Fed Watch: Catching Up

Tim Duy:

Catching Up: I snuck out of town last week and am catching up on Fed/economy news. Highlights from the past week:

1.) The labor report comes in better than expected. Nonfarm payrolls rose by 287k in June compared to the downwardly revised 11k gain in May. These results speak to the volatility typically seen in the employment data. See also Matthew Boesler on impact of end of the school year on the data. On a twelve month basis, job growth has eased only moderately. But on a three month basis, the slowdown is more pronounced:

You have to decide if this is one of those situations when the longer term trend is missing a more severe turning point in the data.

My sense is that these numbers are sufficient to convince many Fed officials that the unemployment rate will decline further in the months ahead. But many will also see reason for caution. First, as noted earlier, near term trends reveal a moderation in the pace of job growth. And the rate of improvement in the unemployment rate has slowed markedly in recent months:

This raises the prospect that job growth is actually not that much higher than that necessary to hold the unemployment rate constant. Moreover, progress toward reducing unemployment has slowed or stalled:

And while wage gains are accelerating, the pace remains tepid, roughly 100bp below the pre-recession rates:

It would be disappointing if wage growth stalled out here. Note also that the long-leading indicator of temporary help employment is tracking sideways to slightly down:

All of these indicators may be headed for upside breakouts in the months ahead, but at the moment I sense some loss of momentum in labor market improvement. This, I think, places the Fed on some precarious ground, something that the bulk of the FOMC likely recognizes. It's not that the fundamentals of the economy have necessarily broken down; it's that the Fed needs to maintain a sufficiently accommodative policy to allow those fundamentals to exert themselves.

2.) Influential policymakers urge patience. Federal Reserve Governor Dan Tarullo came out strongly against additional rate hikes at this time. Via MarketWatch:

“Inflation is not at our stated target, not near our stated target, and hasn’t been so in quite some time,” Tarullo said in a conversation at a Wall Street Journal breakfast.

“This is not an economy that is running hot,” he added.

“For some time now I thought it was the better course to wait to see more convincing evidence that inflation is moving toward and would remain around the 2% target,” Tarullo said.

“To this point, I have not seen that type of evidence,” he said.

It seems to me that Tarullo is looking for something close to the proposed Evans Rule 2.0 - no rate hikes until core-inflation hits 2 percent year-over-year. Even more interesting is this:

Tarullo said he didn’t think that the worry that low interest rates may fuel asset bubbles was an “immediate concern.”

The Fed governor, who is the quarterback of the Fed’s efforts to regulate banks, questioned whether raising rates would ease financial stability concerns in an environment where the market was pessimistic about the economic outlook.

“If markets do regard economic prospects as only modest or moderate going forward, then raising short-term rates is almost surely going to flatten the yield curve, which generally speaking is not good for financial intermediation, and in some sense could exacerbate financial stability concerns,” Tarullo said.

When rates are low, regulators should pay more attention to financial stability issues “but it doesn’t translate into ‘therefore raise rates and all will be well,’” he added.

Tarullo is obviously not pleased that the yield curve continues to flatten

and is not interested in hiking into such an environment. New York Federal Reserve President William Dudley echoes this concern:

Federal Reserve Bank of New York President William Dudley voiced concern Wednesday about very low yields on 10-year Treasury notes, which could be a sign that investor expectations for growth and inflation are waning. Mr. Dudley, who had been meeting with local leaders at Binghamton University in New York, said low yields weren’t “completely good news.”

This suggests these two policymakers would prefer to hike if long-term yield were rising, pulling the Fed along for the ride. Low yields are only feeding into the Fed's suspicion that their expectations of where rates are headed are wildly optimistic.

3.) Williams interview. Gregg Robb of MarketWatch has a long interview with San Francisco Federal Reserve President John Williams. The whole interview is worth a read. Two points. First, Williams is in the camp that the Fed need to act sooner than later to forestall the growth of imbalances:

The risk I think we face in waiting too long, or waiting maybe as long as some of these market expectations are, is that the economy is already pretty strong and if we wait too long in further removal of accommodation I do think imbalances will form more generally. It could show up as more inflation pressures down the road, we’re not seeing those yet, but I think that you do see some of this in terms of real-estate markets and other asset markets which are being priced to perfection based on an outlook of very low interest rates. You are seeing extremely high asset valuations in real estate, commercial real estate, the stock market is very strong relative to fundamentals. That is a natural result from low interest rates, that’s one of the ways monetary policy affects the economy. But if asset prices, real estate prices, continue to go further and further away from longer-term fundamentals I think that creates risk for the economy, I think it creates risks eventually for the financial system.

Note that this runs counter to Tarullo, who argued that the flattening yield curve could worsen, not improve, the financial stability situation. The need to rates rates in the name of financial stability is a growing fault line within the Fed.

Second, Williams gives his view of the disconnect between financial markets and the Fed:

In term of the private-sector forecasts, I think it’s very hard to fully understand what the Fed’s decision-making is given that we haven’t done many active policy steps in the last few years. I mean we did obviously as I mentioned the asset purchases during that period, but since we’ve ended that, we talked a lot about raising rates, we’ve given a lot of “dot plots” about raising rates, we did one rate increase in December, but then it has been over six whole months since then, and - I try to put myself in the shoes of a private sector forecaster - one of the hard things to do is kind of see what is our reaction function. What is it that is driving our decision?...

...Right now we’re just in a situation where there is just not a lot of data on actual actions because, for various reasons we’ve held off a long time on our first rate increase and then we held off so far on a second rate increase.

This I think is wrong; lack of action is a policy choice as much as action. Williams seems to think the only useful information about the Fed's reaction function comes when the Fed changes rates. This implies that holding policy steady conveys no information. I would argue that steady policy is in fact signaling the Fed's reaction function, and hence, in combination with the data flow, financial market participants are concluding that the Fed will continue at a glacial pace regardless of what the "dots" say. Indeed, I would say that financial market participants are signaling that the Fed's stated policy path would be a policy error, an error that they don't expect the Fed to make. I guess you could argue that the market doesn't think the Fed understands it's own reaction function. And given the path of policy versus the dots, the market appears to be right.

4.) Mester, seriously? Cleveland Federal Reserve President Loretta Mester dropped this line in a July 1 speech (emphasis added):

But there are also risks to forestalling rate increases for too long when we are continuing to make cumulative progress on our policy goals. Waiting too long increases risks to financial stability and raises the chance that we would have to move more aggressively in the future, which poses its own set of risks to the outlook. I believe waiting too long also jeopardizes our future ability to use the nontraditional monetary policy tools that the Fed developed to deal with the effects of the global financial crisis and deep recession. If we fail to gracefully navigate back toward a more normal policy stance at the appropriate time, then I believe there is a non-negligible chance that these tools will essentially be off the table because the public will have deemed them as ultimately ineffective. This is a risk to the outlook should we ever find ourselves in a situation of needing such tools in the future. Of course, such a risk is hard to measure and is not one we typically consider. But we live in atypical times, and we need to take the whole set of risks into account when assessing appropriate policy.

The part about low rates and financial instability is, as I noted earlier, a growing fault line within the Fed. But the next part about needing to "gracefully" return to a normal policy stance to regain policy effectiveness of nontraditional tools was unexpected. This a variation on a theme. There is a common misperception that policymakers need to raise rates not because the economy needs it, but because it needs tools to fight a future recession. Completely backwards logic, of course. Premature rate hikes only speeds up the arrival of next recession and ensures that policymakers lack room to maneuver. They don't, as Mester suggests, preserve your options. A central banker should know this.

5.) The minutes. My short takeaway from the minutes is that the divide among FOMC participants is greater than the divide among FOMC members. In other words, a larger percentage of participants are looking to hike rates sooner than members. Until the balance on the FOMC shifts, discount hawkish Fedspeak.

Bottom Line: I am keeping an eye on Tarullo; he has been more public on his monetary policy views in recent months. And those views are fairly dovish. My guess is that he and other doves regret taking one for the team last December and falling in line with a rate hike. They won't go down so easily this time around.