Tim Duy's Fed Watch

We Can't All Be (Net) Exporters

The Greek crisis, which helped further extend the Dollar's uptrend in place since the beginning of the year, is a reminder that global imbalances are still with us - and, if not corrected, will eventually threaten the sustainability of the global recovery. Indeed, how sustainable can any recovery be if the vast majority of nations are pursuing an export oriented growth strategy? After all, clearly that is not a game all can play - there needs to be a net importer to offset the net exports. Who wants to fill that role? If the US is pushed into filling that role, we have simply come full circle over the past three years.

The Administration is clearly aware of this challenge, but concerns are growing that any action will fall short of what is necessary to bring about real change. From Sudeep Reddy at the Wall Street Journal:

President Barack Obama's goal of doubling U.S. exports over the next five years will be difficult to meet, business leaders and economists say, because of the lack of momentum on demolishing trade barriers and the shift by more American companies toward producing overseas.

U.S. exporters want Washington to put more pressure on trading partners to eliminate tariffs, crack down on intellectual-property violations and take a harder line on trading partners' currency policies. American firms say stronger action by the federal government could substantially boost prospects for U.S. exports.

Policymakers argue that it is far too early to admit defeat:

Christina Romer, chair of the White House Council of Economic Advisers, calls the administration's export target "an ambitious but reasonable goal."

"Going up 100% over a five-year period is not such a radical idea when you think about historical experience," she said, noting that exports increased more than 75% between 2003 and 2008. "It is going to be a gradual process. We are just starting the concrete steps in terms of what we can do to lower the fixed costs associated with exporting through trade promotion and commercial diplomacy."

Am I the only one that finds the Administration's focus on doubling exports somewhat disingenuous? Economic growth depends on net exports - doubling exports is a fine goal, as long as import growth is contained, such that the net effect is positive. But with the economy bouncing back, will import growth remain contained? Recent signs are not supportive - the recovery so far has ended the improvement in the real trade gap:

Moreover, Romer claims the process will be "gradual." Will it be so gradual that US firms will resume expansion of overseas capacity at the expense of domestic production? Back to the Wall Street Journal:

But the shift by more U.S. companies toward producing goods overseas is one of the factors that makes doubling exports tougher. These firms have built more factories in fast-growing foreign countries to serve emerging markets, so they often supply the goods and services from an overseas arm—not by loading shipping containers in the U.S.

American businesses say they must contend with a long list of disadvantages, from higher tax rates than in many countries to rising costs for benefits such as health care. U.S. producers also say an artificially low Chinese currency makes Chinese goods especially cheap in foreign markets and therefore tougher competitors for American goods.

Once that production leaves, I suspect it is largely gone for good, barring a very large, sustained, and broad-based shift in the value of the Dollar. To be sure, the Administration is pressing China to revalue the renminbi, but the pace of any appreciation is likely to disappoint. Moreover, the uptrend in the Dollar raises a new concern. From Yves Smith:

A further source of trouble is political. If the euro continues on its expected slide and the pound is devalued, the dollar’s strength will put a major dent in the US ambitions to increase exports. Moreover, the rise in the greenback relative to other currencies will no doubt make China much more reluctant to revalue the renminbi against the dollar

Also, further pressure on the Euro is likely necessary to compensate for the fiscal drag of deficit containment in the PIIGS. Note too that recent events are driving capital to the US, holding down interest rates. From the Wall Street Journal:

Mortgage rates stayed flat last week, rising just slightly to 5.08% from 5.04% one week earlier, according to the Mortgage Bankers Association. So far, the big rise in rates that some had expected when the Federal Reserve ended its mortgage-backed securities purchase program last month hasn’t materialized.

In fact, the instability in Europe amid looming debt woes for Greece and Portugal on Tuesday sent investors looking for safer assets such as the 10-year Treasury, to which fixed-rate mortgages are closely tied. That has helped to keep rates down.

Sustained low rates will help keep US demand from waning, so much the better for to fuel the flow of imports necessary to meet the needs and wants of US consumers (it is not coincidence that the trade deficit began improving when the faltering housing market took the steam off consumer spending). And, intriguingly, Japan looks ready to resume the export push. Also from the Wall Street Journal:

As many Japanese enjoy their annual "Golden Week" holidays starting Thursday, some of Japan's economic ministers will be traveling to the U.S. and Asia to pitch what they hope will become a new driver of the nation's growth: infrastructure exports.

Transport Minister Seiji Maehara will spend Thursday and Friday in Washington to promote Japan's superfast bullet-train system as it chases part of President Barack Obama's high-speed railway project, which has an initial $8 billion price tag. Central Japan Railway Co. is among the hopefuls on some projects.

Meanwhile, Economic Strategy Minister Yoshito Sengoku will be wooing officials in Vietnam to choose a consortium of Japanese nuclear-power companies over French and South Korean rivals. Vietnam last year approved a resolution to build its first two nuclear-power plants, estimated to cost about $10.5 billion at current rates.

"In the past, Japanese ministers were too proud to go out there and cheer for our companies as they worried about failing to deliver successful results," Mr. Maehara said. "I intend to play the role of the top salesman for Japanese companies as their success equals the nation's economic growth."

Tokyo has begun a push to help Japanese companies win multibillion-dollar infrastructure projects abroad as its domestic economy continues to slump and a population decline threatens to sink demand further.

At the same time, rising environmental concerns in developed nations and rapid expansion of emerging economies are resulting in bumper crops of projects in areas like railways, nuclear power and clean energy.

"There is no growth for Japan unless we enhance exports," says Hiroki Mitsumata, director of nuclear-energy policy at the Ministry of Economy, Trade and Industry. "No matter how superior our technology is, if it's confined within Japan, it will become obsolete like the species in the Galapagos."

Given the consistent global policy theme of "more exports," at least one US firm recognizes the potential for disappointment with the Administration's goal:

Todd Teske, chief executive of Briggs & Stratton Corp., a Wauwatosa, Wis.-based small-engine maker, says he is partly counting on more exports to rebuild his sales after the recent downturn. Briggs & Stratton already receives about a fifth of its $2 billion in revenue from sales abroad, particularly in Europe. Mr. Teske calls the U.S. goal of doubling exports a "lofty goal" and one worth pursuing. But he's realistic. "It seems like every country or region wants to fuel their recovery plan with exports," he said.

Bottom Line: My gut tells me that in any battle for export oriented growth, the US will come up the loser. When push comes to shove, the US will do nothing in response to the accumulation of dollar assets abroad. Ultimately, nations need to do more to support domestic demand to drive economic growth. But the risk is that as the broad global financial crisis continues to fade, nations will increasingly attempt to withdraw fiscal support for their economies - even more so with the Greece example now so vivid - and attempt to rely on external growth to compensate. It is not a game everyone can win. But if it deteriorates into competitive devaluations, it is a game everyone can lose.

The Sweet Spot

Last week I described the economy as stuck in the middle, a description of the recovery from the perspective of middle  America - improving, but not at a pace to make much progress in the labor market.  This week I offer an alternative assessment:  For market participants, this economy is in a sweet spot.  Fast enough to push corporate profits upward, not fast enough to attract the attention of the Fed.  The combination of steady, solid growth with low interest rates and no inflation is about as good as it can get for Wall Street - the sudden work ethic on the part of SEC officials not withstanding.

 

Consider this piece from Bloomberg last week:

The latest surge in U.S. stocks may have more to do with historically low interest rates than any rebound in the economy and corporate earnings, according to Peter Boockvar, an equity strategist at Miller Tabak & Co.

 

As the CHART OF THE DAY illustrates, the Federal Reserve’s benchmark interest rate has been negative since November in real terms, adjusted for inflation. The Standard & Poor’s 500 Index, also included in the chart, showed a 17 percent gain for the period as of yesterday.

 

The central bank’s target rate for overnight loans between banks, or federal funds, currently stands at minus 2 percent on an inflation-adjusted basis. This figure is based on the upper end of the Fed’s range, zero to 0.25 percent, and the year-to- year change in consumer prices.

 

Yesterday, the S&P 500 closed above 1,200 for the first time since September 2008. The milestone followed a two-month rally that accounts for most of the index’s advance since the real rate fell below zero.

 

“What’s real and what’s artificial, what’s organic growth and what’s juiced by easy money” can’t be determined with rates at current levels, Boockvar wrote today in an e-mailed note. The question will only be answered, he added, when rates start to increase and the economy must function “without the crutch of cheap money.”

Yes, monetary policy works.  On Wall Street, if not enough on Main Street.  One intent of low rates and easy money is to push market participants into riskier assets.  Does this make it more difficult to discern between real and artificial?  Probably, yes.  Should we care?  Depends on who you are asking.  You care if you are looking three or four years down the road or if you are a policymaker debating the end of stimulus.  Should investors care as long as they can ride the trend up?  Probably best not to think too much about it, and instead just enjoy the ride.

 

The real question is when will the easy money end.  And on that point, Fed officials last week suggested they intend to let the good times roll and remain on the sidelines.  Atlanta Federal Reserve President Dennis Lockhart provided a rather tepid assessment of the recovery, obviously still worried about the anticipated drags on activity later this year:

The Atlanta Fed's base case forecast for the near term looks for growth to continue. The pace of growth will probably be somewhat slow. I expect moderate growth because the economy is working through some formidable adjustments that act as drags on growth….

 

...Given the current state of the economy, I am very comfortable taking a personal position that is neither sanguine about these potential torpedoes nor unduly alarmist or defeatist. I take comfort that each big problem that is actionable is being addressed, and the recovery is moving forward. As I said earlier, so far so good.

 

Having said that, I believe the recovery requires continued support of accommodative monetary policy. I think there is risk associated with starting a process of tightening too soon. In my view, the strong medicine of low rates should remain in place to facilitate adjustment processes that are by their nature gradual.

St. Louis Fed President James Bullard is arguably slightly more optimistic:

Bullard said that he expects growth in the second quarter to be better than the first, and said that while the recovery is not “superstrong” it is “very reasonable.

Sound like the "stuck in the middle" story - very reasonable would be near trend growth, but falls short of the momentum necessary to generate a true V-shaped recovery.   San Francisco Fed President Janet Yellen, offers a pretty optimistic view of the recovery, although, like Bullard, it falls short of a V:

It’s fair to say that my own thinking has recently turned a corner and I am becoming more and more confident that the economy is on the right track. For some time, we were confronted with about the grimmest economic landscape we had ever seen. But about the middle of last year, the economy stabilized and then returned to growth. The latest indicators show a broadening and deepening of the recovery, and point to solid, if not spectacular, expansion in the first half of this year. We won’t get an official reading of the nation’s first-quarter gross domestic product until the end of this month. But based on the information we have in hand, it looks like inflation-adjusted GDP grew somewhere around 3 percent during the first three months of 2010. Assuming that holds up, we’ve now got three straight quarters of growth under our belts. I expect the pace of recovery to gain momentum over the course of this year and next as households and businesses regain confidence, overall financial conditions continue to improve, and lenders increase the supply of credit. For the full year, my forecast calls for output to rise about 3½ percent, picking up to about 4½ percent in 2011. Those are decent numbers, but nowhere as strong as some past V-shaped recoveries, for reasons I’ll go into in a few minutes.

Yellen - often considered to be a dove - is confident enough to place a little uncertainty in the "extended period" language:

I’d like to close with a few words about monetary policy. As I noted earlier, we have pushed the federal funds rate down to zero for all practical purposes. Such an accommodative policy is appropriate because the economy is operating well below its potential, inflation is subdued, and such conditions are likely to continue for a while. Consistent with that view, the Fed’s main policymaking body, the Federal Open Market Committee, last month repeated its statement that it expects low interest rates to continue for an extended period. I agree with this assessment. At some point though, as the economy continues to expand, the Fed will have to pull back some of this extraordinary stimulus.

When will "some point" arrive?  Job growth is critical on this point, and the last week's initial unemployment claims do not provide much hope that the jobs situation is changing soon.    This, of course leaves us with an unhappy mix of data for job seeker, as while the Fed is not inclined to pump additional money into the economy in this environment.  Mathew Yglesias repeats a now long-standing criticism:

... policymakers aren’t just supposed to offer grim forecasts, they’re supposed to take action to improve things.

 

The complacency around these issues continues to be staggering, and I can only [con]clude that the sociological concentration of unemployment among non-whites, young people, and those without college degrees is responsible. My guess is that few members of congress, or top FOMC members, or newspaper editors, spend a great deal of time socializing with members of the hardest-hit demographic groups which makes it a lot psychologically easier to keep glossing over the fact that they’re planning to do nothing about a problem that they recognize is severe.

Bottom Line:  A more aggressive policy stance might be correct for Main Street, but I suspect would upend what is currently a nice little equilibrium on Wall Street.  Raising the prospect that the Fed was trying to raise the inflation target would cement fear that interest rates will move dramatically higher in the years ahead.  In contrast, the current state of the economy, with steady growth combined with low inflation and high unemployment, offers considerable certainty for market participants by putting the Fed on the sidelines.  And that certainty is a valuable commodity.

Consumers Come to Life

 

Today's retail sales report should dispel any lingering concerns that American consumers remain huddled in their basements, clutching a bar of gold with one hand and a loaded shotgun with the other.  Indeed, even a relative pessimist like me has to admit that recent trends (log differences) look pretty good:

 

 

Yes, even on the current trend, it will be a long time to hit the old trend.  And it is clear that the consumer has suffered - the gap between the old trend and the actual level of retail sales less gas is now just about a trillion dollars of foregone spending.  Something of a disaster, at least for retailers (but helping deleverage the household balance sheet).  The data appears to have left Federal Reserve Chairman Ben Bernanke's outlook intact:

On balance, the incoming data suggest that growth in private final demand will be sufficient to promote a moderate economic recovery in coming quarters.

The Beige Book appears to be catching the retail trend, yet provides a tepid assessment of the general economy:

Overall economic activity increased somewhat since the last report across all Federal Reserve Districts except St. Louis, which reported "softened" economic conditions.

Which begs the question:  Is the Fed too pessimistic (not to call the kettle black)?   To be sure, even four percent growth is not enough to quickly pull unemployment rates lower.  And, for the moment, the Fed appears to be content to let lingering doubts about the second half of the year to keep any emerging optimism in check.  Not to mention a sustained disinflationary trend.  From Bernanke:

On the inflation front, recent data continue to show a subdued rate of increase in consumer prices. For the three months ended in February, prices for personal consumption expenditures rose at an annual rate of 1-1/4 percent despite a further steep run-up in energy prices; core inflation, which excludes prices of food and energy, slowed to an annual rate of 1/2 percent. The moderation in inflation has been broadly based, affecting most categories of goods and services with the principal exception of some globally traded commodities and materials, including crude oil. Long-run inflation expectations appear stable; for example, expected inflation over the next 5 to 10 years, as measured by the Thomson Reuters/University of Michigan Surveys of Consumers was 2-3/4 percent in March, which is at the lower end of the narrow range that has prevailed for the past few years.

As the Wall Street Journal notes, this doesn't sound like a guy eager to hike rates anytime soon.  The Beige Book concurs with the inflation assessment.

Retail prices generally remained level, but some input prices increased. Where producers faced cost pressures on inputs, they were largely unable to pass those prices downstream to selling prices, although in Kansas City some manufacturers were considering raising selling prices due to higher raw materials costs.

But if we have learned one thing about Bernanke over the past three years, it is that he is not married to any particular forecast.  If conditions change, he will as well.   And, arguably, at this juncture, the risks to the forecast are feeling a little bit on the upside.  Just a bit (it is OK to admit it).  If this trend persists for much longer, it has got to work into Fedspeak sooner than later. 

 

Bottom Line:   The retail sales report was strong, pointing to both pent-up demand and sustainability.  Yet the Fed remains on hold, realizing that a long, sustained period of high growth is necessary to soak up the un- and underemployed and relieved disinflationary pressures.  Moreover, financial markets remains hobbled, leaving small firms in particular starved for credit.  Still, FOMC members eye the balance sheet warily; makes any respectable central banker nervous.  Faster than expected growth only makes them more nervous. 

What Could Derail the Recovery?

Increasingly, the recovery looks sustainable - sustainable in the sense that a double dip  recession looks unlikely.  As Bloomberg reports, this is the message of the inventory cycle, which appears to have largely run its course.  Inventories surged as the recession intensified, leaving firms scrambling to bring output in line with the new level of sales.  Now, firms have inventories under control:

 

 

At this juncture, production becomes increasingly dependent on the ability of the economy to sustain demand growth, and one critical sector, households, look capable of doing at least part of the job.    Wednesday morning we get retail sales for March, with expectations for a solid 0.5% gain excluding autos - a continuation of a string of generally positive reports that reaches back to the middle of last year.  That's not to say sales have recovered; consumers are far from recapturing the prerecession trend.  Instead, it looks like spending has reset along a lower growth path.  And it is the growth, not the level, that is important to sustaining aggregate demand going forward.

 

The retort for any even remotely optimistic assessment of consumer spending is that the weight of the consumer debt burden - not to mention tighter lending conditions - will curtail spending power.  True enough, but that speaks more to the ability, or lack thereof, of regaining the past trend.  Moreover, household balance sheets are actually improving, with household financial obligations reverting to 2000 levels:

 

 
Finally, the growing stability of the job market (even if still subpar) will further support consumer spending, not just by adding jobs, but also by releasing the pent-up demand via improved confidence. 

 

To derail the recovery at this juncture, look for factors that are not merely weights on the outlook, but will actually reverse the positive momentum.  For example, it is not enough to say that lending is constrained.  To reverse momentum, one needs a story by which lending actually tightens further from the current situation (really, how many more ways can your local banker say "No"?).  What are such stories?  Some floating in the background:

1.)  Renewed surge of foreclosures.  Mounting anecdotal evidence points to a renewed surged by lenders to get failing mortgages off their balances sheets, and the ensuing fire sales will stop the housing recovery in it tracks.  Moreover, falling prices will further cripple household wealth.   This story, however, is most important if you were actually forecasting a housing recovery.  But the lack of the typical post-recession building surge is already one of the factors keeping a lid on the pace of the recovery and preventing the rapid rebound in growth necessary to bring unemployment down quickly.   Will additional foreclosures cause new residential construction to fall dramatically from already rock bottom levels?  Or, as I lean toward, delay and weaken new construction activity?  And note that while additional foreclosures will weigh on housing prices further, much of the big adjustment in prices is likely already behind us.  Also note that foreclosures will accelerate the healing of household balance sheets; dumping an underwater mortgage improves net wealth (one of my central complains about modification programs is that they are efforts to trap households in negative net wealth positions).  

 

2.) Waning fiscal stimulus.  No doubt about it, a significant concern, but one that is already built into most forecasts for the second half of this year and next year, again preventing the sustained above trend growth of a true v-shaped recovery.  More of a risk - that deficit discipline prompts fiscal authorities toward a greater retrenchment than currently expected (perhaps, for example, the Administration does little to offset the expiration of the Bush tax cuts) .  Still, it is tough to see the need for rapid retrenchment when interest rates remain below the 4% mark.  Or the 5% mark, for that matter.

 

3.) Energy price shock.  Jim Hamilton ably handles this issue, noting that the current rise in oil prices does not look sufficient to derail the recovery.  I would agree, but note that we saw oil prices quickly spike in 2007 and 2008, and ongoing and accelerating global growth could prompt a return of the $4 dollar gasoline that undermined the consumer in early 2008.  Note that saving rates remain relatively low; while I increasingly believe the consumer rebound is sustainable, the lack of cash cushion still leaves households vulnerable to unexpected shocks.

 

4.) The external bogeyman.  A Chinese collapse that ripples through the global economy hangs as a seemingly ever present threat, one that I have difficulty gauging.  In my opinion, this is one of those issues that pessimists can cite for years (and have already) before it manifests itself into a real concern.  Not unlike some of the other threats we have been living with for over a decade - like the Japanese "bond bubble."

In short:  I don't consider myself particularly optimistic; the forecast of persistent high unemployment rates leaves me feeling pessimistic.  But even a subpar outcome (one that argues for more policy action, not less) could be consistent with sustainable growth.   To undermine sustainability, it is not enough to focus on factors already weighing on the economy- weak lending, fiscal stimulus waning, crippled housing sector, etc.  We already know those factors are preventing a rapid return to past trends.  Instead, look for factors that are not already baked into the forecast.   Most likely, wait for ongoing growth to create an environment that makes the current dynamic untenable for policymakers - in other words, wait for central bankers to start tightening policy aggressively. We just are not there yet.

Stuck in the Middle

Note to readers:   Sorry for the long absence.  Work and family commitments moved blogging to the back seat in recent weeks - unfortunate but necessary.

 

The US economy shifted into an interesting middle ground in recent months.  The broadening of the manufacturing recovery into activity more generally, coupled with sustained growth in that bulwark of the US economy, consumer spending, supports a stream of data increasingly suggestive of a - gasp - sustainable recovery.  To be sure, doubters remain.  On the more pessimistic side, via Bloomberg:

The U.S. jobless rate may rise above 10 percent at the end of the year and the contraction in consumer credit will persist, said David Rosenberg, chief economist of Gluskin Sheff & Associates Inc. in Toronto.

 

“I think we’ll finish the year above 10 percent,” Rosenberg said in an interview with Tom Keene on Bloomberg Radio. “The credit contraction continues unabated in the household sector.”

 

Economic growth is being fueled by the government’s $787 billion stimulus program, which has been offsetting slumping demand, Rosenberg said. “Final sales lag far behind,” he said. “There’s been no income growth in the personal sense in the past year.”

Yes, there are indeed enough warts on the US economy to make uncharitable comparisons to the skin of a toad.  Chief among those, in my mind, is the ability to make a smooth pass off from federal stimulus to other sectors later in the year.  Add to that list still tight credit conditions, ongoing deterioration in commercial real estate, and a housing market that looks to remain subdued by another wave of foreclosures (although I tend not to fear foreclosures so much in general, viewing them as an effective mechanism to clean household balance sheets).  But even putting all those things together, what appears to be emerging is an economy reverting back to trend growth, maybe a little above, maybe a little below.

 

And therein lies the rub, the problem that leaves policymakers in something of a quandary.  Trend growth just isn't good enough.  Trend plus one percent isn't good enough.  Of course, not anywhere near the more apocalyptic visions of the most pessimistic procrastinators, but far short of the fable V-shaped recovery of Floyd Norris:

The American economy appears to be in a cyclical recovery that is gaining strength. Firms have begun to hire and consumer spending seems to be accelerating.

 

That is what usually happens after particularly sharp recessions, so it is surprising that many commentators, whether economists or politicians, seem to doubt that such a thing could possibly be happening.

Norris apparently believes that we can't see the truth on the strength of the recovery because we have forgotten the experience of the 1980's:

But there are, I think, a number of reasons for the glum outlook that are unrelated to the actual economic data.

 

First, the last two recoveries, after the downturns of 1990-91 and 2001, were in fact very slow to pick up any momentum. It is easy to forget that those recessions were also remarkably shallow. If you are under 45, you probably don’t have much recollection of the last strong recovery, after the recession that ended in late 1982….

Goodness, even a cursory look at the data would dispel the myth that the current episode bore any familiarity with 1982.  Absent the inventory correction, the 5.6% gain in 4Q09 GDP looks paltry by comparison:

 

For the nine quarters beginning in 4Q82, real final sales growth averaged more than three times the 1.7% rate (red line) of the final quarter of 2009, the blowout quarter for the V shape optimists.  And, arguably, this even understates the domestic strength of the mid-80's recovery as the GDP figures were lessened by a surging trade deficit.  (Free Exchange continues the Norris critique here.)

 

In short, yes, given that the US economy has been growing now for three quarters, and is most likely to grow for the next three quarters, room for optimism is surely growing as well, something the pessimists need to accept, lest they fall into the trap of incoherent mumbling for the five years until the next recession provides them with an "I told you so" opportunity.

 

Where the pessimists have room to complain, as I am wont to do, is on the employment issue.  Even the  most more optimistic forecast of former IMF Chief Economist Michael Mussa is not sufficient to drive rapid improvement in the labor market.  Again, think of a real V-shaped recovery like the mid-80's.  Hence the widespread disappointment with the March labor report.  On the surface, the numbers were not terrible.  Subtract out, however, the private and Census temporary workers, adjust for the fact that this supposedly represented a "bounce" from the weather impacted February report, and then recognize that the US economy has been growing for three quarters.  Then you start to think that this is a better report, but not good enough to alleviate the pain in the labor market anytime soon.   But it is not bad enough that anyone is eager to commit to additional stimulus, almost guaranteeing a continuation of the status quo, a job market that will not recoup lost jobs for years, leaving perhaps an indelible mark on a generation of workers.

 

Expectations of persistent labor market weakness - given that even optimistic forecasts fall well short of the V-shaped recovery bar - leaves the Federal Reserve in a holding pattern regarding their key policy rate.  Calculated Risk notes:

For some reason, market participants keep thinking the Fed will raise rates soon (last summer it was by the end of 2009, this year it was by summer).

The reason is that market participants lack the option of betting on a reduction of rates.  Only one way to bet.  This, of course, is why the Federal Reserve has a challenge trying to communicate the lack of policy meaning behind changes to the discount rate.  Every action, every official utterance is subject to analysis regarding one thing, the eventual end of the zero rate policy.  As CR notes, however, Fed officials - with the exception of Kansas City Federal Reserve President Thomas Hoenig - do not appear predisposed to raise rates in the near term. 

 

The expectation - and so far realization - of subpar labor market outcomes leaves monetary policy steady for the time being.  How much improvement do we need to see before policymakers more quickly move in the direction of tightening (which, by the way, will likely begin with quantitative tightening rather than rate tightening).  Federal Reserve Chairman Ben Bernanke laid down an interesting marker in a speech last week:

More than 40 percent of the unemployed have been out of work six months or longer, nearly double the share of a year ago. I am particularly concerned about that statistic, because long spells of unemployment erode skills and lower the longer-term income and employment prospects of these workers.

One can infer that Bernanke would prefer to see the share of long term unemployment drop dramatically prior to a clear policy shift.  One can also infer the possibility of a measurable, albeit, small, structural increase in the unemployment rate. From the soon to be departing Vice Chairman Donald Kohn:

An ongoing concern in this recovery is whether unemployed workers may experience unusual difficulties in re-entering the workforce. The duration of unemployment has been exceptionally long in this business cycle, a development that could erode worker skills and decrease re-employment probabilities. In addition, it may take some time for those who are unemployed to move or retrain for the new jobs that the recovery will bring. For these and other reasons, part of the increase in unemployment over the past two years may be structural, and this part would tend to reverse only slowly.

 

Even if a portion of the rise in unemployment is structural, however, most appears to be cyclical, suggesting that the economy is operating well below its productive potential. This conclusion is supported by other measures of slack, such as capacity utilization in manufacturing, and by the ongoing deceleration in wages and prices.

Finally, the other impediment to policy tightening is the inflation outlook.  The Fed appears to have abandoned its earlier flirtation with the notion that deflationary pressures can be dismissed as a consequence of the housing downturn.  From the most recent minutes:

Participants referred to a wide array of evidence as indicating that underlying inflation trends remained subdued. The latest readings on core inflation--which exclude the relatively volatile prices of food and energy--were generally lower than they had anticipated, and with petroleum prices having leveled out, headline inflation was likely to come down to a rate close to that of core inflation over coming months. While the ongoing decline in the implicit rental cost for owner-occupied housing was weighing on core inflation, a number of participants observed that the moderation in price changes was widespread across many categories of spending. This moderation was evident in the appreciable slowing of inflation measures such as trimmed means and medians, which exclude the most extreme price movements in each period.

Still, Kohn at least sees little room for additional downward pressure on inflation:

With only a moderate recovery likely on tap, I expect unemployment to come down only slowly from its currently elevated level. Although the persistent high level of unemployment will tend to restrain inflation further, the effect of resource slack on inflation does not appear to be as great as some previous episodes might have led us to expect. The difference is that inflation expectations now appear to be much more firmly anchored than they once were, probably reflecting the extended period of low inflation that we have experienced and a credible monetary policy directed at sustaining this performance. I anticipate that inflation will remain low for a while, with core PCE inflation not likely to fall much further from the subdued pace I cited a few minutes ago.

Which leaves him, like I suspect the FOMC in general, still inclined to look only toward a tightening of policy in the future, not any additional loosening that would arguably be appropriate given the current forecasts for both unemployment and inflation.

 

Bottom Line:  It is difficult to argue with the steady stream of data that increasingly suggests the recovery is sustainable.  It is also difficult to argue with the proposition that even if sustainable, the recovery is disappointing from the jobs perspective.  That disappointment, couple with the lingering concern that the economy will not sufficiently transition from fiscal stimulus to sustain the meager labor market improvements to date, leaves monetary policy on hold for the foreseeable future.  The transition from fiscal stimulus would be greatly improved if we could reliably expect the external sector to pick up the slack.  And the economy remains as risk to that familiar gremlin, the exogenous shock.  I find myself a bit more concerned than Jim Hamilton on the risk from oil prices.   But both oil and external trade are issues I intend to follow up with later in the week.