Tim Duy's Fed Watch

Dollar Up

The Dollar continues to gain despite the supposed "Great Debaser" Federal Reserve Chairman Ben Bernanke bringing us multiple rounds of quantitative easing:

Just sayin....

Confidence Boom?

The early read on the Thomson Reuters/University of Michigan Consumer Sentiment index jumped to 83.7 in May, up from 76.4 in April.  Just a quick reminder before we get too excited - sentiment has tended to be low relative to actual spending.  May's sentiment bounce just returns us to trend:

Better than collapsing confidence, but by itself not pointing to an imminent acceleration in consumer spending.  

Busy Data Day

Something of a busy data day.  Not all of it pleasant, but I suspect that the Fed will attempt to see through that unpleasantness.  Start with the surprise jump in initial unemployment claims:

I don't think the jump is out of line with recent volatility, nor does it suggests that the general downtrend is broken.  Next we have a disappointing read on housing starts, primarily due to a drop in the volatile multi-family sector:

I would take comfort in the opposite move in building permits, which will show up as future starts:

The regional manufacturing surveys continue to disappoint, with the Philly Fed survey the latest to fall short of expectations.  Calculated Risk has more, and notes that the incoming regional surveys suggest the next national ISM report will be weak.  Manufacturing looks likely then to continue bouncing along just above the expansion/contraction mark:

One wonders if manufacturing is really slowing, or  if this is a diffusion index issue.  We can't tell from the index if the expanding firms are growing very quickly or slowly.  We do know that they have been keeping their workers busy:

And we also know that while industrial production dipped in April, again there is nothing to suggest it is rolling over:

The CPI release revealed that inflation remains nonexistent.  Indeed, core-CPI tracked lower:

This is what I think the Fed would find as the most important indicator of the day.  One would think that low inflation should give the Fed pause in any consideration of tapering quantitative easing in the near future.  That said, again we seem to have Federal Reserve policymakers who are discounting the low inflation numbers.  San Francisco Federal Reserve President John Williams, in a speech today:

I expect that the decline in inflation will prove to be temporary, and that inflation will climb slowly, but stay below the Fed’s 2 percent longer-run target over the next few years.

Even though he believes that inflation will remain low for a few years (!), he still anticipates beginning the tapering process this summer:

...assuming my economic forecast holds true and various labor market indicators continue to register appreciable improvement in coming months, we could reduce somewhat the pace of our securities purchases, perhaps as early as this summer.  Then, if all goes as hoped, we could end the purchase program sometime late this year. 

He adds the usual caveat:

Of course, my forecast could be wrong, and we will adjust our purchases as appropriate depending on how the economy performs.

I think the lack of concern about low inflation is important.  We also saw this with noted-dove Chicago Federal Reserve President Charles Evans.  Low inflation is simply having less of an impact on policymakers than would be expected.

The other reason I pay attention to Williams is that I don't see him gravitating far from Federal Reserve Chairman Ben Bernanke.  We will hopefully learn more of Bernanke's intentions this weekend so that I can test that theory (what better day than a Saturday to provide some interesting guidance or foreshadow next week's release of the minutes of the last FOMC meeting?). UPDATE:  No, probably won't be a market moving speech.

Bottom Line:  I don't see much in today's data that would lead us to believe the economy is on a substantially different path.  But one part of that path is low inflation, which should be meaningful to the Federal Reserve.  The problem, however, is that as of yet policymakers seem rather apathetic to the low inflation readings.  Apparently even lower numbers are needed to capture their attention.

 

Lumping Everything into the Wealth Effect

After posting my review of Martin Feldstein's WSJ op-ed, I waded through Dallas Federal Reserve President Richard Fisher's latest speech and found this:

The former outcome is that envisioned by the theoreticians that lead the Fed: According to this plot, by driving rates to historical lows along the entire length of the yield curve, investors will rebalance their portfolios and reach out to riskier assets, providing the financial wherewithal for businesses to increase capital expenditures and reengage workers, expand payrolls and regenerate consumption. Rising prices of bonds, stocks and other financial instruments will bolster consumer confidence. The CliffsNotes account of this play has the widely heralded “wealth effect” paving the way for economic expansion, thus saving the day.

The latter outcome posits that the wealth effect is limited, for two possible reasons. One is that our continued purchases of Treasuries are having decreasing effects on private borrowing costs, given how low long-term Treasury rates already are.  Another is that the uncertainty resulting from fiscal tomfoolery is a serious obstacle to restoring full employment. Until job creators are properly incentivized by fiscal and regulatory policy to harness the cheap and abundant money we at the Fed have engineered, these funds will predominantly benefit those with the means to speculate, tilling the fields of finance for returns that are enabled by historically low rates but do not readily result in job expansion. Cheap capital inures to the benefit of the Warren Buffetts, who can discount lower hurdle rates to achieve their investors’ expectations, accumulating holdings without necessarily expanding employment or the wealth of the overall economy.

Is it just me, or is Fisher being explicitly derisive about the wealth effect?  And when did we start lumping all the channels of monetary policy into the "wealth effect"? The wealth effect is but one channel of monetary policy.  See something like this graphic from Frederick Mishkin's money and banking textbook:

While equity prices do operate through a number of channels, only one of those is the "wealth effect."  To his credit, Fisher has a more sophisticated view of those channels than Feldstein, who appears to limit the impact of QE to the strict definition of the wealth effect:

That drives up the price of equities, leading to more consumer spending.

But even if Fisher does see the bigger picture, should he really be lumping together all the channels of monetary policy into the "wealth effect?"  Doing so only feeds the bias against monetary easing by perpetuating the view it is about nothing more than creating an artificial boost of equity prices and benefiting speculators rather than stimulating the economy via a number of channels that subsequently enhance the profitability of firms and thus raises equity prices.

Of course, Fisher and Feldstein are deliberately trying to perpetuate a bias against quantitative easing.  And even after all these years, I still find it odd that Fisher appears to believe his job is to undermine the institution that provides his employment.  

Dodged That Bullet

I was reading Robin Harding's take on the possible nomination of Federal Reserve Vice Chair Janet Yellen for the top job at the Fed, and a chill went down my spine when he reminded me of this:

Mr Bernanke’s own appointment in 2005 was a case in point. There were several candidates that year. According to people involved, then-President George W. Bush leaned towards Martin Feldstein, a former economic adviser to Ronald Reagan.

But fate intervened:

But Mr Feldstein was a director of the insurance company AIG, which restated five years of financial results that May after an accounting scandal. Then in October, Mr Bush ran into a huge backlash after nominating his lawyer Harriet Miers, who later withdrew, to the Supreme Court.

I think we dodged a bullet there.  Indeed, it might be proof of a higher power.   Martin Feldstein could have been Fed chair during the worst financial crisis since the Great Depression.  Consider that in light of May 9, 2013 Wall Street Journal op-ed in which he professes that raising equity prices is the ONLY mechanism by which quantitative easing impacts the economy:

Quantitative easing, or what the Fed prefers to call long-term asset purchases, is supposed to stimulate the economy by increasing share prices, leading to higher household wealth and therefore to increased consumer spending. Fed Chairman Ben Bernanke has described this as the "portfolio-balance" effect of the Fed's purchase of long-term government securities instead of the traditional open-market operations that were restricted to buying and selling short-term government obligations.

Here's how it is supposed to work. When the Fed buys long-term government bonds and mortgage-backed securities, private investors are no longer able to buy those long-term assets. Investors who want long-term securities therefore have to buy equities. That drives up the price of equities, leading to more consumer spending.

As might be expected, Feldstein finds this channel lacking:

...Although it is impossible to know what would happen without the central bank's asset purchases, the data imply that very little increase in GDP can be attributed to the so-called portfolio-balance effect of the Fed's actions.

Even if all of the rise in the value of household equities since quantitative easing began could be attributed to the Fed policy, the implied increase in consumer spending would be quite small. According to the Federal Reserve's Flow of Funds data, the total value of household stocks and mutual funds rose by $3.6 trillion between the end of 2009 and the end of 2012. Since past experience implies that each dollar of increased wealth raises consumer spending by about four cents, the $3.6 trillion rise in the value of equities would raise the level of consumer spending by about $144 billion over three years, equivalent to an annual increase of $48 billion or 0.3% of nominal GDP.

This 0.3% overstates the potential contribution of quantitative easing to the annual growth of GDP, since some of the increase in the value of household equities resulted from new saving and the resulting portfolio investment rather than from the rise in share prices. More important, the rise in equity prices also reflected a general increase in earnings per share and an increase in investor confidence after 2009 that the economy would not slide back into recession.

Oh my.  Can Feldstein really believe that only the wealth effect channel is in operation?  What about other channels that could boost activity and drive the improvements in earnings and confidence?  And does Bernanke believe quantitative easing has an impact only throughthe wealth effect?  I don't think that is the conclusion you reach if you read his speeches.  Bernanke's description of the portfolio-balance impact is a bit more sophisticated than Feldstein's interpretation.  From last year's Jackson Hole speech:

One mechanism through which such purchases are believed to affect the economy is the so-called portfolio balance channel, which is based on the ideas of a number of well-known monetary economists, including James Tobin, Milton Friedman, Franco Modigliani, Karl Brunner, and Allan Meltzer. The key premise underlying this channel is that, for a variety of reasons, different classes of financial assets are not perfect substitutes in investors' portfolios....Thus, Federal Reserve purchases of mortgage-backed securities (MBS), for example, should raise the prices and lower the yields of those securities; moreover, as investors rebalance their portfolios by replacing the MBS sold to the Federal Reserve with other assets, the prices of the assets they buy should rise and their yields decline as well. Declining yields and rising asset prices ease overall financial conditions and stimulate economic activity through channels similar to those for conventional monetary policy. 

Quantitative easing acts through a variety of channels - interest rate, credit, exchange rate, etc. - just like traditional interest rate policy.  And other channels as well:

Large-scale asset purchases can influence financial conditions and the broader economy through other channels as well. For instance, they can signal that the central bank intends to pursue a persistently more accommodative policy stance than previously thought, thereby lowering investors' expectations for the future path of the federal funds rate and putting additional downward pressure on long-term interest rates, particularly in real terms. Such signaling can also increase household and business confidence by helping to diminish concerns about "tail" risks such as deflation. During stressful periods, asset purchases may also improve the functioning of financial markets, thereby easing credit conditions in some sectors.

So, no, Bernanke does not view quantitative easing as acting only through equity price and related wealth effects, and no, Feldstein shouldn't either.  But somehow he does, or wants to trick you into believing that Bernanke's only objective is boosting equity prices. Either way, I don't think this is the intellectual approach we should be looking for in a Fed chair.

With regards to Feldstein's claim that it is impossible to know what would have happened in the absence of quantitative easing, I think Bernanke would have something like this to say:

 If we are willing to take as a working assumption that the effects of easier financial conditions on the economy are similar to those observed historically, then econometric models can be used to estimate the effects of LSAPs on the economy. Model simulations conducted at the Federal Reserve generally find that the securities purchase programs have provided significant help for the economy. For example, a study using the Board's FRB/US model of the economy found that, as of 2012, the first two rounds of LSAPs may have raised the level of output by almost 3 percent and increased private payroll employment by more than 2 million jobs, relative to what otherwise would have occurred....Overall, however, a balanced reading of the evidence supports the conclusion that central bank securities purchases have provided meaningful support to the economic recovery while mitigating deflationary risks.

 Yes, like it or not, quantitative easing has been a successful policy.  

I understand that in the midst of the crisis there was a significant confusion about what monetary policymakers were doing and why.  But we are well past that stage.  We would hope that any potential Fed chair would by now have come to an understanding about what quantitative easing is and how it works.  And we should be relieved that any candidate that has not made that leap did not get the pick for the top job at the Federal Reserve.

Plosser on the Exit

As is well known, policymakers have been coalescing around a QE exit strategy for some time, since at least the March FOMC meeting.  Two central issues with the exit are the timing and the communications.  Officials do not want to undermine the recovery, knowing full-well that previous flirtations with exits have gone awry.  At the same time, however, they fear the cost-benefit analysis may be turning against them.  For some doves it is not the potential inflation cost, but the potential financial instability cost.  Some policymakers want to begin tapering asset purchases at the next meeting, some are looking to the summer, and others looking to the fall.  

Regarding the communications issue, policymakers seem to be taking pains to make clear that the financial markets should not overreact to any one policy move.  The tapering process may be smooth, it may be choppy, it may be long, it may be short.  It is contingent on the state of the economy, something inherently unknown.  Mostly, they want to avoid a 1994-type of miscommunication.  

Today's speech by Philadelphia Federal Reserve President Charles Plosser covers nearly all of these elements. In general, although I do not agree with his conclusions regarding timing, I think he makes a what would be viewed by some as a credible argument for tapering to begin sooner than later.

Begin with his base forecast:

My forecast of 3 percent growth should allow for continued improvements in labor market conditions, including a gradual decline in the unemployment rate, similar to the trend we have seen over the past three years, which was a 0.7- to 0.8-percentage point decline per year. Continuing at such a pace would lead to an unemployment rate close to 7 percent at the end of 2013 and a rate below 6.5 percent by the end of 2014.

Indeed, this year we have already seen the unemployment rate fall from 7.9 percent in January to 7.5 percent in April. Employers added 165,000 jobs in April, but the more positive news came in the revisions for February and March. The revised data indicate that firms added 332,000 jobs in February and 138,000 in March. The upward revisions for these two months added 114,000 jobs.

The forecast of a 6.5% unemployment rate by the end of 2014 is important.  My thought is that the Fed will want to conclude asset purchases before hitting that target.  Moreover, optimally they would like time so that, if necessary, the tapering can be a slow process.  That argues for tapering to begin sooner than later.  Indeed, Plosser would like asset purchases to end this year:

Based on the stated views of the Committee regarding the flexibility in pace of purchases, I believe that labor market conditions warrant scaling back the pace of purchases as soon as our next meeting. Moreover, unless we see a significant reversal in current trends that jeopardizes my forecast of near 7 percent unemployment rate by the end of this year, then I anticipate that we could end the program before year-end. Let's look at some of the data.

The end of the year is actually fast approaching; if you want to taper off over the course of a hand full of meetings, the calendar is driving you to begin now.  Now, back to that data:

In the six months through September 2012, when the decision to initiate the latest open-ended asset purchase program was made, nonfarm payrolls had increased an average of 130,000 per month, and the unemployment rate had averaged 8.1 percent. In the most recent six months, from November 2012 through April 2013, nonfarm payrolls have increased on average 208,000 per month — a 60 percent increase — and the unemployment rate has averaged 7.7 percent. As I noted earlier, April's unemployment rate has now reached 7.5 percent.

Moreover, the average duration of unemployment has fallen, the share of long-term unemployment has dropped, and hours worked and earnings have risen. While further progress would certainly be desirable, I believe the evidence is consistent with a significantly improving labor market. Thus, it is appropriate to begin scaling back the pace of asset purchases.

At this point, I raise my hand and say "But isn't underemployment still too high and being driven by cyclical factors?  Aren't you erring on the side of removing stimulus too early?"  But that arguement is neither here nor there for Plosser.  He has obviously decided these are second-order issues.  He does deliver what (I think) is a novel argument for tapering sooner than later:

Indeed, in my view, were the FOMC to refrain from reducing the pace of its purchases in the face of this evidence of improving labor market conditions, it would undermine the credibility of the Committee's statement that the pace of purchases will respond to economic conditions. Similarly, if there were sufficient evidence that conditions in labor markets had deteriorated, I would expect the FOMC to consider increasing the pace of purchases. After all, this is the meaning of state-contingent monetary policymaking. But if we reach the point that markets only expect us to move in one direction — that is, toward more easing — and we become reluctant to dial back on purchases over concerns of disappointing or surprising markets, then we will find ourselves in a very difficult position going forward.

In short, the Fed communicated a particular strategy - one in which the pace of asset purchases would be determined by recovery in the labor market.  And, by Plosser's reckoning, the 60% increase in the pace of job growth is evidence of exactly the kind of improvement the Fed was looking to achieve.

Notice that Plosser is not appealing to a fear that the Fed's credibility on inflation is at risk. Instead, not acting to slow asset purchases undermines the credibility of the Fed's communications strategy.  This is an argument that might resonate with other policymakers who are already worried that financial markets will misinterpret future policy actions. I suspect Plosser knows inflation concerns are likely to fall on deaf ears.  Indeed, he addresses the inflation topic earlier in the speech:

Should inflation expectations begin to fall, we might need to take action to defend our inflation goal, but at this point, I do not see inflation or deflation as a serious threat in the near term. However, I do believe that our extraordinary level of monetary accommodation will have to be scaled back, perhaps more aggressively than some think, to ensure that inflation over the medium term remains consistent with our target.

Convincing others to pull back on easing due to inflation concerns is something of a challenge when your preferred inflation measure is below target and trending down.  But where that argument fails, perhaps a credibility/communications argument can succeed?

Plosser is careful to add the now required "not tightening" clause:

I want to emphasize that in this state-contingent framework, reducing the pace or even ending asset purchases need not be the start of an exit strategy or more aggressive tightening. Nor would it indicate that an increase in the policy rate was imminent. Instead, these actions would slow and then halt efforts to continuously expand the level of accommodation by increasing the size of the balance sheet. Given the improving economy, dialing back asset purchases is an appropriate response.

I imagine we will see something like this in every speech going forward.  Policymakers do not want market participants to jump to conclusions on the basis of any one policy move.

Bottom Line:  While the Fed is  moving closer to tapering asset purchases, timing remains an issue.  I think that most policymakers will not be swayed to an early end by the "Fed's inflation credibility is at risk" argument.  But a subset is likely swayed by the "financial stability is at risk" argument.  And another subset may be swayed by the "communications credibility is at risk argument" that is an element of Plosser's speech.  In short, the majority favoring continuing asset purchases at the current pace is obviously shrinking.  Hopefully this week's upcoming speech by Federal Reserve Chairman Ben Bernanke and the release of the minutes from the last FOMC meeting will help clarify how quickly that majority is loosing ground.

What Does Japan Mean For The Rest of the World?

Is Abenomics about boosting exports or domestic demand?  I tend to agree with Lars Christensen on this issue:

There has been a lot of focus on the fact that USD/JPY has now broken above 100 and that the slide in the yen is going to have a positive impact on Japanese exports. In fact it seems like most commentators and economists think that the easing of monetary policy we have seen in Japan is about the exchange rate and the impact on Japanese “competitiveness”. I think this focus is completely wrong.

While I strongly believe that the policies being undertaken by the Bank of Japan at the moment is likely to significantly boost Japanese nominal GDP growth – and likely also real GDP in the near-term – I doubt that the main contribution to growth will come from exports. Instead I believe that we are likely to see is a boost to domestic demand and that will be the main driver of growth. Yes, we are likely to see an improvement in Japanese export growth, but it is not really the most important channel for how monetary easing works.

In my view, Abenomics has been remarkably centered on the domestic economy.  The impact on the Yen is almost an afterthought, whereas in the past policymakers would have turned to intervention to directly support the economy.  This looks like policymakers finally realized that such a policy approach wasn't working and they need to change gears to a frontal-assault on domestic policy levers.

That said, a side-effect of Abenomics is currency depreciation, and this will have an impact on global trade.  Investment Week has an interview with hedge fund manager Hugh Hendry:

"Japan's monetary pivot towards QE will not create economic growth out of nothing. Instead it seeks to redistribute global GDP in a manner that favours Japan versus the rest of the world. This is the last thing the global economy needs right now," he said.

So what's right and what's wrong with that quote?  What's right is that there will be a trade impact.  A story floating around right now is that Japanese exporters are not changing prices, but instead just allowing the impact of the weaker Yen to fall straight through to the bottom line.  But they will soon turn their attention to leveraging the weaker Yen to cut prices and take market share.  And they have Europe in their sights.  They might not be able to compete with Chinese exporters, but they can with German ones.

What's wrong, however, is that this is exactly what the global economy needs right now.  If Germany and by extension Europe experiences weaker growth, European policymakers will need to respond.  And they are not likely to respond by buying Yen to hold its value up.  They are likely to respond by stimulating their domestic economy directly via easier monetary policy and, hopefully, easier fiscal policy.

In other words, successful domestically-orientated policy in Japan will have second-round effects that will induce further policy easing Europe.  And a good kick in the pants in Europe is exactly what we need right now. Rather than thinking about Japan's policy as triggering "competitive devaluations," think of it as triggering "coordinated global easing."

What's also wrong is Hendry's usual hedge-fund bias again monetary policy.  By altering expectations to lower real interest rates, Japan's monetary policy is in a sense creating economic growth out of nothing.   We frequently heard that "uncertainty" was holding back the recovery, but isn't this the same thing as creating a recession out of nothing?  If you can create a recession out of nothing, then why not an expansion?

UPDATE:  This morning I saw this from David Beckworth:

With that said, the competitive devaluation arising from Abenomics may be the catalyst to kick start the ECB into more serious efforts if they care about the Eurozone's external competitiveness. The ECB may ease to keep the Euro from getting too expensive and in the process shore up European domestic demand. How ironic it would be if Abenomics were to accomplish in the Eurozone what  intense human suffering could not: moving the ECB to forcefully act. 

 Sounds about right.

Implications of Fed Tightening for Equities

Thinking further about this from Friday's Jon Hilsenrath Wall Street Journal article:

Stocks and bond markets have taken off since the Fed announced in September that it would ramp up the bond-buying program, and major indexes closed at another record Friday. An abrupt or surprising end to it could send stocks and bonds in the other direction, but a delayed end could allow markets to overheat. And some officials feel they've ended other programs too soon and don't want to repeat the mistake.

Although past performance is no guarantee of future performance, it strikes me that previous instances of tighter monetary policy did not trigger immediate widespread declines in equities:

Just an eyeball look at past behavior suggests that equities are mostly flat in the initial stages of monetary tightening, and rise in later stages.  Generally at least two years before the Fed inverts the yield curve and triggers recession.  In addition, we are not expecting the Fed to begin raising rates until late 2014 or 2015. So policy is likely to remain supportive for what, at least three or four more years?  

Fears of an imminent policy-driven collapse in equity prices are likely greatly over-exaggerated.  See also Mark Dow here. 

 

Fed Notes

Gavyn Davies at the Financial Times questions the Federal Reserve's employment target:

On the wider issue of general monetary policy, the behaviour of inflation and unemployment remain the key drivers, and here the Fed has a headache. Its forward guidance on unemployment is in danger of giving misleading signals about the need for tightening, and it probably needs to be changed.

I agree.  Davies cites research indicating that recession-driven underemployment makes the unemployment rate a poor measure of resource utilization.  The policy implications:

What does this imply for policy? It implies that the Fed will have a bias to keep policy aggressively easy long after the unemployment rate has fallen below 6.5 per cent, and even after it has fallen below the estimated natural rate of 5.25 to 6 per cent, provided that the inflation threshold is still intact. This is because the reserve army of disguised unemployed people will exert a downward force on inflation which will not be correctly picked up by the official unemployment statistics. 

See my related piece on structural (or lack thereof) unemployment here.  Davies raises a often-forgotten point: Even though the Federal Reserve is turning its attention to ending quantitative easing, the timing of the first rate hike is most likely much farther off in the future.

A challenge for the Fed is that asset purchases are at least in part a communications device that signals commitment to a given policy path.  Thus, the Federal Reserve will need to take care to avoid the impression of imminent rate hikes as they scale back asset purchases.  Indeed, I thought this was the most important takeaway from Friday's Jon Hilsenrath article in the Wall Street Journal:

Officials are focusing on clarifying the strategy so markets don't overreact about their next moves.

Overreaction can come in many forms:

For example, officials want to avoid creating expectations that their retreat will be a steady, uniform process like their approach from 2003 to 2006, when they raised short-term interest rates in a series of quarter-percentage-point increments over 17 straight policy meetings...An abrupt or surprising end to it could send stocks and bonds in the other direction, but a delayed end could allow markets to overheat. And some officials feel they've ended other programs too soon and don't want to repeat the mistake.

This sounds as if Fed officials are cognizant of this from Davies:

The more precise the forward guidance given, the more the Fed exaggerates the degree of knowledge which the central bank can possibly have about its own future actions, since these actions will depend on many factors which cannot be exactly predicted in advance. 

Which also speaks to the inclusion of "increase or decrease" phrase in the last FOMC minutes.  Back to Hilsenrath:

The Fed said in its postmeeting statement that it was "prepared to increase or reduce the pace of its purchases" as the economic outlook evolved.

The suggestion that the Fed might boost its bond buying was a change in the policy statement that seemed to some an acknowledgment that more aid for the economy might be needed...

...But many officials believe the recovery is on track and aren't yet concerned about the inflation slowdown. Instead, the most recent statement seems more aimed at signaling the Fed's broader flexibility in managing the programs.

Bottom Line: We need to be very careful in extrapolating the implications of the next policy move to future policy moves.  The Fed has only a general strategy for exit, but policymakers lack enough certainty about the future to determine the exact nature of that exit.  Still, even given that uncertainty, the current state of labor force utilization and inflation suggest that while the end of QE may occur this year, the first rate hike is not likely until some point well into the future.  

When Will The Divergence Between PCE and CPI Matter?

The divergence between PCE and CPI measures of inflation remains in the headlines.  Pedro da Costa at Reuters sees a test of the Fed's credibility at hand:

With the inflation rate about half of the Federal Reserve's 2.0 percent target, the central bank is facing a major test and some experts wonder whether it will eventually need to ramp up its already aggressive bond buying program.

The challenge for policymakers is that they are clearly falling short of their dual mandate and that should open the door for additional asset purchases.  But, but, but...I think that additional asset purchases is just about the last thing they want to do right now.  We will see if their thinking evolved much at the last FOMC meeting, but the minutes of the March meeting clearly indicate that a large contingent of FOMC members are looking to end the asset purchase program by the end of this year.  Take ongoing improvements in labor markets, add in concerns about financial stability, mix in some cost-benefit analysis about the efficacy of additional QE, and top-off with a dash of improving housing markets, bake at 350 for 40 minutes, and you get monetary policymakers hesitant to push the QE lever any further.

My sense is that policymakers will thus try to find reasons to dismiss falling PCE inflation as a non-issue.  From an email exchange last week, today da Costa quotes me as saying:

"The Fed may view the divergence between the two measures as indicating that worries about deflation are premature," said Tim Duy, a professor of economics at the University of Oregon. "If core CPI was trending down as well, the Fed would be more likely to conclude that their inflation forecasts should be guided lower."

And also last week in March, Greg Ip at the Economist had this observation:

If CPI inflation were to converge to PCE inflation, that would be a concern. Goldman expects CPI inflation to drop to 1.8% in coming years and PCE inflation to rise to 1.5%. It would be preferable for both to converge to 2%; but so long as inflation expectations remain where they are, it is of little consequence for monetary policy – and a tangible plus for incomes and spending.

Yesterday, Philadelphia Federal Reserve President Charles Plosser had this to add, via the Wall Street Journal:

As of right now, “I’m not concerned” about inflation drifting too far under the central bank’s price target of 2%, Federal Reserve Bank of Philadelphia President Charles Plosser said in response to reporter’s questions at a conference here.

Inflation expectations “look pretty well anchored,” and it’s likely that price pressures as measured by the personal consumption expenditures price index will drift back up to 2% over time and reconverge with the consumer price index, he said.

Today, Chicago Federal Reserve President Charles Evans seemed resigned to low inflation.  Again, from the Wall Street Journal:

“Inflation is low, and it’s lower than our long-run objective,” Mr. Evens said in an interview on Bloomberg Television, adding that he would like to see inflation closer to 2% but expects it to stay below 2% for several more years. Inflation, he said, “can be too low” when the central bank’s objective is 2%.

Asked if low inflation should prompt a policy response from the Fed, Mr. Evans said “I think it’s way too early to think like that.” In the debate over how the Fed might exit from the asset purchase program, Mr. Evans, a voting member of the policy-settingFederal Open Market Committee, said he remains “open minded [and] I’m listening to my colleagues.”

The general story seems to be that as long as inflation expectations remain anchored, and CPI inflation does not drift much below 2%, then the Fed will resist accelerating the pace of asset purchases.  

Also note that the downward inflation drift is an underlying trend, or so concludes the Federal Reserve Bank of Atlanta's macroblog.  The authors use a principle component model to estimate a common trend in the price data, and get these results:

The author's note that by this measure, the decline in PCE is not as ominous as it first seems, but it is clear that inflation by either measure is missing the Fed's target and currently trending away from that target.  They conclude:

Does that mean we should ignore the recent disinflation being exhibited in the core PCE inflation measure? Well, let’s put it this way: If you’re a glass-half-full sort, we’d say that the recent disinflation trend exhibited by the PCE price index doesn’t seem to be “woven” into the detailed price data, and it certainly doesn’t look like what we saw in 2010. But to you glass-half-empty types, we’d also point out that getting the inflation trend up to 2 percent is proving to be a curiously difficult task.

Indeed, very curious given that we tend to think that at a minimum the monetary authority should be able to raise inflation rates.  You are left with thinking that either the Federal Reserve still had more work to do or that monetary policy can do little more at this point than put a floor under the economy.  If the latter, and if you want something more, you need to turn to fiscal policy.  

Bottom Line:  I suspect that at this point the Fed tends to think the costs of additional action still outweigh the benefits, and thus below-target inflation only induces pressure to maintain the current pace of QE longer than they currently anticipate rather than increase the pace of purchases.