Economist's View

FRBSF: The Current Economy and the Outlook

From the FRBSF:

FedViews: Kevin J. Lansing, research advisor at the Federal Reserve Bank of San Francisco, stated his views on the current economy and the outlook as of August 9, 2018.

The initial estimate of real GDP growth in the second quarter of 2018 came in at 4.1% at an annual rate, resulting in a growth rate of 2.8% over the past four quarters. For 2018 as a whole, we expect growth to come in just under 3%, well above our estimate of the economy’s long-run sustainable growth rate. Given the diminishing effects of federal fiscal stimulus over the next few years and the expected tightening of financial conditions, we project that growth will slow to just under 2% by 2020.

The Bureau of Labor Statistics reported that payroll employment increased by 157,000 jobs in July. Data for the previous two months were revised upward, resulting in an average job gain over the past three months of 224,000. Over the past year, the average monthly gain was 203,000 jobs. The unemployment rate edged down to 3.9% from 4% in June. We expect monthly job gains to remain above the breakeven level needed to keep pace with the growth rate of the labor force. Consequently, we expect the unemployment rate to decline further below our 4.6% estimate of the natural rate of unemployment.

Inflation over the past year is close to the Federal Open Market Committee’s (FOMC’s) 2% target. With unemployment below the natural rate and real GDP growth above its long-run sustainable pace, we expect some upward pressure on inflation over the medium term, causing the four-quarter inflation rate to slightly overshoot the 2% target in 2020.

Following the conclusion of its latest meeting on August 1, the FOMC announced its decision to maintain the target range for the federal funds rate at 1¾ to 2%. The Committee noted that recent economic activity has been strong and that risks to the economic outlook appear roughly balanced. The Committee expects further gradual increases in the target range for the federal funds rate.

Interest rates have continued to increase with the ongoing monetary policy normalization. Nevertheless, the current level of the federal funds rate remains accommodative as it stands about 50 basis points below our estimate of the “neutral” federal funds rate.

Few, if any, past recessions have been successfully predicted either by the Federal Reserve or professional forecasters. Forecasting recessions is difficult because each one tends to differ in important ways from previous episodes. Past recessions have been triggered by upward spiking oil prices, increases in policy interest rates designed to bring down high inflation, and bursting asset price bubbles.

Despite the varied triggers, recessions are typically preceded by some characteristic interest rate configurations. These include an inverted Treasury yield curve, an elevated real short-term interest rate, and a compressed credit spread (as measured by the yield difference between Baa corporate bonds and 10-year Treasury bonds).

An inverted yield curve is often observed after a sustained series of monetary policy tightening actions that serve to raise real short-term Treasury yields. Long-term Treasury yields, which reflect expectations of future economic conditions, tend to move up with short-term yields during the early phases of an economic expansion, but may stop doing so (resulting in a flat or inverted yield curve) if investors’ economic outlook becomes more pessimistic.

Corporate bond yields are typically higher than Treasury bond yields because corporate yields must compensate investors for the risk of default. During an economic expansion, default risk declines which causes the credit spread to compress. But a sustained expansion may cause investors to underestimate the risk of default, contributing to weak lending standards, excessive borrowing, and a credit spread that is too low. The onset of an economic slowdown or a recession would trigger the unwinding of such conditions. Research shows that optimistic credit market sentiment, as measured in part by a compressed credit spread, tends to predict slower economic activity at a two-year horizon.

The current interest rate configuration can be described as follows: (1) The Treasury yield curve is relatively flat but not inverted, (2) the real short-term interest rate has been increasing but is still low by historical standards, and (3) the credit spread is compressed. This configuration can be described as providing mixed signals about the future. While the first two observations suggest that the risk of a recession remains relatively low, factoring in the third observation would suggest a somewhat higher risk of a recession than otherwise.

The views expressed are those of the author, with input from the forecasting staff of the Federal Reserve Bank of San Francisco. They are not intended to represent the views of others within the Bank or within the Federal Reserve System.

Trump Hasn’t Prepared Us for the Inevitable Economic Slowdown

Larry Summers:

Trump hasn’t prepared us for the inevitable economic slowdown, Washington Post: President Trump regularly and proudly takes credit for the U.S. economy’s strong performance. And with rapid growth during the second quarter, the stock market strong, the unemployment rate back below 4 percent and the midterm elections looming, Trump’s rhetoric and that of his supporters will probably escalate in coming months.

In fact, however, the president receives more of a boost from the strong economy than the other way around. This conclusion will only be reinforced if Trump’s current steps toward a trade war retard U.S. economic performance, as is increasingly feared. ...

Fiscal stimulus is like a drug with tolerance effects; to keep growth constant, deficits have to keep getting larger. Some combination of gathering foreign storm clouds, the end of growing fiscal stimulus and the delayed effect of tightening monetary policies may converge to slow or end the expansion. 

The choices this administration is making invite foreign retaliation against U.S. exporters and use up fiscal capacity — even as the economy is growing rapidly. Because of this, and because there is limited room for monetary policy, the country will not be in a position to respond strongly if a downturn comes. All the more reason, therefore, to avoid pulling demand forward. 

This is all quite dangerous. The president has taken credit for far more economic success than he deserves. He will disproportionately be blamed when the downturn comes. What follows will be a test of our democracy.

Is GDP Overstating Economic Activity?

From an Economic Letter at the FRBSF:

Is GDP Overstating Economic Activity?, by Zheng Liu, Mark M. Spiegel, and Eric B. Tallman: Two common measures of overall economic output are gross domestic product (GDP) and gross domestic income (GDI). GDP is based on aggregate expenditures, while GDI is based on aggregate income. In principle, the two measures should be identical. However, in practice, they are not. The differences between these two series can arise from differences in source data, errors in measuring their components, and the seasonal adjustment process.

In this Economic Letter, we evaluate the reliability of GDP relative to two alternatives, GDI and a combination of the two known as GDPplus, for measuring economic output. We test the ability of each to forecast a benchmark measure of economic activity over the past two years. We find that GDP consistently outperforms the other two as a more accurate predictor of aggregate economic activity over this period. This suggests that the relative weakness of GDI growth in recent years does not necessarily indicate weakness in overall economic growth.

Discrepancies between GDP and GDI

What drives the discrepancies between GDP and GDI is not well understood. The source data for the components that go into GDP and GDI are measured with errors, which may lead to discrepancies between the two. Further discrepancies can arise because those different components are adjusted for seasonality at different points in time (see, for example, Grimm 2007).

The differences between these two series can be large. For example, in the last two quarters of 2007, inflation-adjusted or “real” GDI was declining whereas real GDP was still growing. The year-over-year growth rate of GDP exceeded that of GDI by almost 2.6 percentage points. Over long periods, however, final measures of growth in GDP and GDI tend to yield roughly equivalent assessments of economic activity. Since 1985, real GDP grew at an average annual rate of about 3.98%, while real GDI grew at a similar average rate of 4.02%.

Since late 2015, the two series have diverged, with real GDP growth consistently exceeding real GDI growth (Figure 1). The differences in growth are significant in this period. For example, if we used GDI growth to assess overall economic activity since July 2015, then the size of real aggregate output by the end of 2017 would be $230 billion smaller than if GDP growth were used. This divergence between the two sends mixed signals regarding the strength of recent economic activity.

Figure 1
Mixed signals from GDP and GDI growth

Source: Bureau of Economic Analysis.

Evaluating GDP, GDI, combination

Researchers often debate which of these series measures economic activity more accurately. Nalewaik (2012) argues that GDI outperforms GDP in forecasting recessions. GDI does appear to exhibit more cyclical volatility than GDP. One reason may be that GDI is more highly correlated with a number of business cycle indicators, including movements in both employment and unemployment (Nalewaik 2010). On the other hand, the Bureau of Economic Analysis has resisted this conclusion, arguing that GDP is in general based on more reliable source data than GDI is (Landefeld 2010).

To evaluate the relative reliability of GDP versus GDI for measuring economic output, we compare their abilities to forecast a benchmark measure of economic activity. We focus on the Chicago Fed National Activity Index (CFNAI) as the benchmark, since it is publicly available. The CFNAI is a monthly index of national economic activity, generated as the common component of 85 monthly series in the U.S. economy. These underlying series include a wide variety of data covering production and income, employment and unemployment, personal consumption and housing, and sales and orders. The CFNAI has been shown to help forecast real GDP (Lang and Lansing 2010). We use the CFNAI as a benchmark activity indicator to evaluate the relative forecasting performances of GDP and GDI and their combinations. Since the discrepancy between these two series has persisted for several years, we focus on the final releases of the GDP and GDI series.

Some have argued that, because the GDP and GDI series contain independent information, it may be preferable to combine the two series into a single more informative activity indicator. One series that uses such a combination is the Philadelphia Fed’s GDPplus series, which is a weighted average of GDP and GDI, with the weights based on the approach described by Aruoba et al. (2016). As a weighted average, GDPplus indicates activity levels between the two individual series. We therefore also consider the forecasting performance of the GDPplus series over this period of extended discrepancy between reported GDP and GDI growth.

To confirm the accuracy of our approach, we repeated our investigation with two alternative series constructed using methodologies similar to the CFNAI. The first alternative is an aggregate economic activity index (EAI) we constructed by extracting the common components of 90 underlying monthly time series. The EAI covers a broader set of monthly indicators than the CFNAI, since we also include information from goods prices and asset prices.

The second alternative indicator we considered is an activity index constructed by Barigozzi and Luciani (2018), which we call the BL index. Like our index, the BL index includes price indexes and other measures of labor costs. The authors base their estimates on the portions of GDP and GDI that are driven by common macroeconomic shocks under the assumption that they have equivalent effects on GDP and GDI. This restriction implies that deviations between GDP and GDI are transitory, and that the two series follow each other over time.

The EAI and the BL index are both highly correlated with the CFNAI and thus yielded similar conclusions. We describe the source data and our methodology for constructing the EAI as well as the analysis using both it and the BL index in an online appendix.

Empirical results

To examine the relative performances of GDP, GDI, and GDPplus for forecasting the CFNAI, we first estimate an empirical model in which the CFNAI is related to four lagged values of one of these measures of aggregate output. Ideally, we would have used the full sample of postwar data in our model, but there are some structural breaks in the data related to factors such as changes in the monetary policy regime since the mid-1980s and the Great Moderation that make this challenging. We therefore choose to focus on the sample starting from the first quarter of 1985 in this discussion; our results using the full sample are similar, as we report in the online appendix.

To examine how well each of the measures of aggregate output are able to forecast the CFNAI, we estimate the model using the sample observations up to the end of 2015, the period before GDP and GDI diverged. Once we determine the estimated coefficients that describe each relationship, we use those values to estimate forecasts for the period when discrepancies developed, from the first quarter of 2016 to the end of 2017. We then calculate the prediction errors, measured by the root mean-squared errors, for each measure of aggregate output. The smaller the prediction error, the better the forecasting performance.

In addition to examining the forecasting performance of GDP, GDI, and GDPplus for predicting the CFNAI economic activity indicator, we also examined their forecasting performance for the unemployment rate as reported by the Bureau of Labor Statistics.

Figure 2 displays the prediction errors from 2016 to 2017 for each of the alternative output measures—GDP, GDI, and GDPplus—estimated from our model for CFNAI and unemployment. For ease of comparison, we normalize the prediction errors from the model with GDP to one. The figure shows that the prediction errors over this period based on the GDP series are substantively lower than those based on GDI or GDPplus. This finding holds true not just for these proxies for economic activity but also for our EAI and the BL index (see the online appendix). Moreover, formal statistical tests of forecasting performance indicate that the forecasts based on GDP are significantly better than those based on GDI or GDPplus at the 95% confidence level. This result suggests that, in recent periods, GDP has been a more reliable independent indicator of economic activity than either GDI or GDPplus.

Figure 2
GDP outperforms GDI, GDPplus in predicting activity

Note: Figure shows prediction errors with GDP indexed to 1.

Conclusion

While GDP and GDI are theoretically identical measures of economic output, they can differ significantly in practice over some periods. The differences between the two series have been particularly pronounced in the past two years, when GDP growth has been consistently stronger than GDI growth. Based on this observation, some analysts have claimed that GDP might be overstating the pace of growth and that GDI, or some combination of GDP and GDI, should be used to evaluate the levels and growth rate of economic activity.

To evaluate the validity of this claim, we compared the relative performances of GDP, GDI, and a combined measure, GDPplus, for forecasting the CFNAI, which we use as a benchmark measure of economic activity over the past two years. We find that GDP consistently outperforms both GDI and combinations of the two, such as GDPplus, in forecasting aggregate economic activity during the past two years. In this sense, GDP is a more accurate predictor of aggregate economic activity than GDI over this period. Therefore, the relative weakness of GDI growth observed in recent years does not necessarily indicate weakness in overall economic growth.

Zheng Liu is a senior research advisor in the Economic Research Department of the Federal Reserve Bank of San Francisco.

Mark M. Spiegel is a vice president in the Economic Research Department of the Federal Reserve Bank of San Francisco.

Eric B. Tallman is a research associate in the Economic Research Department of the Federal Reserve Bank of San Francisco.

References

Aruoba, S. Boragan, Francis X. Diebold, Jeremy Nalewaik, Frank Schorfheide, and Dongho Song. 2016. “Improving GDP Measurement: A Measurement-Error Perspective.” Journal of Econometrics 191(2), pp. 384–397.

Barigozzi, Matteo, and Matteo Luciani. 2018. “Do National Account Statistics Underestimate U.S. Real Output Growth?” Board of Governors FEDS Notes, January 9.

Grimm, Bruce T. 2007. “The Statistical Discrepancy.” Bureau of Economic Analysis Working Paper 2007-01, March 2. 

Landefeld, J. Steven. 2010. “Comments and Discussion: The Income- and Expenditure-Side Estimates of U.S. Output Growth.” Brookings Papers on Economic Activity, Spring, pp. 112–123.

Lang, David, and Kevin J. Lansing. 2010. “Forecasting Growth Over the Next Year with a Business Cycle Index.” FRBSF Economic Letter 2010-29 (September 27).

Nalewaik, Jeremy J. 2010. “The Income- and Expenditure-Side Estimates of U.S. Output Growth.” Brookings Papers on Economic Activity, Spring, pp. 71–106.

Nalewaik, Jeremy J. 2012. “Estimating Probabilities of Recession in Real Time Using GDP and GDI.” Journal of Money, Credit, and Banking 44, pp. 235–253.

Opinions expressed in FRBSF Economic Letter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System.

Price Level Targeting with Evolving Credibility

This is by Seppo Honkapohja and Kaushik Mitra (very wonkish):

Price Level Targeting with Evolving Credibility, by Seppo Honkapohja and Kaushik Mitra: Abstract We examine global dynamics under learning in a nonlinear New Keynesian model when monetary policy uses price-level targeting and compare it to inflation targeting. Domain of attraction of the targeted steady state gives a robustness criterion for policy regimes. Robustness of price-level targeting depends on whether a known target path is incorporated into learning. Credibility is measured by accuracy of this forecasting method relative to simple statistical forecasts. Credibility evolves through reinforcement learning. Initial credibility and initial level of target price are key factors influencing performance. Results match the Swedish experience of price level stabilization in 1920's and 30's.

Jobs Report Gives Fed Cover To Retain Gradual Rate Path

Tim Duy:

Jobs Report Gives Fed Cover To Retain Gradual Rate Path: The jobs report gives the Fed cover to retain a gradual rate path. To be sure, the rapid pace of job growth will leave them nervous about an unsustainable pace of growth. But the flat unemployment rate remains consistent with their forecasts. In addition, low wage growth indicates the economy has not pushed past full employment. If inflation remains constrained, the Fed would be pretty much on target for this year. That suggests the three-hike scenario should remain in play. But increased confidence in the outlook and risk management concerns will push up enough “dots” in the next Summary of Economic projections toward four hikes for this year. ...continued here...

Fed Changing Its Tune

Tim Duy:

Fed Changing Its Tune: Yesterday I called attention to this line from Federal Reserve Chairman Powell’s testimony:

In gauging the appropriate path for monetary policy over the next few years, the FOMC will continue to strike a balance between avoiding an overheated economy and bringing PCE price inflation to 2 percent on a sustained basis.

I interpreted this as a shift in the Fed’s focus. The risks are shifting, hence the new concern about an overheated economy. In contrast, previous iterations of this policy guidance referred to “achieving” and then “sustaining” full employment. Central bankers must view the economy as in a danger zone for inflationary pressures. ...continued here...

Looking For Policy Continuity From Powell

Tim Duy:

Looking For Policy Continuity From Powell, by Tim Duy: Federal Reserve Chairman Jerome Powell will tackle his first Semiannual Monetary Policy Report to the Congress this week. The expectation is that Powell will by and large reiterate the case for continued gradual tightening of monetary policy. That has come to mean three rate hikes in 2018, although given the data dependence of policy the risk is that three becomes four. Market participants remains nervous, however, that Powell will set a more hawkish tone indicating a sharp acceleration of rate hikes. I think this very unlikely at this juncture. I do think there is room, however, to emphasize that if fiscal spending supercharges growth in 2018, then rate hikes will continue into 2019. ...Continued here...

Fedspeak and the January FOMC Minutes

Tim Duy:

Fedspeak Reiterates Gradual Path: Fed speakers continue to reiterate that policy remains on a gradual path of tightening. So far, the inflation data and brightening economy has more emboldened their commitment to gradual rate hikes than a faster pace of hikes. What about fiscal policy? That train has left the station, but central bankers don’t seem too concerned – yet. ...continued here...

And one more from Tim:

First Impressions of the January FOMC Minutes: The minutes of the January FOMC meeting revealed increasing confidence in the economic outlook. That translated into increased confidence that gradual rate hikes remains the appropriate policy path. Does that mean the central bankers stand poised to raise their “dots” such that the median rate hike projection rises to four hikes? I don’t think so. I read the minutes as wiping away lingering concerns about the inflation outlook and allowing policymakers to coalesce around the existing three hike projection. The risk remains, of course, that conditions remain sufficiently buoyant to raise the rate projection in June or September. More important to me at this juncture is I see clear hints that the projections beyond 2018 are vulnerable to upward revisions. ...continued here...

Inflation, General Data Flow, Fiscal Stimulus, And Implications For Monetary Policy

 

Tim Duy:

Inflation, General Data Flow, Fiscal Stimulus, And Implications For Monetary Policy, by Tim Duy: The data flow remains supportive of the Fed’s forecast of sustained moderate growth. A spike in prices, however, drove core CPI inflation to the fastest monthly pace since 2005, again raising fears that the Fed will accelerate the pace of rate hikes. I still think this is premature. To be sure, the risk is that the Fed hikes rates more than the projected three times this year. But Powell & Co. will need more data to support a faster pace of rate hikes. They will not overreact to data that may prove to be nothing more than a flash in a pan. ...continued here...

Stick To The Forecast

Tim Duy:

Stick To The Forecast, by Tim Duy:

So far, I’d say this is small potatoes… -- New York Federal Reserve President William Dudley, February 8, 2018

All that said, given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system. -- Federal Reserve Chairman Ben Bernanke, May 17, 2007

Friday was yet another day of wild swings on Wall Street as market participants continue to digest the implications for stocks and bonds of this new stage of the business cycle. In short, there looks to be a painful repricing underway that involves a new equilibrium set of prices for bonds and stocks. For now, though the Fed doesn’t care about your pain. At least that’s the message from Fed officials. They want to keep the focus on the bigger picture. That bigger picture is the economic forecast – which continues to point to gradual rate hikes. ...[continued here]...

Paul Krugman: Has Trumphoria Finally Hit a Wall?

"all of this would be manageable if key policymakers could be counted on to act effectively":

Has Trumphoria Finally Hit a Wall?, by Paul Krugman, NY Times: When talking about stock markets, there are three rules you have to remember. First, the stock market is not the economy. Second, the stock market is not the economy. Third, the stock market is not the economy.

So the market plunge of the past few days might mean nothing at all. ...

Still, market turmoil should make us take a hard look at the economy’s prospects. And what the data say, I’d argue, is that at the very least America is heading for a downshift in its growth rate; the available evidence suggests that growth over the next decade will be something like 1.5 percent a year, not the 3 percent Donald Trump and his minions keep promising. ...

But should we be worried about something worse than a mere downshift in growth?

Well, asset prices do look high: A widely used gauge of stock valuations puts them at a 15-year high, while a conceptually similar measure says that housing prices have retraced a bit less than half the rise that culminated in the great housing bust.

Individually, these numbers aren’t that alarming: Stocks, as I said, don’t look nearly as overvalued as they did in 2000, housing not nearly as overvalued as it was in 2006. On the other hand, this time both markets look overvalued at the same time, at least raising the possibility of a double-bubble burst like the one that hit Japan at the end of the 1980s.

And if asset prices take a hit, we might expect consumers — who have been spending heavily and saving very little — to pull back.

Still, all of this would be manageable if key policymakers could be counted on to act effectively. Which is where I get worried.

It’s surely not a good thing that Trump got rid of one of the most distinguished Federal Reserve chairs in history just before markets started to flash some warning signs. Jerome Powell, Janet Yellen’s replacement, seems like a reasonable guy. But we have no idea how well he would handle a crisis if one developed.

Meanwhile, the current secretary of the Treasury — who declared of Davos, “I don’t think it’s a hangout for globalists” — may be the least distinguished, least informed individual ever to hold that position.

So are we heading for trouble? Too soon to tell. But if we are, rest assured that we’ll have the worst possible people on the case.

Moving Pieces

Tim Duy:

Moving Pieces, by Tim Duy: There are lots of moving pieces right now. So many that few wanted to step in front of last week’s selling on Wall Street. I am going to try to sort out some of these pieces here.

The employment report and, most notably, the pop in wages caught analysts off guard. If you were expecting the job market to slow down early this year, you continue to be on the wrong side of the story. Employers added 200k workers to payrolls in January, close to the three-month average of 192k. Curiously, the unemployment rate has held steady for four months in a row despite job growth well in excess of labor force growth. To be sure, those numbers come from different surveys, so they don’t need to match up month to month. Still, I think the household survey will eventually catch up and hence we should be prepared for a sharp lurch downward in the unemployment rate in the coming months. ...continued here...

 

Fed Stands Pat, But More Rate Hikes Are On The Way

Tim Duy:

Fed Stands Pat, But More Rate Hikes Are On The Way, by Tim Duy: As anticipated, the Fed left rates unchanged at the conclusion of yesterday’s FOMC meeting. The statement was little changed but the handful of revisions point to continuing rate hikes. The Fed remains on track for three 25bp rate hikes in 2018. For the most part, the turnover at the Fed combined with ongoing solid data has left the remaining doves sidelined. The low inflation warnings of last year were largely a head fake as the Fed was always positioned to continue raising rates as long as there looked to be continuing downward pressure on unemployment. ...Continued here...

Monetary Policy with Negative Nominal Interest Rates

Gauti Eggertsson, Ragnar Juelsrud, and Ella Getz Wold at VoxEU:

Monetary policy with negative nominal interest rates: Economists disagree on the macroeconomic role of negative interest rates. This column describes how, due to an apparent zero lower bound on deposit rates, negative policy rates have so far had very limited impact on the deposit rates faced by households and firms, and this lower bound on the deposit rate seems to be causing a decline in pass-through to lending rates as well. Negative interest rates thus appear ineffective in stimulating aggregate demand. ...

Real-Time Estimates of Potential GDP: Should the Fed Really Be Hitting the Brakes?

Olivier Coibion, Yuriy Gorodnichenko, and Mauricio Ulate at the CBPP:

Real-Time Estimates of Potential GDP: Should the Fed Really Be Hitting the Brakes?: Summary

The most recent releases of Gross Domestic Product (GDP) imply that the current level of U.S. output is almost equal to the Congressional Budget Office’s (CBO’s) estimate of the “potential level of GDP,” a measure of how much the U.S. economy could produce if its resources were fully and efficiently utilized. The World Bank further estimates that this closing of the output gap has occurred not just in the U.S. but across most advanced economies (World Bank 2018). Ten years after the onset of the Great Recession, according to this view, the economy has finally returned to its potential level and economic policy instruments should be gradually returned to normal levels, a process the Federal Reserve is now implementing.

In this brief, based on our earlier research, we challenge this conclusion. According to our analysis, CBO’s and other similar estimates of potential output are too pessimistic, and as such, they encourage policymakers, such as those at the Federal Reserve, to accept lower levels of potential than those which could be achieved. This pessimistic view and associated policies could be extremely costly to U.S. households.

Our findings include:

In deriving potential GDP, current methods used by key agencies tend to under-respond to the shocks they should respond to and over-respond to the shocks that they should not respond to. Most recently, this has led to some frequently used estimates of potential GDP that are as much as $1.2 trillion, or nearly $10,000 per household, below our preferred estimate. Methods that do not feature the under-/over-responsiveness problem we document imply that more active stimulus on the part of the Federal Reserve is warranted to enable actual GDP to finally catch up to potential. The benefits of this policy shift would include significantly greater household incomes and higher employment levels than those engendered by the current policy stance.

Should the Federal Reserve be Raising Rates due to a Closing Output Gap? ...

Democratizing Europe begins with ECB Nominations

This is from Thomas Piketty's blog, but it is a collective effort signed by a group of people (listed at the end of the Piketty post):

Democratising Europe begins with ECB nominations: While our eyes are glued to the interminable vicissitudes of the German Groko, a no less important story is playing out in Brussels, but has so far met with indifference. On January 22nd and February 19th, Eurogroup finance ministers will hold private meetings that will mark the beginning of a profound renewal of the European Central Bank executive board. The first big change will be the planned replacement of current Vice-President, Vitor Constancio. In the next two years, no less than 4 of the 6 members of the executive body of the ECB, Mario Draghi included, will be replaced.

All signs indicate that the future of economic, fiscal and monetary policy in eurozone countries is at stake in this series of nominations. ...

After a decade of crisis, the ECB is no longer the same institution that was drawn up by the Treaties...; it speaks on equal terms with the four other “presidents” of the Union (of the Commission, the Council, Eurogroup, and, finally, the European Parliament) when it comes to designing the political and institutional future of eurozone government, etc.

And yet, it as if the coming nominations are just another technicality. While there is in fact a rare occasion for leading parties and actors of representative politics to make their weight felt on the crucial issue of eurozone governance, everything seems set to keep nominations behind closed doors. ...

The nomination process does not have to be conducted in private. It doesn’t have to be yet another game of European musical chairs. ...

First signatories...

FRBSF FedViews: Current Economy and the Outlook

From Vasco Curdia of the SF Fed:

Vasco Curdia, research advisor at the Federal Reserve Bank of San Francisco, stated his views on the current economy and the outlook as of January 11, 2018.

Real GDP grew at an annual rate of 3.2% in the third quarter, according to the final estimate of the Bureau of Economic Analysis. We forecast that GDP growth averaged 2.5% for 2017. The momentum in GDP growth reflects strong gains in personal income and consumer confidence, supported by continued strength in the labor and financial markets. As monetary policy continues to normalize over the next two to three years, we expect growth to gradually fall back to our trend growth estimate of about 1.7%.

We continue to see strengthening in labor market conditions. Nonfarm payroll employment increased by 148,000 jobs in December, a bit below expectations. Over the past six months, job gains have averaged close to 166,000, well above the amount needed to absorb the flow of new workers into the labor force.

The unemployment rate was unchanged in December from its November value of 4.1%. We expect the rate to fall below 4.0% in 2018 as the economy continues to strengthen. With the gradual removal of monetary policy accommodation, we expect the unemployment rate to return gradually to our estimate of the natural rate of unemployment of 4¾%.

Inflation remains below the FOMC’s target of 2%. In November, the personal consumption expenditure (PCE) price index rose 1.8% over the past 12 months, and the core PCE price index, which removes volatile food and energy prices, rose 1.5%. Transitory developments for a few categories of goods and services held down inflation in 2017. As these developments loosen their hold, we expect continued tightness in the labor market will push inflation up in the coming year.

At the December meeting, the FOMC raised the target range for the federal funds rate by a quarter to 1.25% to 1.50%. Short-term rates followed suit, while longer-term yields did not respond as much to the FOMC announcement.

The relationship between economic slack and inflation is often referred to as the Phillips curve. The theory behind this relationship maintains that conditions that push the economy beyond full employment lead to increased cost pressures on firms and capacity constraints. Cost pressures lead to higher wages and labor costs, while capacity constraints and strained supply chains in the face of high demand push up intermediate costs. In response to these higher costs, firms tend to increase the prices they charge for their goods and services, leading to price inflation.

Various factors can influence cost pressures independently of economic strength. For example, labor market frictions, such as changes in bargaining power, labor force participation, or long-term unemployment can push up the natural rate of unemployment. Oil prices, the strength of the US dollar, or import prices can similarly affect cost pressures in the economy.

Inflation expectations also can affect the transmission from cost pressures to price inflation. For example, high inflation expectations in the early 1980s contributed to elevated price inflation for some time, despite high unemployment. If individual firms expect economy-wide prices to increase at a fast pace, they will be reluctant to slow their own price increases. If many firms follow the same reasoning and expect other firms to keep raising prices, then overall inflation will remain strong. Similarly, strategic industry-specific considerations may affect price inflation. For example, recent price wars in the telecommunications sector have led to weaker inflation numbers.

Staff statistical analysis finds a negative relationship between the unemployment gap and the cyclical component of inflation (excluding components that are not sensitive to business cycle conditions) over the period 2001 to 2017, consistent with economic theory. Currently, the economy is beyond full employment and thus, based on the Phillips curve, we are likely to see an increase in cyclical inflation, in turn pushing up overall price inflation.

The views expressed are those of the author, with input from the forecasting staff of the Federal Reserve Bank of San Francisco. They are not intended to represent the views of others within the Bank or within the Federal Reserve System. FedViews generally appears around the middle of the month. Please send editorial comments to Research Library.

Data Lining Up For The Fed’s Rate Hike Forecast

Tim Duy:

Data Lining Up For The Fed’s Rate Hike Forecast, by Tim Duy: Last Friday the Bureau of Labor Statistics released a fairly lackluster employment report. In most ways, the story remains the same – steady improvement in the labor market but no signs of overheating in the form of wage growth. The mix will keep the Fed on track for three rate hikes this year, as the consensus policymaker will view this kind of report as a reason to neither accelerate nor slow the pace of tightening. ...Continued here...

Five Questions for the Fed in 2018

Tim Duy:

5 Questions for the Fed in 2018, by Tim Duy: The Federal Reserve anticipates continued monetary tightening in 2018, as it seeks to match 2017’s pace of interest-rate hikes with another three quarter-point moves. As always, however, that projection depends on actual economic outcomes. With that in mind, here are five questions the Fed will face in 2018 as it charts a course for policy: ...Continued here on Bloomberg Prophets...

Expect the Fed to Stand By Its 2018 Outlook

Tim Duy:

Expect the Fed to Stand By Its 2018 Outlook, by Tim Duy: As the Federal Reserve prepares to hike interest rates at this week’s Open-Market Committee meeting, market participants are bidding up short-term rates -- moving toward the Fed expectations of more increases in 2018. That move could continue when the central bank reaffirms its commitment to further tightening next year. ...Continued here at Bloomberg Prophets...

Will Growth Slow In 2018? And Why?

Tim Duy:

Will Growth Slow In 2018? And Why?, by Tim Duy: Thinking about the path of policy next year, this quote from Chicago Federal Reserve President Charles Evans (via the New York Times), seems like an important issue:

I think the economy is doing very well. I think it continues to show strength. The second half is looking like very good growth: 2.5 to 3 percent growth. And this is to be measured against our assessment that sustainable growth is more like 1.75 percent. So 2.5 to 3 percent is very strong growth, which should continue to lead to improved labor market activity.

Unless something structural improves to increase trend growth, we’re going to be decelerating to something under 2 percent — and that will still be a pretty good economic picture.

On the surface, this is a fairly straightforward analysis. The supply side of the economy currently grows at roughly 1.75 percent. The demand side is growing at 2.5-3 percent. So it must be true that activity slows to something under 2 percent. ...Continued here...

Fed Frets About Inflation While Preparing Another Rate Hike

Tim Duy:

Fed Frets About Inflation While Preparing Another Rate Hike, by Tim Duy: The minutes of the Oct. 31-Nov. 1, 2018 FOMC meeting made a bit of a splash with their mixed message. The minutes revealed widespread concern with the weak inflation numbers of the past year. Yet the minutes also showed that committee members were committed to a December rate hike. Damn the torpedoes, full speed ahead! Why the mixed message? Two words: “gradual” and “lags.” ...Continued here (blog and newsletter)...

Taking Stock

Tim Duy:

Taking Stock, by Tim Duy: At some point every year I sense a need to reset and clarify my baseline views on the economy and monetary policy. This is that time. ...Continued here...

Fed Will Keep the Rate Hikes Coming

Tim Duy:

Fed Will Keep the Rate Hikes Coming, by Tim Duy: Lots of news from last week, most of which supported the Fed’s current anticipated rate path of one 25bp hike in December followed by three more in 2018. The only potential obstacle on that path is the persistent weakness of inflation. But the ongoing decline in the unemployment rate, along with the promise of further declines in the months ahead, will dominate lingering concerns at the Fed regarding the inflation numbers. ...Continued as newsletter...

Economy Not Likely Easy For Next Fed Chair

Tim Duy:

Economy Not Likely Easy For Next Fed Chair, by Tim Duy: The U.S. appears set to enter a more risky phase of the business cycle as the Federal Reserve attempts to glide the economy into a so-called soft-landing. For President Donald Trump’s likely nominee as chair, Jerome Powell, this means tightening policy enough to settle the economy into full employment, but not so much that it trips into recession.

Navigating this transition will be challenging for investors and the Fed alike. Market participants should be wary of assuming that a slowing economy means a recession is near. At the same time, central bankers need to be wary that they don’t slow the economy too much and set the stage for the next recession. Altogether, this means the relative calm of the past year is likely to end soon. ...[Continued at Bloomberg]...

Federal Reserve Independence: The Never-Ending Story

I have a new article on the past, present, and future of Federal Reserve Independence (it was written during the summer):

Federal Reserve Independence: The Never-Ending Story, by Mark Thoma: In December 1965, President Lyndon Johnson met with Federal Reserve Chairman William McChesney Martin at the president’s surprisingly modest ranch in the Texas Hill Country. Johnson was upset with Martin for tightening credit despite Johnson’s expressed preference for more accommodative policy. At one point, the president began pushing the Fed chairman around the room, haranguing him with one of his patented hard sells, “Martin, my boys are dying in Vietnam, and you won’t print the money I need.”

Martin resisted Johnson at the time, but eventually moved policy in the direction the White House demanded. Looking back years later, Martin, who was dubbed the “happy Puritan” by one journalist, lamented, “To my everlasting shame, I finally gave in to him.”

The idea that monetary policy should be made independent of political influence is widely (though hardly completely) accepted today. As former Fed Chairman Ben Bernanke (2006-14) noted, “Careful empirical studies support the view that more-independent central banks tend to deliver better inflation outcomes than less-independent central banks, without compromising economic growth.” But as the LBJ anecdote suggests, the Fed did not always enjoy the degree of independence it has today. Before the era that began with Paul Volcker (1979-87), political influence on monetary policy was the rule rather than the exception.

The independence of today’s Fed is supported by its unusual institutional framework. But the primary bulwark against interference is psychological, driven less by laws and regulations and more by the convictions of key players that the economy is better off with a central bank that can exercise broad discretion in monetary policy. Hence a president inclined to dismiss Bernanke’s “careful empirical studies” who is abetted by a Congress unwilling to resist meddling could reverse the four-decade precedent. ...[continue]...

Fed Meeting the Nonevent of the Week

Tim Duy:

Fed Meeting the Nonevent of the Week: [Newsletter version here] Central bankers will meet this week, but only to sign off on the existing policy stance. Although it pains this fedwatcher to admit, the FOMC meeting is arguably the least important event of the week. It competes with a slew of critical data, including the employment report for October, to be released Friday. Plus, we should learn President Trump’s pick to lead the Fed when Yellen’s term expires next February. An FOMC meeting widely expected to yield no change in policy and likely little in the accompanying statement simply can’t compete with this week’s news flow. ...Continued here...

Paul Krugman: The Doctrine of Trumpal Infallibility

"What happens to economists who never admit mistakes, and never change their views in the light of experience?":

The Doctrine of Trumpal Infallibility, by Paul Krugman, NY Times: ...we are living in the age of Trumpal infallibility: We are ruled by men who never admit error, never apologize and, crucially, never learn from their mistakes. Needless to say, men who think admitting error makes you look weak just keep making bigger mistakes; delusions of infallibility eventually lead to disaster, and one can only hope that the disasters ahead don’t bring catastrophe...

Which brings me to the subject of the Federal Reserve. ...

You see, when the 2008 financial crisis struck, the Federal Reserve ... cut interest rates to zero and “printed money” on a huge scale — not literally, but it bought trillions of dollars’ worth of bonds by creating new bank reserves.

Many conservatives were aghast. ... In 2010 a who’s who of conservative economists and pundits published an open letter warning that the Fed’s policies would cause inflation and “debase the dollar.”

But it never happened..., the Fed’s preferred measure of inflation has consistently fallen short of its target of 2 percent... Four years after that open letter..., Bloomberg tracked down many of the signatories to ask what they had learned..., not one ... was even willing to admit having been wrong.

So what happens to economists who never admit mistakes, and never change their views in the light of experience? The answer, apparently, is that they get put on the short list to be the new Fed chair.

Consider, for example, the case of Stanford’s John Taylor (one of the signatories of that open letter). ...

Since the financial crisis ... he has repeatedly demanded that the Fed raise interest rates in line with a policy rule he devised a quarter-century ago. Failing to follow that rule was supposed to cause inflation... — but seven years of being consistently wrong hasn’t inspired any rethinking on his part.

What it has inspired is a descent into increasingly strange reasons the Fed should raise rates despite low inflation. ... And never, ever, an admission that maybe something was wrong with his initial analysis.

Again, everyone makes forecast errors. ... But it’s much worse if you can never bring yourself to admit past errors and learn from them.

That kind of behavior makes it all too likely that you’ll keep making the same mistakes; but more than that, it shows something wrong with your character. And men with that character flaw should never be placed in positions of policy responsibility.

In Defense of the Conventional Wisdom

Tim Duy:

In Defense of the Conventional Wisdom: Let’s revisit this from San Francisco Federal Reserve Resident John Williams:

If you look until 2015 or so, the inflation data basically followed our models, emphasizing the role of weakness in the economy. Where this mystery has happened is really in the last year or two. I view both inflation picking up faster than expected in early 2017 and now the pullback as just part of the variability that’s going to happen. I don’t see any signs that somehow the inflation process is fundamentally changed.

I’ve been doing this a long time, and the Phillips curve has been declared dead far more times than Mark Twain.

This is representative of the conventional wisdom at the Fed, summed up succinctly as adherence to a basic expectations-augmented Phillips curve as a primary policy guide. As unemployment falls toward and below full employment, capacity constraints in the economy tighten and eventually create inflationary pressures. The central bank needs to offset these pressures via tighter policy to contain inflation and maintain inflation expectations, the center of gravity for actual inflation over time. ...Continued here...

Incoming Data Supportive of December Rate Hike

Tim Duy:

Incoming Data Supportive of December Rate Hike: If we ignore inflation, then nothing is really standing in the way of a rate hike in December. Of course, given that arguably the primary job of a central bank is to meet its definition of price stability, the Fed shouldn’t really ignore inflation. Policymakers, however, would counter that they are not ignoring inflation. They are simply favoring the inflation forecast over actual inflation. And they would further argue they have good cause – with the economy chugging along, it is only a matter of time before resource constraints become evident and price pressures rise. That’s their story, and they are sticking to it. ...Continued here...

Monetary Policy in a New Era (Video) - Ben Bernanke

Is The Fed Setting Itself Up To Fail In The Next Recession?

Tim Duy:

 

Is The Fed Setting Itself Up To Fail In The Next Recession?: The Federal Reserve remains committed to a December rate hike, persistent low inflation not withstanding. With unemployment below Fed estimates of its longer-run natural rate, most FOMC participants do not need evidence of stronger inflation to justify further rate hikes. Ongoing solid job growth will be sufficient cause for tighter policy, especially in what they perceive to be an environment of loosening financial conditions. The main risk from this scenario is that the US economy enters the next recession with diminished inflation expectations, which could further hobble central bankers already facing the prospect of returning to the effective lower bound in the next cycle. ...Continued here as a newsletter...

 

Fed Watch: Kevin Warsh, Very Serious Person

Tim Duy:

Kevin Warsh, Very Serious Person, by Tim Duy: Scott Sumner is perplexed by Fed chair candidate Kevin Warsh. He reads the 2010 FOMC transcripts and finds Warsh explaining:

First, my views on policy. As I said when we met by videoconference, my views are increasingly out of step with the views of most people around this table. The path that you’re leading us to, Mr. Chairman, is not my preferred path forward. I think we are removing much of the burden from those that could actually help reach these objectives, particular the growth and employment objectives, and we are putting that onus strangely on ourselves rather than letting it rest where it should lie. We are too accepting of dangerous policies from others that have been long in the making, and we should put the burden on them.

I can think, Mr. Chairman, of a tough weekend that the Europeans had, particularly your counterpart at the ECB, in the spring or summer, when we all knew that the European Central Bank, rightly or wrongly, was going to take action. But Jean-Claude Trichet did not take action until very late that Sunday night, until the fiscal authorities did their part. He thought that if on Friday night he were to say all of the things he’d be willing to do, he’d be taking the burden off the fiscal authorities. He chose to wait. I think we would be far better off waiting. If we proceed on this path, as I suspect we will, I would still encourage you to put the burden where it rightly belongs, which is on other policymakers here in Washington, and to do so in a way that is respectful of different lines of responsibility.

Sumner is understandably scratching his head, trying to figure out what Warsh is getting at:

His reasoning process is poor and he lacks good communication skills.  He has very poor judgment when interpreting data.  I really don’t know what he’s trying to say here, but the reference to Trichet is interesting.  Trichet was trying to encourage fiscal authorities to adopt more contractionary fiscal policies, not expansionary policies.  Trichet did not want to “bail out” expansionary policies with ultra-low interest rates, and Warsh seems to be endorsing Trichet’s approach.  And given Warsh’s reputation as a conservative, and the massive deficits being run by Obama back in 2010, I find it odd that Warsh would be advocating fiscal stimulus, as Brannon suggests.  But again, the passage is so garbled that I could easily be wrong.

I don’t think Warsh was advocating for more fiscal stimulus at this meeting. Warsh is a Very Serious Person, and all Very Serious People know that deficits are bad. I believe that Warsh was at this juncture advocating a Trichet-style approach to the crisis, using the independence of the central bank to force the fiscal authorities to rein in those bad deficits, because of course everything wrong in the economy can be tied back to deficit spending. All Very Serious People know this. Of course, Trichet’s approach proved to be disastrous, which is why Sumner is rightfully puzzled when hearing a Fed governor suggest the same.

Sadly, Warsh was not the only Fed official who advocated such an approach. Warsh is apparently cut from the same cloth as the person I believe was the worst regional bank president in recent memory. Recall when the FOMC statement contained this sort of reference:

Household spending and business fixed investment advanced, and the housing sector has strengthened further, but fiscal policy is restraining economic growth.

Of course, if you bothered to know what the FOMC was saying, you knew the complaint was that they believed monetary policy had reached its limits to stimulate the economy, and that faster growth required a more stimulative monetary policy.

Then Dallas Federal Reserve President Richard Fisher either didn’t understand what the FOMC said, or deliberately misinterpreted the FOMC. In a 2013 speech, Fisher says:

Even if we at the Dallas Fed are right and the overall outlook for the economy is better than the current dashboard or the conventional prognostications of economists, there exists a formidable brake on growth. It was referred to point-blank in the last statement issued by the FOMC: “…fiscal policy is restraining economic growth.”

Fiscal policy is inhibiting the transmission of monetary policy into robust job creation…

…The propensity of members of Congress has been to spend in excess of revenues to give pleasure to their constituents and garner their affection…Until the Congress and the president provide a clear road map as to how fiscal rectitude will be implemented, this lack of credible details for limiting the debt-to-GDP ratio and reengineering fiscal policy to stimulate rather than constrain growth is creating undue uncertainty about future tax rates, future government purchases, future retiree benefits and all manner of factors that impact employment and economic growth. Meanwhile, the divisive nature and petty posturing of those who must determine the fiscal path of the nation is further undermining confidence and limiting the effectiveness of monetary policy…

…I argue that the Fed has no hope of moving the economy to full employment unless our fiscal authorities get their act together…Until then, I argue that the Fed is, at best, pushing on a string and, at worst, building up kindling for a massive shipboard fire of eventual inflation.

These aren’t the kind of people you want in charge of monetary policy. We need policymakers that understand their role is not to withhold monetary stimulus to force fiscal authorities to pursue countercyclical policy simply because Very Serious People know that deficit spending is always bad and cutting deficits is the solution to every problem. Monetary policy is about independently assessing the economy and enacting the policy necessary to maintain full employment and price stability. And oftentimes that means taking fiscal policy as an exogenous factor.

What is particularly discouraging is that neither Warsh nor Fisher appears to understand that during a recession, at a minimum automatic stabilizers themselves will swell the deficit. Taking aim at the deficit in such times is naive at best, deliberately spiteful at worst.

My concern remains that a Fed with someone like Kevin Warsh at the helm would prove to be disastrous for Wall Street and Main Street alike when the next recession hits. Neither group needs a central banker that believes a recession is an opportunity to inflict more pain.

Paul Krugman: Will Trump Trumpify the Fed?

"The Fed, which sets monetary policy, is by far our most important economic agency":

Will Trump Trumpify the Fed?, by Paul Krugman, NY Times: By all accounts, Rex Tillerson has demoralized and degraded the State Department to the point of uselessness. Tom Price did much the same to Health and Human Services before jetting off. Scott Pruitt has moved rapidly to eliminate the “protection” aspect of the Environmental Protection Agency. And similar stories are unfolding throughout the executive branch. ...

And one question I don’t see being asked often enough is, will the same thing happen to the Federal Reserve? And if it does, how disastrous will that end up being for the world economy?

The Fed, which sets monetary policy, is by far our most important economic agency...

When the financial crisis struck in 2008, it was essential that the Fed engage in aggressive monetary expansion...

But congressional leaders fought these necessary measures every step of the way. Most notably, Paul Ryan, who gets his ideas about monetary policy from Ayn Rand novels, berated Bernanke, claiming that his policies would debase the dollar and lead to runaway inflation. ...

And it goes more or less without saying that none of the people who kept warning that the Fed would cause terrible inflation have admitted having been wrong, or learned anything from the experience.

What all this means is that if congressional Republicans play a large role in selecting the next Fed chair, they’ll insist that it be someone who has been wrong about everything for the past decade.

Kevin Warsh, a former Fed governor widely considered a favorite for the job, certainly fits the bill. He warned about inflation in the midst of global economic collapse; he argued vigorously against doing anything, monetary or other, to fight 10 percent unemployment; he warned that the United States was about to turn into Greece, Greece I tell you. And he has shown no hint of being chastened by the failure of events to play out the way he expected.

Now, I don’t know who Trump will actually pick to head the Federal Reserve. It might actually end up being someone smart, knowledgeable and honest. Hey, there’s a first time for everything.

But surely it’s possible, even probable, that the Federal Reserve, like other government agencies, is about to get Trumpified, that one of American policy’s last remaining havens of competence and expertise will soon share in the general degradation. And won’t that be fun when the next crisis hits?

Hurricanes Help Boost Data While Powell Reportedly Rises to The Top of The Pack

Tim Duy:

Hurricanes Help Boost Data While Powell Reportedly Rises to The Top of The Pack, by Tim Duy: The ISM manufacturing report for September came in stronger than expected. To be sure, hurricane impacts accounted for some of the boost, particularly in supplier deliveries and prices; anecdotal responses made this clear. But it isn’t all hurricanes. Manufacturing has been gaining steam since last year. The sector continues to throw off the 2015/2016 weakness associated with the oil price decline and rise in the dollar. I often feel this improvement has been overlooked. ...Continued here...

Fed Poised To Downplay Weak Data

Tim Duy:

Fed Poised To Downplay Weak Data, by Tim Duy: Big data week ahead that ends with the employment report for September. Considering the ongoing inflation weakness, one would think the Fed would be looking for a series of very strong job reports to justify a rate hike in December. But with Fed officials largely convinced that the soft inflation numbers are transitory, a middling jobs report would likely be sufficient to keep them on track, and even a weak report if they can attribute disappointing data to the busy hurricane season. ...Continued here...

"Inflation Weakness Is Temporary"

Tim Duy:

“Inflation Weakness Is Temporary,” by Tim Duy: Federal Reserve Chair Janet Yellen made clear two things this week. First, that her and her colleagues are somewhat confounded by the inflation data. And second, that confusion does not yet deter them from their plan for gradual rate hikes. December is still on. ...Continued in newsletter form here...

“Inflation Weakness Is Temporary,” by Tim Duy: Federal Reserve Chair Janet Yellen made clear two things this week. First, that her and her colleagues are somewhat confounded by the inflation data. And second, that confusion does not yet deter them from their plan for gradual rate hikes. December is still on. ...Continued in newsletter form here...

Dueling Federal Reserve Presidents

Tim Duy:

 

Dueling Federal Reserve Presidents, by Tim Duy: The battle over that final rate hike of 2017 continues as some policymakers find it increasingly difficult to ignore weak inflation numbers in recent months. Such concerns, however, do not appear likely to take center stage in December. Indeed, the Fed looks fairly committed to a rate hike at that meeting. But the consensus on that meeting and beyond is being held together by forecasts of a rebound of inflation next year. It will be hard to maintain that consensus if inflation numbers don’t soon give more hope to those forecasts. ...Continued here in new, experimental newsletter format...

 

Has The Fed Abandoned Its Reaction Function?

Tim Duy:

Has The Fed Abandoned Its Reaction Function?, by Tim Duy: The immediate policy outcomes of the FOMC meeting were largely as expected. Central bankers left interest rates unchanged while announcing that the reduction of the balance sheet will begin in October as earlier outlined in June. The real action was in the Summary of Economic Projections. Policymakers continue to anticipate one more rate hike this year and three next. This policy stance looks inconsistent with the downward revisions to projections of inflation and the neutral rate; under the Fed’s earlier reaction function, the combination of the two would drive down rate projections. Arguably, policy is thus no longer as data dependent as the Fed would like us to believe. That or the reaction function has changed. ... Continued here in new, experimental newsletter format...

FOMC statement

No change in the target range for the federal funds rate, balance sheet unwinding to begin in October:

Federal Reserve issues FOMC statement: Information received since the Federal Open Market Committee met in July indicates that the labor market has continued to strengthen and that economic activity has been rising moderately so far this year. Job gains have remained solid in recent months, and the unemployment rate has stayed low. Household spending has been expanding at a moderate rate, and growth in business fixed investment has picked up in recent quarters. On a 12-month basis, overall inflation and the measure excluding food and energy prices have declined this year and are running below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Hurricanes Harvey, Irma, and Maria have devastated many communities, inflicting severe hardship. Storm-related disruptions and rebuilding will affect economic activity in the near term, but past experience suggests that the storms are unlikely to materially alter the course of the national economy over the medium term. Consequently, the Committee continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, and labor market conditions will strengthen somewhat further. Higher prices for gasoline and some other items in the aftermath of the hurricanes will likely boost inflation temporarily; apart from that effect, inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee's 2 percent objective over the medium term. Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.

In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1 to 1-1/4 percent. The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.

In October, the Committee will initiate the balance sheet normalization program described in the June 2017 Addendum to the Committee's Policy Normalization Principles and Plans.

Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Patrick Harker; Robert S. Kaplan; Neel Kashkari; and Jerome H. Powell.

Fed Would Surprise Markets If It Stays Hawkish

Tim Duy:

Fed Would Surprise Markets If It Stays Hawkish, by Tim Duy: The Federal Reserve meeting this week will likely end with unchanged policy rates and the initiation of balance-sheet normalization. Market participants widely expect these outcomes, so they will come as no surprise. The real action in this meeting will come from the Fed’s description of the economy, the quarterly economic projections and Chair Janet Yellen’s press conference. The totality of the commentary should lean dovish as the Fed expresses concerns about the inflation outlook. The surprise would be a Fed that still leans more heavily toward the hawkish side of policy spectrum. ...[Continued at Bloomberg Prophets]...

Fed May Have Too Much Faith in Inflation Forecasts

Tim Duy:

Fed May Have Too Much Faith in Inflation Forecasts, by Tim Duy: Despite a low unemployment rate, inflation slowed this year, confounding central bankers who set in motion a tightening cycle on the expectation of firming prices. This leaves the Federal Reserve stuck in a quandary. Either transitory factors restrain inflation only temporarily, or perhaps expectations sink below the Fed’s 2 percent target. If the former, the central bank can continue along the current path of gradual rate hikes. The majority of monetary policy makers lean in this direction. But if the latter, sticking to the current plan risks excessive slowing and even recession. It is the type of policy mistake we should fear in the mature stages of a business cycle... ...[Continued at Bloomberg Prophets]...

Fed Watch: Fed Round-Up For September 7, 2017

Tim Duy:

Fed Round-Up For September 7, 2017, by Tim Duy: Federal Reserve hawks were on the march today, laying the groundwork for an additional rate hike this year despite weak inflation. 

First off, Cleveland Federal Reserve President Loretta Mester (voter next year), reiterated the "it's only temporary story" regarding inflation:

In assessing where we are relative to the inflation goal, it’s always a good idea to look through temporary movements in the numbers, both those above and those below our goal, and focus on where inflation is going on a sustained basis. For example, when assessing the underlying trend in inflation, we should look through a temporary increase in gasoline prices stemming from disruptions caused by Hurricane Harvey. Similarly, some of the weakness in recent inflation reports reflects special factors, like the drop in the prices of prescription drugs and cell phone service plans earlier in the year. It may take a couple more months for these factors to work themselves through, but these types of price declines aren’t signaling a general downward trend in consumer prices from weak demand. Instead, they reflect supply-side factors and relative price changes.

She did give a nod to Federal Reserve Governor Lael Brainard's argument that maybe trend inflation has fallen:

At the same time, we need to recognize that weak inflation numbers, no matter what the source, can become a problem if they start to undermine the public’s expectations about future inflation. If inflation expectations were to become unanchored and began steadily declining, it would be much more difficult to raise inflation back to the Fed’s goal.

But she doesn't buy it:

I don’t expect the economy to get to that point, and my current assessment is that inflation will remain below our goal for somewhat longer but that the conditions remain in place for inflation to gradually return over the next year or so to our symmetric goal of 2 percent on a sustained basis. These conditions include growth that’s expected to be at or slightly above trend, continued strength in the labor market, and reasonably stable inflation expectations.

On the inflation forecast, this is interesting:

We need to recognize that there are risks around any inflation projection—both upside risks, considering the current and future expected strength in labor markets, and downside risks, given the softness in recent inflation readings. In fact, inflation is difficult to forecast: based on historical forecast errors over the past 20 years, the 70 percent confidence range for forecasts of PCE inflation one year ahead is plus or minus 1 percentage point, and a significant portion of the variation in inflation rates comes from idiosyncratic factors that can’t be forecasted. Indeed, since the 1990s, assuming that inflation will return to 2 percent over the next one to two years has been one of the most accurate forecasts. In the recent period, this is perhaps a testament to the importance of well-anchored inflation expectations and of the FOMC’s commitment to its 2 percent symmetric inflation goal. In any case, I will be scrutinizing incoming data on inflation and inflation expectations and the reports from my business contacts to help me assess the inflation outlook.

Since 1990, a 2 percent forecast has worked more than not, so lets just stick with that as the baseline for policy? By that logic, since the great recession, a 1.75% forecast has worked more than not, a testament to the Fed's one-sided inflation target and falling inflation expectations. I am not buying into her inflation forecast story yet.

Regardless, Mester's commitment to the faith on the inflation forecast means that as of now, she is probably sticking with the current rate path, including a December hike.

Meanwhile, FOMC heavyweight New York Federal Reserve William Dudley stuck to his guns as well tonight. His basic outlook:

Overall, the economy remains on a trajectory of slightly above-trend growth, which is gradually tightening the U.S. labor market.  Over time, this should support a rise in wage growth.  When combined with a firmer import price trend—partly reflecting recent depreciation of the dollar—and the fading of effects from a number of temporary, idiosyncratic factors, that causes me to expect inflation will rise and stabilize around the FOMC’s 2 percent objective over the medium term.  In response, the Fed will likely continue to remove monetary policy accommodation gradually.  But, the upward trajectory of the policy rate path should continue to be shallow, in part because the level of short-term interest rates consistent with keeping the economy on a sustainable long-run growth path is likely to be considerably lower than it was in prior business cycles. 

Dudley, however, will continue watching the inflation numbers, looking for this story:

If it turns out that structural changes have played a significant role, I would generally view this as a positive, rather than negative, development.  It would imply that the U.S. economy could operate at a higher level of labor resource utilization without generating a troublesome large rise in inflation.  More people could be put to work on a sustainable basis, enabling them to gain opportunities not just to earn greater income, but also to develop their skills and grow their human capital.

This opens up a downward revision of estimates of the natural rate of unemployment. Still, he thinks the Fed should continue hiking rates, in part due to easing financial conditions:

This judgment is supported by the fact that financial conditions have eased, rather than tightened, even as the Fed has raised its short-term interest rate target range by 75 basis points since last December. 

Yep, this is an expected response from Dudley. So is his pushback on inflation concerns:

 In addition, the long and variable lags between monetary policy adjustments and their impact on the economy imply that the FOMC may need to remove accommodation even when inflation is below its goal.  In particular, if the unemployment rate were already below its longer-run natural rate, as may be the case currently, the impact on wage growth and price inflation would still likely take some time to become evident. 

But, OMG, he follows up with this:

This would be particularly true if inflation expectations were well-anchored at or slightly below our 2 percent objective, as is the case currently. 

Brainard strikes again! But notice that HE SEES IT AS MORE LIKELY THAT INFLATION EXPECTATIONS ARE BELOW THAN ABOVE TARGET! One would think this would give him a bit more concern before pushing forward with more rate hikes, but no.

Fundamentally, Dudley wants to keep hiking as long as financial conditions keep easing. 

That's enough on Fed speakers for now. Time to return to yesterday's topic of new Fed appointees. This from Bloomberg:

The White House is considering at least a half-dozen candidates to be the next head of the Federal Reserve, including economists, executives with banking experience and other business people, according to three people familiar with the matter.

The breadth of the search goes against the narrative that has taken hold in Washington and on Wall Street that the Fed chair nomination is a two-horse race between National Economic Council Director Gary Cohn and current Fed Chair Janet Yellen, whose term expires in February.

Some of the other possible contenders include former Fed Governor Kevin Warsh, Columbia University economist Glenn Hubbard and Stanford University professor John Taylor, one of the people familiar said. Lawrence Lindsey, a former economic adviser to President George W. Bush, has been discussed. Former US Bancorp CEO Richard Davis and John Allison, the former CEO of BB&T Corp., have also been considered.

This doesn't sound good for Yellen. Sounds like a wide-open field that will keep us guessing for weeks. 

Separately, on the data front, we get this from Commerce, via Reuters:

The U.S. economy probably grew faster than reported in the second quarter, with data on Thursday suggesting stronger consumer spending than previously estimated. 

The quarterly services survey, or QSS, from the Commerce Department implied consumer spending increased more briskly than the 3.3 percent annualized rate reported last week in its second estimate of gross domestic product.

The Fed forecasts are based on more modest growth numbers. Stronger growth numbers will tilt them toward further rate hikes.

On the other hand, the anecdotal evidence via the Beige Book was less optimistic. In that read of the economy, activity was only modest to moderate with limited wage and inflation pressures. That said, I tend to believe that data trumps anecdotal evidence when it comes to policy.

Bottom Line: Hawks are still pushing for additional rate hikes, holding to the story that low inflation is all about transitory factors. This I think remains the dominant position on the FOMC. For what its worth, market participants do not believe this is how it will play out. The odds of a December rate hike are now hovering around 25%. Markets participants are not seeing the same story as most central bankers. Something's gotta give.

Fed Watch: The Times They Are A-Changin'

Tim Duy:

The Times They Are A-Changin' , by Tim Duy: The Federal Reserve is now destined to get a dramatic makeover in the next few months. That is assuming that the Trump administration carves some time out of their busy schedule of managing chaos to nominate more governors. And the Senate finds the time to confirm those nominations.

Until the time the administration and Senate get their acts together, the balance of power at the Federal Reserve will shift to the regional presidents. And that could put monetary policy on a less certain course over the next year as doves on the FOMC are replaced with hawks and the Board lacks sufficient person-power to hold a steady line.

The Board of Governors of the Federal Reserve is supposed to have seven members. At the beginning of the Trump era, two spots were open. Then former Governor Daniel Tarullo resigned. That left four members and three openings.

Today we learned that Vice Chair Stanley Fischer will soon depart, on or around October 13 of this year. The stated explanation for his departure is "personal reasons." I fear this means a serious health issue. If so, my thoughts and prayers go out to him and his family.

That leaves three members and four openings. To give a sense of what this means operationally for the Fed, take a gander at the Board Committee assignments:

Federal Reserve Governor Lael Brainard is serving on SEVEN committees! Federal Reserve Governor Jerome Powell is on FIVE. You might think he is slacking, but he is the chair of those committees. Fischer currently has four assignments. Unless we get some new governors soon, Brainard and Powell will have to step it up a bit more to cover for him. I am thinking they are overworked. Just a bit.

Hats off to Brainard and Powell. Committee work is some of my least favorite work.

Who am I kidding? It is my least favorite work.

So now we are down to three governors and five regional presidents on the FOMC. At least in theory, this means the regional presidents can roll the governors on policy votes. Which means I have to start taking the presidents a little more seriously. Because in all honestly when the Board is fully staffed, that is where the power resides. And there is only so much time in the day to read speeches. The presidents talk a lot (but will the come speak at my events in Portland, a little hop from San Francisco - noooo), the governors too little.

Moreover, the Board generally offers a certain consistency of thought across years, whereas the regional presidents on the FOMC rotate. So next year, for example, the torch will pass from the dovish Minneapolis and Chicago Presidents Neal Kashkari and Charles Evans to the more hawkish San Francisco and Cleveland Presidents John Williams and Loretta Mester. Also added will be the still-to-be-announced Richmond Federal Reserve President, a hawkish spot in recent years.

The tide might turn on the hawks this year though, as it is easy to tell a story where Chair Yellen, Powell, Philadelphia President Patrick Harker, and New York President William Dudley all support a December rate hike while Brainard, Kashkari, Evans, and Dallas President Robert Kaplan oppose. What fun would that meeting be?

Of course, Randy Quarles is waiting in the wings for Senate confirmation, so perhaps he would tip the balance to the hawkish side. Marvin Goodfriend is rumored for another open position, but has yet to be nominated (I can see both hawk and dove in his record, but I am thinking he will lean hawkish). So it may be that by the beginning of the year the voting power will tip back to the Board, backed by a fairly hawkish rotation of presidents. So if the doves want to take a longer pause before hiking rates again, they need to ensure Yellen is on their side going into the end of the year.

Speaking of Yellen, a decision on the Chair will soon need to be made. Yellen term expires in February of next year. Trump has toyed with the financial press by claiming she is in the running. I hope this is true, but Trump appears more interested in wiping the slate clean of Obama appointees than anything else. And she would be the pro-regulatory fly in the ointment, opposing Trump's preferred deregulatory agenda. So I can't get on board the Yellen train just yet.

White House economic advisor Gary Cohn had been thought to be in the front-running for the spot, but the latest word is that he tanked that opportunity with his frank (but belated) criticism of Trump's handling of the Charlotsville incident. What a way to go - catching it on one end for not speaking out soon enough and then, after already having lost that battle, grows a conscience and then catches it on the other end. Long story short, the White House is scrambling for a new name - and now need to get a replacement for Fischer (who could have stayed after his term as Vice Chair ended).

The Washington Post is reporting that Powell could be up for the job. That would be a good pick in my opinion. Former Governor Keven Warsh is also reportedly in the running. He has something few can match: Trump's childhood friend Ron Lauder is Warsh's father-in-law. It's not what you know, it's who you know. My feelings about Warsh are not warm.

Also, to add a bit more excitement into the mix, Yellen can stay on as Governor even if she is not the chair. Would she stay? Maybe not. Maybe. No chair has stayed since Mariner Eccles. Maybe it is a good time for one to stick around a few more years.

Bottom Line: Phew. I think that is the current state of play. Many potentially significant changes happening at the Fed over the next several months, and it is hard to predict how it will all end. All we know for now is a reported debt-ceiling deal removes the final potential obstacle to balance sheet reduction this month. That first step of unwinding the quantitative easing of the crisis years has wide support at the Fed; central bankers would like to get it underway before leadership changes begin in earnest.

Fed Watch: Can She Do It Again?

Tim Duy:

Can She Do It Again?, by Tim Duy: In the fall of 2015, Federal Reserve Governor Lael Brainard began building the intellectual framework to slow the pace of rate increases. Not soon enough to stop the rate hike of December that year, but the rest of the Fed soon fell in line, and the projected four rate hikes in 2016 became only one actual hike, a hike delayed until December of 2016.

Can she shift the focus of the FOMC again? She made a valiant effort today. But will her colleagues get on board as they did last time?  A key issue: he doesn't have the downtrend in the economy and financial markets of 2016 to back her up.

 Brainard begins by acknowledging the problem facing the Federal Reserve:

The labor market continues to bring more Americans off the sidelines and into productive employment, which is a very welcome development. Nonetheless, there is a notable disconnect between signs that the economy is in the neighborhood of full employment and a string of lower-than-projected inflation readings, especially since inflation has come in stubbornly below target for five years. 

The US economy is in the midst of what could easily become a record breaking expansion. Labor markets have shown dramatic improvement in that time as steady job growth pushed the economy into the range of full employment. Moreover, the outlook remains bright:

There has been a noteworthy pickup in business investment this year compared with last year. Investment in the equipment and intellectual property category has risen at an annual rate of 6 percent so far this year after remaining roughly flat last year. The latest data on orders and shipments of capital equipment suggest that solid growth will likely continue in the second half of the year. In addition, oil drilling had rebounded this year after dropping sharply last year, although Hurricane Harvey creates uncertainty about drilling in coming months. While lackluster consumer spending was one of the key reasons for the weak increase in first-quarter gross domestic product (GDP), growth in personal consumption expenditures (PCE) bounced back strongly in the second quarter, and recent readings on retail sales suggest another solid increase in consumer spending this quarter.

And, as Brainard notes, even if the anticipated fiscal stimulus has failed to materialize, the economy has been supported by a global upturn in growth as well. Sure, Hurricane Harvey may dent the short-term numbers, the medium term picture is solid.

But all is not well:

In contrast, what is troubling is five straight years in which inflation fell short of our target despite a sharp improvement in resource utilization. 

Brainard runs through the usual suspects offered as explanations for the inflation numbers - import prices, resource utilization, and transitory factors - and finds them all wanting. So what's going on? Brainard turns her attention to a fundamental element of the Fed's inflation model:

...In many of the models economists use to analyze inflation, a key feature is "underlying," or trend, inflation, which is believed to anchor the rate of inflation over a fairly long horizon. Underlying inflation can be thought of as the slow-moving trend that exerts a strong pull on wage and price setting and is often viewed as related to some notion of longer-run inflation expectations.

There is no single highly reliable measure of that underlying trend or the closely associated notion of longer-run inflation expectations. Nonetheless, a variety of measures suggest underlying trend inflation may currently be lower than it was before the crisis, contributing to the ongoing shortfall of inflation from our objective...

This is a big deal. Brainard suggests that inflation expectations are not anchored at 2 percent. And they have not become unanchored to the upside as so many of her colleagues fear will happen if they do not act preemptively. Expectations are unanchored to the downside.

Why are expectations falling? Brainard posits that perhaps households and firms are reacting to the persistent undershooting in recent years. She also relates this to low neutral interest rates, noting that the resulting lack of conventional monetary policy power increases the episodes of below target inflation, further entrenching low inflation expectations.

Now comes the tricky part. How should policymakers respond? Can low unemployment do the job? This is interesting:

Given the flatness of the Phillips curve, it could take a considerable undershooting of the natural rate of unemployment to achieve our inflation objective if we were to rely on resource utilization alone. 

For all these reasons, achieving our inflation target on a sustainable basis is likely to require a firming in longer-run inflation expectations--that is, the underlying trend. The key question in my mind is how to achieve an improvement in longer-run inflation expectations to a level that will allow us to achieve our inflation objective. The persistent failure to meet our inflation objective should push us to think broadly about diagnoses and solutions.

It is not enough to just force down unemployment. Policymakers need to match such a policy with a commitment mechanism that pulls up inflation expectations. And that mechanism likely includes explicit overshooting of the inflation target. 

She highlights this point in the context of setting rates. Brainard believes the neutral rate is low and likely to stay low (this will be exacerbated by the balance sheet run off). Consequently, the Fed might reach the neutral level of the federal funds rate in very short order. That means they need to be cautious moving forward, and should adjust down the expected path of tightening accordingly. Moreover, central bankers need to match the policy with a stronger goal:

To the extent that the neutral rate remains low relative to its historical value, there is a high premium on guiding inflation back up to target so as to retain space to buffer adverse shocks with conventional policy. In this regard, I believe it is important to be clear that we would be comfortable with inflation moving modestly above our target for a time

But will Brainard's colleagues listen as they did in 2016? At that point the economic conditions appeared fragile as the impact of the oil price crash filtered through the manufacturing sector. Moreover, financial conditions had tightened with a period of higher corporate yield spreads, declining equity prices, and a strong dollar. The opposite is true now - not only does the economy look healthier, but financial conditions have loosened despite Fed tightening. So I am not yet convinced she can carry the day. But this is undoubtedly a space worth watching.

Bottom Line: Brainard is making a push to slow the pace of rate hikes. I am not sure she will be as successful as her last effort to change the course of policy. But she still has two important takeaways for investors. First, if you think interest rates will rise sharply, think again. The neutral rate of interest is too low to expect much more tightening - we need much faster growth to justify a higher estimate of the neutral rate. Second, assuming she is right and the Fed doesn't take her advice, her colleagues are positioning themselves for a substantial policy error that would both bring the expansion to an end sooner than later and further entrench disinflationary expectations. And that would only make the Fed's job harder in the future.

Fed Watch: Mediocre To Solid Data Flow, But Weak Inflation Still Key

Tim Duy:

Mediocre To Solid Data Flow, But Weak Inflation Still Key, by Tim Duy: The data flow is generally supportive of additional Fed action, surely enough to allow the Fed to move forward with balance sheet action later this month. But what about another rate hike? That remains an open question as low inflation remains an obstacle to further rate hikes for a sizable faction within the Fed.

The employment report disappointed with job growth of 156k, shy of expectations for 180k. Previous months were revised downward. Looking through the monthly volatility, the report does little to change the basic story that job growth continues the slow downward trend that began in 2015: 

Mediocre, but not disastrous. A key issue for the Fed is where does this slowdown stop? If they were reasonably confident job growth would soon stabilize around 100k a month, then the pressure for additional rate hikes would ease substantially. For the Fed that figure would be sufficient to bring stability to the unemployment rate. For now, though, it looks like the current pace of job growth is likely to bring further declines in the unemployment rate:

In other words, the recent stability in unemployment around 4.3-4.4% is only temporary. A significant faction of the Fed will worry that additional declines in unemployment will signal that the economy is operating beyond full employment, placing inflation stability at risk. Hence that faction will press for additional pre-emptive tightening.

That said, tepid wage growth calls into question the Fed's current estimates of full employment:

I think that going forward the Fed will essentially split the difference by edging down estimates of full employment while remaining concerned that the pace of job growth still exceeds that required for inflation stability over the medium-term. On net, that leaves December still open for a rate hike. More on that later.

In the meantime, it looks like the manufacturing sector continues to shake off the 2015-6 doldrums. The latest ISM report was strong:

To be sure, a slowdown in auto sales will weigh on manufacturing in the months ahead. That said, Hurricane Harvey wiped out a half a million vehicles in Texas, so that throws some needed support to that sector going forward. 

Overall, consumer spending looks solid, continuing to hold the pace of the last 18 months:

Not the best of the cycle, but not the worst either. Something that might be expected in a more mature phase of the cycle, which is probably about right. And within a reasonable margin of error of what might be expected given consumer sentiment numbers:

 And then there is inflation. Or, more accurately there isn't inflation, at least any to be concerned about:

It is fairly clear that the disinflation this year is more persistent than the Fed would like to believe. It seems like too many one-sided errors to be just coincidence. Truth be told, looking at that chart makes me think that inflation expectations are anchored around 1.75% rather than the Fed's target of 2%. I don't think the Fed thinks that, but I also don't think it is an unreasonable idea either.

Bottom Line: So where does this leave us? The Fed continues to be caught between the push of the generally positive momentum of the US economy and the pull of the surprise weakness on the wage/inflation front. Luckily for them, they don't need to decide between the two until December. Their next move is to start reducing the balance sheet - they want to have that process underway before any leadership changes next year. Moreover, they would like to ensure the process begins smoothly before returning to the issue of rate hikes. My expectations about December are, not surprisingly, data dependent. If the current mix of activity continues - generally upward momentum suggestive of actual or forecasted declines in unemployment, coupled with what the Fed will view as fairly easy financial conditions (watch the dollar!) - the Fed will hike in December even if inflation remains tepid. I think the Fed will need to see more evidence of slowing in the real economy before they cease rate hikes - I suspect they will see the economy as operating to close to full employment to risk the potential inflationary consequences of delaying additional rate hikes.

Yellen's Odds of Being Reappointed Get Slimmer

Tim Duy:

Yellen's Odds of Being Reappointed Get Slimmer: The Federal Reserve Bank of Kansas City’s annual Jackson Hole conference offered little direct insight into the path of monetary policy for this year and next. But that doesn’t mean it was a nonevent. Perhaps the biggest takeaway is that the already small odds of Chair Janet Yellen being reappointed by the Trump administration when her term ends in February just got a lot slimmer. ...Continued at Bloomberg Prophets...

The Market Is Behaving Much Like It Did in the Past

Tim Duy:

The Market Is Behaving Much Like It Did in the Past: The prevailing wisdom these days is that markets are behaving in inexplicable ways.

I have a different view. If the market means U.S. equities, the behavior since the Federal Reserve began this tightening cycle has been very consistent with the behavior of past cycles. It's not sure all that complicated -- it’s about consistent economic growth -- and I am pretty sure fighting it is a losing bet. ...Continued at Bloomberg Prophets...

Fed Has Good Reason to Expect Faster Wage Growth

Tim Duy:

Fed Has Good Reason to Expect Faster Wage Growth: Federal Reserve officials must think that something soon has to give in this economy. The current equilibrium, characterized by low inflation, low unemployment, low wage growth and high corporate profit margins, isn’t sustainable indefinitely, but they don’t know how or when it will crack. ...Continued at Bloomberg Prophets...

Fed Watch: Retail Sales, Dudley, Wages

Tim Duy:

Retail Sales, Dudley, Wages, by Tim Duy: Some quick thoughts for the day.

First, New York Federal Reserve President William Dudley gave an extended interview to the Associate Press. Definitely worth the time to read. Some highlights:

1.) Dudley never put a Trump bump in his forecast, so his forecast is essentially unchanged:

 I think we’re still on the same trajectory we’ve been on for several years. Above trend growth, gradually tightening labor market, inflation -- somewhat below our objective -- but we do expect as the labor market continues to tighten, to see firmer wage gains and that will ultimately filter into inflation moving up towards our 2% objective.

2.) He expects inflation numbers to improve. He wants us to ignore the year-over-year numbers (of course, recent month-over-month numbers are not great):

Well, the reason why inflation won’t get up to 2% very quickly on a year-over-year basis is because we’ve had these very low inflation readings over the last 4 or 5 months. So it’s going to take time for those to sort of drop out of the year-over-year calculation.

3.) Assuming the forecast continues as he expects, he believes the Fed will hike rates again: 

I think it depends on how the economic forecast evolves. If it evolves in line with my expectations, I would expect -- I would be in favor of doing another rate hike later this year.

4.) Bubble? What bubble?

My own view is that -- I’m not particularly concerned about where our asset prices are today for a couple of reasons. The main one is that I think that the asset prices are pretty consistent with what we’re seeing in terms of the actual performance of the economy.

5.) But - and I think this is important - financial conditions continue to easy despite rate hikes:

Now the reason why I think you’d want to continue to gradually remove monetary policy accommodation, even with inflation somewhat below target, is that 1) monetary policy is still accommodative, so the level of short-term rates is pretty low, and 2) and this is probably even more important, financial conditions have been easing rather than tightening. So despite the fact that we’ve raised short-term interest rates, financial conditions are easier today than they were a year ago.

The stock market’s up, credit spreads have narrowed, the dollar has weakened, and those have more than offset the effects of somewhat higher short-term rates and the very modest increases that we’ve seen in longer-term yields.

6.) Balance sheet normalization is coming:

Well, we obviously have to have the FOMC meeting to make that decision at the next FOMC meeting. But, I don’t think the expectations of market participants are unreasonable. In June, following the June FOMC meeting, we laid out a plan in terms of how we would actually do our balance sheet normalization. How we would allow Treasury and agency mortgage-backed securities to gradually run off our portfolio over time.

And so the plan is out there. It’s been I think generally well-received, and fully anticipated. People expect it to take place. In the last FOMC statement, we said that we expected this to happen relatively soon. So, I expect it to happen relatively soon.

7.) At the end of the day, the balance sheet reduction might amount to very little:

My own view is, if I had to say today, we’re probably going to see a balance sheet five years from now that’s probably in the order of 2-1/2 to 3-1/2 trillion rather than the 4-1/2 trillion dollar balance sheet.

Overall, Dudley continues to adhere to what amounts to the Fed's median forecast, and that means he thinks another rate hike this year is solidly in play.

Separately, retail sales for July were up:

The monthly data is noisy, so be wary that it reflects the true state of spending. The three-month and twelve-month changes (for core sales) are similar at 3.2% and 3.6% respectively and more likely reflect the underlying trend. Basically, the consumer continues to press forward at a modest pace. Stop worrying about consumer spending. It isn't an imminent threat to the outlook.

And why should it be a threat? Like, job growth, wage growth is actually fairly solid. The headline weakness in wage growth is all about demographic shift, at least according to new research from Mary Daly of the Federal Reserve Bank of San Francisco. Via Bloomberg:

Fresh research from the San Francisco Fed provides an explanation: baby boomers. As they retire in droves, their exit from the workforce is distorting the data for average earnings, according to a blog post published Monday on the bank’s website.

“Wage growth isn’t as disappointing as it looks,” Mary Daly, director of economic research at the San Francisco Fed, said in an interview. “Wage growth, when cleaned up, looks consistent with other measures seen in the labor market.”

 The implication is that the labor market low wage growth does not necessarily imply the labor market is weak. It is an artifact of demographic change. That change has been fairly persistent, but at the end of the note Daly holds out some hope that it may be changing:

Overall, these factors have combined to hold down growth in the median weekly earnings measure by a little under 2 percentage points (Figure 2), a sizable effect relative to the normal expected gains.

Most recently, the effect from flows into and out of full-time work has started to tick upward and might be a sign of stronger growth ahead.

We will see.