Tim Duy's Fed Watch

Notes on the Fed Meeting

Just a quick note today – I am swamped with classes and travel this week, and sadly cannot really do justice to the wealth of information provided today by the Fed.

The basics are well known at this point.  The Fed extended its expectation for low rate out through the end of 2014, with the new hawk on the FOMC, Richmond Fed President Jeffrey Lacker, dissenting.  The growth and inflation forecasts for 2012 were downgraded, while the unemployment forecast was upgraded slightly.   Individual forecasts of the path of the Federal Funds rate were revealed, with six participants anticipating interest rate hikes in 2012 or 2013, in contrast to the broader expectation for low rates through 2014.  The Fed now has an explicit inflation target of 2%.  No new QE at this time.

Some initial thoughts: 

First, the forecast for unemployment and inflation, combined with the restatement of the dual mandate with an explicit inflation target, scream for additional QE at this time.  This is especially so when you realize the range of 2014 inflation forecasts remains centered on something south of the 2% target.   Simply put, the Fed is clearly falling short of both mandates at this point.  We need to be patient for the minutes where we can expect to learn more about QE options, and I agree with Calculated Risk that the Chairman paved the way for additional QE, assuming of course that the economy does not show immediate signs of improvement.  Still, the delay is frustrating given the forecasts.  That said, I think in the last minutes it was clear the Fed was moving in stages, and the communication stage is now complete.  Now we can focus on the next round of QE.  In addition, most participants would not see a need for immediate action given the improvement in the data flow combined with still stable inflation expectations.

Second, the unemployment forecast appears vulnerable given how quickly the rate decreased in recent months.  If the rate of job growth necessary to keep with labor force growth is significantly less than the 125k-150k estimates often used, then I would expect even tepid growth would send the unemployment rate lower than the Fed’s forecast.   The Fed is likely expecting a rebound in the labor force participation rates, but is that likely given the tepid growth forecasts?  And how much of a decline of unemployment over the next month or two would prompt Bernanke to put a hold on QE3?

 Third, I don’t read too much into the divide between the hawks and the doves regarding the timing of a rate increase.  That timing is based on each participant’s individual forecasts, with the hawks likely having somewhat more optimistic forecasts for growth and employment compared to the doves.  If forecasts disappoint, then the hawks will not be in a position to push for a more aggressive path of tightening.  Likewise, the doves will modify their position relative to how their forecasts evolve.  Which is why I am looking at that unemployment rate forecast – it seems the most vulnerable. 

Bottom Line:  The Fed is poised for additional easing, but the next round of QE is not quite a certainty yet.  But I think we would need to see some significant upside surprises in the data in the near term to put plans for additional easing on hold.  Watch the unemployment rate.  We are already at 8.5%, the upper end of the Fed’s forecast.  The lower end is just 8.2% - not far away, and something that is plausible at early as next week.  The Fed’s forecast just doesn’t feel right given the 0.6 percentage point decline over the past four months. 

Japan, Revisted

I haven't had a chance to comment on the recent debate regarding Japan's lost decades, so I am coming to the party a bit late.   A view is forming that the situation is not as dire as many believe.  Paul Krugman notes:

This picture suggests that the Japanese economy was indeed depressed for about 16 years, and deeply so after the slump of the late 1990s. But it may have returned to more or less potential output on the eve of the current crisis.

Just to be clear, this is not a picture of policy success; it is, in fact, a picture of enormous waste. But the condition wasn’t permanent.

Yes, the lost years surely indicate a policy failure. But arguably there is some success.  On one hand, we can see this as vindication of massive deficit spending.  But is this really success?  Because on the other hand, there is no end in sight of such deficit spending.  On Japan's 2012 budget, via the FT:

Even by current grim international fiscal standards, Japan’s budget for the year from April 1 makes scary reading.

For the fourth year in a row, government revenue from bond issuance is set to exceed that from all taxes. Outstanding government debt is expected to hit an extraordinary Y937tn.

I don't intend to go down the "Japan's bond market is about to collapse" path.   But what I am wondering about is Krugman's description of the condition as not permanent. Do we need to see a reversal of debt to GDP ratios to declare victory?  Well, even on that metric it looks like there was some hope heading into the recent downturn:

But such hopes have since been dashed.  

Where does this leave me?  Yes, fiscal policy can work - it can back fill missing demand.  But we haven't seen enough activity in Japan to really jump start the economy to a point that fiscal policy is no longer an economic necessity.  And I am not sure we can expect such a jump start without more explicit help from the central bank.  In which case, Japan has not truly "recovered."  Thus, we cannot yet conclude their condition is not permanent.

In short, before we can declare recovery in Japan, we need to define what a successful recovery should look like. Is it just about returning to potential output (adjusted, in this case, for demographics), or should it be recovery to the point that deficit spending is no longer necessary to support that output?

Is Europe About to Unravel?

Even the illusion of political unity in Europe appears to be dissolving before our eyes.  This, of course, should come as no surprise to anyone watching the European crisis unfold.  The key problem always was the internal imbalances, a problem for which European policymakers have never offered a credible solution.  They simply don't have such a solution in the context of a system of fixed exchange rates.  I believe that currency devaluation is the only option that will change relative competitiveness in any reasonable timeframe and restore internal balance. But that option is unavailable for Euro members. 

Lacking currency devaluation as a tool to resolve imbalances, European policymakers turned to fiscal austerity.  That plan has failed, pushing nation after nation into ever deepening recession.  With Greece going on its fifth year of recession, I imagine by now that Portugal, Spain, and even Italy now see the writing on the wall for themselves.  Sadly, however, the alternative is exiting the Euro, which almost certainly means financial chaos for the Continent as a whole.  

The Eurozone is like a roach motel.  You can get in, but you can't get out.

Still, peripheral nations can only accept so much pain before the costs of being in the Euro outweigh the costs of leaving.  And Italy is now sending Berlin a clear warning that such an endgame is approaching.  Via the Financial Times:

Italy’s prime minister has pleaded for Germany and other creditor countries to do more to help lower his country’s borrowing costs, warning there would be a “powerful backlash” among voters in the eurozone’s struggling periphery if they did not...

..Rome would push the German government to realise it was in “its own enlightened self-interest” to lend more of its fiscal weight to lowering borrowing costs of Italy and other highly indebted governments. The single currency had brought “huge benefits …and maybe [to] Germany even more than others,” he said....

...The stance could put Mr Monti, whose appointment to replace Silvio Berlusconi was cheered by German chancellor Angela Merkel, on a collision course with Berlin. 

What can Germany do?  Germany could do lots of things to help - running a massive budget deficit to drive consumption and inflation higher comes to mind.  Monti, however, is looking for something a little more reasonable, real help on interest rates via Eurobonds and a German commitment to a larger rescue fund.  Arguably small concessions given the magnitude of the problem, but Germany resists.  He also holds out hope for additional ECB aid:

But he said he believed the ECB should feel more secure to move once a new fiscal discipline treaty is agreed at an Brussels summit at the end of the month. 

Perhaps he hopes for too much:  A deep rift between politicians and the ECB looks to be growing.  A stunning development, again via the Financial Times:

The European Central Bank has harshly criticised negotiators working on a new treaty to enshrine fiscal discipline in the eurozone, saying that recent revisions to the draft amounted to “a substantial watering down” of the pact’s strictures intended to force down debt levels within the single currency.

Jörg Asmussen, a member of the ECB’s executive board, wrote to negotiators that new provisions in the treaty that would allow highly indebted eurozone countries to breach budget deficit limits “in periods of severe economic downturn” amounted to an “escape clause” that could lead to “easy circumvention of the rule”.

“These revisions in my view clearly run against the spirit of the initial general agreement on an ambitious fiscal compact,” Mr Asmussen wrote in a letter on the ECB’s behalf, dated Thursday.

The original compact would of course be watered down - it was never credible to begin with, as it called for a level of fiscal austerity across the Eurozone compatible only with Depression.  The ECB is looking for just such an outcome:

In proposed treaty language accompanying the letter, Mr Asmussen suggested that eurozone countries should only be allowed to breach the deficit limit – which is defined in the text as 0.5 per cent of economic output – in times of “natural catastrophes and serious emergency situations outside the control” of eurozone governments.

How far with the ECB push the issue?  Will they back away from further bond purchases?  Edward Harrison and Martin Feldstein have more here and here.  I would add that it pays to remember the ECB plays for keeps, and is not above outright extortion to get what it wants.  

Meanwhile, via Naked Capitalism, Wolf Richter informs us of another rift growing in the Eurozone rescue efforts, this time in the disaster that is Greece:

But now the Troika itself is in disarray. It surfaced today at an IMF press briefing in Washington: the IMF no longer supports austerity as a guiding principle. Athens News quoted a senior IMF source, who was speaking on condition of anonymity. Frustration was practically palpable:

Horizontal austerity measures are constantly being adopted that are leading nowhere, whilst further wage and pension cuts are unjustified because the only way to improve competitiveness is through growth-creating market liberalization, the opening of closed professions, and productive investments.

The three Troika inspectors—Poul Thomsen from the IMF, Mathias Morse from the EU, and Klaus Mazouch from the ECB—are supposed to head to Greece next week to inspect its books; the budget deficit is once again higher than the revised limit that Greece had vowed to abide by. And they’re supposed to negotiate additional “structural reforms.” But there probably won’t be three inspectors, according to senior IMF sources. Missing: Poul Thomsen. The IMF has had enough.

Finally, note that last week's S&P downgrade came down especially hard on Portugal.  That bailout is headed toward another round of private sector involvement.  Only a matter of time.  

Bottom Line:  In Europe, the unstoppable force of austerity is colliding with the immovable object that is reality.  Expect fireworks.

How's That Austerity Working?

From a Wall Street Journal article on the collapse of the Greek debt talks:

The negotiations have been tortuous. After first insisting no default by any euro-zone country would be possible, leaders agreed in July to seek a deal to cut about 10% from the face value of Greece's bonds in private hands. By October, Greece's prospects had deteriorated, and euro-zone governments and the IIF agreed to pursue a deal to cut the face value in half. Since October, Greece's economy, which is entering its fifth year of recession, has weakened further, worsening the state of its government finances. That means a bigger gap in Greece's budget that must be filled either by more debt relief or more new lending from official creditors.

How can this downward spiral end with anything other than a technical default?  It can't, which is why the debt talks collapsed.  The cuts necessary to bring Greek debt down to anything even remotely sustainable is much greater than the supposed 50% haircut agreed to last October.  And that 50% headline number is now a source of heartburn for European politicians.  Via the FT:

Charles Dallara, the IIF’s managing director, told the Financial Times on Sunday that he believed an agreement in principle needed to be completed by the end of this week if the restructuring deal was to be finalised in time for a €14.4bn Greek bond redemption due on March 20.

Though he said Greek officials were negotiating in good faith, he was critical of other eurozone negotiators, saying they were not living up to the outlines of the haircut deal reached at a tense October EU summit. “[Ms Merkel and Mr Sarkozy] and all the European heads of state said they wanted a deal with a 50 per cent [haircut] and a voluntary agreement,” Mr Dallara said. “Some of their own collaborators are not following that decision.”...

...Greek debt managers had agreed with bondholders on a coupon just below 5 per cent but creditors last week proposed a much lower interest rate.

Germany has proposed a 2-3 per cent coupon that would increase bondholders’ losses from 60 per cent to more than 80 per cent in net present value terms.

It looks like Merkel and Sarkozy are trying to pull the old bait and switch on creditors.  The difference between a 60% and an 80% cut is meaningful, and sufficient to drive some debtholders, such as hedge funds that picked the stuff up on the cheap, to think they are better off to take the chance on their CDS counterparties rather than submit to a "voluntary" restructuring of the magnitude necessary to bring real relief to Greece's fiscal situation.

One has to say this about European policymakers - they sure keep it interesting.  

Meanwhile, German Chancellor Angela Merkel appears to have learned nothing from the ongoing debt-deflation dynamics throughout much of Europe.  Responding to the S&P downgrades, via the FT:  

Ms Merkel said the downgrade made implementation of steps towards fiscal union – to be codified in an inter-governmental treaty which could be signed by the end of January – urgent. She called on leaders to resist softening up the so-called fiscal compact “here, there and everywhere” as details were hammered out.

Even after German GDP turned negative in the final quarter of last year, Merkel can find no other option than fiscal austerity.  Perhaps some hope from France:

François Fillon, prime minister, at the weekend ruled out more austerity measures, saying the government’s efforts were aimed at boosting growth.

Then perhaps, maybe not:

But he also said in an interview with Journal du Dimanche, a Sunday newspaper: “We will do everything to get it [the triple A] back.” 

Does France have any choice but additional austerity?  What would happen politically if the core refused to embrace what it pushed upon the periphery?  Spain appears ready to double-down on the austerity path, even as a slowing economy pushes the budget deficit over 8% of GDP:

Mariano Rajoy, the centre-right prime minister who took power in Spain last month, has responded to Friday’s credit downgrade from Standard & Poor’s by saying that his government will persevere with austerity and economic reforms, cutting the budget deficit, modernising labour laws and restructuring the banking sector.

Good luck with that - it has worked so well in Greece.

Bottom Line:  The actions of the European Central Bank greatly eased the immediate financial pressures in the Eurozone.  But the underlying problem of internal imbalances remain, and the European response is still  not addressing those imbalances.  Instead, the commitment to the fixed exchange rate combined with Germany's failure to recognize that their current account surplus must turn to deficit if they ever hope to be repaid promises to lock the Eurozone on the path of ongoing recession.

Output Gaps and Inflation

Regarding, again, the size of the output gap, this remark is found in the most recent Fed minutes:

However, a couple of participants noted that the rate of inflation over the past year had not fallen as much as would be expected if the gap in resource utilization were large, suggesting that the level of potential output was lower than some current estimates.

I think this has less to do with the size of the output gap and more to do with downward nominal wage rigidities.  Note that wages are still rising, although the pace of wage growth for production and nonsupervisory workers is still falling: 

Perhaps a better example is the relatively new series, wages for all workers: 

Overall private wage growth bottomed out in 2009 and held around 1.75%, perhaps just beginning to rise in recent months.  

Despite very high unemployment and underemployment, wage growth is still positive.  It tends to be very difficult to induce workers to take wages cuts (think also how the newly unemployed will resist taking new jobs with a substantially lower pay), which in-turn helps put a downside to inflation.  In other words, one would expect the relationship between the output gap (or, similarly, high unemployment) and inflation to flatten as inflation rates fall toward zero.  

This is also covered by Paul Krugman here and here.

Also note that rising wages doesn't necessarily imply higher inflation.  Between the two is productivity growth.  To account for the latter, we can look at unit labor costs: 

Not exactly a lot of inflationary pressures stemming from unit labor cost growth.  Presumably, high real wages could come by redistributing productivity gains to workers in the context of low inflation.  For that to happen, however, I think we will need a lot more upward pressure on the labor market than we are seeing right now.

 

More on the Output Gap

Only time for a quick post between classes today...

Hoisted from the comments from my last piece, Steve notes:

In an interview with Bloomberg last week, Bullard explicitly said he expected the economy to follow a new output trend out of the base of the recession rather than a recovery to a trend from the previous peak. The written media didn't pick up on these quotes; rather they focused his comments that explicit inflation targeting is near.

I missed that interview, but found it here.  And yes, St. Louis Federal Reserve President James Bullard does say that estimates of the output gap are too high and will be revised downward. He says the outcomes of the last expansion were not related to economic fundamentals and thus we should not expect to be able to return to those levels of output and, presumably, employment.  He does not aim to return to the pre-recession trend of output growth and is instead ready to manage the economy along the new path.  Bullard does admit, however, that he has gotten little traction for his view.

On the other end of the spectrum, San Fransisco Federal Reserve President John Williams offers an interview to the Wall Street Journal, and sounds dovish even after the most recent employment report:

 In a follow-up email exchange, Mr. Williams wrote that the report didn't fundamentally alter his views on the economy.

"My view of it is inflation is going to be for a sustained period below target," he said. "Unemployment is going to be sustained above a reasonable estimate of the natural rate of unemployment, which is closer to 6.5% than the 8.5% that we have now. That does make an argument that we should have more stimulus."

There is a caveat, however:

Mr. Williams also hedges, though, adding that it "really depends in how much confidence you have in that forecast. And also there are costs to taking greater policy action. There are always trade-offs that have to be weighed."

This is frustrating, because if there is indeed an argument further stimulus, what is holding the Fed back?  Why hedge by questioning the forecast?  And what are the costs?  Presumably the cost is higher inflation, but Williams already says he expects inflation to be below target.  So why pull your punches?

I am starting to wonder if the whole "we can do more" meme from the dovish side of the FOMC has more to do with just offering a counterweight to the hawks who seem to see an imminent need for tightening rather than a push for an actual policy change.  

QE3 or Not?

Last week - before the most recent employment report - the Wall Street Journal offered up the odds of another round of quantitative easing:

“Primary dealers,” those 21 lucky banks that answered the Old Bridge Troll’s questions correctly and were granted the right to do business directly with the Fed, see QE3 coming and don’t see the Fed raising rates for at least two years.

That’s according to the results of a new survey of primary dealers by the New York Fed.

Primary dealers, on average, assign a 45% chance of a Fed interest-rate increase in the second quarter of 2014. Before that, the chances of a rate increase are never higher than 15%.

High expectations are not a surprise given the propensity of some officials to make remarks like these from New York Federal Reserve President William Dudley:

However, because the outlook for unemployment is unacceptably high relative to our dual mandate and the outlook for inflation is moderate, I believe it is also appropriate to continue to evaluate whether we could provide additional accommodation in a manner that produces more benefits than costs, regardless of whether action in housing is undertaken or not.

It's no secret some Fed officials have been looking into additional purchases of mortgage-backed assets to support the economy via the housing market.  And once they started talking about it, market participants began to assume it was imminent.  Moreover, the idea of additional easing popped up in the most recent minutes:

A number of members indicated that current and prospective economic conditions could well warrant additional policy accommodation, but they believed that any additional actions would be more effective if accompanied by enhanced communication about the Committee's longer-run economic goals and policy framework.

So now we have a timeline - first, enhanced communication.  Second, additional easing.  Seems straight forward, especially now that inflation looks to be trending downward, alleviating the panic that appeared to seize FOMC members in the first part of 2011.

But after the first part of 2011 comes a string of relatively solid data, at least as solid as one gets in this recovery.  That data culminates with the decidedly not-terrible employment report.  How long could it be before monetary policymakers started to question the need for additional easing?

Just a single day.  On Saturday, St. Louis Federal Reserve President started to toss cold water on the idea of additional easing.  Via MarketWatch:

 “I don’t think it [QE] is very likely right now because the tone of the data has been very strong right now,” Bullard told reporters after a speech at the American Economic Association meeting....

...Bullard said he was encouraged by the December employment report that showed a drop in the unemployment rate to near a three-year low of 8.5%.

“I thought the jobs report was encouraging. Hopefully it is harbinger of more robust activity,” he said.

Bullard said he thinks Wall Street is too gloomy about the outlook.

“I think forecasters are a bit too pessimistic about the U.S. economy,” he said. “The recession has been over for fair amount of time. It is a logical point in the recovery where you would expect somewhat more rapid growth and somewhat better jobs market, so we’ll see if that is what happens.”

The logical point to see more rapid growth is in the quarters immediately following a significant contraction, not two years later.  But putting that aside for the moment, I think it is easy for the Federal Reserve to read the recent data as signs the Great Depressing is beginning to unwind.  Consider recent behavior of monthly private nonfarm payrolls:

Just eyeballing the chart, it looks like payroll growth is settling into a trend consistent with something around what we would think of as potential growth, except that growth may be a little slower than in the pre-recession period and is occurring along an equilibrium path below the pre-recession path.  And that growth is translating into a falling unemployment rate:

At this rate, we could be approaching 7% by next year, which would then put unemployment below the Fed's forecast for 2014.  By my standards still an unacceptably slow pace given that decelerating inflation provides room for additional easing, but I can easily see where FOMC members decided the risk of additional easing outweigh the benefits.  

Now, in my mind, this would guarantee that the Fed would not be really unwinding the Great Depression as much as managing a the economy along a new trend.  Unwinding the Great Depression, I think, means fully reversing the drop in the employment to population ratio: 

Note that in the previous recession, the employment to population ratio edged up, but fell short of regaining the previous peak.  Imagine the same occurring this time.   Complicating a complete unwind is the economy's dependence on asset bubbles to support high levels of employment: 

It seems that the loss of net wealth equal to 100% of GDP must be a depressing effect on spending.  My sense is that we are unlikely to craft another widespread asset bubble and thus we will be missing a piece of demand that was critical to supporting the economy. How I think you might compensate for this lost demand is for the Fed to explicitly raise the inflation target and stimulate growth such that nominal wages rise sufficiently to quickly erode the real value of debt.  If the Fed doesn't allow that to happen, instead sticking with the 2% target, then I suspect they will reduce accommodation long before the economy would regain the pre-recession equilibrium path.  In other words, the Fed manages the economy along the new equilibrium path, and makes no pretense of trying to achieve pre-recession employment targets.  

Could the Fed credibly commit to a higher inflation target and make actionable such a commitment?  I think they can, but would need to announce they are making some permanent additions to the money stock and ease the expectation that the balance sheet expansion will be fully unwound at the first possible moment.  In other words, to convince the public that you intend to raise the level of the price path relative to the existing path, you need to be willing to allow for the permanent increase in the money supply that would allow that to happen.  Barring that, they can target the dollar directly and do what they won't do - buy foreign currency or foreign debt.  But this is now a more academic than practical discussion.  The Fed has a target.  Period.  End of story.

Bottom Line:  Bullard reminds us that QE3 is not a certainty.  True, inflation is easing and in aggregate the labor market remains weak, even if recent numbers are coming in a bit stronger.  Arguably plenty of room for additional easing, which is why I have tended to think the Fed would eventually take additional action (that and the never-ending European mess).  But the Fed hasn't shown an eagerness to ease further despite what they saw as a very slow reduction in unemployment - and it is reasonable to assume that forecast is getting a little bit brighter.  Under such conditions, one or two months of "positive" employment news could fully derail the QE3 train.  I increasingly think it depends on what the Fed's ultimate objective is - to unwind the Great Recession and attempt to restore pre-recession employment to population ratios, or just manage along a new output path.  I used to think the former was the Fed's objective, but now am questioning that belief.

Ultimately, It's About the Inflation Target

Ryan Avent reports from Chicago on the willingness to believe the Fed is powerless to produce additional inflation:

Why is Mr Hall—why are so many economists—willing to conclude that the Fed is helpless rather than just excessively cautious? I don't get it; it seems to me that very smart economists have all but concluded that the Fed's unwillingness to allow inflation to rise is the primary cause of sustained, high unemployment. And yet...this is not the message resounding through macro sessions. Instead, there are interesting but perhaps irrelevant attempts to model the funny dynamics of a macro challenge that actually boils down to the political economy constraints (or intellectual constraints) facing the central bank. Let's focus our attention on that, for heaven's sake.

Avent is correct.  It does seem that most economists believe that at the zero bound, allowing inflation expectations to rise is an effective - perhaps the only effective - mechanism for the central bank to accelerate activity.  Moreover, if, as Avent says, we believe the Fed can prevent deflationary expectations, then they can certainly create inflationary expectations.  The fact that they don't would then be something of a mystery, as certainly we don't see Federal Reserve Chairman Ben Bernanke as intellectually deficient on this issue.  He can clearly do the math as well as anyone.

An answer to this conundrum is evident in the Fed's forecasts (dark blue is the central tendency):

The disconnect between the unemployment and inflation forecasts is clear.  The Fed has a dual mandate, and, according to its forecasts, it cannot meet both of the mandates in the near to medium terms under the expected policy path.  So a choice needs to be made.  And the Fed has chosen to focus on meeting the inflation side of the mandate  (note, headline PCE inflation in the long-run, which is why I focused on that measure in a piece last week).  No mystery.  No reason for vast intellectual expenditures.  Price stability means 2% inflation, and if we can't meet the unemployment target within that mandate, so be it.  

In other words, they are certainly capable of inducing higher inflation.  They just don't because, in their view, 2% is a firm target, and the costs of exceeding that target, or, more importantly, changing that target, are effectively assumed to be infinite and thus by definition exceed any expected benefits.  

Now, you could argue, that it really isn't this simple, since the "price stability" objective is not legally defined at 2% (Notice also that 2% is really the upper limit.  On average, it appears that monetary policymakers would actually like something closer to 1.8%).  There is a real question here that I don't believe the Fed has adequately answered - why should the definition of price stability be 2% rather than 3%? 

So what is the constraint - political, intellectual, or irrational - that forces the Fed to adopt a 2% inflation target, and then choose to act as if that target was written in stone?  I imagine policymakers would respond to the first point by claiming that price stability really means zero percent inflation, and that they choose 2% because we overestimate inflation and need some cushion from the lower bound problem. Fine, but what if you are already in the liquidity trap?  For the second part, they would argue that the economy would be less stable in the absence of a firm target.  My reply is that this might be correct for the eight decades a century that you are not in a liquidity trap, but what about the other two decades you are in a liquidity trap? Is a target calibrated during normal economic conditions then supporting suboptimal outcomes in a liquidity trap?

I expect to get some relief in at least the near term inflation forecasts at the conclusion of the next FOMC meeting, a decrease of the lower boundary of the central tendency which then helps clear the way for additional Fed easing.  Core inflation has clearly been rapidly decelerating in recent months:

If you believe, as the Fed appears to, that core-inflation provides useful information on the direction of headline inflation, then the message is clear - headline inflation is likely to drift lower, and the economy needs more stimulus.  What the Fed will deliver, however, will still be within the bounds of the 2% inflation target, and thus still falls short of the increase in expected inflation that the Fed should really be delivering. 

 

 

A Few Quick Charts on Consumer Spending

In my last piece, I noted that excessive optimism or pessimism essentially cancelled each other out over the course of 2011 when tracking the overall economy.  The same held true of consumption spending as well:

 
Since the recession ended, consumer spending has been tracking a slightly slower growth trend than prior to the recession.  Again, there looks to have been a long-lasting shock to the path of consumer spending.  Interesting changes have occurred underneath the surface, however.  The path of spending on services is markedly lower:

This was the subject of a Wall Street Journal article last November:

Increasingly, that means service businesses find it harder to get their share of consumer spending, which is prompting many business owners to scale back. At The Wall Street Journal's CEO Council conference this month, Alan Krueger, chairman of the president's Council of Economic Advisers, highlighted the service sector's central role for jobs growth. "Services account for about half of GDP, and over half of jobs," Mr. Krueger said. "Particularly discretionary services…people have been putting off getting their cars repaired because of concerns about jobs and income growth."

This is certainly something weighing on job growth.  That said, consumers are not foregoing all spending.  The Wall Street Journal pieces ends with:

Small cutbacks are a big reason Massimo Liguori, owner of Salon Massimo in Connecticut, closed down one of his two locations...In turn, Mr. Liguori said he now goes out to dinner with his wife twice a month or so, compared with at least once a weekend previously. "What happens is you start becoming skeptical of the future," he said...Still, a sense of austerity didn't prevent him from buying a $49,000 Lexus sport-utility vehicle. "A car is different because I put my family in that," he said.

Which brings us to the upturn in durable goods spending:

 
The rebound in auto sales clearly is supporting this trend.  How much of this is pent-up demand that has already been satisfied?  How much support will we get from auto sales in 2012?  Hopefully enough to match last year's growth, but MarketWatch recently pointed to a troubling sign:

But there’s also some negative news buried in the Conference Board release, and that’s a big drop in the percentage planning to buy an automobile in the next six months. At 9.8%, it’s the worst since October 2010.

One can always discount a single data point, but the decline fits a broader story: Americans needed to buy cars after the Great Recession because theirs were simply getting too long in the tooth.

But this replacement-cycle impact, which has been a tailwind for the likes of General Motors and Ford Motor Co., was bound to end at some point.

Has much of the auto rebound already taken place?  How much more can we expect given the vehicle miles driven continues to decline, suggesting existing vehicles will last even longer?  Something to think about as we ponder the strength of the economy this year.

Finally, the path of nondurable goods spending has been erratic:

 
Certainly, the upturn in gas prices played a role in tempering the pace of growth in nondurable spending this year:

The trend of nondruable goods spending is tracking the pre-recession trend.  So, at this point, we are seeing overall consumption supported by a rebound in durable goods spending that offsets a deterioration in the path of spending on services.  The bounce in durable goods spending will come to an end at some point, as 16 million units is likely an upper bound for auto sales.  Will service spending accelerate to compensate?  Or will we see a new normal, with a constrained consumer spending at a path and rate below those prior to the recession?  I am sympathetic to that outcome, with a corresponding increase in export growth to foster rebalancing of the economy (of course dependent upon growth in the rest of the world, something in question at this point).

But that still is not a story that rapidly returns the economy to potential output.  Which brings me back to a familiar place - putting aside the threats to the economy, it is easy to see a positive growth path for the economy, but more difficult to see a rapid closure of the output gap.  

Still Cautious Heading Into 2012

I have been hesitant to embrace the recent positive data flow - once bitten, twice shy perhaps.  Something about the current dynamics that seems a little too familiar.  Indeed, I felt something of relief when FT Alphaville came to a similar conclusion in the waning days of 2011.  Cardiff Garcia reports on a Nomura research note that details a new bias in the seasonal adjustment process, noting:

Up next, writes Nomura, you can expect exaggeratedly strong readings from the Chicago PMI later this month and the next ISM manufacturing survey at the start of January.

I imagine it is premature to call the readings "exaggerated," but both did surprise on the upside, as much data has of late.  Read the whole piece - it is worth the time.

Indeed, flirtations with either excessive optimism or excessive pessimism were not richly rewarded last year, as on average the economy simply edged upward in pretty unremarkable fashion:

 
It seems reasonable to expect the same in 2012, at least as a baseline - a slow "recovery" that is really more of an adjustment to what appears to be the economy's new equilibrium path, one that is decisively subpar to the pre-recession trend.  I don't believe that such an adjustment is necessary, as in my view it simply reflects a shortfall of aggregate demand.  That said, the longer the cyclical downturn grinds on, the more likely it is that we will indeed see a new equilibrium path.  A greater percentage of the cyclical unemployment will become structural unemployment or permanent shifts in the labor force participation rate.  In addition, investments will go unmade as firms hoard cash.  And, increasingly, policymakers will manage policy along the new equilibrium path, forgetting entirely the pre-recession path.

More than not, this is already the case.  To be sure, some FOMC members are moving toward QE3, setting the stage for additional asset purchases, perhaps in the spring now that inflation concerns have eased somewhat. Still, the pace of policy change is agonizingly slow.  From the most recent minutes:

 A number of members indicated that current and prospective economic conditions could well warrant additional policy accommodation, but they believed that any additional actions would be more effective if accompanied by enhanced communication about the Committee's longer-run economic goals and policy framework. A few others continued to judge that maintaining the current degree of policy accommodation beyond the near term would likely be inappropriate given their outlook for economic activity and inflation, or questioned the efficacy of additional monetary policy actions in light of the nonmonetary headwinds restraining the recovery. For this meeting, almost all members were willing to support maintaining the existing policy stance while emphasizing the importance of carefully monitoring economic developments given the uncertainties and risks attending the outlook. One member preferred to undertake additional accommodation at this meeting and dissented from the policy decision.

"Could well" warrant, but might not.  Other than Chicago Federal Reserve President Charles Evans, FOMC members have been hesitant to act further despite the gaping and persistent output gap.  It would seem that they are more willing to manage the economy along it current path, allowing unemployment to slowly decrease gradually - job gains or labor market exodus - rather than risk another percentage point of inflation.  And with the PCE price index essentially now returned to pre-recession trend, there has been little enthusiasm to embrace such a risk:

But again only Evans appears willing to accept higher inflation.  Perhaps policy change will accelerate now that Presidents Kocherlakota, Fisher, and Plosser are rotated off the FOMC, but note that this was always a minority block.  Had the majority wished to advance policy more aggressively, they could have.  The majority simply was not motivated enough to fight such a battle.  And while they would act should the economy falter, that action will be delayed if the incoming data once again reflects Nomora's upward seasonal bias, regardless of the underlying trend.  

In short, while the FOMC has been edging toward additional action - and will likely do something after first enhancing communication procedures with additional rate forecast - they have not done so with the urgency called for by the anemic recovery.     

While a repeat of last year is a reasonable baseline, I remain more concerned with downside rather than upside risks.  Europe is still on the ropes, in my opinion.  The ECB has bought some time with its LTRO, but the still high yields on long-term Italian debt suggest that that southern European nation is suffering from something closer to a solvency crisis than a liquidity crisis.  And the austerity push is far from over, as, unsurprisingly, peripheral European nations will continue to miss budget targets, with Spain being the latest example.  In my view, the European periphery will have trouble breaking the debt-deflation dynamic in the absence of currency devaluation.  Such devaluation is a key mechanism to resolving balance of payments crisis, allowing for a rapid increase in competitiveness and stoking inflation that reduces the real burden of domestic-denominated debt.  No such option is available to European nations, locked in as they are to the Euro.   Consequently, I see 2012 as another year of challenge as Europe struggles to hold the Euro together by pressuring troubled nations into ever-greater austerity.  

In addition to Europe, I remain concerned that US politics will usher in an ill-timed fiscal contraction.  The payroll tax credit was extended for just another two months, and Stan Collender is warning that there may not be an easy path to an extension.  And I continue to think that spending would be vulnerable to any sudden hit to income, especially when disposable personal income isn't exactly surging forward: 

Finally, the festering Iran situation is a wildcard, with posturing by both the US and Iran looking increasingly like a game of chicken, and both sides looking to provoke the other into a rash action.  Of course, if any escalation of hostilities triggers an actual supply disruption that spikes oil back to $150 or higher, we would expect the global economy to lurch downward.  Note, however, this is a perennial concern, and one that will not fade until we find an alternative to fossil fuels.  Something we simply learn to live with, it seems.

Bottom Line:  I want to believe the recent improvement in the tenor of economic data signals that activity is set to accelerate substantially in 2012.  But the ups and downs on the past two years smoothed out to nothing exciting or catastrophic, just a moderate path of activity that remains woefully insufficient to return the US economy to its pre-recession trend. For now, I will stick to that middle ground, while remaining watchful of the all-too-many downside risks that leave me just a little bit sleepless each night.