Tim Duy's Fed Watch

Barro on Boehner

This by Bloomberg's Josh Barro deserves to be highlighted:

Yesterday, in an interview with Bloomberg Television, House Speaker John Boehner warned that the U.S. government must balance its budget. After all, he said:

We have spent more than what we have brought into this government for 55 of the last 60 years. There’s no business in America that could survive like this. No household in America that could do this. And this government can’t do this.

It’s hard to think of better evidence for the sustainability of budget deficits than the fact that we have run them for 55 of the last 60 years. If our fiscal practices haven’t caught up to us after 60 years, when will they? Or does Boehner take a David Stockman-like position that the last several decades of American advancement have in fact been a ghastly failure?

So simple, so true.

Really? One Basis Point?

Bloomberg has a story with an ominous opening paragraph:

Bank of Japan Governor Haruhiko Kuroda’s stimulus policies are backfiring in the housing market, where mortgage rates are rising even as the central bank floods the financial system with cash.

Lions, tigers, and bears, oh my!  The next paragraph:

Fixed 35-year home-loan costs rose to 1.81 percent this month, the first increase since February and up from an all-time low of 1.8 percent in April, according to data compiled by the Japan Housing Finance Agency. Federal Reserve Chairman Ben S. Bernanke’s monetary easing almost halved 30-year U.S. mortgage rates since 2008 to 3.35 percent on May 2.

Seriously?  The case against Kuroda is that after declining since February, mortgage rates climbed a whole basis point?  And Kuroda is expected to accomplish in a few months what took Bernanke five years?  And I thought I could be a harsh critic of central bankers!

Hopefully this is just a typo; I can't seem to locate a time series of the 35-year mortgage rate in Japan.  Otherwise, one might be tempted to conclude that the reporters were biased against Abenomics.

Rising Structural Unemployment?

This tweet from Andy Harless caught my eye:

HIres-to-openings ratio looking uglier & uglier bls.gov/news.release/j… Looks like rising structural unemployment

— Andy Harless (@AndyHarless) May 7, 2013

The chart:

The ratio of hires to openings fell to the low of the last cycle.  Now compare the ratio to the unemployment rate:

Unemployment appears to be too high relative to the hires/openings ratio (caution is warranted, however, as the JOLTS data only extends back to 2001).  One would normally associate such a low ratio with low unemployment as the number of hires would be relatively low because of the lack of available workers.  In this case, however, the number of hires appears to be low despite a large pool of potential employees, consistent with the concern that available workers lack the skills firms seek.  Structural unemployment, as Harless suggests.

That said, recall that Matthew O'Brien pointed us at research here and here suggesting that high unemployment is attributable not to structural factors, but instead to a bias against the long-term unemployed.  O'Brien recognizes the insidious nature of this problem:

Circles don't get more vicious than this. The people who need work the most can't even get an interview, let alone a job. It's a cycle that could end with the long-term unemployed becoming unemployable. It's what economists call hysteresis, the idea being that a slump, left untreated, can make us permanently poorer by reducing our future ability to do and make things. 

Bias against the long-term unemployed might explain why wage growth remains muted:

One would think that a low hires/openings ratio suggests that wage growth would be accelerating (as employers appear to face a relative shortage of workers), but that is not the case.  Indeed, low wage growth is one reason to believe that excessive unemployment is cyclical in nature.  How does this fit with the long-term unemployed story above?  Perhaps that although firms have a bias against the long-term unemployed, those potential workers still place downward pressure on wages.  The newly unemployed don't require higher wages despite demand for their skills because they know there is a large pool of people available with similar skills.  If the newly unemployed demand too high wages, they may induce employers to take another look at the pool of long-term unemployed.  Consequently, they do not seek higher wages.

Incidentally, this also explains the low quits rate.  The consequences of becoming long-term unemployed are particularly severe, raising the expected cost of voluntarily leaving a job.

So I guess the "good" news would be this:  If bias against the long-term is simply creating the illusion of structural unemployment, then we are not yet faced with the problem of hysteresis.  If the pool of long-term unemployed can place downward pressure on wages, then they must have a valuable skill set.  Otherwise, they would not represent a threat to the newly unemployed.  Keep the demand up for employees long-enough, and firms will eventually give up their bias against the long-term unemployed (I assume this would be preferable to the alternative of prematurely escalating wages).  Eventually, the pool of unemployed would decrease and then wage pressures increase.

Still, the longer we wait for this bias to diminish, the more likely it is that the unemployment does indeed become structural. Then we would expect rapidly rising wages despite elevated unemployment.  Another argument for pulling on all the stimulus levers. Alas, that is not the case. 

Update:

And after I wrote all this, I saw this Harless tweet:

Likely part of the reason 4 low hires/opening is that most applicants r now long-term unemployed, who face a more rigorous screening process

— Andy Harless (@AndyHarless) May 8, 2013

Apparently on the same path.

Consistency of the Underlying Trends

Calculated Risk comments on this morning's JOLTS report:

Not much changes month-to-month in this report - and the data is noisy month-to-month, but the general trend suggests a gradually improving labor market.

This observation extends far beyond just the JOLTS report to virtually the entire set of labor market data.  While we often get caught up in the month-to-month gyrations of various employment reports, the underlying trend of those data have been remarkable consistent:

General, consistent improvement is evident across an array of indicators.  The pace of that improvement, however, consistently falls short of what is necessary to rapidly alleviate excessively high levels of underemployment, counter demographic trends impacting labor force participation, or induce significantly higher wage growth.  And you can find that generally steady pace of improvement in other indicators as well.  For example:

In short, it looks as if monetary policymakers have put a bottom under the economy but are unable to accelerate the pace of recovery.  Whether the lack of acceleration is attributable to shortfalls on the monetary side of policy (insufficient quantitative easing, unwillingness to allow inflation expectations to drift higher, etc) or lack of cooperation of fiscal authorities (there seems to be no reason to hasten the pace of deficit reduction) remains a matter of debate.  I tend to believe that the economy needs additional monetary and fiscal support, in part because I tend to worry that we will not lift off the zero lower bound in this recovery, setting the stage for even larger policy challenges in the next recession.  In any event, regardless of where you think policy should be, right now it looks to be accomplishing something of a minimum by setting a floor for activity.  

What does this mean for monetary policy going forward?  

First, I think we will need to keep a focus on the trend and not think policy will be swayed (in either direction) by every gyration of the data.  The data is inherently noisy, and the Fed will be looking through that noise.  

Second, the Fed recognizes the same underlying consistency in the data, and likely concludes that there is little they can do to accelerate that recovery without further substantive changes to policy (dramatically increase asset purchases or changing the inflation target).  The costs of those policy shifts are perceived to outweigh the benefits (this is a revealed preference at this point).  Hence we should not anticipate the Fed will scale up asset purchases, even though this option was on the table in the last FOMC statement.  Scaling up would only happen in the event of a sharp deterioration of the forecast.  

Third, they will not scale up asset purchases as long as they expect the impact of fiscal contraction to have largely passed by the end of this year.  If not for the fiscal contraction, the economy would already be accelerating at a more rapid pace, and we would probably be looking at the Fed tapering off asset purchases sooner than later.

Fourth, even if the forecast for 2014 devolves into a continuation of the slow and steady improvement of the past nearly four years (!) since the end of the recession, I doubt the Fed will accelerate the pace of asset purchases.  The problem is the 6.5% unemployment threshold for considering the path of short-term interest rates.  Slow and steady improvement will place that threshold in sight by the middle of next year, and the Fed will want to be done with asset purchases well before the economy hits that threshold.  That helps explain why FOMC members seem to have coalesced around an expectation that they can wind down and end asset purchases by the end of this year.  In short, they will be increasingly hesitant to increase asset purchases (and more anxious to begin tapering) as we move closer to the 6.5% unemployment target.  

Bottom Line:  Pay attention to the underlying trend, discount the month-to-month noise.  The farther out we get from the recession, that noise becomes less important.  That underlying trend seems to be generally consistent with the unemployment rate coming within sight of the 6.5% threshold by the middle of next year, which explains the interest in ceasing asset purchases by the end of this year.  Despite talk of the ability to increase the pace of purchases, I have a hard time seeing the circumstances that would make such a dramatic shift in policy direction.  Such a shift will require a substantial negative shock that stalls the pace of activity and brings the threat of deflation back to the front burner - think circumstances that threaten to take out the Fed's current floor under the economy.

 

14,000

Seems like just yesterday Japanese policymakers were looking to push the Nikkie to 13,000.  It even seemed like a overreaching at the time.  Here is Matthew Boesler at Business Insider:

The 13,000 index target implies around 17 percent upside in February and March. The pace may sound ambitious, but then again, Japan is one of the hottest momentum trades in the world right now.

Today the Nikkei pushed past 14,000:

Note too that the 10-year Japanese government bond holds well below 1 percent - fears that aggressive policy would cause rates to skyrocket are once again proved unfounded.

So far, so good for Abenomics.  Now the question is will policymakers back off soon after seeing such positive results?  We have seen such stop-go policy in Japan in the past when attention turns back toward the size of the deficit.  Are Japanese policymakers in it for the long-haul?  

When Deficits Become a Problem

L. Randall Wray (ht FTAlphaville) thinks the Paul Krugman has made the leap to MMT by acknowledging the ability of the central bank to control interest rates.  Wray sees that Krugman was faced with an intellectual roadblock to MMT:

The sticking point has been “crowding out”—the idea that once we get beyond the liquidity trap and return to a more “normal” ISLM world, government deficits will push up interest rates. And that will then reduce private investment, which tends to lower economic growth. Higher interest rates plus lower growth means the government’s deficit and debt ratios grow beyond “sustainable” levels.

Wray argues that ultimately the central bank does not need to fear the bond vigalantes because the Treasury need not issue long-term debt and can instead issue only short term debt.  The Fed is assumed to have complete control over rates on short term debt:

But as I explained last week, the short term rate is completely within the control of the Fed....Long term rates depend on the state of liquidity preference plus expectations of future Fed policy. But in any case, the Vigilantes cannot force Treasury to issue long term debt. It can stick to the short end of the maturity structure and then pay whatever rate the Fed targets.

Actually, I would go one step further than Wray and argue that the Fed's expectations tools coupled with large-scale asset purchases allows them to influence the entire yield curve.  Wray then explains that this means the danger is not the vigilantes, but the Federal Reserve:

The real danger is not that the Vigilantes go all vigilant on Uncle Sam, but rather that the Fed decides to do a Volcker (raise the overnight rate to 20%). Congress can stop that by legislating that the Fed cannot act like a Vigilante. Or, alternatively, Treasury can stay on the short end. Both of these are policy choices, completely outside the influence of Vigilantes.

Wray takes Krugman's post today as evidence that Krugman believes that crowding out is not a issue either in a liquidity trap or at potential output.  The Krugman quote:

the short-term interest rate is set by the Bank of England. And the long-term rate, to a first approximation, is a weighted average of expected future short-term rates. Unless markets believe that Britain is going to default — which it isn’t, and they won’t — this is more or less an arbitrage condition that ties down the long run rate no matter what happens to confidence. 

Wray's interpretation:

All he has to do is to carry that analysis beyond the current downturn. This can go on forever, of course. Keep short term interest rates low, or keep Treasury out of long maturities.

Wray seems to believe that this means Krugaman has departed from his earlier story:

I could go on, but you get the point: once we’re no longer in a liquidity trap, running large deficits without access to bond markets is a recipe for very high inflation, perhaps even hyperinflation. And no amount of talk about actual financial flows, about who buys what from whom, can make that point disappear: if you’re going to finance deficits by creating monetary base, someone has to be persuaded to hold the additional base.

But I don't see anything inconsistent between the Krugman of the past and that of today.  The crowding out argument is a simply a bit more nuanced than in Wray's description.  Wray seems to want to overlook the inflation part of Krugman's position.  Specifically that in a more "normal" ISLM world, which I would interpret as near potential output, then additional government spending would tend to increase interest rates and crowd out private spending or - and this is an important or - that the Federal Reserve could accommodate the increased government spending and hold interest rates low, but that the end result would be higher inflation.

In other words, I doubt that Krugman fears the bond vigilantes even at potential output, but that he would expect the Federal Reserve to allow interest rates to increase to prevent inflation.  Presumably this crowds out private investment, and shifts the mix of demand toward the government sector.  

Does this mean that additional debt lowers growth in a Rogoff/Reinhart sense?  No, but it does mean that the Fed will not allow output to exceed potential due to inflation concerns.  The claim that crowding out leads to lower potential growth in the long-run is generally a supply-side type story in which an excessive level of government spending reduces the rate of resource (labor/technology/capital) growth.

In short, I doubt that Krugman's acknowledgment of the Federal Reserve's control over interest rates implies that he now believes that government deficits do not matter or that he will make such an intellectual leap.  Krugman appears to have always believed that the Fed can control interest rates, thus leaving the bond vigilantes impotent.  And there is nothing in his blog today to suggest that he no longer believes that at some point (hopefully) inflation - and by extension, interest rates - will once again be a concern.  Believe it or not, it is not logically inconsistent to believe that concerns about rising interest rates are not valid today, but might be valid at some point in the future.  

Update:  I see Ed Harrison is writing on Krugman and the bond vigilantes as well, and sees the difference in not the so much the outcome

Of course running enormous deficits when the economy is operating at full capacity causes inflation to go haywire. Of course it does.

But in the rhetorical approach:

The difference is he straw-manned the deficit as an exogenous policy variable in 2011 when it simply isn’t one. 

Harrison (correctly) views the deficit as largely endogenous.  When the economy improves, then the deficit will dissapear (or at least be greatly reduced).  So arguing about the deficit's impact on interest rates is pointless:

This could only happen if our politicians went mad and added yet more fiscal stimulus to the economy even after it was overheating.

The key point is inflation:

Wait until inflation starts to creep up. Then the bond vigilantes can get going. But this is a long way off.

 

Quick Employment Thoughts

Running to meeting in a few minutes, but have some quick thoughts on the employment numbers:

Don't Get Fooled Again.  San Franscisco Fed President John WIlliams discounted the last employment report, and he was right to do so.  The underlying economy continues to grind along at a slow and steady pace; it doesn't pay to get pulled into becoming overly optimistic or pessimistic about what the latest numbers.  The twelve month moving average is remarkably steady:

Summer Tapering Back On The Table.  The recent data flow suggested that plans to begin tapering QE this summer with a year-end target for ending the program.  And the inclusion of the "may increase or decrease" clause in the last statement seemed to imply that the recognized the shift in the tone of the data.  But the Fed did not alter its economic outlook at the latest FOMC meeting.  The combination suggests that the Fed would delay plans to end QE if the data faltered, that such a plan was not a sure thing.  But this data suggests that their forecast was more correct than not, which then gives them room to follow the plan that appeared to be coalescing as the last meeting.  In short, over the last six months, nfp growth has been 208k a month in spite of the sequester.  This can certainly be interpreted as stronger and sustainable improvement.

Bottom Line:  The employment report does not alter the Fed's forecast, but provides renew confidence in that forecast.  Which could bring a summer tapering of QE back into play.

FOMC Leaves Policy Unchanged

The FOMC concluded their two-day meeting by holding policy constant, as expected.  The assessment of the economy was largely unchanged.  From March:

Information received since the Federal Open Market Committee met in January suggests a return to moderate economic growth following a pause late last year.  Labor market conditions have shown signs of improvement in recent months but the unemployment rate remains elevated.  Household spending and business fixed investment advanced, and the housing sector has strengthened further, but fiscal policy has become somewhat more restrictive.  Inflation has been running somewhat below the Committee's longer-run objective, apart from temporary variations that largely reflect fluctuations in energy prices.  Longer-term inflation expectations have remained stable.

Now:

Information received since the Federal Open Market Committee met in March suggests that economic activity has been expanding at a moderate pace. Labor market conditions have shown some improvement in recent months, on balance, but the unemployment rate remains elevated. Household spending and business fixed investment advanced, and the housing sector has strengthened further, but fiscal policy is restraining economic growth. Inflation has been running somewhat below the Committee's longer-run objective, apart from temporary variations that largely reflect fluctuations in energy prices. Longer-term inflation expectations have remained stable.

Notably, recent data has had little impact on the Fed's economic outlook.  This includes the last employment report as well.  The inclusion of the term "on balance" was clearly intended to downplay the March numbers.  

My interpretation is that the Fed is attempting to move away from being pulled this way and that by the monthly fluctuations of the data and instead focus on the underlying trend; presumably, it is that trend that should be guiding policy decisions. Of course, one could argue that that underlying trend should induce them to additional action, but that is neither here nor there at this point.  From their perspective, policy is appropriate given that trend. The Fed also strengthened its language on fiscal policy, but again the damage so far is not sufficient to change the course of policy.  Or, probably more accurately, the damage is not so great that the Fed is willing to let Congress hit the ball into their court.

The other significant change came latter in the statement.  From March:

The Committee will closely monitor incoming information on economic and financial developments in coming months.  The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.  In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives.

Now:

The Committee will closely monitor incoming information on economic and financial developments in coming months. The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes. In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives.

In the wake of the last meeting, comments from some Fed presidents as well as the minutes themselves seemed to imply that further expansion of the large scale asset purchase program was out of the question.  Instead, it seemed the focus had firmly shifted to ending QE as soon as possible, with the end of this year as a goal.  With this language shift, the FOMC pulls back on this direction, and instead makes it clear than an expansion of the program is still possible.  And possible not only due to a changing employment outlook, but also due to a deteriorating inflation picture.

But isn't the inflation picture already deteriorating?  Yes, the latest numbers suggest a worsening disinflation trend.  The Fed, however, probably has not adjusted their forecast; they probably do not expect that substantially lower inflation is likely given that inflation expectations remain anchored and economic activity is not deteriorating.   In such an environment, they likely are not all that concerned that inflation is running somewhat below target.  

Moreover, the Fed has that cost-benefit analysis thing working in the background, and likely believes that any more than $85 billion a month is not likely to have large, positive marginal benefits.  Not enough to justify expanding policy further for any small changes to the forecast.

 Bottom Line:  The urge to taper off quantitative easing has lessened since the last meeting. That pushes the beginning of the end back to the later back of the year.  The door is open to additional stimulus as well, but I suspect that it would have to be driven by the employment side of the mandate.  Clear evidence of a deflationary threat is likely necessary to drive action on the other side of the mandate; such a threat seems unlikely in an expanding economy.

What About Inflation?

I find Binyamin Applelbaum's Fed preview to be rather depressing and distressing.  Applelbaum begins with a solid insight - reducing the unemployment rate is not the same as maximizing employment:

The Federal Reserve is making modest progress in its push to reduce the unemployment rate. But that is not the jobs goal Congress actually established for the Fed. The central bank is supposed to be maximizing employment. And on that front, it is not making progress.

Applelbaum points to the employment to population ratio as evidence that the Fed is falling short of the mandate.  But are Fed officials ready to do more? No:

There is little sign, however, that Fed officials are considering an expansion of their four-year-old stimulus campaign as the Fed’s policy-making committee prepares to convene Tuesday and Wednesday in Washington.

Applelbaum notes that the recent flow of data has forced monetary policymakers to back away from talk of ending large scale assets purchases.  But among the reasons to avoid expansion of the program we find this:

Another reason the Fed is not embracing new measures is that it already has tied the duration of low interest rates to the unemployment rate. The Fed said in December that it intended to hold interest rates near zero at least as long as the unemployment rate remained above 6.5 percent, provided that inflation remained under control. The theory is that the economy will get as much stimulus as it needs.

But what if the inflation rate is persistently below the target?  Or, worse, trending lower?  Clearly then the economy is not getting the stimulus it needs.  If we are missing on both targets, then the economy needs more stimulus.  And while we can debate the efficacy of monetary policy in influencing the pace of employment growth, surely monetary policy can influence the inflation rate.  Correct?

The distressing part of this article is that it reads as if the Fed has given up not only on its ability to influence the pace of employment growth, but also on its ability to influence the inflation rate.  Or, possibly worse, that the Fed is simply no longer concerned with the inflation rate now that the obvious threat of deflation has passed.  This again feeds suspicion that the Fed's 2 percent target is really an upper bound.  

Bottom Line:  The Fed is supposed to have a dual mandate.  Dual, as in two.  Maximum employment and price stability.  One would think that failing at the latter would be at least as important as failing at the former.  Perhaps we are learning that the Evan's rule is flawed - it should not be about only conditions before which the Fed considers removing stimulus, but also conditions by which the Fed deliberately considers adding additional stimulus. A two-side Evan's rule is needed.

Just a Few Weeks Makes a World of Difference

The minutes of the last FOMC meeting, concluded on March 20, included this passage:

In light of the current review of benefits and costs, one member judged that the pace of purchases should ideally be slowed immediately. A few members felt that the risks and costs of purchases, along with the improved outlook since last fall, would likely make a reduction in the pace of purchases appropriate around midyear, with purchases ending later this year. Several others thought that if the outlook for labor market conditions improved as anticipated, it would probably be appropriate to slow purchases later in the year and to stop them by year-end. Two members indicated that purchases might well continue at the current pace at least through the end of the year.

The center of the FOMC appeared to be shifting toward agreement that large scale asset purchase program would likely be wrapped up by year end.  Of course, they included a caveat:

It was also noted that were the outlook to deteriorate, the pace of purchases could be increased.

Since the last FOMC meeting, it has become clear that the economy continues along a suboptimal path, as illustrated by the disappointing 2.5 percent GDP growth for the first quarter; just a few weeks ago, Macroeconomic Advisors was anticipating a 3.6 percent growth rate.  In addition, both employment and manufacturing reports have been less than impressive (see Calculated Risk for his take on today's Dallas Fed numbers and the implications for the ISM report).  Moreover, fiscal austerity continues to bite:

The end result is that investors have concluded, rightly, that FOMC members looking forward to cutting the pace of purchases by mid-year were overly optimistic.  Consequently, the 10-year yield was bid down to just 1.67 percent this afternoon, well below the 2.05 in early March.

Probably more important, at this juncture is that disinflation is again evident, with headline and core PCE up just 1.0 and 1.1 percent, respectively, compared to last year:

In an April 17 Wall Street Journal interview, St. Louis Federal Reserve President James Bullard highlighted the possibility that a deteriorating inflation trend might require additional easing. Other policymakers have joined him in this concern.  From Bloomberg:

“I’d of course be giving serious thought” to additional stimulus if disinflation persists, Richmond Fed President Jeffrey Lacker, who voted against the bond program last year, said last week -- while adding he doesn’t think that will happen. The Minneapolis Fed’s Narayana Kocherlakota also said this month weaker inflation may be reason to consider more accommodation.

The important point is that low inflation prompts concern even among policymakers who think the Fed can have little impact on employment growth.  For this group, high unemployment is distressing but not actionable.  But low inflation is both distressing and actionable.  Thus, at a minimum, the low inflation numbers should push the FOMC back to avoiding a premature end to quantitative easing.  In addition, it is easy to argue that the Fed should be thinking about additional easing.  Not only are they missing on the employment mandate, but increasingly it looks like they are missing on the price stability mandate as well.  A policy failure all around.

Bottom Line:  The FOMC statement should shift to indicate the softer economy and falling inflation numbers; I am watching for how much emphasis they place on the latter as a signal as to the likelihood of easing further in future meetings.  Like most, I don't anticipate an expansion of the program at this juncture.  I doubt the FOMC would see the current data as justifying a leap from thinking about ending the program to expanding the program just six weeks later.  It would be interesting if Kansas City Federal Reserve President Esther George pulls her dissent.  Her objection has been that the Fed's policy stance risks financial stability for little economic benefit.  Pulling her dissent in response to falling inflation would signal that disinflation concerns run deep in the FOMC.