quite a lot.
First of all, if break-evens (the difference between interest rates on ordinary bonds and inflation-protected bonds) are any guide, inflation expectations have fallen sharply...
Second, while interest rates on Treasuries are down, rates on private securities viewed as even moderately risky are up quite a lot...
So real borrowing costs are up sharply for many private borrowers. This is a significant headwind for the U.S. economy, which was hardly growing like gangbusters in any case.
A Fed hike now looks like an even worse idea than it did a few days ago.

Monday, August 24, 2015

'The Fed Looks Set to Make a Dangerous Mistake'

Larry Summers says "Raising rates this year will threaten all of the central bank’s major objectives":

The Fed looks set to make a dangerous mistake: Will the Federal Reserve’s September meeting see US interest rates go up for the first time since 2006? Officials have held out the prospect that ... rates will probably be increased... Conditions could change... But ... raising rates ... would be a serious error that would threaten all three of the Fed’s major objectives— price stability, full employment and financial stability.
Like most major central banks, the Fed has ... a 2 per cent inflation target. The biggest risk is that inflation will be lower than this — a risk that would be exacerbated by tightening policy... Tightening policy will adversely affect employment levels... Higher interest rates will also increase the value of the dollar, making US producers less competitive... This is especially troubling at a time of rising inequality. Studies ... make it clear that the best social program for disadvantaged workers is an economy where employers are struggling to fill vacancies.
There may have been a financial stability case for raising rates six or nine months ago, as low interest rates were encouraging investors to take more risks... That debate is now moot. With credit becoming more expensive, the outlook for the Chinese economy clouded at best, emerging markets submerging, the US stock market in a correction, widespread concerns about liquidity, and expected volatility having increased at a near-record rate, markets are themselves dampening any euphoria or overconfidence. The Fed does not have to do the job. ...
It is no longer easy to think of economic conditions that can plausibly be seen as temporary headwinds. ... This is the “secular stagnation” diagnosis...
New conditions require new policies. There is much that should be done, such as steps to promote public and private investment so as to raise the level of real interest rates consistent with full employment. Unless these new policies are implemented, inflation sharply accelerates, or euphoria in markets breaks out, there is no case for the Fed to adjust policy interest rates.

Thursday, August 20, 2015

Fed Watch: FOMC Minutes Give No Clear Signal

Tim Duy:

FOMC Minutes Give No Clear Signal, by Tim Duy: The FOMC minutes from the July 28-29 FOMC meeting were released today. Arguably they are stale. Arguably they have been overtaken by events. And because the Fed has been very good about not signaling their exact intentions, arguably you can read anything into them you want. If you want to take a hawkish view, I think you focus on this and similar portions of the minutes:

During their discussion of economic conditions and monetary policy, participants mentioned a number of considerations associated with the timing and pace of policy normalization. Most judged that the conditions for policy firming had not yet been achieved, but they noted that conditions were approaching that point. Participants observed that the labor market had improved notably since early this year, but many saw scope for some further improvement. Many participants indicated that their outlook for sustained economic growth and further improvement in labor markets was key in supporting their expectation that inflation would move up to the Committee's 2 percent objective, and that they would be looking for evidence that the economic outlook was evolving as they anticipated.

When considering a rate hike, "many" participants were willing to dismiss current low inflation if they believe evidence of stronger growth supports their conviction that inflation would trend toward target over time. The data since the July meeting tends to support that view. July retail sales were healthy, and revisions to previous months points toward upward revisions to second quarter GDP growth to 3.0 percent or higher. Industrial production was higher, perhaps starting to move past the declines related to the sharp drop in oil prices. Single family housing starts continued their slow but steady rise, reaching a level last seen in 2007. Homebuilder confidence is up. While manufacturing has been soft, the service sector as measured by the ISM non-manufacturing measure is picking up the slack. And the employment report was yet another in a long line of employment reports suggesting slow yet steady gains. Overall, a picture generally supportive of sustained growth and further improvement in labor markets.

A dovish view, however, could be easily derived from the following sentences and similar portions:

However, some participants expressed the view that the incoming information had not yet provided grounds for reasonable confidence that inflation would move back to 2 percent over the medium term and that the inflation outlook thus might not soon meet one of the conditions established by the Committee for initiating a firming of policy. Several of these participants cited evidence that the response of inflation to the elimination of resource slack might be attenuated and expressed concern about risks of further downward pressure on inflation from international developments. Another concern related to the risk of premature policy tightening was the limited ability of monetary policy to offset downside shocks to inflation and economic activity when the federal funds rate was near its effective lower bound.

Many market participants took this and related comments specifically referring to China and currency prices to argue that September was all but off the table. I would not be so quick; the former view is held by "many," whereas the latter was held by "some." Moreover, I find it hard to believe that any would think it a surprise that some officials explicitly discussed China and currencies. How could they not? How could you not think that in a wide-ranging discussion they had not discussed all that is both good and bad in the economy? That said, as I noted earlier, the minutes are stale. The depreciation of the yuan and further declines in commodity prices since the last FOMC meeting give reason to believe that the ranks of "some" has grown.

The latter points also appealed to those inclined against a rate hike. For instance, prior to the release of the minutes, the prescient Cullen Roche argued:

There is still a lot of chatter about the potential for a September rate hike by the Fed. I have to be honest – I think this is nuts at this point.

After the minutes he added:

My guess is that the odds of a Sept rate hike are fast approaching 0%.

— Cullen Roche (@cullenroche) August 19, 2015

I am clearly sympathetic to the view that the Fed looks to be rushing with the rate hike talk. That said, it is what many officials are talking about since the last FOMC meeting while looking at the same data we are. Via John Hilsenrath at the Wall Street Journal:

Officials speaking since the July meeting have sent conflicting signals about where the group as a whole is most likely to go. In an interview with The Wall Street Journal earlier this month, Atlanta Fed President Dennis Lockhart said he was inclined to move in September. St. Louis Fed President James Bullard said in an interview with Market News International on Wednesday he would push for it. But in an opinion piece written in The Wall Street Journal on Wednesday, Minneapolis Fed President Narayana Kocherlakota said it would be a mistake and Fed governor Jerome Powell said earlier this month a decision hadn’t been made.

Lockhart is seen as swaying with the general consensus, which argues for September. Bullard arguably shouldn't be pushing for a rate hike given his path tendency to follow the direction of market-based inflation expectations, but the neo-Fisherians seem to be making some traction with him. Powell is wisely keeping his cards close to his chest. They should not, after all, have made any decisions yet. And I would say that if Kocherlakota feels so strongly a need to argue against a rate hike in the Wall Street Journal, he must think the momentum is shifting the other direction.

Former Federal Reserve Governor Lawrence Meyer is also interesting here:

“What are you worrying about, September or December? It doesn’t matter. Just pull the trigger,” said Laurence Meyer, co-founder of Macroeconomic Advisers, a research firm, in an interview before the release of the minutes.

Just sick of the debate and wanting to move on? Or a real conviction that the Fed is set to move?

Bottom Line: I have believed that there was a better than 50% chance that the Fed would move in September and am hesitant to move much below 50%. I didn't expect the minutes would give a clear signal regarding September, and am not surprised by the dimensions of the general discussion. And I am wary the Fed may be less responsive to financial market disruption than during most of the post-crisis era given than the economy is close to their estimate of full employment. This is shaping up to be one of the most contentious meetings since the tapering debates. We will soon learn more exactly what data the Fed is data dependent on.

FRBSF: The Economic Outlook

The economic outlook according to Michael Bauer of the SF Fed:

FedViews: Michael Bauer, senior economist at the Federal Reserve Bank of San Francisco, states his views on the current economy and the outlook.

GDP growth rebounded from slow Q1

  • Revised estimates indicate that real GDP rose by 0.7% at an annualized rate in the first quarter of 2015, wiping out the previously reported contraction. A first estimate of 2.3% growth in the second quarter is consistent with an ongoing moderate expansion of the U.S. economy, confirming that the first-quarter weakness was largely due to transitory factors.
  • We expect the U.S. economy to grow slightly above its 2% long-term trend for the next four quarters, and then return to trend by the end of 2016. Positive fundamentals include both rising asset prices, which bolster wealth and balance sheets, and a strengthening labor market, which supports household income and consumer spending. However, the stronger dollar over the past year constitutes a headwind for net exports and a drag on growth. Uncertain economic conditions abroad, including in China and Europe, pose some risks to this outlook, but overall we view upside and downside risks as roughly balanced.

Solid job growth continues

Economy near full employment

  • Labor market conditions have continued to improve, and the economy is nearing full employment. Job growth has been strong and consistent, jobless claims are near a 40-year low, and the unemployment rate of 5.3% in July indicates that there is very little slack in labor markets. While significant growth in wages and compensation has yet to appear, we expect a pickup in wage growth as labor markets tighten further.

Inflation expected to return to target

  • Inflation remains below the Federal Open Market Committee’s 2% long-run target. We may see some further weakness in overall inflation in the second half of the year due to lower oil prices and a stronger dollar. However, we expect inflation to gradually move back to the target over the medium term as energy prices and the value of the dollar stabilize or reverse direction and as the slack in product and labor markets diminishes.

Financial conditions are supportive

  • Financial conditions have modestly tightened in the first half of this year, as evidenced by a stronger dollar, modestly wider credit spreads, and more volatile global equity prices. However, overall they remain very supportive of aggregate demand and should continue to positively affect economic growth.

Global decline in long-term rates

  • U.S. long-term interest rates have fallen over the past 30 years and are near historic lows. Three facts stand out about this secular decline: First, it has been a global phenomenon, as the decline in the United States was paralleled by a similar trend in most developed countries. Second, the decline was largely unexpected, and forecasters consistently overestimated the future level of interest rates at various points in the past. Third, the decline was evident not only in nominal interest rates but also, and more importantly, in real (that is, inflation-adjusted) interest rates, which drive saving and investment decisions.

Nominal and real rates both falling

  • Structural long-lived changes in the world economy have played an important role in this decline in long-term interest rates. In particular, trend growth of output and productivity has markedly slowed in developed countries—the phenomenon of so-called secular stagnation—which has reduced investment demand. Also, the global saving glut, mostly due to fast-growing emerging market economies with excess saving due to large trade surpluses, has exerted downward pressure on real interest rates. Another important contributing structural factor is the shortage of “safe” assets, such as high-quality government securities, the supply of which is failing to keep up with strong global demand.
  • Cyclical, transitory factors are also keeping long-term interest rates down. In particular, easy monetary policy in developed countries, implemented through low policy rates and quantitative easing, has kept short-term and long-term interest rates low.  In addition, uncertainty surrounding the ongoing euro-area crisis and other related risks has led to precautionary savings and flight-to-safety demand. Finally, deleveraging by households and firms in the aftermath of the financial crisis in order to reduce their debt levels and improve their balance sheets has contributed to the global supply of savings.
  • The eventual reversal of the cyclical factors affecting investment and saving in financial markets should lead to some normalization of long-term interest rates. However, the structural factors are not expected to change rapidly. Hence, there is likely to be a new normal for long-term real rates, which will be different—and lower—than in the past.
  • In such an environment, borrowers would benefit from lower interest rates. On the other hand, savers seeking higher returns may take on more risk. A low interest rate environment would also give less potential room for monetary policy to stimulate economic growth through policy rate changes. In sum, lower real interest rates involve both benefits and risks.     

Thursday, August 13, 2015

'Do Asset Purchase Programs Push Capital Abroad?'

Thomas Klitgaard and David Lucca at the NY Fed's Liberty Street Economics"

Do Asset Purchase Programs Push Capital Abroad?: Euro area sovereign bond yields fell to record lows and the euro weakened after the European Central Bank (ECB) dramatically expanded its asset purchase program in early 2015. Some analysts predicted massive financial outflows spilling out of the euro area and affecting global markets as investors sought higher yields abroad. These arguments ignore balance of payments accounting, which requires any financial outflow from the euro area to be matched by a similar-sized inflow, absent a quick and substantial current account improvement. The focus on cross-border financial flows also is misguided since, according to asset pricing principles, the euro and global asset prices can move without any change in financial outflows. ...
The recent experience with quantitative easing in Japan helps illustrate our point. In late 2012, the yen started to depreciate with the increased likelihood that the country would expand its asset purchase program. In April 2013, when the policy was actually implemented, commentary similar to that on the ECB program anticipated a “wall of money” flowing out of Japan in search of higher yields and affecting global asset prices. Indeed, analysts worried that emerging countries would have trouble absorbing these flows, leading to asset price bubbles. While asset prices and exchange rates adjusted in Japan and abroad, a surge in outflows never occurred. ... The wall of money never materialized.
Nor does euro area data suggest substantial financial outflows. ...
The euro’s fall has been a key channel through which the ECB’s asset purchase policy has affected financial markets in the rest the world. However, the idea that foreign asset prices would be pushed up by a surge in money flowing out of the region, as some observers predicted, runs contrary to balance of payments accounting and asset pricing principles and should be discounted.

Wednesday, August 12, 2015

Worst Forecaster at the Fed

Brad DeLong:

Worst Fed Forecaster: It is quite an accomplishment to both be (a) the worst economic forecaster among your peers, and yet (b) engage in no public reflection and discussion of how and why you got the past wrong, and how you are changing your model of the economy in order to get it less wrong when you forecast in the future.
Charles Plosser has managed that accomplishment.
Those close to him in the WSJ rankings of Fed forecasting success--Bullard, Lacker, Kocherlakota, Williams, and Bernanke--have all discussed, sometimes at great length, what they got wrong, why they think they got it wrong, and what they think they have learned. Not Charles Plosser--at least, nowhere that I have seen. I have not even found any recognition by Charles Plosser that every single year he was President of the Federal Reserve Bank of Philadelphia he did get it wrong, did misjudge the economy, and was recommending monetary policies that would be unduly and inappropriately restrictive. None.

Tuesday, August 11, 2015

'The History of Discount Window Stigma'

Liberty Street Economics with the history of the Fed's discount window:

History of Discount Window Stigma, by Olivier Armantier, Helene Lee, and Asani Sarkar, FRBNY: In August 2007, at the onset of the recent financial crisis, the Federal Reserve encouraged banks to borrow from the discount window (DW) but few did so. This lack of DW borrowing has been widely attributed to stigma—concerns that, if discount borrowing were detected, depositors, creditors, and analysts could interpret it as a sign of financial weakness. In this post, we review the history of the DW up until 2003, when the current DW regime was established, and argue that some past policies may have inadvertently contributed to a reluctance to borrow from the DW that persists to this day.
The Discount Window’s Tradition against Borrowing
The Fed was established in 1913 to create an elastic money supply that would expand to meet high demand for liquidity during times of stress and contract once conditions improved. At that time, there were no open market operations (the buying and selling of government securities in the open market) to conduct monetary policy. Instead, the Fed adjusted the money supply by lending directly to banks through the DW. During these initial years, the DW was used extensively, and there appears to have been no mention of stigma attached to DW borrowing.
From the late 1920s, the DW gradually fell into disuse as the Fed began to take a dim view of DW borrowing and adopted a stance against the practice. The Fed observed that banks were becoming habitual borrowers from the DW, and it was concerned that an overreliance on DW borrowings would weaken banks and make them more prone to failure. Moreover, the Fed had switched to open market operations as its primary tool for conducting monetary policy. Accordingly, it viewed the DW as playing a more subordinate role by providing limited amounts of short-term credit to banks, to meet emergency needs, for example.
Although it discouraged DW borrowing, the Fed generally kept the DW rate below the market rate, in part because the Fed lacked independence from the Treasury and was obliged to keep the DW rate below the market rate to help the federal government finance its deficits at low rates. The Treasury–Federal Reserve Accord of 1951 freed the Fed from pressure from the Treasury, but the Fed continued to maintain the DW rate below the market rate despite recommendations to the contrary. It did so because it believed that banks that legitimately needed DW funds should not face a punitive rate. Thus, between 1914 and 2003, the DW rate was generally below the market rate on banks’ primary sources for short-term funding (in other words, the commercial paper rate before 1954 and the federal funds rate since 1954; see chart below).

Continue reading "'The History of Discount Window Stigma'" »

Tuesday, August 04, 2015

Fed Watch: Gearing Up For Employment Day

Tim Duy:

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


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


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


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


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

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

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

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

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


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

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

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

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

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

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

Saturday, August 01, 2015

'Lehman Brothers Once Again...'

Brad DeLong:

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

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

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

I have two points to make here…

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

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

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

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

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

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

Thursday, July 30, 2015

Fed Watch: GDP Report

Tim Duy:

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


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


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


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

Wednesday, July 29, 2015

Fed Watch: FOMC Recap

Tim Duy:

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


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


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

FOMC Press Release

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

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

Tuesday, July 28, 2015

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

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

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

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

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

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

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

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

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

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

As I've said before, I agree.

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

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

Friday, July 17, 2015

Fed Watch: The Case For September

Tim Duy:

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


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


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


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


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



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


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

Tuesday, July 14, 2015

Fed Watch: More Mediocrity

Tim Duy:

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


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


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

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

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

Monday, July 13, 2015

'Janet Yellen’s Unusual Optimism'

Teresa Tritch of the NY Times editorial board:

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

Thursday, July 09, 2015

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

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

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

Wednesday, July 08, 2015

'Policy Lessons From The Eurodebacle'

Paul Krugman:

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

Wednesday, July 01, 2015

Fed Watch: Ahead of the Employment Report

Tim Duy:

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


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


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


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


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

Monday, June 29, 2015

Fed Watch: Events Continue to Conspire Against the Fed

Tim Duy:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Famous last words.

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

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

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

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

Tuesday, June 23, 2015

Fed Watch: Dovish Fed

Tim Duy:

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

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


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


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

Thursday, June 18, 2015

'Wage Increases Do Not Signal Impending Inflation'

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

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

Wednesday, June 17, 2015

Fed Watch: June FOMC Recap

Tim Duy:

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


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


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

Tuesday, June 09, 2015

'Interest Rates: Natural or Artificial?'

Antonio Fatás:

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

After discussion, he concludes:

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