Category Archive for: Monetary Policy [Return to Main]

Friday, May 29, 2015

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

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

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

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

Wednesday, May 27, 2015

'Do Central Banks Need Capital?'

The start of a longer post from Cecchetti & Schoenholtz

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

Thursday, May 14, 2015

Fed Watch: Get Used To It

Tim Duy:

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

Gdpnow-forecast-evolution

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

CLAIMS051315

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

GDP051315

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

Monday, May 11, 2015

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

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

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

Tuesday, May 05, 2015

'Inflation Expectations and Recovery from the Depression in 1933'

Andrew Jalil and Gisela Rua:

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

Monday, May 04, 2015

Ben Bernanke's Bad Example

At MoneyWatch:

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

Saturday, May 02, 2015

'Assessing the Effects of Monetary and Fiscal Policy'

From the NBER Reporter:

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

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

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

Thursday, April 30, 2015

Fed Watch: Data Note

Tim Duy:

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

PCEa043015

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

PHILLIPS043015

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

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

Brad DeLong:

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

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

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

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

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

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

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

Wednesday, April 29, 2015

Fed Watch: FOMC Snoozer

Tim Duy:

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

GDPa042815

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

GDPb042815

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

Tuesday, April 21, 2015

'An Overwhelming Argument for Draconian Bank Regulation'

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

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

Monday, April 20, 2015

'Labor Market Slack and Monetary Policy'

Let's hope the Fed is listening:

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

[Open link]

Tuesday, April 14, 2015

Sometimes, Boosting Supply Requires More Demand

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

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

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

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

SR-LR-AS-1

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

SR-LR-AS-2

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

SR-LR-AS-3

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

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

Friday, April 03, 2015

Fed Watch: Air Pocket

Fed Watch:

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

NFPa040315

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

NFPc040315

NFPb040315

Broad yet still slow general improvement in underemployment indicators.

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

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

And:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Thursday, April 02, 2015

'Central Bank Solvency and Inflation'

Marco Del Negro and Christopher A. Sims:

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

U.S. Monetar Base

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

'Liquidity Traps, Local and Global'

More on the secular stagnation debate from Paul Krugman:

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

Wednesday, March 25, 2015

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

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

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

The 'Audit' the Fed Crowd

Audit the Fed?:

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

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

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

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

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

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

Tuesday, March 24, 2015

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

Brad DeLong:

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

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

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

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

Wednesday, March 18, 2015

Fed Watch: Yellen Strikes a Dovish Tone

Tim Duy:

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

FOMCa

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

FOMCb

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

FOMCc

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

FOMC Press Release

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

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

Monday, March 16, 2015

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

Tim Duy:

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

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

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

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

Stronger dollar means lower prices of imported items.

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

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

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

Is faster wage growth a precondition to raising interest rates?

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

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

A related question regards the interpretation of the yield curve:

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

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

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

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

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

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

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

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

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

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

Friday, March 13, 2015

Paul Krugman: Strength Is Weakness

Is the rising value of the dollar good news?:

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

Thursday, March 12, 2015

Fed Watch: Will the Dollar Impact US Growth?

Tim Duy:

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

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

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

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

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

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

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

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

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

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

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

Monetary and Fiscal Policy in a Post-Inflation World

Alice Rivlin:

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

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

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

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

Wednesday, March 11, 2015

'Hard Money'

Brad DeLong:

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

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

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

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

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

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

Indeed, it seemed to me not to be coherent:

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

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

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

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

A great and enduring puzzle...

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

Monday, March 09, 2015

Paul Krugman: Partying Like It’s 1995

Patience!:

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

Saturday, March 07, 2015

'Remembrance of NAIRUs Past'

Paul Krugman:

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

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

Friday, March 06, 2015

Fed Watch: 'Patient' is History

Tim Duy:

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

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

NFPa030615

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

NFPb030615

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

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

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

NFPg030615

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

NFPf030615

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

NFPe030615

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

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

Tuesday, March 03, 2015

Fed Watch: Does The Fed Have a Currency Problem?

Tim Duy:

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

PCEa030215

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

PCEb030215

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

PCEc030215

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

DOLLAR030215

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

Monday, March 02, 2015

Fed Watch: Game On

Tim Duy:

Game On, by Tim Duy: Almost too much Fed news last week to cover in one post.

The highlight of the week was Federal Reserve Chair Janet Yellen's testimony to the Senate and House. On net, I think her assessment of the US economy was more optimistic relative to the last FOMC statement, which gives a preview of the outcome of the March 17-18 FOMC meeting. Labor markets are improving, output and production are growing at a solid pace, oil is likely to be a net positive, both upside and downside risks from the rest of the world, and, after the impact of oil prices washes out, inflation will trend toward the Fed's 2% target. To be sure, some challenges remain, such as still high underemployment and low levels of housing activity, but the overall picture is clearly brighter. No wonder then that the Fed continues to set the stage for rate hikes this year. Importantly, Yellen gave the green light for pulling "patient" at the next FOMC meeting:

If economic conditions continue to improve, as the Committee anticipates, the Committee will at some point begin considering an increase in the target range for the federal funds rate on a meeting-by-meeting basis. Before then, the Committee will change its forward guidance. However, it is important to emphasize that a modification of the forward guidance should not be read as indicating that the Committee will necessarily increase the target range in a couple of meetings. Instead the modification should be understood as reflecting the Committee's judgment that conditions have improved to the point where it will soon be the case that a change in the target range could be warranted at any meeting.

She is under pressure from both hawks and moderates to leave June open for a rate hike, which requires pulling "patient" from the statement. But at the same time, they don't want the end of "patient" to be a guarantee of a rate hike in June. And that is the message Yellen sends here.

More broadly, though, Yellen is signaling the end of extensive forward guidance. They don't know how the data will unfold at this point, so they are no longer willing to guarantee one particular monetary policy path or another. This was also the message sent by Federal Reserve Vice Chair Stanley Fischer. Via the Wall Street Journal:

Mr. Fischer said that while many believe the Fed will move rates steadily higher, meeting by meeting, in modest increments, it is unlikely the world will allow that to happen. “I know of no plans to follow one of those deterministic paths,” he said, adding, “I hope that doesn’t happen, I don’t believe that will happen.”

Instead, Mr. Fischer affirmed that whatever the Fed does with short-term rates will be determined by the performance of the economy, which will almost certainly offer the unexpected.

Mr. Fischer said there is value in making sure you don’t take markets “by surprise on a regular basis.” But at the same time, offering too much guidance can shackle monetary policy makers, and “there’s no good reason to telegraph every action.”

It's "game on" for Fed watchers! Figure it out, because the Fed will no longer be holding our hands.

Separately, San Francisco Federal Reserve President John Williams echoes Yellen's assessment of the US economy. Via the Wall Street Journal:

In an interview with The Wall Street Journal, Mr. Williams expressed a good deal of confidence in the U.S. outlook, especially on hiring. He said the jobless rate could fall to 5% by the end of the year, which means the central bank is getting closer to boosting its benchmark short-term interest rate from near zero, where it has been since the end of 2008.

“We are coming at this from a position of strength,” Mr. Williams said. “As we collect more data through this spring, as we get to June or later, I think in my own view we’ll be coming closer to saying there are a constellation of factors in place” to make a call on rate increases, he said.

He also gives guidance on why the Fed will soon be confident that inflation will trend back toward target. It's all about the labor market:

Mr. Williams said it is likely that the Fed will see a hot labor market that should in turn produce the wage pressures that will drive inflation back up to desired levels. He said much of the weakness seen now in price pressures is due to the sharp drop in oil prices, which he said isn’t likely to last.

“The cosmological constant is that if you heat up the labor market, get the unemployment rate down to 5% or below, that’s going to create pressures in the labor market” causing wages to rise, he said.

Williams also bemoans the failure of financial market participants to, as he sees it, catch a clue:

Mr. Williams said there is a “disconnect” between Fed officials’ and markets’ expectations for the path of short-term rates. He said he hopes that can be bridged by effective communication explaining central bank policy choices.

St. Louis Federal Reserve President James Bullard has often stated the same concern, and does so again in yet another interview with the Wall Street Journal:

Mr. Bullard said he is worried financial markets aren’t fully taking on board the likely path of monetary policy, and are underpricing what the Fed will do with interest rates.

“The market is pricing in a later and slower and shallower pace of increases” compared to what central bankers think, the official said. “The mismatch has to get resolved at some point, and I think there’s some risk it could be resolved in a violent way,” which he suspects no one would like to see.

Similarly, New York Federal Reserve President William Dudley warns that the Fed will need to choose a more aggressive rate path if financial market participants don't figure it out after the Fed starts raising rates:

As an example, one significant conundrum in financial markets currently is the recent decline of forward short-term rates at long time horizons to extremely low levels—for example, the 1-year nominal rate, 9 years forward is about 3 percent currently. My staff’s analysis attributes this decline almost entirely to lower term premia. In this case, the fact that market participants have set forward rates so low has presumably led to a more accommodative set of financial market conditions, such as the level of bond yields and the equity market’s valuation, that are more supportive to economic growth. If such compression in expected forward short-term rates were to persist even after the FOMC begins to raise short-term interest rates, then, all else equal, it would be appropriate to choose a more aggressive path of monetary policy normalization as compared to a scenario in which forward short-term rates rose significantly, pushing bond yields significantly higher.

All of which sounds to me like the Fed wants to see the term premium start drifting higher - in other words, the situation is now the opposite of the unintended climb in term premiums during the 2013 "Taper Tantrum" incident.

When will that first hike occur? Far too much attention is placed on that question says Fischer:

He said there has been “excessive attention” paid to the issue of when rates will be lifted, and not enough to attention to what happens with short-term rates once they’ve been boosted off of their current near-zero levels.

That I suspect is correct; I am more interested in how the Fed proceeds after the first rate hike (June still on the table, but I don't know if they will have sufficient data to be confident in the inflation outlook) than the timing of the rate hike itself. Is the Fed really as eager to challenge financial markets as Dudley suggests? I am a little nervous this is shaping up to be a repeat of the Riksbank incident.

Bottom Line: The Fed's confidence in the US economy is driving them closer to policy normalization. The labor market improvements are key - as long as unemployment is falling, confidence in the inflation outlook is rising. The more important message, however, is as the timing of the first rate hike draws closer, the level of uncertainty is rising. And it is not just about the timing of that rate hike. The Fed is sending a clear message that the subsequent path of rates is also very uncertain, and they don't think that uncertainty is being taken seriously by market participants. In their view, financial markets are too complacent about the likely path of interest rates.

Sunday, March 01, 2015

'What is the New Normal for the Real Interest Rate?'

Jim Hamilton:

What is the new normal for the real interest rate?: The yield on a 10-year Treasury inflation protected security was negative through much of 2012 and 2013, and remains today below 0.25%. Have we entered a new era in which a real rate near zero is the new normal? That’s the subject of a new paper that I just completed with Ethan Harris, head of global economics research at Bank of America Merrill Lynch, Jan Hatzius chief economist of Goldman Sachs, and Kenneth West professor of economics at the University of Wisconsin...
For the project we assembled annual data on the interest rate set by the central bank (or close substitute) along with inflation estimates for 20 different countries going back in some cases to 1800, along with more detailed quarterly data since 1970. ...
We found little support in these data for two of the popular conceptions many people have about real interest rates. First, although it is often assumed in theoretical models that there is some long-run constant value toward which the real interest rate eventually returns, our long-run data lead us to reject that hypothesis, consistent with other studies...
We also found little support for the popular assumption that the long-run economic growth rate is the primary factor driving changes in the equilibrium real interest rate over time. ...
We conclude that changes in personal discount rates, financial regulation, trends in inflation, bubbles and cyclical headwinds have had important effects on the average real rate observed over any given decade. We examine the secular stagnation hypothesis in detail. On balance, we find it unpersuasive, concluding that it confuses a delayed recovery with chronically weak aggregate demand. ...
It’s worth remembering that recoveries from financial crises often take many years. ... Our paper reviews a great deal of evidence that leads us to conclude that those who see the current situation as a long-term condition for the United States are simply over-weighting the most recent data from an economic recovery that is still far from complete...
Finally, our paper discusses the implications of these findings for monetary policy. ... We conclude that, given that we do not know the equilibrium real rate, there may be benefits to waiting to raise the nominal rate until we actually see some evidence of labor market pressure and increases in inflation. ...

Thursday, February 26, 2015

'Can Helicopter Money be Democratic?'

Simon Wren-Lewis:

Can helicopter money be democratic?: Helicopter money started as an abstract thought experiment..., in technical terms this is a combination of monetary policy (the creation of money) and fiscal policy (the government giving individuals money). Economists call such combinations a money financed fiscal stimulus. With the advent of Quantitative Easing (QE), it has also been called QE for the people.
Some have tried to suggest that central banks could undertake helicopter money for the first time without the involvement of governments. This is a fantasy that those who dislike the idea of government have concocted. Others who dislike the idea of fiscal policy have suggested that helicopter money is not really a fiscal transfer. That is also nonsense. ...
If initiation by the central bank is the defining feature of helicopter money, and this policy always requires the cooperation of government, might it be possible to imagine a form of helicopter money that was more ‘democratic’? ... A left wing government might decide that, rather than giving money to everyone including the rich, it would be better to increase transfers to the poor. A right wing government might decide it should only go to ‘hard working families’, and turn it into a tax break. We could call this democratic helicopter money.
I can see two problems with democratic helicopter money. ...
Given these problems, why even think about democratic helicopter money? One reason may be political. A long time ago I proposed giving the central bank limited powers to make temporary changes to a small set of predefined tax rates, and I found myself defending that idea in front of the UK’s Treasury Select Committee. To say that the MPs were none too keen on my idea would be an understatement. Making helicopter money democratic may be what has to happen to get politicians to support the idea.

Monday, February 23, 2015

Fed Watch: Yellen Heading to the Senate

Tim Duy:

Yellen Heading to the Senate, by Tim Duy: All eyes will be focused on Federal Reserve Chair Janet Yellen as she presents the semi-annual monetary policy testimony to the Senate Banking Committee. I anticipate that she will stick to an economic outlook very similar to that detailed in the last FOMC statement and related minutes. Expect her to indicate that the Fed is closing in on the time of the first rate hike - after all, this was clearly the topic of conversation at the January FOMC meeting. I anticipate the "Audit the Fed" movement will be on display in the Q&A, which will provide Senators the opportunity to display their ignorance of monetary policy. And with any luck, we will learn how "patient" the Fed really is.
That said, I am wary of expecting much in the way of insight on "patient." The Fed has trapped itself with that language, and I am thinking that it will take the collective power of the FOMC to devise a way out. And they have little choice but to deal with that issue at the March FOMC meeting. The basic problem is this: The hawks would be happy with pulling the trigger on 25bp at the March meeting. The center isn't ready to go along with that, but they want the option of being able to pull the trigger in June. But Yellen, in trying to signal in December that a rate hike was not imminent, linked the term "patient" to two meetings. So if they keep "patient" in the statement, it seems to imply that June is off the table, but that message will brings squeals of unhappiness from the hawks and even leave the center uncomfortable. But just pulling "patient" risks leaving the impression that a June hike is a certainty, which is a message the center doesn't want to send.
If you think this is a dumb way to manage monetary policy, you are correct. Now that the Fed is closer to meeting their employment mandate, they simply cannot credibly signal intentions six months in advance. They need to let the data start doing the work for them, but don't know how to make that transition.  
It something of a shame that Yellen couldn't leave well enough alone in December and let financial market participants believe that "patient" would be used as it had been in 2004. In that case, "patient" would have no time horizon other than that dropping the word "patient" meant that a rate hike was likely just one meeting away. They could credibly manage such a signal. Anything more than one meeting ahead is problematic.
On the economic outlook, I would say that if Yellen were to deviate from the January FOMC meeting, it would be in a generally positive direction. I think they will take the subsequently released upbeat employment report as strong evidence that underlying trends remain solid. The news that Wal-Mart is raising salaries will likely be viewed as just the tip of the iceberg. I doubt anyone on the FOMC believes Wal-Mart leadership acted out of the kindness of their hearts. Yellen herself will probably think something to the effect that "I told you that the quits rate was important."  

RETAILQUITS

Assuming the Greece situation holds together for another 24 hours, that coupled with easing by global central banks in recent weeks will lead FOMC members to believe that global risks have dissipated. And to top it off, US equities pushed back to record highs. What's not to like? Maybe the GDP numbers, but Cleveland Federal Reserve President Loretta Mester gave what I think is the consensus view on the topic:
WSJ: Putting aside the tailwinds that you’re seeing. The growth data look a little soft at the moment.
MESTER: Not really. The fourth quarter came in after two quarters of really robust growth. The employment report actually was revised up for those last couple of months. There is this tendency to look at the last data point. I’m just not that concerned. I think we’ve seen growth pickup. I think there is more momentum in the economy.
Hence why I also don't agonize about what a snowstorm means for monetary policy. It means nothing.
There is plenty on the docket beyond Yellen this week. Existing and new home sales, consumer confidence, regional Fed manufacturing indexes, durables goods orders, CPI, Case-Shiller, GDP revisions, and, if that weren't enough, speeches by Fed Presidents of Atlanta (Lockhart), Cleveland (Mester), and New York (Dudley), and Federal Reserve Governor Stanley Fischer. The fun just won't stop!
Bottom Line:  I expect the Fed will continue to walk the fine line between keeping June in play while signaling that the data will soon justify a rate hike though not necessarily in June. And watch for signs of an effort to shift the focus to the expected gradual pace of rate hikes in an effort to minimize adverse market reaction to the possibility of June. Expect generally positive views of recent data; the Fed thinks the economy is finally on the right path.

Sunday, February 22, 2015

'Helicopter Money and the Government of Central Bank Nightmares'

Simon Wren-Lewis:

Helicopter money and the government of central bank nightmares: If Quantitative Easing (QE), why not helicopter money? We know helicopter money is much more effective at stimulating demand. Helicopter money is a form of what economists call money financed fiscal stimulus (MFFS). In their current formulation independent central banks (ICB) rule out MFFS, because the institution that can do the stimulus (the government) is not allowed to cooperate on this with the institution that creates money (the ICB). In a world where governments - through ignorance or design - obsess about deficits when they should not, it turns out that MFFS or helicopter money is all we have left to prevent large negative demand shocks leading to deep and prolonged recessions. So why is it taboo? 
One reason why it is taboo among central banks is that they want an asset that they can later sell when the economy recovers. QE gives them that asset, but helicopter money does not. The nightmare (as ever with ICBs) is not the current position of deficient demand, but a potential future of excess inflation that they are unable to control. .... Helicopter money ... puts money into the system at the ZLB, in a much more effective way than QE, but it cannot be put into reverse by central banks alone. The central bank cannot demand we pay helicopter money back. [4] 
If the government cooperates, this is no problem. The government just ‘recapitalises’ the central bank, by either raising taxes or selling more of its own debt. Economists call this ‘fiscal backing’ for the central bank. In either case, the government is taking money out of the system on the central bank’s behalf. So the nightmare that makes helicopter money taboo is that the government refuses to do this. [1] ...

After explaining, he concludes

So this nightmare that makes helicopter money taboo is as unrealistic as most nightmares. The really strange thing is that ICBs have already had to confront this nightmare. It is more than possible that when central banks sell back their QE assets, they will make a loss, and so will be faced with exactly the same problem as with helicopter money. [3] A central banker knows better than not to worry about something because it might not happen. So the nightmare has already been faced down. It therefore seems doubly strange that the taboo about helicopter money remains. ...

Wednesday, February 18, 2015

Fed Watch: January FOMC Minutes

Tim Duy:

January FOMC Minutes, by Tim Duy: Minutes from the January FOMC meeting were released today. It is fairly clear that the Fed is gearing up for rates hikes:

Participants discussed considerations related to the choice of the appropriate timing of the initial firming in monetary policy and pace of subsequent rate increases. Ahead of this discussion, the staff gave a presentation that outlined some of the key issues likely to be involved...

The debate sounds familiar. On one side are those concerned that the Fed's zero rate policy will overstay its welcome:

Several participants noted that a late departure could result in the stance of monetary policy becoming excessively accommodative, leading to undesirably high inflation. It was also suggested that maintaining the federal funds rate at its effective lower bound for an extended period or raising it rapidly, if that proved necessary, could adversely affect financial stability...

while on the other side doesn't want to pull the trigger too early:

In connection with the risks associated with an early start to policy normalization, many participants observed that a premature increase in rates might damp the apparent solid recovery in real activity and labor market conditions, undermining progress toward the Committee's objectives of maximum employment and 2 percent inflation. In addition, an earlier tightening would increase the likelihood that the Committee might be forced by adverse economic outcomes to return the federal funds rate to its effective lower bound.

I would say that "many" is greater than "several," which means that as of January, the consensus leaned toward later than sooner. Indeed:

Many participants indicated that their assessment of the balance of risks associated with the timing of the beginning of policy normalization had inclined them toward keeping the federal funds rate at its effective lower bound for a longer time...

Here it would be helpful to know the expected time horizons. How long is a "longer" time? My sense is that the possibility of a March hike was on the table at the request of the hawks, and "longer" meant sometime after March. But when after March? That is data dependent, but the Fed is challenged to describe exactly what conditions need to be met before justifying a rate hike:

Participants discussed the economic conditions that they anticipate will prevail at the time they expect it will be appropriate to begin normalizing policy. There was wide agreement that it would be difficult to specify in advance an exhaustive list of economic indicators and the values that these indicators would need to take.

Still, they have some broad guidelines:

Nonetheless, a number of participants suggested that they would need to see further improvement in labor market conditions and data pointing to continued growth in real activity at a pace sufficient to support additional labor market gains before beginning policy normalization. Many participants indicated that such economic conditions would help bolster their confidence in the likelihood of inflation moving toward the Committee's 2 percent objective after the transitory effects of lower energy prices and other factors dissipate.

It seems then that "many" participants are focused primarily on the labor market. It would be interesting to see how "many" of those "many" saw their confidence increase after the positive January numbers. Others pointed to inflation measures and wages as important indicators:

Some participants noted that their confidence in inflation returning to 2 percent would also be bolstered by stable or rising levels of core PCE inflation, or of alternative series, such as trimmed mean or median measures of inflation. A number of participants emphasized that they would need to see either an increase in market-based measures of inflation compensation or evidence that continued low readings on these measures did not constitute grounds for concern. Several participants indicated that signs of improvements in labor compensation would be an important signal, while a few others deemphasized the value of labor compensation data for judging incipient inflation pressures in light of the loose short-run empirical connection between wage and price inflation.

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

On communication, the Fed sees that is has trapped itself:

Participants discussed the communications challenges associated with signaling, when it becomes appropriate to do so, that policy normalization is likely to begin relatively soon while remaining clear that the Committee's actions would depend on incoming data. Many participants regarded dropping the "patient" language in the statement, whenever that might occur, as risking a shift in market expectations for the beginning of policy firming toward an unduly narrow range of dates. As a result, some expressed the concern that financial markets might overreact, resulting in undesirably tight financial conditions.

If "patient" means exactly two meetings as is widely believed, then why would dropping patient imply higher rates in an "unduly narrow range of dates"? Isn't "two" two? If "two" is two, why the need for the adjective "unduly"? The definition of "unduly" according to the dictionary is:

to an extreme, unreasonable, or unnecessary degree

So "two" is thus extreme or unreasonable? Either "two" isn't two or patient wasn't meant to imply always two meetings. Indeed, Cleveland Federal Reserve President Loretta Mester suggests that "two" is only one interpretation. Via the Wall Street Journal:

WSJ: When you say that, do you have April in mind or do you have June in mind?

MESTER: Given what we’ve communicated, June is a viable date. We have the patient language which has been interpreted as two meetings.

The language "has been interpreted" not "means" two meetings. If "two" is plainly two, how can it have any other interpretation? And "has been interpreted" by whom, for that matter?

You get the point. The Fed can't keep itself from making calendar dependent statements, and thus undermines it's own communications. Yellen should have said "patient" means "until the data says otherwise." But she couldn't help herself by not including some kind of calendar dependent qualifier. As a consequence, now the Fed is stuck with modifying the language to keep a June rate hike on the table.

Wait, is a June rate hike still on the table? Although the minutes were interpreted dovishly by financial market participants, I doubt the Fed will want to pull the plug on June just yet. Incoming Fed speak continues to signal a rate hike is coming (including Mester describing June as a "viable option" this week), the January labor report was solid, via the minutes the Fed sees external risks as dissipating, we have four more employment reports before the June meeting, and I doubt the Fed really wants to start signaling policy two periods in advance. Too early to pull June off the table, but they can't move in June without something solid on the inflation front. So the March statement, or subsequent press conference, will be about dealing with the "patient" language, and the April meeting will be about whether they really expect to move in June or not.

One more consideration. It has been noted that the length of the minutes ballooned in January. Less noted is that the FOMC has a new secretary, Thomas Laubach, who succeeds William English. The additional detail may reflect that change, and the additional detail may swing our interpretation of the minutes relative to past minutes.

Bottom Line: The Fed is plainly focused on raising rates. As a group, they sense the time is coming to begin policy normalization. But they don't yet know when exactly that time will be. They don't yet have everything they need to begin, and they don't know when they will have everything (which is why they need to end calendar-dependent language). We know not yet. June? Maybe, maybe not.

'Betting the House: Monetary Policy, Mortgage Booms and Housing Prices'

How risky is it when interest rates are held too low for too long?:

Betting the house: Monetary policy, mortgage booms and housing prices, by Òscar Jordà, Moritz Schularick, and Alan Taylor: Although the nexus between low interest rates and the recent house price bubble remains largely unproven, observers now worry that current loose monetary conditions will stir up froth in housing markets, thus setting the stage for another painful financial crash. Central banks are struggling between the desire to awaken economic activity from its post-crisis torpor and fear of kindling the next housing bubble. The Riksbank was recently caught on the horns of this dilemma, as Svensson (2012) describes. Our new research provides the much-needed empirical backdrop to inform the debate about these trade-offs.
The recent financial crisis has led to a re-examination of the role of housing finance in the macroeconomy. It has become a top research priority to dissect the sources of house price fluctuations and their effect on household spending, mortgage borrowing, the health of financial intermediaries, and ultimately on real economic outcomes. A rapidly growing literature investigates the link between monetary policy and house prices as well as the implications of house price fluctuations for monetary policy (Del Negro and Otrok 2007, Goodhart and Hofmann 2008, Jarocinski and Smets 2008, Allen and Rogoff 2011, Glaeser, Gottlieb et al. 2010, Williams 2011, Kuttner 2012, Mian and Sufi 2014).
Despite all these references, there is relatively little empirical research about the effects of monetary policy on asset prices, especially house prices. How do monetary conditions affect mortgage borrowing and housing markets? Do low interest rates cause households to lever up on mortgages and bid up house prices, thus increasing the risk of financial crisis? And what, if anything, should central banks do about it?
Monetary conditions and house prices: 140 years of evidence
In our new paper (Jordà et al. 2014), we analyse the link between monetary conditions, mortgage credit growth, and house prices using data spanning 140 years of modern economic history across 14 advanced economies. Such a long and broad historical analysis has become possible for the first time by bringing together two novel datasets, each of which is the result of an extensive multi-year data collection effort. The first dataset covers disaggregated bank credit data, including real estate lending to households and non-financial businesses, for 17 countries (Jordà et al. 2014). The second dataset, compiled for a study by Knoll et al. (2014), presents newly unearthed data covering long-run house prices for 14 out of the 17 economies in the first dataset, from 1870 to 2012. This is the first time both datasets have been combined. ...

After lots of data and analysis, they conclude:

... We have established that loose/tight monetary conditions make credit cheaper/dearer and houses more expensive/affordable. But what about the dark side of low interest rates – do they also increase the risk of a financial crash?
The answer to this question is clearly affirmative, as we show in the last part of our paper using crisis prediction models. Over the past 140 years of modern macroeconomic history, mortgage booms and house price bubbles have been associated with a higher likelihood of a financial crisis. This association is even stronger in the post-WW2 era, which was marked by the democratization of leverage through the expansion of housing finance relative to GDP and a rapidly growing share of real estate loans as a share of banks’ balance sheets.
Conclusion
Our findings have important implications for the post-crisis debate about central bank policy. We provide a quantitative measure of the financial stability risks that stem from extended periods of ultra-low interest rates. We also provide a quantitative measure of the effects of monetary policy on mortgage lending and house prices. These historical insights suggest that the potentially destabilizing by-products of easy money must be taken seriously and considered against the benefits of stimulating flagging economic activity. Policy, as always, must strike a fine balance between conflicting objectives.
An important implication of our study is that macroeconomic stabilization policy has implications for financial stability, and vice versa. Resolving this dichotomy requires central banks to make greater use of macroprudential tools alongside conventional interest rate policy. One tool is insufficient to do two jobs. That is the lesson from modern macroeconomic history. ...

Monday, February 16, 2015

'The Congressional Reserve Board: A Really Bad Idea'

Cecchetti & Schoenholtz:

The Congressional Reserve Board: A Really Bad Idea: “We are – I’ll be blunt – audited out the wazoo. Every Federal Reserve Bank has a private auditor. We have our auditor of the system. We have our own inspector general. We are audited. What he’s talking about is politicizing monetary policy.” Richard Fisher, President, Federal Reserve Bank of Dallas, Dallas Morning News, February 9, 2015.
What would you think if you were to open your morning newspaper to find the following headline?
“Congress Closes Down Fed, Takes Over Monetary Policy”
If you’re like us, you’d panic. In short order, you’d think that long-term inflation expectations would rise, pushing bond yields higher. You’d anticipate an increase in the volatility of growth, employment and inflation. That more volatile environment would drive up the risk premium required on new investments, hindering long-term economic growth. Finally, you'd be very worried about how these Congressional policymakers would manage the next financial crisis.
This is not a pretty picture. Why would anyone want it to become a reality? Well, these are surely not the intended goals, but they are the likely outcomes should lawmakers ever replace the Federal Reserve Board with what we would call a Congressional Reserve Board.
While the Federal Reserve Transparency Act of 2015 – aka, the “Audit the Fed” Act – doesn’t shut down the Federal Reserve, it would go a long way to putting Congress directly in charge of monetary policy and to weakening the Fed’s effectiveness as a lender of last resort.
To explain our concerns, we will start by describing why it has become almost universally accepted practice to make the institution setting monetary (and regulatory) policy independent of political interference. That is, why most advanced and emerging market economies have opted to make their central banks “independent.” We will also explain why the “Transparency Act” is really about controlling monetary policy, not about making the Fed accountable (the short answer: it already is). And, finally, we will explain the bill’s impact on the Fed’s lender of last resort powers. ...

Friday, February 13, 2015

Paul Krugman: Money Makes Crazy

Why are conservatives so crazy about money?:

Money Makes Crazy, by Paul Krugman, Commentary, NY Times: Monetary policy probably won’t be a major issue in the 2016 campaign, but it should be. It is, after all, extremely important, and the Republican base and many leading politicians have strong views about the Federal Reserve and its conduct. And the eventual presidential nominee will surely have to endorse the party line.
So it matters that the emerging G.O.P. consensus on money is crazy — full-on conspiracy-theory crazy. ...
So monetary crazy is pervasive in today’s G.O.P. But why? Class interests no doubt play a role — the wealthy tend to be lenders rather than borrowers, and they benefit at least in relative terms from deflationary policies. But I also suspect that conservatives have a deep psychological problem with modern monetary systems.
You see, in the conservative worldview, markets aren’t just a useful way to organize the economy; they’re a moral structure: People get paid what they deserve, and what goods cost is what they are truly worth to society. ...
Modern money — consisting of pieces of paper or their digital equivalent that are issued by the Fed, not created by the heroic efforts of entrepreneurs — is an affront to that worldview. Mr. Ryan is on record declaring that his views on monetary policy come from a speech given by one of Ayn Rand’s fictional characters. And what the speaker declares is that money is “the base of a moral existence. Destroyers seize gold and leave to its owners a counterfeit pile of paper. ... Paper is a check drawn by legal looters.”
Once you understand that this is how many conservatives really think, it all falls into place. Of course they predict disaster from monetary expansion, no matter the circumstances. Of course they are undaunted in their views no matter how wrong their predictions have been in the past. Of course they are quick to accuse the Fed of vile motives. From their point of view, monetary policy isn’t really a technical issue, a question of what works; it’s a matter of theology: Printing money is evil.
So as I said, monetary policy should be an issue in 2016. Because there’s a pretty good chance that someone who either gets his monetary economics from Ayn Rand, or at any rate feels the need to defer to such views, will get to appoint the next head of the Federal Reserve.

Wednesday, February 11, 2015

'A Fed Insider Calls for Reform'

Hmm. I must be missing something, for once I don't strongly disagree with Richard Fisher:

A Fed Insider Calls for Reform, by James Freeman, WSJ: Richard Fisher, President of the Federal Reserve Bank of Dallas, believes “there’s too much power concentrated in the New York Fed.” And that goes as well for the Fed’s Washington headquarters. ... It’s ... an effort to head off Congressional efforts that Mr. Fisher believes could threaten the independence of the central bank. ...
To reform the Fed while maintaining its independence, Mr. Fisher first proposes to end the long tradition of the New York Fed President serving as the vice chairman of the FOMC. ...
Mr. Fisher would further boost representation for those outside of Washington and New York. Today, the Washington-based Fed governors and the Chairman hold a total of seven votes on the FOMC. That would not change. But whereas today New York gets a permanent seat and the other 11 regional banks take turns sharing four remaining seats, the regional banks would hold six seats under the Fisher plan. New York would lose its permanent seat and instead take its turn in the rotation for one of the six regional seats. So the Fed governors and Chairman, selected by the President and confirmed by the Senate, would still have a majority on the FOMC, but power would be further dispersed outside of the Acela corridor. ...
And to address “the potential for regulatory capture,” Mr. Fisher says that teams in charge of supervision of a “systemically important” bank should come from a district outside where the giant bank is based. ...

There is resistance to giving the regional banks more power (in part because of people like Fisher), but I think the Fed is viewed suspiciously by most. If we can make typical households believe the Fed is representing their interests, it would help. Not sure this proposal is the best way to do that, but I do feel that most people have the perception (as opposed to the reality) that the Fed has been captured by interests other than their own.

Tuesday, February 10, 2015

Fed Watch: Fedspeak Points To June

Tim Duy:

Fedspeak Points To June, by Tim Duy: Federal Reserve speakers were out and about today. First off, Richmond Federal Reserve President Jeffrey Lacker set a fairly high bar for NOT hiking in June. Via the Wall Street Journal:
“At this point, raising rates in June looks like the attractive option for me,” Mr. Lacker told reporters following a speech Tuesday in Raleigh, N.C. “Data between now and then may change my mind, but it would have to be surprising data.”...
...“The economy’s clearly growing at a more rapid, sustained pace than it was a year ago,” he said. “Economies that are growing faster need higher real interest rates, and a variety of indicators point to the need for higher real rates.”
What about inflation? It is all about oil:
Mr. Lacker said the effects of lower gasoline prices on inflation should be transitory, and he expects inflation will move back toward the Fed’s 2% annual target over the next year or two. “The inflation rate was clearly moving towards 2% before oil prices began falling last summer,” he said.
Here I worry, because Lacker is clearly ignoring the data, or least weighing the year-over-year changes far too heavily. Inflation actually accelerated in the second half of 2013, but was clearly decelerating by the beginning of 2014 (right idea, wrong dates) first half of 2014, but was clearly decelerating by June, prior to the oil shock. By July, the 3-month annualized change in core was just 0.97% while oil was still above $100 and gas above $3.50:

PCEb020215

But the Fed is close to achieving the employment mandate, so inflation data be damned! Still think the employment part of the dual mandate is really a good idea?
San Francisco Federal Reserve President John Williams digs in his heals and assures us a rate hike is coming. Via the Financial Times:
John Williams, president of the Federal Reserve Bank of San Francisco, said the time for the US central bank to start raising rates is getting “closer and closer” amid faster-than-expected wage rises in January and “really strong” hiring. Some investors may be caught out by a rate increase, but that should not stop the Fed from tightening policy if necessary, he said.
What about inflation? No problem, it is all about the lags:
...Economists including Lawrence Summers, a former US Treasury secretary, have urged the Fed to leave rates unchanged until there is clear evidence that inflation, and inflation expectations, are set to breach its 2 per cent target.
However Mr Williams dismissed such calls, warning of the risk that the Fed gets behind the curve on inflation and that it could end up being forced to hike rates “much more dramatically” to rein in inflation, provoking market turmoil. Given the trails with which monetary policy operates it was better to start raising interest rates “gradually, thoughtfully”, he said.
Note that he pulled out the "if we don't hike now we will need to hike more later" argument. That, along with the financial stability argument, is how they will justify a rate increase in the absence of inflation. Williams, however, hedges on June:
A key question obsessing financial markets is whether the Fed pulls the trigger in the middle of the year or waits longer. Mr Williams did not commit himself to voting for a move in June, saying instead that the decision of whether to hike or delay a bit longer would be “in play” at that point.
Time is growing short for the wage gains necessary to begin hiking in June.
Importantly, Williams also rejects the idea that bond markets are signaling secular stagnation:
He dismissed arguments that low long-term bond yields in the US reflect fears of a gloomy outlook for the American economy, saying they more likely were a result of global financial conditions, amid slowdowns and policy easing in large parts of the rest of the world.
US policy would still be very accommodative even after the Fed raised rates, he stressed. “That first step of raising interest rates is just removing a sliver of that accommodation,” he said.
The last paragraph is key. Williams, like the rest of the FOMC argues that conditions will remain very accommodative after even a small rate hike. As I noted last night, this is not true under the secular stagnation hypothesis:

TAYLORb020815

It would be interesting if we had William's estimate of the equilibrium rate for comparison. Wait, we do - from his January 2014 Brookings paper:

WILLIAMS021015

Oh my, that brownish-greenish line appears to be a fairly pessimistic estimate of the natural rate, certainly one inconsistent the assertion that conditions remain accommodative after even just a small rate hike. Perhaps some journalists should start pressing Williams on the policy implications of his research. And, for that matter, I think the Fed's view on the equilibrium real rate should be a front-and-center topic for the next FOMC press conference.
Meanwhile, soon-to-retire Dallas Federal Reserve President Richard Fisher is pegging his rate outlook to wage gains:
“If we were to see employment continue to increase, we’re getting much, much better on that front and you begin to see the wage price pressures, that should govern what we do with interest rates.”
The Fed simply has no justification to raise rates in June absent acceleration in wage growth. Even Fisher agrees. Fisher also pushes back against the renewed "Audit the Fed" movement:
“We are — I’ll be blunt — we are audited out the wazoo. Every Federal Reserve Bank has a private auditor. We have our auditor of the system. We have our own inspector general. We are audited. That’s not what he’s talking about. What he’s talking about is politicizing monetary policy.”
That's the plain truth. It has nothing to do with economics, and everything to do with politics.
Bottom Line: The Fed wants to hike in June. They continue to dismiss the inflation data, but they still need wage growth to hike. They dismiss the secular stagnation hypothesis. I hope they are right on that, or this is going to get ugly. Quickly.

Sunday, February 08, 2015

Only Raise Rates when Whites of Inflation’s Eyes are Visible

Larry Summers:

Only raise US rates when whites of inflation’s eyes are visible: ... Especially after Friday’s very strong employment report, there can be no doubt that cyclical conditions are normalising. ... All of this taken in isolation would suggest that interest rates should not remain at zero much longer.
On the other hand, the available inflation data suggests little cause for concern. ... Perhaps most troubling: market indications suggest inflation is more likely to fall than rise .
The Fed has rightly made clear that its decisions will be data dependent. The further key point is that it should allow the flow of information on inflation rather than on real economic activity to determine its timing in adjusting interest rates. And it should not raise rates until there is clear evidence that inflation, and inflation expectations, are in danger of exceeding its 2 per cent target. Here are four important reasons why. ...

Friday, February 06, 2015

Fed Watch: Upbeat Jobs Report

Tim Duy:

Upbeat Jobs Report, by Tim Duy: The January jobs report came in above expectations, with nonfarm payrolls growing by 257k and, more importantly, there were large upward revisions to the previous two months. Simply put rumors of the demise of the US economy continue to be premature.
The pace of job gains accelerated further on average:

NFPa020615

Oil and gas extraction jobs declined by 1.9k, but we all know more are coming. But outside of that sector, the economy added 255k jobs. The oil and gas extraction sector itself is only 200k jobs. In short, the fears that this sector is going to topple the US economy are just simply not going to come to pass.
In the context of data Federal Reserve Chair Janet Yellen has previously signaled as important:

NFPc020615

NFPd020615

Ongoing general improvement with measures of underemployment still elevated. There was some excitement about the 12 cent gain in average hourly earnings. I myself am less impressed as to me this largely represents a correction from December's anomalous drop. Wage growth remains fairly anemic year-over-year:

NFPb020615

I would also like to see what happens after the impact of minimum wage hikes dissipates. The Fed, however, my take more comfort in the uptick than me. It goes without saying that a June rate hike remains on the table, although I think it is difficult to justify without faster wage growth. Still four jobs reports till then, so plenty of time to pull that number upward.
Jon Hilsenrath reiterates the view that if the Fed wants to keep the June option open they need to pull the word "patient" in March:
Second, Fed officials will decide at their March meeting whether to change or drop the language in their policy statement pledging to “be patient” in deciding when to raise their benchmark short-term interest rate from zero. That phrase means they won’t move for at least two more meetings.
After the March gathering, the Fed has meetings scheduled for April and June. If the policy makers keep the “patient” language in the statement, that would indicate they don’t think they’ll raise rates at those meetings. If they scrap the phrase, that would give them the option to move as early as June if the economic data hold up.
I doubt this is as black and white as Hilsenrath argues. I don't think Yellen intended to imply that "patient" always means two meetings. Perhaps I just have too many memories about "considerable time" first meaning six months and then not. Plus, the Fed is aware of its past history, and in 2004 "patient" turned to "moderate" just one meeting before the hike. But it was technically the second meeting after "patient" was dropped, so is that two meetings? Also, as we saw with the "considerable" to "patient" transition, the Fed has its own unique way of wordsmithing that can deliver something for everyone. And finally, Yellen has the press conference to redefine her interpretation of "patient." But maybe I am wrong. In any event, I am not taking a fixed stand on what "patient" means until the press conference.
Bottom Line: The US economy has very real momentum on its side at the moment. It is more resilient to shocks than commonly assumed. This isn't 2011. June is still on the table.

Thursday, February 05, 2015

Fed Watch: Fed Updates

Tim Duy:

Fed Updates, by Tim Duy: Some quick notes on monetary policy this afternoon:

1.) Another policymaker in favor of a first half rate hike.  Cleveland Federal Reserve President Loretta Mester supports a rate hike by June.  Via Michael Derby at the Wall Street Journal:

Expressing confidence weak inflation will eventually rise again, Federal Reserve Bank of Cleveland President Loretta Mester said Wednesday the U.S. central bank remains on track for raising rates in the next few months.

Noting that Fed policy isn’t on a “pre-set path,” Ms. Mester said “if incoming economic information supports my forecast, I would be comfortable with liftoff in the first half of this year.” Because Fed policy actions affect the economy over a long period of time, the central banker said the Fed will need to act before it has fully achieved its job and price mandates.

She is, however, watching the survey data:

The official told reporters after her speech that if inflation expectations began to weaken, especially ones derived from surveys, “that would give me pause” when it comes to advocating for rate increases.

While the timing of any policy move remains in flux, Mester's basic story is close to consensus: The Fed is looking at putting the economy on a glide path to achieving its mandates, which means moving ahead of those mandates.

2.) But another is pointing out the danger of low inflation. Boston Federal Reserve President Eric Rosengren doesn't speak to the timing of rate hikes, but low inflation is clearly on his mind:

Of course today, after significant labor market improvement, and with the horizon over which inflation will return to its target being uncertain, inflation has taken on a more prominent role in our deliberations.

Currently, an obvious caveat in interpreting the low inflation rate in the U.S. is the supporting role played by the recent decline in energy prices. Oil shocks have been associated with major changes in monetary policy before. The failure to control inflation in the United States during the 1970s, in the presence of an adverse oil supply shock, highlighted a serious dilemma facing monetary policy at that time. Importantly in that case, what might have been a temporary pass-through of oil to non-oil prices turned into a more lasting problem with overall inflation, as wage and price dynamics at that time helped turn increases in oil prices into fairly protracted increases in overall inflation. Former Federal Reserve Board Chairman Volcker is rightfully recognized for taking forceful action to address the situation and ultimately tame inflation in the United States.

Currently, a concern is that central banks are facing the mirror image of the problem in the 1970s. The problem of significantly undershooting inflation – a dynamic which could well keep interest rates at the zero lower bound – is likely to be a key challenge to central bankers in the first two decades of the 21st century. And I would say that as with the oil shock in the 1970s, the current shock has served to accentuate a potential monetary policy pitfall – in this case, the failure to quickly and vigorously address a significant undershooting of inflation targets, potentially leaving economies stagnant at the zero lower bound. 

He would support later rather than sooner with regards to the first rate hike.  

3.) Fed ready to lower NAIRU?  I have argued in the past that if the Fed is faced with ongoing slow wage growth, they would need to reassess their estimates of NAIRU.  Cardiff Garcia reminded me:

@TheStalwart @TimDuy Whether/extent to which Fed reverts nat-rate estimates to pre-2010 range is one of 2015's big Qs pic.twitter.com/CKieHx2zRC

— Cardiff Garcia (@CardiffGarcia) February 4, 2015

While David Wessel adds today:

JPMorgan run the Fed's statistical model of the economy and says the NAIRU (which was 5.6%+ through 2013 data) is now down to 5%.

— David Wessel (@davidmwessel) February 5, 2015

Jim O'Sullivan from High Frequency Economics says not yet:

"Hard-to-fill" @NFIB jobs series up to 26 in Jan (+1). Corroborates unempl decline, with no sign of lower #NAIRU pic.twitter.com/DVYGyGV4e6

— Jim O'Sullivan (@osullivanEcon) February 5, 2015

A reduction in the Fed's estimate of the natural rate of unemployment would likely mean a delayed and more gradual path of policy tightening, should of course the Fed ever get the chance to pull off the zero bound.  Keep an eye on this issue!

4.) Will the Fed remain "patient" in March?  Jon Hilsenrath at the Wall Street Journal says the Fed needs to remove "patient" from the FOMC statement in March if they want to move in June:

The “patient” assurance, Fed chairwoman Janet Yellen has said, means no rate increases for at least two more policy meetings. The next two policy meetings after March are in April and June. If officials think they might raise rates in June, they need to remove “patient” in March to give themselves the option to proceed if economic data justify a move by June.

Interesting - this is a stricter interpretation of "patient" than I had from Yellen's comments. I did not think that "patient" would always mean just two more meetings, only that in December "patient" meant two more meetings. During the last rate hike cycle, the Fed maintained "patient" until March, switched to "measured" in May, and hiked in June. So they hiked the second meeting after the last "patient." Does that meet the definition that Yellen gave in December? I don't know, but I an not sure she meant to imply that "patient" always and forever means no hike for the next two meetings. So I guess we have our first question for the next press conference. At the moment, following the last cycle, I don't think that keeping "patient" means they are taking June off the table.

5.) Employment report watch.  Calculated Risk notes that Goldman Sachs cut their forecast for tomorrow's employment report to a 210k gain in nonfarm payrolls and a 5.5% unemployment rate, at the low end of consensus and similar to my forecast. But the January number might be an even bigger crapshoot than usual anyway. Via Bloomberg:

 A significant risk to the January payroll print is that the seasonal adjustment may not be properly calibrated. If employers added more seasonal workers than usual based on a firmer assessment of economic conditions, then there may be more layoffs in January. If the seasonal factors do not properly account for this, then a weaker-than-expected payroll gain could result.

And note that one number doesn't make a trend:

Underlying labor market momentum is largely being sustained, as economic growth remains decent, albeit slower than the mid-year hot streak between Q2 and Q3 of 2014. As such, if January employment disappoints, it is probably an anomaly related to seasonal adjustment issues, not a meaningful downshift in the pace of hiring.

The ongoing improvement in consumer attitudes is an encouraging sign that households continue to sense a healthy labor market.

6.) Falling interest rates worldwide. The global push for easier monetary policy continues. China's central bank is now officially in easing mode, while the Danish Central Bank moves deeper into negative territory. The Fed wants to be able to move in the opposite direction, but financial markets are telling them this isn't the time to move off of zero. The Fed will resist - this isn't 2011 when the US economy was much further from reaching its employment mandate than it is today. That said, they eventually had to relent and ease in 1998, so holding steady would be familiar territory (they are not bringing QE back to life yet). But will they worry that easing then helped sustain an asset bubble, a situation they do not want to repeat? Increasingly, the Fed looks to be back in a place they hoped they had left behind - between a rock and a hard place.

And with that we await tomorrow's employment report. Sorry I don't have time to give each of these topics the time they deserve.

Wednesday, February 04, 2015

Fed Optimism Could Cost the Economy Dearly

Me, at MoneyWatch:

Fed optimism could cost the economy dearly: Is the Fed overoptimistic about where the economy is headed? If so, that could cause the central bank to raise interest rates too soon, a policy error that could leave the economy stuck in a "deflationary trap" and remain at subpar growth levels for an extended time period.
The answer to that question is yes. The Fed's tendency to be overly optimistic about the economy is documented in a recent Economic Letter from the San Francisco Fed. In the Economic Letter, Kevin Lansing and Benjamin Pyle note that the Fed's economic forecasts "(1) did not anticipate the Great Recession that started in December 2007, (2) underestimated the severity of the downturn once it began, and (3) consistently overpredicted the speed of the recovery..."
The following two charts presented along with the researchers' findings show how far off the Fed's projections for the economy have been...
This had consequences. Although the central bank's monetary policy was much better than Washington's fiscal policy, the "green shoots" the Fed saw around every corner often caused policymakers to be too slow to put new policy in place (e.g. to turn from interest rate policy to quantitative easing, and then to new rounds of quantitative easing), and to be less aggressive than needed. ...
The risk now is that the Fed will repeat these mistakes. ...

Tuesday, February 03, 2015

Fed Watch: Brief Comment

Tim Duy:

Brief Comment, by Tim Duy: It is always interesting to see how others perceive you. For instance, I wasn't sure what to make of this from Paul Krugman:

The monetary-policy gap between insiders and outsiders — between economists at the Fed and other policy institutions, who still seem eager to raise rates, and those of us on the outside, who think this is a really, really bad idea — continues to widen. This morning Tim Duy — one of the outsiders who, commenting from his perch at Mark Thoma’s invaluable blog, has seemed most sympathetic to the urge to hike rates — joins the what-are-they-thinking chorus.

When I read that I realized that perhaps I wasn't defining my space quite right. Primarily, I attempt - albeit, admittedly, not always successfully - to understand the world as Federal Reserve policymakers see it. Failing to put your personal opinion in the background is one of the biggest mistakes a Fed Watcher can make. Right now, for example, policymakers are somewhat hawkish relative to market expectations, so my writing has a hawkish tilt, which is what I think Krugman interprets as "sympathetic." 

Occasionally, however, my opinions become more evident, which is what Krugman interprets as joining the "what-are-they-thinking chorus."  In truth I am not particularly sympathetic with the Federal Reserve's campaign to normalize policy. That campaign is predicated on the belief that the economy is close to full employment. Krugman sees the natural rate of unemployment as mostly likely below 5%. I concur. The Fed's Summary of Economic Projections, however, places the natural rate in the 5.2-5.5% range. My thinking is that is as much as 0.5 percentage points or even more too high. That is a big, big error, somewhere around 800,000 real lives impacted. A lot of jobs to risk when inflation is trending downward, in my opinion.

I also believe that the fact that we have experienced two recessions since 1991 yet no outbreak of inflation is prima facie evidence that the Fed, on average, maintains too tight a monetary policy.  Seems likely a little bit looser policy would yield significant welfare gains.

Anyway, I think readers probably get the idea at this point. My expectations of a particular Fed policy does not necessarily indicate support for that policy. In future writing I will endeavor to more clearly delineate between the two.

'Tough Fedding'

Paul Krugman hopes the Fed is listening:

Tough Fedding: The monetary-policy gap between insiders and outsiders — between economists at the Fed and other policy institutions, who still seem eager to raise rates, and those of us on the outside, who think this is a really, really bad idea — continues to widen. This morning Tim Duy — one of the outsiders who ... has seemed most sympathetic to the urge to hike rates — joins the what-are-they-thinking chorus. Core inflation is drifting downward, not upward, and is now well below the Fed’s target. So why hike?
The immediate answer appears to be a fixation on the unemployment rate, which is close to standard estimates of full employment. But is this really a solid justification for raising rates absent any actual sign of the rising inflation we’re supposed to see at full employment?
Actually, what do we mean by full employment, anyway? ...
You don’t want to push this too hard, but my point is that recent data are perfectly consistent with the view that full employment requires an unemployment rate below 5 percent; the most recent data would suggest an even lower rate. This might or might not be right; I don’t know. But the Fed doesn’t know either.
And in the face of that uncertainty, the crucial question is what happens if you’re wrong. And the risks still seem hugely asymmetric. Raise rates “too late”, and inflation briefly overshoots the target. How bad is that? (And why does the Fed sound increasingly as if 2 percent is not a target but a ceiling? Hasn’t everything we’ve seen since 2007 suggested that this is a very bad place to go?) Raise rates too soon, on the other hand, and you risk falling into a deflationary trap that could take years, even decades, to exit.
I really, really hope this is getting through.

Monday, February 02, 2015

'Persistent Overoptimism about Economic Growth'

An SF Fed Economic Letter from Kevin Lansing and Benjamin Pyle:

Persistent Overoptimism about Economic Growth: In November 2007, the Federal Open Market Committee began releasing projections for real GDP growth four times per year in its Summary of Economic Projections (SEP). The SEP reports the central tendency and range for real GDP growth forecasts from the Federal Reserve Board members and Federal Reserve Bank presidents. Over the past seven years, many growth forecasts, including the SEP’s central tendency midpoint, have been too optimistic. In particular, the SEP midpoint forecast (1) did not anticipate the Great Recession that started in December 2007, (2) underestimated the severity of the downturn once it began, and (3) consistently overpredicted the speed of the recovery that started in June 2009. The SEP growth forecasts have typically started high, but then are revised down over time as the incoming data continue to disappoint. Similar patterns are observed in the consensus private-sector growth forecasts compiled by the Blue Chip Economic Survey. This Economic Letter reviews the SEP’s track record of forecasting growth and considers some explanations for the optimistic bias. ...

Fed Watch: Fed's Preferred Inflation Measure Dives

Tim Duy:

Fed's Preferred Inflation Measure Dives, by Tim Duy: Not only is core-PCE inflation on a year-over-year basis trending away from the Fed's target:

PCEa020215

but the deceleration in recent months is truly shocking:

PCEb020215

It is hard to see how the Fed can be confident that inflation with trend back to target when looking at these numbers. They need some acceleration in wage growth to justify their intentions to begin normalizing policy, and even with such acceleration, I think their case is fairly weak in the context of the current inflation environment. If they make a case, they will base it on these three pillars:

1.) With unemployment nearing 5%, they have reached their employment mandate.
2.) Monetary policy is exceptionally accommodative even if they raise interest rates.
3.) Failure to raise rates invites asset bubbles.

On point three, refer to New York Federal Reserve President William Dudley:

Quickly, let me give two examples that illustrate how variable this linkage can be.  First, during the 2004-07 period, the FOMC tightened monetary policy nearly continuously, raising the federal funds rate from 1 percent to 5.25 percent in 17 steps.  However, during this period, 10-year Treasury note yields did not rise much, credit spreads generally narrowed and U.S. equity price indices moved higher.  Moreover, the availability of mortgage credit eased, rather than tightened.  As a result, financial market conditions did not tighten.  

As a result, financial conditions remained quite loose, despite the large increase in the federal funds rate.  With the benefit of hindsight, it seems that either monetary policy should have been tightened more aggressively or macroprudential measures should have been implemented in order to tighten credit conditions in the overheated housing sector.

It may be that the Fed looks at the tech and housing bubble episodes and concludes that zero interest rates are not desirable even if inflation is below trend. Yes, I know, macroprudential before interest rates when addressing asset bubbles. But at a point when the economy is at the Fed's idea of full-employment, and given the events of recent decades? Easy to see the Fed seeing danger in putting all of their eggs in the macroprudential basket. 

Bottom Line: Below trend inflation as the economy nears full-employment is a very uncomfortable position for the Federal Reserve. It will be interesting to see how Federal Reserve Chair Janet Yellen navigates these waters at the upcoming Congressional testimony.

Fed Watch: As of Yet, Fed Not Changing Tune

Tim Duy:

As of Yet, Fed Not Changing Tune, by Tim Duy: Early salvos by Federal Reserve policymakers in the wake of last week's FOMC non-event suggest that recent developments have had little impact on Fed thinking with regards to the appropriate timing of rate hikes. The middle of this year remains the internal forecast. Whether data or events cooperate is of course another question.

I think it is worth viewing Friday's two interviews with St. Louis Federal Reserve President James Bullard at Bloomberg and San Francisco Federal Reserve President John Williams at CNBC. Bullard is fairly clear in his view that financial markets are doing it wrong:

“The market has a more dovish view of what the Fed is going to do than the Fed itself,” Bullard said in an interview Friday in New York. “Markets should take it at face value” from the Fed’s rate projections, and it’s “reasonable” to expect an increase in June or July.

In contrast, I would say that Williams is a bit more cautious:

Given this projection, Williams said he thought "around the middle of this year is the time that I think, in my view, that we'll be getting closer to 'Should we raise rates now, or should we wait a little longer, collect some more data, get more confidence in the forecast?'"

The baseline story, however, is generally the same. They believe the US economy has sufficient momentum to weather any external shocks. They both view the first quarter GDP report as consistent with their underlying forecast. So did I, for that matter. You need to be able to tease out the underlying trend when parsing the data. Calculated Risk gets it right. R-E-L-A-X:

There are legitimate concerns about a strong dollar, and weak economic activity overseas, impacting U.S. exports and GDP growth. However, overall, the Q4 GDP report was solid.

In short, neither Williams nor Bullard is seeing anything in the recent data to worry them significantly. Regarding the timing of a rate hike, I think that if you view the videos, you will see a line of logic fairly similar to what I described last week. They see unemployment falling to 5% or less this year. They do not think that such a situation as consistent with zero rates. They think they need to move ahead of actual inflation. They think that even after hiking rates, monetary policy will remain accommodative.

A couple of clarifications and extensions:

First, my take is that the Fed wants to pull the focus off of the first rate increase to the subsequent path of policy. What comes first is not as important as what comes after. The "comes after" is one reason they want to move sooner than later given the current economic environment. Bullard views it important to narrow the gap between zero and normal rates because he fears that falling behind the curve will necessitate a steeper subsequent policy path. This thinking is probably endemic within the Federal Reserve.

Second, notice that again Bullard dismisses market-based measures of inflation expectations as distorted by the massive drop in the price of oil. And his opinion is not illogical: There is no reason to think 5y5y forward exceptions to be impacted in lock step with the collapse in oil prices. He wants to see how that situation plays itself out.

Third, Bullard says that we are 400bp below normal policy and that his view of normal policy has not changed much. There is no new normal. This too I think is endemic in Fed thinking and where I think lies the greatest potential for a policy error. They should not be holding a dogmatic view of what is normal. The bond markets are telling me that would be a mistake.

Fourth, Bullard was not disturbed by the rise of the dollar as he sees it as a natural consequence of a stronger US economy and weaker economies abroad. This contrasts with the general view that the Fed is panicking over the dollar.

So what does Fed Chair Janet Yellen think? Well, both Bullard and Williams are coming right out of the gates of an FOMC meeting, and I doubt either would take a position that was strongly in contrast to Yellen. That said, expectations seem to be growing for Yellen to head a different direction. Via the Wall Street Journal:

“If the markets stay how they are today three months from now, the Fed would have a hard time raising interest rates,” Alan Rechtschaffen, a financial adviser at UBS, said this week. That would make Ms. Yellen’s twice-yearly testimony before the House and Senate, expected in the third week of next month, a potential opportunity for beginning to show increased concern about low inflation—particularly if measures of prices excluding energy and food costs keep moving lower.

“As early as the Humphrey-Hawkins testimony the Fed could begin to lay the groundwork for a transition in monetary policy” toward a later date for interest-rate increases, Mr. Rechtschaffen said.

Like I thought that there would be little change in the FOMC statement, I am cautious about expecting a change in Yellen's tone. It might be good to consider this anecdote from former Federal Reserve Governor Larry Meyer:

The final question is whether Janet is really a dove. Let me tell you a story. Janet and I held very similar views when we were colleagues on the Committee, despite the fact that I was immediately viewed as a hawk and she was already viewed as a dove. (I thought of myself at the time as being a “hawkish dove.”) In any case, when it comes to ensuring price stability and maintaining well-anchored inflation expectations, there are no doves on the Committee. Before the September 1996 FOMC meeting, Janet and I went to see the Chairman to talk about the policy decision at that meeting and at following meetings. This was the only time I ever visited the Chairman (at my initiative) to talk about monetary policy, before or after a meeting. Janet and I were both worried about inflation, even though it was very well contained at the time. We told the Chairman that we loved him but could not remain at his side much longer if he continued, as he had been doing for some time, to push the next tightening action into the next meeting, and then not follow through. He listened, more or less patiently. I recall, though this may have not been the case, that he just smiled and didn’t say a word. After an awkward silence, we said our good-byes. Needless to say, we didn’t win this argument. Yet, we never dissented. That is another matter of etiquette for the entire Board, at least since when I was there: The Board is a team, always votes as a block, and, therefore, always supports the Chairman.

The reason I bring this up is that if my analysis of the Fed's baseline thinking is generally correct, then Yellen will have a hard time staying a dove if her underlying framework is unchanged from 1996. And I think we are seeing that as the economy heads into more normal territory, that underlying framework is indeed unchanged. This is especially the case when she could view former Federal Reserve's Chair Alan Greenspan's 1996 bet as being a special case attributable to higher productivity, and she does not have productivity in her corner this time around. Just something to think about.

Bottom Line: I am not convinced the Fed is changing its thinking as quickly as markets think the Fed is changing its thinking. That means that Fedspeak might continue to be hawkish relative to expectations.