Fed Watch: Dudley, Plosser, JOLTS, Potential Output

Tim Duy:

Dudley, Plosser, JOLTS, Potential Output, by Tim Duy: Not enough time to do any of these topics justice, but some quick takeaways for the last two days.

First, read today's speech by Federal Reserve President William Dudley in which he discusses the global implications of US monetary policy. Some keys points:

1. Still dismissing the recent drop in inflation expectations. Dudley says:

In assessing inflation expectations, I currently put more weight on survey-based measures of inflation expectations as opposed to market-based measures. Survey-based measures have been generally stable, consistent with inflation expectations remaining well-anchored. However, market-based measures, such as those based on breakeven inflation derived from the difference between yields on nominal versus Treasury Inflation-Protected Securities (TIPS), have registered declines over the past few months, even on a 5-years forward basis. Research done by my staff suggests that much of this decline in market-based measures of inflation compensation reflects a fall in the inflation risk premium—that is, what investors are willing to pay to protect themselves against inflation risk. Adjusting for the fall in the inflation risk premium, inflation expectations appear to have declined much less than implied by TIPS inflation breakeven measures.

The Fed is not taking the market-based measured of inflation expectations at face value, especially now that the Fed is closer to its employment objectives and they are increasingly confident that the recovery is more likely than not to strengthen further.

2. Cautious about prematurely raising rates. Dudley on the implications of his outlook for monetary policy:

In considering the appropriate timing of lift-off, there are three important reasons to be patient. First, the Committee is still undershooting both its employment and inflation objectives...Second, when interest rates are at the zero lower bound, the risks of tightening a bit too early seem considerably greater than the risks of tightening a bit too late. A premature tightening might lead to financial conditions that are too tight, resulting in a weaker economy and an aborted lift-off...Finally, given the still high level of long-term unemployment, there could be a significant benefit to allowing the economy to run “slightly hot” for a while in order to get these people employed again. If they are not employed relatively soon, their job skills will erode further, reducing their long-term prospects for employment and, therefore, the productive capacity of the U.S. economy.

Hence, no need for a rate hike now. But...

3. Rate hikes are coming. Dudley continues:

All that said, I hope the economic outlook evolves so that it will be appropriate to begin to raise interest rates sometime next year. While raising interest rates is often portrayed as a difficult task for central bankers, in fact, given the events since the onset of the financial crisis, it would be a development to be truly excited about. Raising interest rates would signal that the U.S. economy is finally getting healthier, and that the Fed is getting closer to achieving its dual mandate objectives of maximum employment and price stability. That would be very good news, even if it were to cause a bump or two in financial markets.

The economy is improving, hence normalization is coming. And note he does not specify any time frame other than next year. Based on previous comments we might reasonably conclude that he thinks mid-year, but it is a data-dependent decision. I think his is "patient" in the sense that it is not going to happen this year (which really isn't a question to begin with). But I doubt he has ruled out the end of the first quarter of next year. And again, don't expect the Fed to change course on the basis of some market turbulence. They expect it as part of the policy transition.

Outgoing Philadelphia Federal Reserve President Charles Plosser, in contrast, is looking for action sooner than later. While Dudley sees the risks of premature tightening, Plosser thinks the risk of wanting too long before normalization are higher:

First, we do not know how to confidently determine whether the labor market is fully healed or when we have reached full employment...Second, if we wait until we are certain that the labor market has fully recovered before beginning to raise rates, policy will be far behind the curve. One risk of waiting is that the Committee may be forced to raise rates very quickly to prevent an increase in inflation...This would represent a return of the so-called "go-stop" policies of the past...A third risk to waiting is that the zero interest rate policy has generated a very aggressive reach for yield as investors take on either credit or duration risk to earn higher returns...For these reasons, I would prefer that we start to raise rates sooner rather than later. This may allow us to increase rates more gradually as the data improve rather than face the prospect of a more abrupt increase in rates to catch up with market forces, which could be the outcome of a prolonged delay in our willingness to act. Of course, financial markets are not always patient, so some volatility will be unavoidable.

Still a minority position on the FOMC, but eventually hawks (or those that remain, see below) and doves will converge. I still think that convergence will happen in the middle of next year with the risks weighted more on the second than the third quarter. Indeed, the JOLTS report for September suggests the labor market improvement is accelerating as we head into the final months of the year. Notably, the quits rates spiked:

I suspect that a faster quit rate will force employers to step up the pace of higher out of necessity. Moreover, unemployment below 6% and heading south and quit rates heading north to pre-recession levels suggests that wage growth is coming. And that wage growth will push FOMC moderates toward the "hike sooner than later" side of the debate. Call me an optimist on the near-term outlook.

Finally, via Mark Thoma, researchers at the Federal Reserve are questioning the ability of the economy to regain anything like what we thought was potential output prior to the recession:

The economic collapse in the wake of the global financial crises (GFC) and the weaker-than-expected recovery in many countries have led to questions about the impact of severe downturns on economic potential. Indeed, for several major economies, the level of output is nowhere near returning to pre-crisis trend (figure 1). Such developments have resulted in repeated downward revisions to estimates of potential output by private- and public-sector forecasters. In addition, this disappointment in post-recession growth has contributed to concerns that the U.S. economy, among others, is entering an era of secular stagnation. However, the historical experience of advanced economies around recessions indicates that the current experience is less unusual than one might think. First, output typically does not return to pre-crisis trend following recessions, especially deep ones. Second, in response, forecasters repeatedly revise down measures of trend...

...Although these calculations are simple, they raise deeper questions about the impact of recessions on trend output. The finding that recessions tend to depress the long-run level of output may imply that demand shocks have permanent effects. The sustained deviation of the level of output from pre-crisis trend points to flaws in the way the economics profession models the recovery of output to economic shocks and raises further doubts about the reliance on measures of output gaps to determine economic slack. For policymakers, the results also point to the cost of recessions, especially deep and long ones, and provide a rationale for strong and rapid policy responses to economic downturns.

Those of us concerned by the risk that the lengthy cyclical downturn would yield structural damage would not be surprised by this conclusion. Note that the more the Fed believes output is close to potential, the less patient they will be in holding rates low. And note that the have already pretty much given up on the CBO potential output numbers:

If he don't get back to that estimate of potential output by 2017, that estimate just isn't going to hold. Call me a pessimist on this point. I think it more likely than not that the CBO estimate of potential is revised downward again. I suspect the Fed has already done so.

And in a late-breaking development, Dallas Federal Reserve President Richard Fisher announced his retirement today, effective March 19, 2015. Another hawk down.

Bottom Line: Watch the data. In my opinion, the pessimistic focus from both the left and the right risks underestimating the degree of economic improvement. The Fed's patience will wane in the face of further improvement in the pace of activity.