Category Archive for: Monetary Policy [Return to Main]

Monday, May 02, 2016

Paul Krugman: The Diabetic Economy

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

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

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

Saturday, April 30, 2016

When Europe Stumbled

Paul Krugman:

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

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

Friday, April 29, 2016

Fed Watch: Warning: Hawkishness Ahead

Tim Duy:

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

Fulcrum

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

Wednesday, April 27, 2016

No Rate Hike. Will it Happen in June?

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

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

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

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

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

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

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

Tuesday, April 26, 2016

The Fed Is Meeting in April to Talk About June

Tim Duy:

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

Sunday, April 24, 2016

Presidential Candidates and Fed Accountability

Carola Binder:

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

Friday, April 15, 2016

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

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

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

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

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

for the economy's productive potential Y*.

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

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

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

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

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

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

And here we sit.

Thursday, April 14, 2016

Central Bank Mistakes: More on Count 2'

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

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

Sunday, April 10, 2016

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

Simon Wren-Lewis:

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

Thursday, April 07, 2016

How Much of an Overshoot?

Tim Duy:

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

Wednesday, April 06, 2016

Fed Watch: Dovish Minutes

Tim Duy:

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

Meeting participants were generally confident in the outlook:

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

But outside of the consumer, all is not rosy:

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

And global concerns loomed large:

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

Caveats abound, however:

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

Is the economy at full employment? Maybe:

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

Maybe not:

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

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

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

But concerns about too low inflation clear dominated:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Safe Asset Problem is Back: Negative Interest Rate Edition

David Beckworth:

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

Tuesday, April 05, 2016

Fed Watch: Fed Has Little Reason to Hike Rates

Tim Duy:

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

EMPREPf041616

and nonmanufacturing:

EMPREPg041616

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

EMPREPh041616

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

EMPREPa041616

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

EMPREPb041616

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

EMPREPe041616

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

EMPREPk041616

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

EMPREPj041616

EMPREPi041616

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

Monday, April 04, 2016

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

At MoneyWatch:

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

Friday, April 01, 2016

Fed Watch: Yellen Pivots Toward Saving Her Legacy

Tim Duy:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Thursday, March 31, 2016

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

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

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

Wednesday, March 30, 2016

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

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

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

 

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

Tuesday, March 29, 2016

Yellen: The Outlook, Uncertainty, and Monetary Policy

The end of Janet Yellen's speech today:

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

Monday, March 28, 2016

Fed Watch: Oil, Inflation Expectations, and Credibility

Tim Duy:

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

OBSa032816

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

OBSb032816

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

OBSE032816

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

OBSc032816

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

OBSa032816

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

OBSd032816

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

Friday, March 18, 2016

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

Ben Bernanke:

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

Thursday, March 17, 2016

'The Fed and the Quest to Raise Rates'

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

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

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

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

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

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

The Fed Should Allow Wages to Rise

At MoneyWatch:

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

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

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

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

Wednesday, March 16, 2016

No Change in the Fed's Target Interest Rate

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

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

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

Monday, March 14, 2016

'The Real Reason to Worry About China'

Narayana Kocherlakota:

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

Thursday, March 10, 2016

'China’s Trilemma—and a Possible Solution'

Just say no to monetary policy:

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

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

Tuesday, March 08, 2016

The 'Strong Case' Against Central Bank Independence Critically Examined

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

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

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

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

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

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

Monday, March 07, 2016

Fed Watch: State of Play

Tim Duy:

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

NFP030416

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

UN030416

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

LF030416

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

FIN030416

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

BAML030416

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

Wednesday, March 02, 2016

'Four Common-Sense Ideas for Economic Growth'

Larry Summers:

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

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

Fed Watch: Dudley the Dove

Tim Duy:

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

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

Tuesday, March 01, 2016

'How Low Can They Go?'

Cecchetti & Schoenholtz:

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

Skipping past the detailed explanation:

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

Monday, February 29, 2016

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

Tim Duy:

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

PRICES22916

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

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

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

The persistent of this shock has significant implications for policy:

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

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

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

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

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

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

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

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

The implication for US policy:

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

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

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

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

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

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

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

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

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

Thursday, February 25, 2016

Fed Watch: Lacker, Kaplan, Fischer

Tim Duy:

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

SP22316

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

Wednesday, February 24, 2016

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

Tim Duy:

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

CLAIMS021816

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

QUITS21816

Industrial production ticked up and weakness remains fairly concentrated:

IP021816

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

RETAIL21816

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

PRICES21816

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

Monday, February 22, 2016

FRBSF: Economic Outlook

The economic outlook from Kevin Lansing of the SF Fed:

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

Moderate growth likely to continue

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

Solid employment growth continues

Unemployment dips below natural rate

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

Inflation expected to increase gradually

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

Credit spreads have widened

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

Equity and oil prices signal slowdown

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

Industrial production slipping

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

Recent data indicate below trend growth

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

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

Friday, February 19, 2016

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

Brad DeLong:

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

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

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

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

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

There are three possible positions for us to take now:

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

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

Thursday, February 18, 2016

Fed Watch: FOMC Minutes and More

Tim Duy:

FOMC Minutes and More, by Tim Duy: So much Fed, so little time. But the short story is this: The Fed is in risk management mode, which means they will leave rates on hold until they see clear evidence that markets are stabilizing, growth remains on track, and they are even leaning towards needing to see the white in the eyes of the inflation beast. This has the makings of a significant strategic shift. To date, the Fed has argued for early and modest action toward "normalizing" policy with the ultimately goal of staying ahead of the inflation curve. We are moving to a new strategy where Fed policy lags the cycle. The cost of a Fed pause now is the risk of more aggressive policy later.
The minutes of the January FOMC meeting revealed that policymakers struggled to reconcile market volatility with their economic outlook:
In discussing the appropriate path for the target range for the federal funds rate over the medium term, members agreed that it would be important to closely monitor global economic and financial developments and to continue to assess their implications for the labor market and inflation, and for the balance of risks to the outlook. Members expressed a range of views regarding the implications of recent economic and financial developments for the degree of uncertainty about the medium-term outlook, with many members judging that uncertainty had increased. Members generally agreed that the implications of the available information were not sufficiently clear to allow members to assess the balance of risks to the economic outlook in the Committee's postmeeting statement.
That said, they could agree on the following:
However, members observed that if the recent tightening of global financial conditions was sustained, it could be a factor amplifying downside risks.
And they had plenty of reasons to fear the downside risks:
Almost all participants cited a number of recent events as indicative of tighter financial conditions in the United States; these events included declines in equity prices, a widening in credit spreads, a further rise in the exchange value of the dollar, and an increase in financial market volatility. Some participants also pointed to significantly tighter financing conditions for speculative-grade firms and small businesses, and to reports of tighter standards at banks for C&I and CRE loans. The effects of these financial developments, if they were to persist, may be roughly equivalent to those from further firming in monetary policy.
It is very unlikely that these fears will be ameliorated by the March meeting, or even the April meeting, and Fed speakers are signaling as much. See, for example, remarks by Philadelphia Federal Reserve President Patrick Harker and Boston Federal Reserve President Eric Rosengren.
These concerns are growing:
Several participants noted that monetary policy was less well positioned to respond effectively to shocks that reduce inflation or real activity than to upside shocks, and that waiting for additional information regarding the underlying strength of economic activity and prospects for inflation before taking the next step to reduce policy accommodation would be prudent.
And echo a repeated warning from the Fed staff:
The staff viewed the uncertainty around its January projections for real GDP growth, the unemployment rate, and inflation as similar to the average of the past 20 years. The risks to the forecast for real GDP were seen as tilted to the downside, reflecting the staff's assessment that neither monetary nor fiscal policy was well positioned to help the economy withstand substantial adverse shocks; the downside risks to the forecast of economic activity were seen as more pronounced than in December, mainly reflecting the greater uncertainty about global economic prospects and the financial market turbulence in the United States and abroad. Consistent with the downside risk to aggregate demand, the staff viewed the risks to its outlook for the unemployment rate as skewed to the upside. The risks to the projection for inflation were seen as weighted to the downside, reflecting the possibility that longer-term inflation expectations may have edged down and that the foreign exchange value of the dollar could rise substantially further, which would put downward pressure on inflation.
The recent unpleasantness in financial markets has likely prompted the FOMC to take the downside risks more seriously than they did in December. The fact of the matter is that they have very little left in their toolkit should the economy take a turn for the worse. Yes, they could turn toward more quantitative easing, but I think on average they are loathe to go down that route. And yes, they could consider negative interest rates, but that now looks a lot riskier than it did just a few weeks ago. Indeed, from the minutes:
The effects of a relatively flat yield curve and low interest rates in reducing banks' net interest margins were also noted.
A financial system based on banking starts to run into challenges when banks can't make a profit. Significantly negative rates likely require some substantial re-plumbing of the financial pipes to be effective.
The Fed may be turning toward my long-favored policy position - the best chance they have of lifting off from the zero bound is letting the economy run hot enough that inflation becomes a genuine concern. That means following the cycle, not trying to lead it. And I would argue that if the recession scare is just that, a scare, they are almost certainly going to fall behind the curve. The unemployment rate is below 5 percent and wage pressures are rising. The economy is already closing in on full-employment. If we don't have a recession, then how much further along will the economy be by the time the Fed deems they are sufficiently confident in the economy that they can resume raising rates? And note the importance of clearly progress on inflation:
Several participants reiterated the importance of monitoring inflation developments closely to confirm that inflation was evolving along the path anticipated by the Committee.
and:
A couple of members emphasized that direct evidence that inflation was rising toward 2 percent would be an important element of their assessments of the appropriate timing of further policy firming.
By the time we actually see inflation we will be in my "scenario five":
Financial markets remain choppy in the first half of the year, pushing the Fed into “risk management” mode despite solid labor market activity. The Fed skips the March and April meetings. Officials’ delayed response calms markets and prevents a slowdown in activity, but they feel behind the curve and try to catch up with a steeper pace of hikes late in the year.
Separately, some members questioned the effectiveness of the Fed communication strategy:
A couple of participants questioned whether some financial market participants fully appreciated that monetary policy is data dependent, and a number of participants emphasized the importance of continuing to communicate this aspect of monetary policy.
St. Louis Federal Reserve President James Bullard was likely one such participant. From the press release of his speech tonight:
Bullard noted that the FOMC has repeatedly stated in official communication and public commentary that future monetary policy adjustments are data dependent. He then addressed the possibility that the financial markets may not believe this since the SEP may be unintentionally communicating a version of the 2004-2006 normalization cycle, which appeared to be mechanical.
“The policy rate component of the SEP was perhaps more useful when the policy rate was near zero, and the Committee wished to commit to the idea that the policy rate was likely to remain near zero for some period into the future,” Bullard explained. “But now, post liftoff, communicating a path for the policy rate via the median of the SEP could be viewed as an inadvertent calendar-based commitment to increase rates.”
You might forgive market participants for believing that the SEP infers some calendar-based guidance when Federal Reserve Vice Chair Stanley Fischer says things like:
Well, we watch what the market thinks, but we can't be led by what the market thinks. We've got to make our own analysis. We make our own analysis and our analysis says that the market is underestimating where we are going to be. You know, you can't rule out that there is some probability they are right because there's uncertainty. But we think that they are too low.
Saying the markets are wrong implies that the policy direction is fairly rigid. In any event, I am not confident there is yet much support for Bullard's position (you would think to switching to a press conference at every FOMC meeting would be easier, but he hasn't apparently made much progress there either). Instead, the Fed is debating enhancing the SEP with fan charts around the projections to illustrate the associated uncertainty. My preference is to reveal each participant's forecast and their associated dot, as well as the Greenbook forecast. This can be done anonymously. Then we could throw out the crazy forecasts and focus on the reaction functions of the remaining forecasts. I don't think, however, the Fed wants us identifying any forecasts as crazy because they would like us to believe all are equally valid. And they don't want to use the Greenbook forecast because that would imply a central FOMC forecast, which they maintain does not exist. So we are stuck with the dot plot for the foreseeable future.
Bullard has also gone full-dove. He remembered that he thought inflation expectations were supposed to be important, and the decline in 5-year, 5-year forward expectations has him spooked. And he thinks that the excess air has been released from financial markets, so his fears of asset bubbles has eased. Hence, the Fed can easily pause now. But note that Bullard is fickle - just one higher inflation number and he will quickly change his tune.
Bottom Line: The Fed is on hold, stuck in risk management mode until the skies clear. If you are in the "recession" camp, the path forward is obvious. The Fed cuts back to zero, drags its heals on more QE, and fumbles around as they try to figure out if negative rates are a good or bad thing. Not pretty. But if you are in the "no recession" camp, it's worth thinking about the implications of a Fed pause now on the pace of hikes later. Being on hold now raises the risk that by the time the Fed moves again, they will be behind the cycle.

Tuesday, February 16, 2016

'The Fed’s Interest Payments to Banks'

Ben Bernanke and Don Kohn:

The Fed’s interest payments to banks: At Janet Yellen’s recent hearing before the House Financial Services Committee, a few representatives expressed concern that the Federal Reserve is making interest payments to banks. Specifically, the Fed uses authority granted by Congress in 2008 to pay interest on the reserves that banks hold with it. Total payments to banks last year were about $7 billion. Why is the Fed paying such sums to banks? Are they “giveaways” to the financial sector, as some have implied? We’ll argue in this post that the interest payments the Fed is making are well-justified. In particular, they are essential to prudent monetary policy in current circumstances and do not unduly subsidize banks. ...

Friday, February 12, 2016

Paul Krugman: On Economic Stupidity

Going "off the deep end on macroeconomic policy":

On Economic Stupidity, by Paul Krugman, Commentary, NY Times: ... If you’ve been following the financial news, you know that there’s a lot of market turmoil out there. It’s nothing like 2008, at least so far, but it’s worrisome. ... So how well do we think the various presidential wannabes would deal with those challenges?
Well, on the Republican side, the answer is basically, God help us. ... Leading the charge of the utterly crazy is ... Donald Trump, who ... asserted that Janet Yellen ... hadn’t raised rates “because Obama told her not to.” ... Yet ... Mr. Trump’s position isn’t that far from the Republican mainstream. After all, Paul Ryan ... not only berated Ben Bernanke ... for policies that allegedly risked inflation (which never materialized), but he also dabbled in conspiracy theorizing, accusing Mr. Bernanke of acting to “bail out fiscal policy.”
And even superficially sensible-sounding Republicans go off the deep end on macroeconomic policy. John Kasich’s signature initiative is a balanced-budget amendment that would cripple the economy in a recession, but he’s also a monetary hawk, arguing, bizarrely, that the Fed’s low-interest-rate policy is responsible for wage stagnation.
On the Democratic side, both contenders talk sensibly about macroeconomic policy... But Mr. Sanders has also attacked the Federal Reserve in a way Mrs. Clinton has not — and that difference illustrates in miniature both the reasons for his appeal and the reasons to be very worried about his approach.
You see, Mr. Sanders argues that the financial industry has too much influence on the Fed, which is surely true. But his solution is more congressional oversight — and he was one of the few non-Republican senators to vote for a bill, sponsored by Rand Paul, that called for “audits” of Fed monetary policy decisions. ...
Now, the idea of making the Fed accountable sounds good. But ... such a bill would essentially empower the cranks — the gold-standard-loving, hyperinflation-is-coming types who dominate the modern G.O.P., and have spent the past five or six years trying to bully monetary policy makers into ceasing and desisting from their efforts to prevent economic disaster. Given the economic risks we face, it’s a very good thing that Mr. Sanders’s support wasn’t enough to push the bill over the top.
But even without Mr. Paul’s bill, one shudders to think about how U.S. policy would respond to another downturn if any of the surviving Republican candidates make it to the Oval Office.

Thursday, February 11, 2016

Fed Watch: Fed Yet To Fully Embrace A New Policy Path

Tim Duy:

Fed Watch: Fed Yet To Fully Embrace A New Policy Path, by Tim Duy: The Fed will take a pause on rate hikes. An indefinite pause. The sooner they admit this, the better off we will all be. Indeed, the sooner they admit this, the sooner financial markets will calm and the the sooner they would be able to resume hiking rates. Federal Reserve Chair Janet Yellen had two high profile opportunities this week to make such an admission. Yet she failed to do so. She gave some ground on March, to be sure. But overall, the Fed just isn’t ready to stop talking about rate hikes later this year.
The framework from which I consider the Fed’s current predicament begins with this chart:

FED021116

Beginning in 2013 and extending through most of 2015, the domestic side of the US economy surged as consumer spending accelerated, investment stabilized, and government spending gained. The trade deficit acted as a pressure valve, widening to offshore some of the domestic demand. On net, economic activity was sufficient to collapse the output gap. By the end of 2015, the economy was near full-employment.
At full-employment, a combination of factors would work in tandem to slow activity to that of potential growth. I think of it as a new constellation of prices consistent with sustained full-employment. I can’t tell you exactly what the new constellation would look like other than the most likely combination: A mix of higher dollar, higher inflation, higher wages, and higher short term interest rates (tighter monetary policy).
How much monetary policy tightening is consistent with the new equilibrium depends on the evolution of the other prices. A reasonable baseline at the end of last year was that 100bp of tightening would be consistent with achieving full-employment. That was the Fed’s starting point as well.
The international interconnectivity of financial markets, however, dealt a blow to the expectation of even a gradual rate increase. The actual and expected policy divergence between the Federal Reserve and the rest of the world’s major central banks drove a rally in the dollar. That unexpected strength of that rally means that some other price has to move accordingly to sustain full employment. The most likely price is short-term interest rates. That’s the signal from the collapse in long rates. That signals the Fed will be lower for longer, reducing the magnitude of the policy divergence, and allowing the dollar to retreat.
Ironically, I suspect the Bank of Japan’s foray into negative interest rates sealed the fate of the divergence trade. First by pushing market participants into US Treasuries, signaling that the Fed would need to respond to the BOJ by reducing the expected short-term policy path. Second by killing bank stocks. Market participants in the US were already primed by Fed Vice Chair Stanley Fisher that negative rates could be a policy tool. And this point was seconded by Yellen this week.
But the collapse in banking stocks suggests strongly that negative interest rates are not compatible with our current economic institutions. The system relies on the banks, and the banks need to make money, and they struggle to do so in a negative rate environment. Should it be any surprise that the threat of global negative rates is slamming the financial sector?
If then zero (or something just below zero) is indeed a practical lower bound, and all major central banks are pulled in that direction, then the scope for policy divergence is limited. Again, this suggests the policy divergence trade – a one-way bet on the dollar – is nearing the end if not already there. It had to end sooner or later. A one-way bet would eventually cripple the US economy.
In sum, a key factor in keeping the US economy on the rails is acknowledging that tightening financial conditions via the dollar obviates the need to tightening conditions via monetary policy. This will also sustain the expansion and allow wage growth and inflation accelerate. The Fed can stand down, and let my scenario five evolve. All of this is well and good, but the Fed has yet to fully embrace this story. And that leaves them sounding relatively hawkish. Yellen’s testimony continues to emphasize that the Fed expects to keep raising rates. To be sure, she includes the data dependent caveat, and this:
Financial conditions in the United States have recently become less supportive of growth, with declines in broad measures of equity prices, higher borrowing rates for riskier borrowers, and a further appreciation of the dollar.
should be sufficient to take March off the table despite solid labor data. But the underlying message is that they expect higher rates. It is only the pace that changes, not the direction. There is just no reason to promise higher rates. All the Fed needs to say is:
“Monetary policy will be appropriate to achieve the Fed’s mandate.”
Yellen & Co. don’t need to emphasize the direction of rates. They just can’t stop themselves. Worse yet, they feel compelled to describe the level of future rates via the Summary of Economic Projections. A level entirely inconsistent with signals from bond markets, no less. They don't really know what the terminal fed funds rate will be, so why keep pretending they do? The “dot plot” does nothing more than project an overly-hawkish policy stance that leaves market participants persistently fearful a policy error is in the making. It is time to end the “dot plot.”
It might be helpful to add:
“We will not pursue negative interest rates if such a policy is incompatible with stability in financial sector.”
They should stop with the random and partially considered talk of negative interest rates. Instead, adopt a basic talking point indicating the idea has yet to be thoroughly vetted and as such any speculation on the topic is premature.
Bottom Line: The Fed has yet to fully embrace the change in financial conditionals and the implications for the path of policy. To be sure Yellen gave enough this week to take March off the table. That said, policymakers will hesitate to dramatically change their general policy outlook focused on higher rates. Consequently, I anticipate Fedspeak with seemingly unrealistic hawkish undertones. Essentially, they will leave the fear of policy error simmering on the back-burner.

Tuesday, February 09, 2016

'Negative Rates: A Gigantic Fiscal Policy Failure'

Narayana Kocherlakota:

Negative Rates: A Gigantic Fiscal Policy Failure: Since October 2015, I’ve argued that the Federal Open Market Committee (FOMC) should reduce the target range for the fed funds rate below zero. Such a move would be appropriate for three reasons:

  • It would facilitate a more rapid return of inflation to target.
  • It would help reduce labor market slack more rapidly.
  • It would slow and hopefully reverse the ongoing and dangerous slide in inflation expectations.

So, going negative is daring but appropriate monetary policy. But it is a sign of a terrible policy failure by fiscal policymakers.

The reason that the FOMC has to go negative is because the natural real rate of interest r* (defined to be the real interest rate consistent with the FOMC’s mandated inflation and employment goals) is so low. The low natural real interest rate is a signal that households and businesses around the world desperately want to buy and hold debt issued by the US government. (Yes, there is already a lot of that debt out there - but its high price is a clear signal that still more should be issued.) The US government should be issuing that debt that the public wants so desperately and using the proceeds to undertake investments of social value.

But maybe there are no such investments? That’s a tough argument to sustain... With a 30-year r* below 1%, our government can afford to make progress on a myriad of social problems. It is choosing not to.

If the government issued more debt and undertook these opportunities, it would push up r*. That would make life easier for monetary policymakers, because they could achieve their mandated objectives with higher nominal interest rates. But, more importantly, the change in fiscal policy would make life a lot better for all of us.

I don't think that Chair Yellen will say the above in her Humphrey-Hawkins testimony tomorrow - but I also think that it would be great if she did.

Friday, February 05, 2016

Fed Watch: Solid Jobs Report Keeps Fed In Play

Tim Duy:

Solid Jobs Report Keeps Fed In Play, by Tim Duy: Just when you think it's safe to jump in the water, reality strikes. While I still think that the Fed passes in March, the solid jobs report is just what is takes to keep the Fed in the game. Back it up with another such report in March and a stronger inflation signal in one of the upcoming price reports and you set the stage for a divisive battle at the next FOMC meeting.
Nonfarm payrolls grew by 151k, below consensus but within a reasonable range of estimates. The twelve-month moving average reveals a very modest slowing of job growth over the year:

JOBSd020516

The jobs numbers in the context of data Federal Reserve Chair Janet Yellen pervasively identified as what to watch:

JOBSe020516

JOBSf020516

Notably, wage growth has accelerated over the past year, suggesting that the Fed's estimate of NAIRU is within range of reality:

JOBSc020516

Prior to the 2001 recession, wage growth typically accelerated at unemployment approached 6%. Now it looks like 5% is the magic number:

JOBSb020516

I suspect the the employment cost index will soon follow the wage numbers higher:

JOBSa020516

There are no signals of recession in this data. For those who will complain that it is lagging data, I suggest watching the temporary employment component:

JOBSg020516

Temporary hiring should flatten out as the cycle matures, and you can arguably see the beginning of that process. If you squint, that is. Even so, the process evolved over a two year period before the last recession struck. Even if the seeds of recession were sown this January, we wouldn't expect recession until 2017 at the earliest. Still not by base case; using history as a guide I have a recession penciled in for 2018. (Short story: economy is in later stages of a business cycle, Fed resumes tightening later this year and pushes it too far by middle of 2017. In a perfect world the Fed could moderate the pace of activity to hold unemployment near NAIRU for an extended period of time. That, however, has proven to be a challenge for the Fed in the past.)
Bottom Line: This jobs report complicates the Fed's decision making process. They are stuck with instability in the financial markets as the economy reaches full employment. They are concerned that in the absence of temporary factors, inflation will quickly jump higher if the economy continues on this trajectory. While they would like unemployment to settle somewhat below NAIRU to eliminate lingering underemployment, they don't want it to settle far below NAIRU. They don't believe they can easily tap the breaks to lift unemployment higher. Recession is almost guaranteed to follow. Hence they would like to be able to rates rates gradually to feel their way around the darkness in which the true value of NAIRU lies. They fear that if they delay additional tightening, they will pass the point of no return in which they are forced to abandon their doctrine of gradualism. The Fed's policy challenge just became a little bit harder today.

Thursday, February 04, 2016

'Dovish Actions Require Dovish Talk (To Be Effective)'

Narayana Kocherlakota:

Dovish Actions Require Dovish Talk (To Be Effective): The Federal Open Market Committee (FOMC) has bought a lot of assets and kept interest rates extraordinarily low for the past eight years.  Yet, all of this stimulus has accomplished surprisingly little (for example, inflation and inflation expectations remain below target and are expected to do so for years to come).   Does that experience mean that we should give up on monetary policy as a useful way to stimulate aggregate demand?  
My answer is no.  I argue that, over the past seven years, the FOMC's has consistently talked hawkish while acting dovish.  This communications approach has weakened the effectiveness of policy choices, probably in a significant way.  Future monetary policy stimulus can be considerably more effective if the FOMC is much more transparent about its willingness to support the economy - that is, about its true dovishness.
My starting point is that households and businesses don’t make their decisions about spending based on the current fed funds rate - which, is after all, a one-day interest rate.  Rather, spending decisions are based on longer-term yields.  Those longer-term yields depend on market participants’ beliefs about how monetary policy will evolve over the next few years.  Those beliefs are a product of both FOMC actions and FOMC communications. 
In December 2008, the FOMC lowered the fed funds rate target range to 0 to a quarter percent. It did not raise the target range until December 2015, when the unemployment rate had fallen back down to 5%.   But - with the benefit of hindsight - a shocking amount of this eight years’ worth of unprecedented stimulus was wasted, because it was largely unanticipated by financial markets. (Full disclosure: I took part in FOMC meetings from November 2009 through October 2015, and it could certainly be argued that I was part of the problem that I describe until September 2012.)  
I’ll illustrate my basic point in the most extreme way that I can.  In November 2009, the Committee’s statement said that the fed funds rate might be raised after “an extended period” - a term that was generally interpreted to mean “about six months”.  Accordingly, as footnote 25 of this speech notes, private forecasters in the Blue Chip survey projected that the unemployment rate would be near 10 percent at the time of the first interest rate increase.  
Now, suppose that the FOMC had communicated its true reaction function in November 2009 (or even as late as December 2012): as long as inflation was anticipated to be below 2% over the medium-term, the Committee would not raise the fed funds rate until the unemployment rate had fallen to 5% or below.  We can’t know the impact of such communication with certainty.   But most macroeconomic models would predict that this kind of statement would have put significant upward pressure on employment and prices.  In other words: the models predict that if the FOMC had been willing to communicate its true willingness to support the economy, the Committee would have been able to (safely) raise rates much sooner.  
I want to be clear: my point in this post is not to express regrets or recrimination over past “mistakes”.    (It would have been good in 2009 to know what we know now, but we didn’t.)  And my point is not that monetary policy is some kind of panacea.  In the presence of a lower bound on nominal interest rates, expansionist fiscal policy would have been helpful in the past (and could be now too). 
My point is this: we shouldn’t make judgements about the efficacy of future monetary policy stimulus based on the experience from the past seven years.   Unfortunately, much of the potential impact of that lengthy stimulus campaign was vitiated by the FOMC’s generally hawkish communications.   
In my view, the FOMC can deliver useful impetus to aggregate demand with its remaining tools.  But it needs to communicate ahead of time about its true willingness and ability to support the economy.   Without that prior communication, later attempts at stimulus are likely to prove in vain - and the Fed’s credibility may suffer further damage.

Fed Watch: Jobs Day

Tim Duy:

Jobs Day, by Tim Duy: The jobs report for January is upon us. I would like to say this one will receive special attention but they all receive special attention. Consensus forecast is for nonfarm payrolls to gain 188k, with a range of 170k-215k, while unemployment holds constant at 5%. Calculated Risk looks at five indicators and concludes:
Unfortunately none of the indicators above is very good at predicting the initial BLS employment report. However, based on these indicators, it appears job gains will be below consensus.
One of the indicators CR considers in consumer sentiment, which as CR says is influenced by factors other than the labor market, so I will discount it in what follows. A regression of the monthly change in nonfarm payrolls on the remaining indicators - monthly change in ADP payrolls (ADP), the ISM employment index for manufacturing (NAPMEI), the ISM employment index for nonmanfucturing (NMFEI), and the monthly change in initial jobless claims (CLAIMS2) - yields:

NFPFORa020416

This is a quick and dirty regression, to be sure, and I would caveat it by saying that it is more accurately described as a model of the revised nonfarm payrolls number than the initial release. Note also that the coefficient on the manufacturing employment index is not significant. As CR says:
Note: Recently the ADP has been a better predictor for BLS reported manufacturing employment than the ISM survey.
With these caveats in mind, the one-step ahead forecasts are:

NFPFOR020416

The point forecast for January is 202.64k, a tad higher than consensus, but the 95% confidence interval is wide at (48k to 357k). Which is a reminder that trying to predict monthly payrolls is something of a fool's errand. I would not be surprised by any outcome within the 68% confidence interval, or 123k to 280k. A significant miss relative to consensus should not be a surprise. It would still be within the range of recent outcomes.
The Fed will be watching for signs that the economy has slowed precipitously since the final quarter of 2015. They will also be watching the unemployment rate and underemployment indicators to assess remaining slack in the economy. Further declines in the unemployment rate will make them increasingly uneasy with holding steady even as financial markets suggest they should. Watch wages for confirmation that slack has or has not diminished. And, finally, for those on recession watch, ignore the headlines whether they be weak or strong and look at temporary help payrolls and signs that long-term unemployment is back on the rise. Both tend to be leading indicators, especially the former.
In other news, New York Fed President William Dudley was reported to have cooled on rate hikes:
"One thing I think we can say with more confidence is that financial conditions are considerably tighter than they were at the time of the December meeting," said Dudley, a permanent voter on the Federal Open Market Committee, the Fed's monetary policy arm.
"So if those financial conditions were to remain in place by the time we get to the March meeting, we would have to take that into consideration in terms of that monetary policy decision," he said.
While the Wall Street Journal reports that Fed Governor Lael Brainard reiterated her warnings from last year:
Her concern is that stresses in emerging markets including China and slow growth in developed economies could spill over to the U.S. “This translates into weaker exports, business investment and manufacturing in the United States, slower progress on hitting the inflation target, and financial tightening through the exchange rate and rising risk spreads on financial assets,” Ms. Brainard said Monday in response to questions from The Wall Street Journal.

“Recent developments reinforce the case for watchful waiting,” she said.

Both are clearly more cautious than Kansas City Fed Esther George. And more influential as well. I enjoyed this:
“I don’t think it served Janet Yellen well,” former Dallas Fed President Richard Fisher said in an interview of Ms. Brainard’s critique. “It’s the only time I’ve known her when she didn’t appear to be a team player,” he said of Ms. Brainard, with whom he worked in the Clinton administration.
Seriously? Fisher has the gall to criticize Brainard as not a team player? Google "fisher dallas dissent" and see what you get. A sample:

FISHER

Being a team player isn't always what the Fed needs. Fisher obviously thought so when he was on the FOMC. Yet he insists Brainard be the team player he wasn't. Sad.
Separately, Goldman Sachs has erased their expectations of a rate hike in March, but left three more penciled-in for the rest of the year. Clearly in the "no recession" camp. I think that March is unlikely, as is a chance to "catch-up" in April. But I can make a story on the back of calm in financial markets and two strong employment reports that March comes back on the table. Not my baseline though.
Bottom Line: Fed mostly coming around to delaying the next rate hike. Would need to see a lot of change over just a few weeks to get them back on their original track. More than seems likely. Rest of the year? If you are in the "no recession" camp like me, you anticipate the Fed will resume hiking later this year. If you are in the "recession" camp, it's all over.

Wednesday, February 03, 2016

Fed Watch: Resisting Change?

Tim Duy:

Resisting Change?, by Tim Duy: Monday Federal Reserve Vice Chair Stanley Fischer offered up a speech and lengthy discussion on recent monetary policy. It was both illuminating and frustrating at once. Although his confidence is fading, I also sense that he is resisting change. Fischer begins by reviewing the December decision:

Our decision in December was based on the substantial improvement in the labor market and the Committee's confidence that inflation would return to our 2 percent goal over the medium term. Employment growth last year averaged a solid 220,000 per month, and the unemployment rate declined from 5.6 percent to 5.0 percent over the course of 2015. Inflation ran well below our target last year, held down by the transitory effects of declines in crude oil prices and also in the prices of non-oil imports. Prices for these goods have fallen further and for longer than expected. Once these oil and import prices stop falling and level out, their effects on inflation will dissipate, which is why we expect that inflation will rise to 2 percent over the medium term, supported by a further strengthening in labor market conditions.

This covers familiar territory, as does his subsequent remarks the even after raising rates, policy remains accommodative:

I would note that our monetary policy remains accommodative after the small increase in the federal funds rate adopted in December. And my colleagues and I anticipate that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate, and that the federal funds rate is likely to remain, for some time, below the levels that we expect to prevail in the longer run.

This is the first source of my frustration, because his definition of "accommodative" depends upon a specific idea of the neutral Fed Funds rates. From the subsequent discussion:

Well, I think we have to wait to see precisely where this process will take us. We expect now that the numbers given in the survey, we can now make projections, the SEP of members of the FOMC, of somewhere around 3 ¼, 3, 3 ½ percent, which is on average a bit lower than in the past. But we’ll be data-dependent and we’ll see what happens. We don’t have to fix a rate that we’ll be at. We can indicate what members of the FOMC believe, which is what the number I’ve just given you is.

If you don't know the longer-run rate, how can you know how accommodative policy is? If the longer-run rate is close to 2 percent, then policy is less accommodative than you think it is. The endgame of policy is the dual employment/price stability mandate, not a specific level of interest rates.

The Fed's forecasts, however, have been foiled by oil and the dollar:

At our meeting last week, we left our target for the federal funds rate unchanged. Economic data over the intermeeting period suggested that improvement in labor market conditions continued even as economic growth slowed late last year. But further declines in oil prices and increases in the foreign exchange value of the dollar suggested that inflation would likely remain low for somewhat longer than had been previously expected before moving back to 2 percent.

This in and of itself would suggest a slower or delayed pace of rate hikes, but more on that later. As for market volatility and external events:

In addition, increased concern about the global outlook, particularly the ongoing structural adjustments in China and the effects of the declines in the prices of oil and other commodities on commodity exporting nations, appeared early this year to have triggered volatility in global asset markets. At this point, it is difficult to judge the likely implications of this volatility. If these developments lead to a persistent tightening of financial conditions, they could signal a slowing in the global economy that could affect growth and inflation in the United States. But we have seen similar periods of volatility in recent years that have left little permanent imprint on the economy.

This is unimpressive. Are we allowed to say that about Fischer? First, the likely implications of the volatility are straightforward. The decline in longer term yields signals the Fed is likely to be lower for longer. Second, it seems that Fischer does not acknowledge the Fed's role in minimizing the impact of similar bouts of volatility. They have responded by either easing via additional quantitative easing, or easing by delaying tightening (such as pushing back expectations of the taper or skipping their hoped-for September 2015 rate hike).

I find this distressing because when you fail to recognize your role, you set the stage for a policy error. They can't use the logic that they should hike in March because past volatility had no impact on growth when that same volatility actually changed their behavior and thus the economic outcomes. I guess they can use that logic, but they shouldn't.

So is March on the table still? I don't think they will have the inflation data to support such a move. But I can tell a story where they push ahead on the labor data alone. Back to Fischer:

As you know, in making our policy decisions, my FOMC colleagues and I spend considerable time assessing the incoming economic and financial information and its implications for the economic outlook. But we also must consider some other issues, two of which I would like to mention briefly today.

First, should we be concerned about the possibility of the unemployment rate falling somewhat below its longer-run normal level, as the most recent FOMC projections suggest? In my view, a modest overshoot of this sort would be appropriate in current circumstances for two reasons. First, other measures of labor market conditions--such as the fraction of workers with part-time employment who would prefer to work full time and the number of people out of the labor force who would like to work--indicate that more slack may remain in labor market than the unemployment rate alone would suggest. Second, with inflation currently well below 2 percent, a modest overshoot actually could be helpful in moving inflation back to 2 percent more rapidly.

The economy is currently operating near the Fed's estimate of the natural rate of unemployment. Upward pressure on wages is constant with that hypothesis. The Fed would like unemployment to drop further to dissipate lingering underemployment and put upward pressure on inflation. So their is room for additional declines in the unemployment rate. But:

Nonetheless, a persistent large overshoot of our employment mandate would risk an undesirable rise in inflation that might require a relatively abrupt policy tightening, which could inadvertently push the economy into recession. Monetary policy should aim to avoid such risks and keep the expansion on a sustainable track.

Here Fischer echoes the comments of New York Federal Reserve President William Dudley. Policymakers fear that they cannot allow unemployment to drift far below the natural rate because they do not believe they could just nudge it back higher without causing a recession. They can only glide into a sustainable path from above. Hence one can envision the Fed getting caught up in the employment data between now and March. That is two reports; if those reports suggest that labor markets remain strong, then the Fed will resist holding rates steady. At a minimum, it would certainly complicate the March meeting and sap my confidence that they stand pat. Indeed, one voting member is already working hard to downplay recent events. Today's speech by Kansas City Federal Reserve President Esther George:

While taking a signal from such volatility is warranted, monetary policy cannot respond to every blip in financial markets. Instead, a focus on economic fundamentals, such as labor markets and inflation, can help guard against monetary policy over- or under- reacting to swings in financial conditions. To a great extent, the recent bout of volatility is not all that unexpected, nor necessarily worrisome, given that the Fed’s low interest rate and bond- buying policies focused on boosting asset prices as a means of stimulating the real economy. As asset prices adjust to the shift in monetary policy, it is to be expected that the pricing of risk will realign to this different rate environment…

…The exact timing of each move, however, is subject to the economic environment. Because monetary policy affects the economy with lags, decisions must necessarily rely on forecasts and their associated risks — not waiting until desired objectives are realized.

If we wait for the data to provide complete confirmation before making a policy decision, we may well have waited too long. Likewise, policy may be faced with altering its trajectory if the economy’s progress points to a different outlook. But in the absence of any substantial shift in the outlook, my view is that the Committee should continue the gradual adjustment of moving rates higher to keep them aligned with economic activity and inflation. These actions are often difficult, but also necessary to keep growth in line with the economy’s long-run potential and to foster price stability.

An additional point: Watch for policymakers to downplay the inflation numbers as well. Back to George:

Finally, inflation has remained muted as a result of lower oil prices and the strong U.S. dollar. Recent movements in each of these have been quite large by historical standards. Yet, despite these headwinds, core measures of inflation have recently risen on a year-over-year basis. And although inflation rates over the past few years have hovered below the Fed’s goal of 2 percent, they have been positive and broadly consistent with price stability.

Note the "positive and broadly consistent" line. And Fischer:

And our view of progress is what the law calls maximum employment and what we call maximum sustainable employment, and a 2 percent inflation rate. And when we get there—we’re there—we’re very close to there on employment, and on inflation the core number that came out this morning was 1.4 percent. You know, that’s not 2 percent. It’s not in another universe. It’s not a negative number. But inflation’s been pretty stable, and we’d like it to go up.

Not in "another universe' from 2 percent. Not negative. Sure we'd like it to go up, but are we really worried about it? Doesn't sound like it to me.

Bottom Line: Fischer is clearly less confident than earlier this month when he claimed that market participants were underestimating the pace of rate hikes. The baseline of four hikes is clearly is doubt; see here for my five potential scenarios. Financial market participants have almost completely discounted any rate hikes this year. This is a recession scenario that I am not enamored with. That said, I suspect market volatility and lack of inflation data keep them on hold in March and maybe April even if the recession does not come to pass. However (although not my baseline), I can tell a story where they feel like the employment data forces their hand. Especially so if they continue to downplay the inflation numbers. A substantial part of their policy still appears directed by a pre-conceived notion of "normal" policy. This I think is the Fed's largest error; the fact that the yield curve stubbornly resists being pushed higher suggests that the Fed's estimates of the terminal fed funds rates is wildly optimistic. There appear to be limits to which the Fed can resist the global pull of zero (or lower) rates.

Saturday, January 30, 2016

5 to 4

Narayana Kocherlakota:

5 to 4: On Friday, the Policy Board of the Bank of Japan decided to lower its deposit rate into negative territory for the first time.  The vote was five to four.  In this post, I argue that US monetary policy would be stronger if the Federal Open Market Committee (FOMC) were willing to issue statements and take actions that were supported by such narrow margins.
As is well-known, the FOMC operates by consensus.  No decision has had more than three No votes in at least twenty-five years.  There has not been a No vote by a governor in ten years, and there has not been more than one No vote by a governor at a meeting in over twenty years.  (See this great article by Thornton and Wheelock for a deeper review.)  
This decision framework is not statutory.  Rather, it is a Committee norm.  The norm is buttressed by Fed watchers and the media, who often refer approvingly to the absence of dissents at a meeting.  (Even today, this FT article refers to the lack of dissents at the December 2015 meeting as being a sign of a successful liftoff.)
This tradition of consensus has three main deficiencies. 
First, consensus creates a strong status quo bias that reduces the sensitivity of monetary policy to incoming data.   The current Committee norms imply that it requires a super-majority of the FOMC to implement a change in direction.  Without that super-majority, the Committee tends to stick to its prior course.   This automatically makes monetary policy relatively insensitive to incoming information.  
Second, the tradition of consensus opens up the possibility that relatively small minorities of FOMC voters can have a disproportionate influence  on monetary policy decisions.   For example, the above history suggests that the FOMC is following a practice under which all decisions need near-unanimous support from the governors.  If so, it becomes theoretically possible for a bloc of one or two governors to exercise veto rights over changes in the direction of monetary policy.
Finally, and perhaps most troublingly, the desire/need for consensus tends to strip collective Committee statements of their clarity.   (See a recent Wall Street Journal op-ed by Charles Plosser for a similar concern.)  For example, here’s how the current FOMC statement describes the conditionality of the path for the fed funds rate: 
“In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.”
This length of this list of conditioning variables helps create consensus, but it also serves to reduce the public’s understanding of the overall FOMC strategy.  This uncertainty can be a drag on the effectiveness of policy. 
Bold policy moves often engender significant disagreement.   Policy-making bodies must have cultures that can allow those decisions to get made, despite that disagreement.   Clearly, the Policy Board of the BOJ has that kind of culture.   I worry that the FOMC, with its emphasis on consensus, does not. 
I’ll write more about the potential economic importance of the BOJ’s move in a later post.  For now, I’ll simply say that, given the challenges facing the global economy, I applaud Governor Kuroda’s willingness to lead the BOJ in this new direction.

Wednesday, January 27, 2016

Fed Watch: On The Dispersion, Or Lack Thereof, of Economic Weakness

Tim Duy:

On The Dispersion, Or Lack Thereof, of Economic Weakness, by Tim Duy: Gavyn Davies writes:
It is true that much of the weakness in the nowcast is identified by economic variables that relate to the industrial sector. But these variables have, in the past, been very closely correlated with activity in the economy as a whole, and are therefore usually among the best indicators of overall activity. It is dangerous to ignore weakness in these industrial variables that persists for a long period, which is what is happening now....The full model, including the industrial sector data, estimates that the recession probability has been hovering around 15-20 per cent (above right graph), no longer an entirely negligible risk. If the weak industrial data are excluded, on the grounds that they are “transitory” – a word often used by Fed officials – then the recession probability drops to about 10 per cent.
He adds this picture:

FT

Recession odds of just 10% would hardly be worth getting out of bed for. So how much weight should we be placing on the manufacturing data? I often see claims that manufacturing is already in recession. And Andrew Levin, former advisor to Federal Reserve Chair Janet Yellen, places much weight on the industrial production slowdown:
Unfortunately, the latest economic data underscore the risk that the economy may now be heading into another recession. Last Friday, the Federal Reserve Board reported that its index of industrial production sank further in December and was down 1.8% from a year earlier. Indeed, as shown in the accompanying chart, this pace of contraction has only occurred during prior recessionary periods. In some instances, the fall in industrial output was a harbinger at the onset of a recession. In other episodes, the industrial sector had been booming previously and turned downward after a recession was already underway. But since 1970 there has never been a case where the industrial sector shrank nearly 2 percent on a 12-month basis and the broader economy was left unscathed.
I think it is important to be very cautious with this aggregate data. What makes a recession a recession is that the decline in activity is felt widely throughout the economy. From the National Bureau of Economic Research:
During a recession, a significant decline in economic activity spreads across the economy and can last from a few months to more than a year.
With this in mind, I direct you to my fellow Oregon economist Josh Lehner, who correctly notes that in comparison to past recessions, the decline in manufacturing activity is not well disbursed across the sector. My version of Josh's chart:

RECESSIONb012516

The point is that during a recession, the vast majority of manufacturing industries (or all!) are declining. We are nowhere near that point. In other words, even manufacturing - arguably the most distressed sector of the US economy - is not recession. And if manufacturing is not even in recession, it is difficult to see that the US economy is in recession. Or even nearing it.
Initial unemployment claims across states tells a similar story:

RECESSIONa012516

In this version, I count the sates experiencing a 5% or greater change in year-over-year unemployment claims (I used 5% to account for the fact that as the cycle matures, claims will flatten out for more states and thus you would expect a wider dispersion of marginally higher claims). As is evident, recessions are characterized by rising claims across a wide swath of sates. In other words, a recession in Texas does not a US recession make. Note also that the economy can experience a fairly widespread increase in claims but not a recession. See 1995. Which means that while I think initial claims is an excellent leading indicator, it by itself is not infallible.
Aside from the recession risk, there is another important aspect of Davies's chart - discounting manufacturing, it indicates growth of just 2% in the US. This is fairly close with the Federal Reserve's estimate of potential growth, and I suspect that is the direction we will be heading by the end of the year if not sooner. Key sources of growth, such as autos, multifamily housing, and technology, that helped propel the economy closer to fully employment are likely leveling off. If so, that means the economy is at an inflection point as it transitions back to trend. The Fed expects that process will require addition tightening. The financial markets aren't so confident.
Bottom Line: The lack of widespread economic weakness across the economy indicates that the US is not currently in recession. It is not even evident manufacturing is in recession. If the economy were heading into recession, expect the dispersion of weakness will spread further across the economy, both geographically and sectorally.

Tuesday, January 26, 2016

'The Five Scenarios Now Facing the Federal Reserve'

Tim Duy:

The Five Scenarios Now Facing the Federal Reserve: Federal Reserve policymakers are likely enjoying this month about as much as market participants are.
Central bankers at the Fed don’t like fast-moving markets to begin with, and they especially won’t like the implication that their supposedly inconsequential 25-basis-point interest rate hike in December was a mistake. The only saving grace for the Fed is that January was off the table for a rate hike anyway, so the volatility on Wall Street will have little impact on this week’s policy outcome, due to be announced on Wednesday... Continue reading at Bloomberg ...

Sunday, January 24, 2016

Banks' Influence on Congressional ''Reform'' of the Fed

Narayana Kocherlakota:

Banks' Influence on Congressional “Reforms” of the Fed: Senator Sanders’ December 23 NYT op-ed expressed concern about what he perceived to be an undue influence of the financial sector on the Federal Reserve. In my last post, I explained how the Fed could allay these concerns through greater transparency about the role of the Board of Governors. In this post, I elaborate on what I see as a much bigger problem: the financial sector’s influence on Congress as it seeks to “reform” the Fed.
Here’s an example of what I mean. Last year, Congress amended Section 10.1 of the Federal Reserve Act. That section now requires a person who is experienced with community banks to be on the Board of Governors. There is no other explicit sectoral requirement of this kind in the Act.
How should one interpret this new statutory requirement? The issue is not whether it is often beneficial to have a Board member who has prior experience with community banks. I fully agree that it is. But that’s true of many other sectors in the US economy. So why is Congress picking this particular sector as being one that needs to be represented on the Board?
Unfortunately, the answer is clear to me (as I suspect that it will be to anyone who fills this new slot): Congress wants the Fed to tilt supervision, regulation, and monetary policy to be more favorable to community banks. This interpretation is consistent with the fact that the passage of this statutory change came after six years of lobbying from the Independent Community Bankers of America.
This statutory preference for community banks is disturbing. It’s true that community banks are often located on Main Street. But the interests of community banks are absolutely not the same as the interests of Main Street.
In terms of supervision and regulation: lax supervision and regulation increases the probability of bank failure. Bank failures impose a cost on the FDIC which is, ultimately, backstopped by the taxpayer. Community banks operating in the interests of their shareholders should not - and don’t - fully internalize these taxpayer costs. Accordingly, community banks systematically favor less supervision and regulation than would be in the public interest.
In terms of monetary policy, the profits that banks derive from many of their products are positively correlated with the overall level of interest rates in the economy. For this reason, community bankers typically favor higher interest rates than is in the general public interest. (Of course, this preference is shared by larger financial institutions for similar reasons.)
In writing the above, I’m not intending to be critical of community banks. They’re private businesses. No one should expect the interests of a given private business to coincide with the general public interest.
The problem is with Congress. Congress is supposed to act in the interest of the public. But this law is not in the public interest. Instead, it is a rather clear attempt to influence the Fed so that it acts more in the interest of (part of) the financial sector.
In his op-ed, Senator Sanders says that he wants to reform the Fed so that “the foxes would no longer guard the henhouse”. The first step in this agenda should be to repeal the recent amendment to section 10.1 of the Federal Reserve Act. This step will not be easy to accomplish. The amendment passed with overwhelming support from both parties in both Houses of Congress.

Friday, January 15, 2016

Are Long-Term Inflation Expectations Declining? Not So Fast, Says Atlanta Fed

From the Atlanta Fed's Macroblog:

Are Long-Term Inflation Expectations Declining? Not So Fast, Says Atlanta Fed:
"Convincing evidence that longer-term inflation expectations have moved lower would be a concern because declines in consumer and business expectations about inflation could put downward pressure on actual inflation, making the attainment of our 2 percent inflation goal more difficult."
—Fed Chair Janet Yellen, in a December 2, 2015, speech to the Economic Club of Washington
To be sure, Chair Yellen's claim is not controversial. Modern macroeconomics gives inflation expectations a central role in the evolution of actual inflation, and the stability of those expectations is crucial to the Fed's ability to achieve its price stability mandate.
The real question on everyone's mind is, of course, what might constitute "convincing evidence" of changes in inflation expectations. Recently, several economists, including former Treasury Secretary Larry Summers and St. Louis Fed President James Bullard, have weighed in on this issue. Yesterday, President Bullard cited downward movements in the five-year/five-year forward breakeven rates from the five- and 10-year nominal and inflation-protected Treasury bond yields. In November, Summers appealed to measures based on inflation swap contracts. The view that inflation expectations are declining has also been echoed by the New York Fed President William Dudley and former Minneapolis Fed President Narayana Kocherlakota.
Broadly speaking, there seems to be a growing view that market-based long-run inflation expectations are declining and drifting significantly away from the Fed's 2 percent target and that this decline is troublingly correlated with oil prices.
A problem with this line of argument is that the breakeven and swap rates are not necessarily clean measures of inflation expectations. They are really better referred to as measures of inflation compensation because, in addition to inflation expectations, these measures also include factors related to liquidity conditions in the markets for these securities, technical features of the inflation protection in each security, and inflation risk premia. Here at the Atlanta Fed, we've built a model to separate these different components and isolate a better measure of true inflation expectations (IE).
In technical terms, we estimate an affine term structure model—similar to that of D'Amico, Kim and Wei (2014)—that incorporates information from the markets for U.S. Treasuries, Treasury Inflation-Protected Securities (TIPS), inflation swaps, and inflation options (caps and floors). Details are provided in "Forecasts of Inflation and Interest Rates in No-Arbitrage Affine Models," a forthcoming Atlanta Fed working paper by Nikolay Gospodinov and Bin Wei. (You can also see Gospodinov and Wei (2015) for further analysis.) Essentially, we ask: what level of inflation expectations is consistent with this entire set of financial market data? And we then follow this measure over time.
As chart 1 illustrates, we draw a very different conclusion about the behavior of long-term inflation expectations. The chart plots the five-year/five-year forward TIPS breakeven inflation (BEI) and the model-implied inflation expectations (IE) for the period January 1999–November 2015 at a weekly frequency. Unlike the raw BEI, our measure is quite smooth, suggesting that long-term inflation expectations have been, and still are, well anchored.

160115a

After making an adjustment for the inflation risk premium, we term the difference between BEI and IEs a "liquidity premium," but it really includes a variety of other factors. Our more careful look at the liquidity premium reveals that it is partly made up of factors specific to the structure of inflation-indexed TIPS bonds. For example, since TIPS are based on the non-seasonally adjusted consumer price index (CPI) of all items, TIPS yields incorporate a large positive seasonal carry yield in the first half of the year and a large negative seasonal carry yield in the second half. Chart 2 illustrates this point by plotting CPI seasonality (computed as the accumulated difference between non-seasonally adjusted and seasonally adjusted CPI) and the five-year breakeven inflation.

160115b

Redemptions, reallocations, and hedging in the TIPS market after oil price drops and global financial market turbulence can further exacerbate this seasonal pattern. Taken together, these factors are the source of correlation between the BEI measures and oil prices. To confirm this, chart 3 plots (the negative of) our liquidity premium estimate and the log oil price (proxied by the nearest futures price).

160115c

Our measure of long-term inflation expectations is also consistent with long-term measures from surveys. Chart 4 presents the median along with the 10th and 90th percentiles of the five-year/five-year forward CPI inflation expectations from the Philadelphia Fed's Survey of Professional Forecasters (SPF) at quarterly frequency. This measure can be compared directly with our IE measure. Both the level and the dynamics of the median SPF inflation expectation are remarkably close to that for our market-based IE. It is also interesting to observe that the level of inflation "disagreement" (measured as the difference between the 10th and 90th percentiles) is at a level similar to the level seen before the financial crisis.

160115d

Finally, we note that TIPS and SPF are based on CPI rather than the Fed's preferred personal consumption expenditure (PCE) measure. CPI inflation has historically run above PCE inflation by about 30 basis points. Accounting for this difference brings our measure of the level of long-term inflation expectations close to the Fed's 2 percent target.
To summarize, our analysis suggests that (1) long-run inflation expectations remain stable and anchored, (2) the seemingly large correlation of market-implied inflation compensation with oil prices arises mainly from the dynamics of the TIPS liquidity premium, and (3) long-run market- and survey-based inflation expectations are remarkably close in terms of level and dynamics over time. Of course, further softness in the global economy and commodity markets may eventually drag down long-term expectations. We will continue to monitor the pure measure of inflation expectations for such developments.

Thursday, January 14, 2016

'Information in Inflation Breakevens about Fed Credibility'

More on the "risk" of inflation. This is from Narayana Kocherlakota:

Information in Inflation Breakevens about Fed Credibility: The Federal Open Market Committee has been gradually tightening monetary policy since mid-2013. Concurrent with the Fed’s actions, five year-five year forward inflation breakevens have declined by almost a full percentage point since mid-2014. I’ve been concerned about this decline for some time (as an FOMC member, I dissented from Committee actions in October and December 2014 exactly because of this concern). In this post, I explain why I see a decline in inflation breakevens as being a very worrisome signal about the FOMC”s credibility (which I define to be investor/public confidence in the Fed’s ability and/or willingness to achieve its mandated objectives over an extended period of time).
First, terminology. ...
Conceptually, the five-year five-year forward breakeven can be thought of as the sum of two components:
1. investors’ best forecast about what inflation will average 5 to 10 years from now
2. the inflation risk premium over a horizon five to ten years from now - that is, the extra yield over that horizon that investors demand for bearing the inflation risk embedded in standard Treasuries.
(There’s also a liquidity premium component, but movements in this component have not been all that important in the past two years.)
There is often a lot of discussion about how to divide a given change in breakevens in these two components. My own assessment is that both components have declined. But my main point will be a decline in either component is a troubling signal about FOMC credibility.
It is well-understood why a decline in the first component should be seen as problematic for FOMC credibility. The FOMC has pledged to deliver 2% inflation over the long run. If investors see this pledge as credible, their best forecast of inflation over five to ten year horizon should also be 2%. A decline in the first component of breakevens signals a decline in this form of credibility.
Let me turn then to the inflation risk premium (which is generally thought to move around a lot more than inflation forecasts). A decline in the inflation risk premium means that investors are demanding less compensation (in terms of yield) for bearing inflation risk. In other words, they increasingly see standard Treasuries as being a better hedge against macroeconomic risks than TIPs.
But Treasuries are only a better hedge than TIPs against macroeconomic risk if inflation turns out to be low when economic activity turns out to be low. This observation is why a decline in the inflation risk premium has information about FOMC credibility. The decline reflects investors’ assigning increasing probability to a scenario in which inflation is low over an extended period at the same time that employment is low - that is, increasing probability to a scenario in which both employment and prices are too low relative to the FOMC’s goals.
Should we see such a change in investor beliefs since mid-2014 as being “crazy” or “irrational”? The FOMC is continuing to tighten monetary policy in the face of marked disinflationary pressures, including those from commodity price declines. Through these actions, the Committee is communicating an aversion to the use of its primary monetary policy tools: extraordinarily low interest rates and large assetholdings. Isn’t it natural, given this communication, that investors would increasingly put weight on the possibility of an extended period in which prices and employment are too low relative to the FOMC’s goals?
To sum up: we’ve seen a marked decline in the five year-five year forward inflation breakevens since mid-2014. This decline is likely attributable to a simultaneous fall in investors’ forecasts of future inflation and to a fall in the inflation risk premium. My main point is that both of these changes suggest that there has been a decline in the FOMC’s credibility.
To be clear: as I well know, in the world of policymaking, no signal comes without noise. But the risks for monetary policymakers associated with a slippage in the inflation anchor are considerable. Given these risks, I do believe that it would be wise for the Committee to be responsive to the ongoing decline in inflation breakevens by reversing course on its current tightening path.