Tim Duy's Fed Watch

Something to Chew On

Something to chew over while you wait for the employment report.  From the Wall Street Journal's bit on Cleveland Fed President Sandra Pianalto's speech:

With the economy on “a firmer footing,” she said, U.S. corporate leaders seem inclined to continue investing in equipment and software despite such worries as turmoil in the Middle East, the Japanese earthquake and the sovereign debt crisis in Europe. “On this firmer footing, these shocks are hitting us, but it seems like we’re more resilient and able to absorb these shocks,” she said.

I am not sure that we should find this resiliency surprising, despite the seemingly perpetual fears of market participants.  I believe that all US recessions, at least post-WWII, are attributable directly to domestic disturbances  - monetary policy and/or domestic financial crisis - or oil price shocks.  Arguably, the Asian Financial Crisis was close via the Long Term Capital Management fiasco, but no cigar, as the US economy powered ahead until the tech bubble collapse (a domestic story).

Hence, I have been hesitant to put much economic concern on Japan and Europe - the transmission mechansims appear too weak to appreciably change the US outlook.  One can suggest that financial crisis in Europe will filter back through to US institutions, but I think this would have been more likely two or three years ago than now.  Back then, we could credibly believe that a US financial institution could fail.  Now, however, I am pretty sure the financial sector has an explicit government guarantee.  Financial exigency clauses will come into play sooner than later this time around.

I am concerned about the potential for a sharp rise in energy prices to knock the wind out of consumers this year, but also recognize that the increase refelcts improving growth prospects.  See spencer's note at Angry Bear on this point.

None of this is meant to imply that the US economy is without warts; nothing could be further from the truth.  Only that the primary risks are internal demand and energy shocks, not other external shocks.

Running the Fed Like an Economics Department

My central complaint with Federal Reserve Chairman Ben Bernanke is his penchant for what is often described as running the Fed like a university economics department.  Internally, I do not see this as a challenge, and for the Fed’s culture may be an effective management style.  Externally, I see this a potential communications disaster always in the making.  The recent uptick in inflation heightens my unease at this approach, and I think Ryan Avent hits the nail squarely on the head:

 …An increase in inflation is only worrying to the extent that it undermines the Fed's efforts to satisfy those mandates, and the above clearly doesn't count. Yet the simple fact of increasing inflation sends writers running to speculate on and, in many cases, demand central bank action.

And central bankers often play along. You have a number of regional Fed presidents warning that they may be ready to end the latest round of asset purchases ahead of schedule. I don't know whether there's any communications strategy within the Fed—whether Ben Bernanke is tacitly approving of these comments or upset by them—but it's fairly certain that the comments themselves represent a tightening of monetary to the extent that they shape actual market expectations (and there does seem to have been some impact).

That's no way to make policy. It's a poor means of communication and a poor decision to tighten. And these poor choices are encouraged by writing that misrepresents the extent of current inflation and its consistency with Fed mandates.

It seems to me that the Fed lacks a coherent communication strategy – there is no willingness on the part of the leadership to enforce talking points.  As a consequence, there is enormous pointless chatter from Fed officials that might be interesting in some sense, but provide misleading guidance about policy direction.  Recent talk about scaling back the size of the large scale asset program, for instance.  Almost certainly not going to happen – so why talk about it?  Sadly, it appears to be an almost deliberate effort to create uncertainty among market participants at a time when the opposite is so important.

Of the frequent Fed speakers, I think Chicago Fed President Charles Evans and Atlanta Fed President Dennis Lockhart are particularly good.  And not because they tend to say things that I agree with, but because they say things that I think reflects the majority view of the monetary policymakers.  I suspect incoming San Francisco Fed President John Williams will fall into that same category.  The so-called hawks Philadelphia Fed President Charles Plosser and Richmond Fed President Jeffrey Lockhart are interesting, but one needs to discount their tendency toward inflation/balance sheet concerns.  And, I hate to say it about a Fed official, but I wouldn’t take much stock in the words of Dallas Federal Reserve President Richard Fisher.  He may talk tough, but I believe he would always fall in line with the majority decision of the FOMC.

Hopefully, regular press conferences by Bernanke will foster a more consistent voice among Fed officials, or at least a guidepost by which market participants can more easily identify and dismiss the loose talk of policymakers and the fringes of policy.

 

Quick PCE Notes

The February Personal Income and Outlays report revealed the drag of higher food and energy costs as a 0.3 percent gain in nominal disposable personal income was knocked back to a 0.1 percent loss in real terms. Similarly, the 0.7 percent gain in nominal spending turned into a just 0.3 percent real gain. While better than the flat reading in January, the relatively weak performance of PCE this quarter will lead analysyst to knock down Q1 growth forecasts. I try not to read too much into any one quarter, and tend to view the consumer slowdown in light of the acceleration at the end of last year. Overall, the trend in PCE growth since the middle of last year is consistent with annual gains of around 3% a year. The footing is firming, and it is sustainable, but it is still far short of what is needed to rapidly return consumption to its pre-recession trend.

Since the recession ended, real PCE gained at a rate of 0.18 percent per month:

 
By a year into the recovery, household spending accelerated, and since July of 2010 has grown at 0.23 percent per month, just about the prerecession trend:

The new normal, it seems.  On one hand, I have a preference for steady growth over recession and stagnation.  On the other, the gap between the new trend and old at least partially reflects the lack of job opportunities for the nation’s unemployed – and few are expecting that situation to change dramatically this year.  Even an “optimistic” outlook of 200k jobs a month yields only a small improvement in the unemployment rate.  Also note that some of the gains for net new hiring would be offset by reduction in spending power as people fall off the unemployment rolls.  And finally, some of the gains in spending are driven by a rebound on auto sales, which will not continue forever.  In short, without a force that greatly accelerates job growth and drops unemployment rates quickly, it is difficult to see consumption returning to the pre-recession trend.

Given that spending accelerated faster than income, the saving rate by definition fell, although it continues to hover around the 6% mark.  The higher saving rate provides some cushion for higher food and energy prices, allowing households to absorb and adapt to these price gains without an abrupt change in behavior.  It is worth noting that although the recent increases appear dramatic, they are consistent with a return to the prerecession trend:

 
For much of that period, the economy managed to weather commodity price inflation.  It was only the superspike in prices coupled with the evolving US financial crisis that brought spending to a standstill in 2008.  Hence, I tend to think the economy can withstand the gains already experienced, but continued gains at recent rates would be increasingly worrisome.  Remember, in comparison the previous energy shocks, prices have not yet gone to new highs.  Psychologically, we have yet to see new territory. 

Finally, note that recent core inflation numbers have been ticking up:

  

This should not have been unexpected as some of the pass-through from higher commodity prices would undoubtedly show up as temporary gains in core inflation.  From the most recent FOMC statement:

The recent increases in the prices of energy and other commodities are currently putting upward pressure on inflation. The Committee expects these effects to be transitory, but it will pay close attention to the evolution of inflation and inflation expectations.

Again, see the commodity chart above.  Core inflation has remained remarkably stable during the past decade despite the instability of commodity prices.  This suggests that overall monetary policy has not been far off the mark.

The real fireworks will ensue if core-inflation accelerates above 2% on a year-over-year basis.  I believe that, assuming ongoing high levels of unemployment, Federal Reserve Chairman Ben Bernanke will tolerate somewhat higher inflation to compensate for the recent period of low inflation.  Be forewarned:  This will leave inflation hawks, notably Dallas Fed President Richard Fisher, foaming at the mouth. 

The steady but uninspiring gains in US economic activity continue to argue for a steady hand on monetary policy.  From today’s speech by Chicago Fed President Charles Evans:

With regard to policy today, slow progress in closing resource gaps and underlying inflation trends that are too low lead me to conclude that substantial policy accommodation continues to be appropriate. This accommodative policy will foster a return of economic conditions consistent with our dual mandate.

Please read Evan’s speech for his patient explanation of inflation dynamics.  An excerpt:

Monetary policy cannot affect the scarcity of resources. Indeed, think about what happens when the price of a commodity rises but other prices do not change. We call this a change in the relative price of the commodity. Changes in relative prices provide an important signal to market participants, encouraging consumers to find ways to economize and giving suppliers an incentive to increase production. Changes in relative prices are not inflation. Inflation, by definition, is a continuing increase in the general level of prices of all goods and services in the economy.

There is much more in the speech as Evans is doing what all Fed officials should be doing at this point – clearly elucidating the near for policymakers to focus on core, not headline inflation.  See also David Altig.

Bottom Line:  Try to look through the data to spot underlying trends; this is what the Fed is doing, and it will lead them to complete the current round of asset purchases. Watch energy prices closely, keep an eye on the other risks (Europe, Japan, etc) while awaiting the next big test - the exit of the Fed from large scale asset purchases.  The economy stumbled last year when the Fed shifted to neutral.  Coincidence, or should have been expected given that housing would not rebound and fiscal stimulus would fade?  We will have another test of the importance of the Fed lifeline in the second half of this year.

Williamson on the Fed

This weekend on Mark’s blog I stumbled across the link to Stephen Williamson’s piece The Fed and Inflation.  Rarely does one encounter a piece with so many inconsistencies and misrepresentations that it requires an almost line by line retort.  The core of Williamson’s piece begins:

While it is certainly true that there is nothing alarming on the inflation front if we look at what forecasters are predicting and the yields on TIPS, maybe we should examine some other evidence.

This sentence alone should raise red flags, as he might as well say:  “The overwhelming evidence is that inflation is not a problem, but the evidence is obviously lying because it is inconsistent with my opinion.” He continues:

What's the goal here? Fed people, including Bernanke, make vague statements about a 2% inflation rate being what the Fed is shooting for. But what does that mean? Do we set the target at 2% in January and then say that we achieved our goal if the year-over-year inflation rate as of the next January falls between 1% and 3%?

I don’t find the Fed vague at all.  Indeed, Federal Reserve Chairman Ben Bernanke seems quite clear.  From October:

The longer-run inflation projections in the SEP indicate that FOMC participants generally judge the mandate-consistent inflation rate to be about 2 percent or a bit below. In contrast, as I noted earlier, recent readings on underlying inflation have been approximately 1 percent. Thus, in effect, inflation is running at rates that are too low relative to the levels that the Committee judges to be most consistent with the Federal Reserve's dual mandate in the longer run.

If the current inflation rate and its forecast are below the target, consider additional easing.  If above, tighten.  How complicated is this?  The point that is arguably vague is the definition of the “longer run,” but I think it is safe to assume this is the period beyond the three year forecast horizon.  More from Williamson:

 If we exceed the target are we going to have a lower inflation target for a while?

Note the bias that ignores the recent period of low inflation.  The question can be reversed.  Since we have been under target recently, shouldn’t we be willing to accept a period of higher than target inflation?

I thought about the costs of inflation earlier, in this post, and would make the case that price level targeting might work well.

Same problem.  If Williamson believes that price level targeting might work, then shouldn’t he want a period of above target inflation to return the price level to trend?

Suppose, for example, that our target price level path is 2% inflation forever. Then, intervention by the Fed which always aims to hit the target path within a relatively short period of time (say a quarter or two) should minimize the uncertainty in real interest rates over any horizon. I think real interest rate uncertainty is a key cost of variable inflation, if not the primary one. Most debt is denominated in nominal terms, default is costly, and uncertainty is costly. Just ask Paul Krugman.

Is there anyone that believes the lags in monetary policy are sufficiently short to allow the Fed to always hit an inflation target within two quarters?  Anyone?  We usually think of long and variable lags to monetary policy. Further on:

In the chart, you can see that headline CPI inflation is about 1% above target, core CPI inflation is about 1.5% below target, and pce deflator inflation is about on target.…Of course, what the Fed should do in this context depends on what measure of inflation it wants to focus on. The Fed, and many economists, make the case that we should focus on some core inflation meausure, either core cpi, or the pce deflator with food and energy prices stripped out. The argument is either that movements in volatile prices tend to be temporary, so we should ignore them, or an appeal to New Keynesian ideas, whereby we only care about the sticky prices, which are the non-volatile ones.

No, not quite, the story is more nuanced.  Policymakers focus on core inflation because it measures what Paul Krugman describes as "inflation interia":

Now imagine an economy in which everyone is doing this [resetting prices on the basis of inflation expectations]. What this tells us is that inflation tends to be self-perpetuating, unless there’s a big excess of either supply or demand. In particular, once expectations of, say, persistent 10 percent inflation have become “embedded” in the economy, it will take a major period of slack — years of high unemployment — to get that rate down. Case in point: the extremely expensive disinflation of the early 1980s.

Now, the measurement issue: we’d like to keep track of this sort of inflation inertia, both on the upside and on the downside — because just as embedded inflation is hard to get rid of, so is embedded deflation (ask the Japanese). But in the real world, while some (many) goods behave like this, some don’t: their prices rise quickly with supply and demand changes, and don’t display inertia. So we need a measure that extracts the signal from the noise, getting at the inertial part of the story.

Consider also the actual behavior or core vs. headline inflation:  

Notice in particular the relative stability of core in recent years vs. the instability of headline.  Attempting to manage policy via headline inflation would have made policy even more volatile. Eveidently, policymakers are clearly doing a better job managing "inflation inertia" than in the 1970s despite a decade of steadily rising commodity prices.  More on that later.  Williamson continues:

Bernanke, in his Congressional testimony, takes the first route:

...the most likely outcome is that the recent rise in commodity prices will lead to, at most, a temporary and relatively modest increase in U.S. consumer price inflation...

My concerns here are the following: (i) Maybe these price increases are not temporary; with the world economy coming back (problems in Japan aside) and very strong growth in some places, resources in the world are becoming increasingly scarce.

Bernanke did not say the commodity price increases were temporary, he said the impact on inflation would be temporary. See my post here.  Moreover, Williamson claims that higher commodity prices are simply an artifact of an improving economy.  Does this mean he was happier when the global economy was in recession and commodity prices depressed?  Shouldn’t the rebound of commodity prices be seen a vindication of monetary policy?   Why be so worried about current inflation yet have no concern about past deflation?  On top of that, Williamson even adds that an additional problem is a supply constraint, which is something beyond the purview of the Fed and thus one of the reasons we expect the Fed to keep an eye not on headline inflation but the pass-through from higher commodity prices to core-inflation.  More:

(ii) Inflation is inflation. I make the case here for looking at broader measures than core price indices.

All inflation is not the same.  Spencer at Angry Bear:

It is starting to look like the cyclical bottom in inflation may be at hand. But there is much confusion over current price changes. There are two types of price changes to consider. One is the change in relative prices. The other is the change in the overall price level, or inflation. Currently we are seeing large change in relative prices, but little change in the overall price level, or inflation.

Spencer’s position is not controversial.  More Williamson:

(iii) Public relations: What people see is headline inflation; indeed the prices they observe most frequently are food and energy prices. If the Fed speaks to core inflation, it can end up looking devious.

All right, I am tempted to throw Williamson a bone on this one, as the recent experience of New York Federal Reserve President William Dudley speaks to the challenge of differentiating between headline and core inflation.  Still it appears that Williamson’s solution is that we should just give up and pursue the wrong policy because the right policy is hard to do.  This is clearly irrational, and a rational response would be to construct an alternative measure of inflation that more theoretically identifies the volatile and temporary components of inflation. 

Of course, such measures exists, see Calculated Risk for the latest update on the Cleveland Fed trimmed mean CPI, which also shows no evidence that inflation is currently a problem.  Williamson is ignorant of such measures.  And that is not just my opinion.  His responses in the comments:

I've heard about "trimmed mean PCE," but don't know what it is. How do you modify the raw PCE to get that?

Maybe I'm good at faking that I know something. The Atlanta Fed sticky price index uses some kind of trimming procedure, but it's not period-by-period, but based on the Bils-Klenow data, I think. I think you drop specific prices from the index, much like the CPI ex food and energy. Do you have a theory for the PCE trimming procedure?

Onward:

What about the future? What causes inflation? Some people, including Christina Romer, think that inflation is all about Phillips curves.

Why a derisive attack on Romer?  Albeit I don't know her personally, just via her research and press interviews, I just can’t see why she should be singled out for attack.

According to these people, if we get more inflation than we bargained for, that would be no problem. In their view, we have a long way to climb up the Phillips curve, a huge output gap, and plenty of spare capacity.

No, “some people” do not believe that missing inflation targets is without consequence (on either side of the target, I might add, as Williamson appears to fear only one-sided errors).  “Some people” do believe, however that because of the spare capacity inflation is not currently a threat.  That is not the same thing as saying higher than anticipated inflation in "no problem."  Williams then brings out the 1970s to dismiss “some people”:

Of course Christina and her fellow Phillips-curve types seem to want to ignore the 1970s.

When did it become an insult to be compared to or grouped with Christina Romer?  What exactly did I miss?  Slogging forward:

The mid-1970s US economy was of course not identical to what we see today, but some of the same factors were at play. Recently there has been a runup in commodity prices, real GDP and employment have taken a hit, and there is an accommodative Fed working in the background, all of which were also true of the mid-70s…

It is not the similarities that are important, but the differences.  And the key difference is the inability of the labor force to translate higher prices into higher wages.  A wage-price spiral cannot exist on increasing prices alone.  A look at the record:

Apparently, we don’t have much to worry about until wage gains put more substantial upward pressure on unit labor costs.  This is key element of propogating inflation expectations.  The Fed very much needs to keep an eye on actual wage pressures, not hypothetical inflation pressures.  

Then we get to the money issue.  You knew it was coming.

What about the stock of currency? That has been growing substantially as well, though what we are seeing may or may not alarm you…

…you can see that the stock of currency has been growing at an increasing rate, indeed at an annual rate of 10.6% since the inception of the QE2 program. If sustained, and assuming constant velocity and 4% GDP growth, we would get something approaching 7% inflation, which I think would start to make people unhappy.

Notice that Williamson expresses concern about the growth of the stock of currency, but presents the chart in levels. Let’s look at the historical record on currency growth:

 

Exactly where is the reason for concern?  Move along folks, nothing to see here.  Williamson feels a need to create a problem where none exists. Of course, he ignores data that reasonably should raise eyebrows.  A money multiplier less than one, for example:

Or declining velocity in the face of massive monetary easing, a combination consistent with a liquidity trap scenario:

I will leave the criticisms of using simple versions of the quantity theory of demand to Brad Delong and Jim Hamilton.

Just hold tight, it's almost over:

Ben Bernanke says not to worry, though…So, what could go wrong? Plenty...

All of the necessary conditions are there for a substantial inflation. I'm thinking of something on the order of 5% to 10%, and once it gets going it will be costly to stop it. The total stock of reserves will rise to about $1.6 trillion by the end of June, and that represents an accident waiting to happen.

All of the necessary conditions are not met – note lack of wage pressures above.

Right now, as Bernanke points out, financial markets are taking the Fed at its word. The margin between TIPS yields and nominal Treasury yields is not very large, reflecting modest anticipated inflation. But if people start to anticipate that the Fed will not be reducing the size of its balance sheet any time soon, and start to anticipate higher inflation, then nominal rates of return on assets will rise, making reserves undesirable to hold.

People already anticipate the Fed is not poised to reduce the balance sheet – the general consensus is that the Fed will not consider a rate hike until early next year, and the rate hike seems likely to come before an effort to whittle away at the balance sheet – yet 10 year Treasury rates remain well below 4%. 

The Fed can make reserves more desirable to hold by increasing the interest rate on reserves, thus cutting off the incipient inflation, but it will have a hard time doing that. Unemployment may still be high and employment growth slow, and the Fed may not want to be blamed for slowing the recovery.

Here Williamson is making an argument that much of the increase in unemployment is structural.  Despite another study suggesting the opposite, I concede there is a reasonable chance that some of the unemployment increase is structural (see David Altig here and here).  What I don't agree with is the assumption the Fed will unwittingly miss the shift.  Of course, they won't if they are watching wages, which should start to rise earlier than anticipated in the event of a significantly higher structural rate of unemployment. 

Further, the Fed has locked itself into a portfolio of long-maturity assets which will drop in value if short-term interest rates go up substantially. Ultimately, the Fed may not have the stomach to fight the inflation, in which case the higher anticipated inflation becomes self-fulfilling.

The Fed has not locked itself into a portfolio; the Fed has carefully considered how to reduce that portfolio when necessary.  And it has always been the case that if monetary authorities do not act in a manner consistent with price stability, inflationary expectations and actual inflation will move higher. in another time, this could have occurred in the absence of massive balance sheet expansion. Also note the argument works in reverse - if the Fed did not act to fight deflation, it would become self-fulfilling.  Basically, Williamson argues that we should deliberately pursue the wrong policy today because we might pursue the wrong policy tomorrow. 

Bernanke makes it sound like the Fed has a lot of tools. Surely with so many tools, things have to work, right? However, there are really only two instruments that matter in these circumstances: the interest rate on reserves, and the quantity of assets in the Fed's portfolio.

The tools are intended to ensure an orderly withdrawal of the monetary expansion should it become necessary, and those tools specifically relate to managing the size of the portfolio should interest rates paid on reserve alone prove insufficient.  Fed staff have clearly spent substantial time and effort understanding how to manage the balance sheet (including its duration), yet Williamson simply dismisses that effort without explanation, without any reason to believe it won’t work. 

If all hell breaks loose, there could be conflict on the FOMC. With a positive stock of excess reserves in the system, it is the interest rate on reserves that matters. The fed funds rate target is irrelevant. But the Board of Governors sets the interest rate on reserves. What if the Board and the regional Fed Presidents who vote on the FOMC disagree? What happens then?

A nonsensical hypothetical war within the Fed.  The FOMC is comprised of seven board members plus 5 regional presidents, one of which is always the New York Fed president.  The latter can be assumed to vote with the Board, in which case it is virtually impossible for the will of the Board of Governors to be different from that of the FOMC.  Simply put, the interest rate on reserves will be managed in such a way as to be consistent with the policy stance of the FOMC – Williamson has nothing here but an irrelevant straw man.  Moreover, a few years ago it sure looked like all hell was breaking loose, and the Fed managed to minimize conflict.  Why so little faith that same will not be true in the future?

Ben Bernanke wants you to think that everything is OK. Policy is proceeding in a normal fashion. We understand what is going on. I think the truth is that he is making it up as he goes along. The Fed has undertaken a risky experiment. I can see ways in which this will not turn out OK. Maybe I'm wrong, and that would be good.

I am not sure that Bernanke believes in any way, shape, or form that everything is OK.  I am pretty sure the opposite is true.

Bottom Line: This is uncharted territory for the central bank.  Could mistakes be made?  Yes – but I would prefer that possibility above of the certainty of ongoing recession in the absence of correct policy today.  And don't fall into the trap that some hyperinflation scenario will sudenly sneak up on us.  The signs will be evident long in advance, notably sharply rising unit labor costs and nominal interest rates.  Those conditions simply have not been yet, leaving no reason to believe we need to rush into policy reversal, either monetary or fiscal.

Intervention Thoughts

It is worth pointing out some interesting reporting regarding last week’s G7 intervention.  I think this summary via the Wall Street Journal is basically correct:

The Group of Seven’s coordinated efforts Friday to weaken the value of the Japanese yen are likely designed more to temper panicked markets than targeting a specific currency level, economists say….

“This is a short-term measure that has more the goal of stabilization and averting a short-run panic than taking a view about how global imbalances might evolve and what the right value of the yen is against other currencies,” said Ralph Bryant, a former director of the U.S. Federal Reserve‘s international finance division, now a fellow at the Brookings Institution.

I have a hard time reading anything more than the obvious into the G7 intervention.  In response to the earthquake and subsequent tsunami the Yen was appreciating rapidly in what appeared to be a disruptive fashion.  The Japanese authorities would have acted on their own sooner or later, but secured the backing of their G7 partners to provide evidence that efforts to stabilize the Yen should not be confused with attempts to direct the value of the Yen to achieve a trade advantage.  It will work as a break on speculative activity, but will have limited impact, if any, on any long-run, fundamental forces driving the value of the currency.  To fight the latter requires a committed, repeated effort on the part of the Ministry of Finance, something that at the moment does not appear to be on the table.

The Wall Street Journal also has a more curious piece relating the currency intervention to the Federal Reserve’s balance sheet that reads like it was rushed on a Friday afternoon.  (which I can identify with, as most pieces I rush fall short of where they should be).  The piece begins:

The Federal Reserve‘s contribution to a global effort to weaken the yen is limited by the central bank’s war chest of Japanese currency and currency-like assets.

The Fed’s modest holdings are indicative of the dollar’s position as the world’s key reserve currency...

…While reports from traders about the size of the Fed’s participation in Friday’s interventions were as uneven as one would expect in the absence of official confirmation — it seems they sold around $600 million — the overarching fact is the Fed doesn’t have much yen to sell.

I am not sure that we should care that the Fed doesn’t have much Yen to sell, but they seem to have plenty for this kind of operation:

According to fourth quarter 2010 data from the Fed, the most recent available, the central bank held a total of $11.922 billion in yen denominated assets. That consists of $3.882 billion in cash and $8.039 billion in securities, the type of which the Fed doesn’t describe.

Enough for ten ventures into the Yen market of the same magnitude as last week’s action – actually more since interventions are typically split between the Fed and Treasury.  Seems like plenty given only a couple of interventions a decade.  The article does get around to the critical point – the Fed is only a symbolic player in this effort.  There is no problem finding Yen to sell.  The Bank of Japan can print theoretically unlimited amounts of the stuff:

All of that points to participation by the Fed that’s important, but largely symbolic. In this action, “the impact is not going to come from the G-7, non-Japan. The holdings are just too limited,” said Tom Porcelli, economist with RBC Securities. The heavy lifting “is going to have to be done by the Bank of Japan” because they’ve got the yen to make a real difference, should that sort of force be required.

So, again, isn’t the size of the Fed’s holdings essentially a nonissue when it comes to beating down the value of the Yen?  Sounds like a Japanese problem with a Japanese solution.  The piece then takes an interesting turn:

The mechanics of the Fed acquiring more yen for its balance sheet are unclear. The New York Fed declined to say how it possess the yen and yen-assets it has, and did not say how it could get more if it wanted. It seems unlikely the Fed’s currency swap arrangements, which exist to provide dollar liquidity to major central banks, could be used to get more yen, given how they are set up.

Are the mechanics of reserve accumulation really unclear? After all, rather than issuing a “sell” order, the markets group in New York could instead issue a “buy” order.  That should do the trick.  If the problem is how can they get more Yen to drive down it value, it is a nonissue.  See above – in the long run, this in the Bank of Japan’s problem, and they have the tools to deal with it. 

I could live with all the above, but the article takes yet another interesting direction when it implies monetary policy implications:

The forecasters of Wrightson ICAP said the Fed may have had another reason for embracing the intervention. While the Fed would clearly be amenable to aiding Japan, “We suspect that at least some FOMC [Federal Open Market Committee] members would be pleased by the idea of zeroing out the Fed’s yen-denominated portfolio.”

That’s because it would streamline the eventual contraction of the balance sheet and help limit the options of future policymakers who wish to pursue foreign exchange interventions for more typical goals.

Wow.  I usually don’t challenge the Wrightson ICAP research, and have much respect for their Chief Economist Lou Crandall.  But wow.  I imagine this could be true, but I have trouble believing that given the magnitude of the Fed’s balance sheet expansion, Fed officials are really looking for salvation in a piddling little $12 billion in Yen-denominated assets.  Consider that they bought $6.58 billion of Treasuries last Thursday – 10 times the Fed’s estimated yen intervention. Are some FOMC members really secretly worried about the size of the foreign exchange holdings when they are in the process of sucking up $600 billion of Treasuries?  If they are, I am indeed much more concerned about the Fed’s ability to contract the balance sheet when it becomes necessary, because there must be far less room for error than Fed officials even come close to acknowledging.

Moreover, how in the world does selling off the Yen portfolio “limit the options of future policymakers who wish to pursue foreign exchange interventions for more typical goals”?  Isn’t the more “typical goal” to weaken the value of the domestic currency, in this case the Dollar?  To achieve that goal, you need to buy foreign denominated assets.  This can be accomplished even if the Fed has already dispensed with their foreign exchange reserves. (And, I should add, would not really be in the Fed’s purview, as the value of the Dollar is a responsibility currently held by US Treasury Secretary Timothy Geithner).

Bottom Line:  Don’t read too much into the Fed’s participation in last week’s G7 intervention.  Take it at face value – symbolic support to curb what can reasonably be described as a destabilizing Yen appreciation.  No more, no less.  Any sustained action of the value of the Yen will have to come from the Japanese authorities. 

 

 

 

 

 

 

Policy Still on Autopilot, For Now

The Federal Reserve did as expected, leaving policy unchanged.  But policymakers tweaked the statement ever to slightly to suggest that indicators are at a minimum not moving away from the objectives of the dual mandate – a critical first step on the road toward normalizing monetary policy.

First, apparently there was some surprise that the Federal Reserve failed to mention the unfolding crisis in Japan.  From the Wall Street Journal:

Federal Reserve policy statements are supposed to outline the forces that will drive monetary policy over coming months, so while it wasn’t unexpected, it’s nevertheless puzzling central bankers omitted the biggest risk of all: Japan.

I suspect they did not mention Japan because little information is known about the economic risk or they don’t perceive it to be the primary risk in the US outlook.  Indeed, we have been down this road before with Hurricane Katrina - even very large disasters in advanced economies appear to have limited overall economic impact, although the regional impacts could be quite severe.  I often wonder if economists have a tendency to initially overestimate the potential impact of such events as they believe the economic impacts must somehow reflect the human impact, or that if they don’t play up the economic impacts they will be seen as downplaying the human impact.  I tend to be less concerned about the economic impact (particularly over the longer term; market economies have proven to be remarkably resilient) and instead am much, much more concerned about the very devastating and long-lasting human impact of this tragedy.  I recommend the guest post at Econbrowser on this topic.  To be sure, policymakers will be watching this and other situations closely, but I suspect they would turn to this kind of research as a guide and conclude for now that the global economic impact will be largely transitory. 

Indeed, instead of focusing on the downside risk, policymakers turned their attention largely to on the moderately positive news.  First, as has been widely noted, the Fed upgraded the economic assessment – the recovery is not only on “firmer footing,” but labor markets “appear to be gradually improving.”  The last bit is important.  The lack of any meaningful improvement in labor markets has been a central feature of this recovery, and a major impediment to any change in policy.  Signs of improving labor conditions are a welcome relief for policymakers.

Note also that the language regarding commodity prices is focused on the inflationary, not deflationary, implications.  I tend to believe the Fed would ultimately be forced to ease policy further in the event of a significant oil price surge, but there is no indication here that this is the concern. 

Furthermore, notice the slight change in the language regarding the inflation trend.  The Wall Street Journal missed it:

The language on its closely watched measures — core inflation and expectations — is unchanged. The bottom line here is that policy makers aren’t overly concerned about inflation right now. 

True, they are not overly worried about inflation.  But Calculated Risk spots the small but important change:

Inflation "subdued" instead of "trending downward"

If you are looking for QE3, you need some combination of ongoing labor market stagnation and threat of deflation (the two go hand in hand).  Instead, what the Fed sees is improving labor markets and inflation that appears to have hit a floor:

Of course, despite indications data is actually heading in the direction of the dual mandate, the size of the output gap, high unemployment, and weak wage growth all argue against tightening policy in any way, shape, or form.  Hence the current large scale asset program continues unabated.  I still believe the calendar argues against any deviation from this plan.  Even if incoming data strongly surprised on the upside, by the time the Fed was able to assess such data and act, the policy would be nearly at an end.  Changes would be essentially pointless.

Bottom Line:  Monetary policy continues on autopilot – they still plan that QE2 will end as expected at which time policymakers will turn their attention to policy normalization, setting the stage for a rate hike in 2012.  Watch for signs that the downside risks (oil, Japan, Europe, etc.) are evolving in such a way that they are impacting actual data, with the weak reading on consumer confidence being a cautionary tale.  But if the data holds up, with steadily improving labor markets and improving inflation measures, the next test for monetary policy will be the end of QE2.  Will markets falter in the absence of a steady drip of monetary policy?

 

Speculators Gone Wild?

At the risk of becoming involved in the ongoing Paul Krugman/Yves Smith debate regarding the influence of speculators on commodity prices, I direct readers to Colin Barr at CNN Money:

 The surge of speculative money into the oil futures pits shows that big financial players are expecting the price of WTI crude to surge well above the recent $105 or so seen last week. If they are right, it will bring $4 gasoline a step closer….

…"It does not get any clearer which way Wall Street is trying to take oil," says Stephen Schork, who writes the Schork Report energy markets newsletter in Villanova, Pa.

Schork notes that speculators now own nearly six times as many barrels of oil – 268,622 futures contracts representing nearly 269 million barrels – as can be stored at the WTI trading hub in Cushing, Okla. And since the CFTC numbers released Friday only go through last Tuesday, they likely underestimate the degree of speculative fervor building in the energy markets.

Money appears to be flooding into energy markets to chase a sure thing, with potentially severe consequences for a global economy still on the mend.  The article continues:

The speculative fervor is so remarkable that the big trading firms now have nearly twice as many long contracts open as they did in 2008, when oil spiked to $147 in the summer, a development that either foreshadowed or caused the global economic meltdown, depending on how you look at it.

I think this suggests that the recent oil price gains are driven more by speculation that in 2008.  And note that we know how quickly oil prices collapsed when the global recession knocked down energy demand.  So if oil prices are being driven by even more extreme speculative activity today, the possibility for a sharp reversal also exists – the question is whether that reversal comes before or after oil prices bring the global economy to its knees. 

Presumably, growing tranquility in the Middle East would cause speculators to run for the exits.  This, however, seems unlikely.  Instead, it might be an interesting time for a large, surprise release from the Strategic Petroleum Reserve.  This is not something I expect or would really argue for given I don’t think that $100 oil qualifies as a national emergency.  But I would like to understand more about the importance of speculative activity in driving oil prices, and perhaps this is something best understood only by catching a lot of traders on the wrong side of a “sure thing.” 

 

Ignore Hawkish Rhetoric

The Wall Street Journal suggests the Fed is facing a policy conundrum.  I would suggest that "conundrum" is an overstatement.  Push comes to shove, there will be little debate - if the current oil price shock turns nasty, Fed officials will embrace another round of quantitative easing.

Dallas Federal Reserve President Richard Fisher offers the hawkish view, and remains colorful as always.  Today he ranted against QE2:

To be sure, there are some, including me, who worry that the Fed ultimately may have taken out too much insurance against a double-dip recession and slippage into a deflationary spiral. There are some, including me, who argued against the last tranche of insurance we took out in committing to buy $600 billion in U.S. Treasuries between last November and the end of this coming June as we were simultaneously purchasing additional Treasuries to make up for the roll off in our mortgage-backed securities portfolio. There was a strong feeling among those of my policy persuasion that we had already sufficiently refilled the tanks holding the financial fuel businesses needed to drive their job-creating machines. They felt that by being too accommodative, we might run the risk of planting the seeds that could germinate into renewed volatility, speculation and inflation, or give comfort to a government that for far too many congressional cycles has fallen down on the job by spending and borrowing and committing to unfunded programs with reckless abandon. 

Am I the only one who sees Fisher as a remarkably irresponsible policymaker?  I get the sense that at best he is trying to undermine the effectiveness of monetary policy by repeatedly emphasizing that it doesn’t work. At worst, he is deliberately trying to feed inflation expectations, for what purpose I know not.  I think the responsible policy approach would be to exude confidence in the Federal Reserve, particularly during period of turmoil.  The policy is in play; no good comes from public derision at this junction.  Simply reiterate that the Fed has the tools to remove the accommodation should it become necessary.

Goodness, if anyone took him seriously, he could do some real damage.  Luckily, I think by now we have been trained to largely dismiss Fisher.  For a more nuanced and thoughtful policy approach, I suggest the competing speech by Atlanta Fed President Dennis Lockhart, with what I think is a key insight:

Where my views might depart from the mainstream to some extent is on the question of the range of plausible economic scenarios from this juncture. In thinking about an appropriate and balanced policy for at least the near term, it seems to me a critical question is whether the range of plausible scenarios is narrowing (that is, is certainty growing) or widening (that is, is uncertainty growing). My view is the range has widened—not dramatically, but somewhat. For some time, my list of headwinds and risks has encompassed European sovereign debt, our own federal, state and municipal fiscal challenges, house prices, and commercial real estate. My sense of the balance of risks has shifted with the addition of unrest in the Middle East and North Africa.

That growing uncertainty has weighed on me in recent weeks.  Rather than digging in his heels like Fisher, Lockhart allows policy flexibility in the months ahead:

With the information I have today, my first inclination is to be very cautious about extending asset purchases after June. Given the emergence of new risks, however, I prefer a posture of flexibility as regards policy options. As we have seen, conditions can change rapidly, so I will continue to evaluate the incoming information as much as possible with fresh eyes as I approach each meeting and each decision.

Lockhart’s position will become the dominant view at the Fed.  A month ago, the likelihood of additional easing was nearly zero.  QE2 would end as scheduled, and the Fed would turn its attention to the timing of policy reversal.  The evolving commodity price shock, however, clouds that outlook.  To be sure, Lockhart recognizes the potential inflationary impact of recent events:

To recap, one can't help but notice rising inflation anxiety among the business community as well as consumers based on recent experience with highly visible and highly publicized commodity prices. So far, this anxiety has not translated to a loosening of the moorings of inflation expectations….But my concern is that broad inflation worries—even if in reaction to what are probably temporary relative price movements—could shift and cut loose inflation expectations. It goes without saying that we policymakers must watch indications of expectations very carefully and be on guard for an approaching inflection point.

 But he recognizes that this should not be the baseline expectation.  Instead:

In my opinion, central to the question of the potential for price action becoming broad inflation is the behavior of wages. I remember the early eighties well. I was in a management role in a bank then, and in my organization we were moving salaries around 10 percent a year to retain our people. Wage accommodation of rising prices has the effect of institutionalizing and embedding inflation. However, I do not see widespread wage pressures developing any time soon in the current circumstances of upwards of 20 million people either out of work or working part-time for economic reasons.

The February employment report would appear to support Lockhart’s position – average hourly wages climbed by a mere penny.  Indeed, it is hard to see the basis of a wage-price inflation spiral evolving:

Spencer at Angry Bear adds succinctly:

With income growth this weak fears of significantly higher inflation appear to be misplaced. Although headline inflation may be ticking up because of food and energy, the weak income growth implies that the impact of higher food and oil prices will be felt much more in weak consumer spending rather than higher inflation expectations.

Bottom Line:  The ongoing commodity price shock argues for further monetary accommodation, not less.  In the current environment, efforts to pass through higher prices to consumers will only erode spending power, not provide the basis for additional wage gains.  This is not Europe or Asia; dismiss policymakers who suggest otherwise.

 

 

 

 

Game Changers?

The strong data flow continues.  Following up on its manufacturing counterpart, the ISM’s service sector report extended January’s improvement.  Retail sales appeared to bounce higher in February, supporting the contention that January’s weakness in retail sales was weather related.  When the roads cleared, consumers realized they had a few extra dollars burning a hole in their pockets.  And, most importantly, initial unemployment claims sank, bringing the 4-week average below the 400k mark.  We are at levels that typically foreshadow solid labor market improvement, which is undeniably good news.

All in all, incoming data reinforce my sense that the upside and downside risks to the forecast are intensifying, which could make for a very interesting few months.  I sense there is a tendency to downplay the upside risk because of the depth of the US employment and output holes.  To be sure, there remains significant slack in the economy, enough so that a steady stream of good data should not induce monetary or fiscal authorities to withdraw stimulus anytime soon.  This, of course, is the mistake the ECB looks likely to make:

European Central Bank President Jean-Claude Trichet said the ECB may raise interest rates next month for the first time in almost three years to fight mounting inflation pressures.

An “increase of interest rates in the next meeting is possible,” Trichet told reporters in Frankfurt today after the central bank set its benchmark rate at a record low of 1 percent for a 23rd month. “Strong vigilance is warranted,” he said, adding that any move would not necessarily be the start of a “series.”

Overeager ECB policymakers aside, one can see the foundation of a shockingly sustainable recovery forming.  I know, it has been so long since we saw good data that the natural inclination is to be dismissive.  But at this point, all we really need is to light a little fire under the labor market to entrench a positive feedback loop.  And the sharp improvement in initial claims suggests that fire has been lit.  It is just a matter of time before it shows up in nonfarm payrolls.

But lighting the fire is not enough to prompt the Fed to make a rapid policy reversal.  Some policymakers will focus on what they see as brewing inflation.  From the Beige Book: 

Manufacturing and retail contacts across Districts reported rising input costs. Manufacturers in many Districts conveyed that they were passing through higher input costs to customers or planned to do so in the near future. Homebuilders in the Cleveland and Atlanta Districts noted rising material costs, but acknowledged little ability to pass through the costs to buyers. Retailers in some Districts mentioned they had implemented price increases or were anticipating such action in the next few months.

Efforts to pass along higher prices, however, should not be enough to unsettle the Fed as a whole.  Eyes should be drawn to the next sentence:

There is little evidence of wage pressures across Districts. Wages remained steady in the Boston, Philadelphia, Cleveland, Kansas City, and Dallas Districts, while moderate wage pressures were reported in the Chicago, Minneapolis and San Francisco Districts. Philadelphia, Dallas, and San Francisco noted that most wage increases were for workers with specialized skills.

Until we see enough labor demand, and reduced slack, that we see some widespread upward momentum in wages, it is tough to see how higher input cost do anything but temper demand growth.

Simply put, the baseline scenario should be that labor markets are not going to improve sufficiently quickly to unsettle the Fed’s plans.  Still, there is a risk that we are underestimating the degree of slack in labor markets.  I think one needs to pay more attention to that risk should we see a string of solid employment reports.

At the same time the economy is showing signs of sustained momentum, thus raising the specter of upside risks, we are faced with the downside risks from the commodity side.  Undoubtedly, higher commodity prices are a drag on activity.  But the last shock came in the context of waning US economic activity and rock bottom saving rates.  This time, the US economy is on the upswing, with positive saving rates to provide cushion, suggesting that for now the commodity shock can be managed.  Still, I can outline a scenario where low interest induces a flood of money into commodities to chase a supply induced price shock.  And I am more inclined to believe that this would trigger a recessionary rather than inflationary environment.

Bottom Line:  We await yet another employment report, facing intensifying risks on both sides of the forecast.  The possibility of some real game changing developments is at hand.  At this moment, I think the balance of risks are now on the upside, but am very, very conscious of how quickly that balance can change in the wake of a commodity price shock.  I would be wary about letting the depth of this recession interfere with your read of the data, just as wary as you should be about letting the data tempt you from thinking it is time to push stimulative policies into reverse.

The Rearview Mirror

The rearview mirror is looking pretty good this week.  The ISM manufacturing index extended January’s impressive gains, again with improving internals.  Note declines in the inventory measures, which suggests manufacturing momentum is set to continue.  One can wring their hands over the Personal Income and Outlays report, which revealed a very small 0.1 percent decrease in real spending.  This should be taken in context of likely weather-related issues rather than some impending consumer slowdown.  Bolstering that view is the 0.4 percentage point gain in the saving rate; bank accounts swelled a bit as weather restrained shopping activity.  Moreover, the February spending report will get a boost from autos, with car dealers reporting well-above-expectations sales of 13.44 million units, SAAR.   No wonder consumer confidence was up in February.  Buying new cars makes people happy.

All told, incoming data continues to be on the bright side.  To be sure, it is reasonable to complain about the depth of the hole we are in – the “real” recovery remains nascent, beginning just in the final quarter of 2010.  A handful of solid data should not be reason to abandon monetary and fiscal stimulus and threaten building momentum.  But the data is solid, so much so that it is surprising to see the comments of Harvard’s Martin Feldstein.  Via Bloomberg:

“There is a mixed picture now in terms of how much the economy is on track,” Feldstein said in an interview on Bloomberg Television’s “InBusiness With Margaret Brennan.” Growth “started slowing down toward the end of the fourth quarter. The January numbers are not very good at all.”

Feldstein cited less-than-forecast consumer spending in January, continuing monthly declines in U.S. housing prices and weakness in industrial production. While fourth-quarter growth was bolstered by consumers spending more after a rise in the stock market, those gains came as the personal savings rate fell, he said.

“So this is not a strong economy,” Feldstein said. “There hasn’t been a pull-through from the fourth quarter to the first quarter.”

I disagree; the pull-through has been strong.  The industrial production weakness in January was the consequence of the often-volatile mining and utility sectors.  Manufacturing production gained 0.3 percent, extending a 0.9 percent gain the previous month.  And the ISM reports promise additional strength going forward.  I already commented above on the consumer spending picture.  Feldstein, however, is correct on housing.  But this should not come as a surprise – a housing recovery figures into precious few forecasts this year.

Federal Reserve Chairman Ben Bernanke also does not side with Feldstein.  Making his semi-annual trek to Capitol Hill, Bernanke gave a relatively upbeat assessment of the economy:

More recently, however, we have seen increased evidence that a self-sustaining recovery in consumer and business spending may be taking hold. Notably, real consumer spending has grown at a solid pace since last fall, and business investment in new equipment and software has continued to expand. Stronger demand, both domestic and foreign, has supported steady gains in U.S. manufacturing output.

The combination of rising household and business confidence, accommodative monetary policy, and improving credit conditions seems likely to lead to a somewhat more rapid pace of economic recovery in 2011 than we saw last year.

Enough optimism to change policy in the near term?  No:

While indicators of spending and production have been encouraging on balance, the job market has improved only slowly... Until we see a sustained period of stronger job creation, we cannot consider the recovery to be truly established.

It will take a few months of solid jobs data to convince Fed officials that the economy is out of harms way – and by that time, the Fed’s current asset purchase plan will be effectively over.  Maybe we will get the first such report on Friday; I am optimistic that nonfarm payrolls will look better than the weather mangled January read.  Interestingly, Oregon reported solid numbers for January, a month that was unseasonably warm.  No snow to disrupt the jobs picture. 

Given where Bernanke is today, I find it difficult to believe that he will follow the path suggested by St. Louis Fed President James Bullard.  From the Wall Street Journal:

“We are still very far away from achieving our dual mandate of maximum sustainable employment and price stability,” Dudley said. “Faster progress toward these objectives would be very welcome and need not require an early change in the stance of monetary policy,” he said.

Bullard sees things a little differently. In his television appearance he explained the Fed is “determined” to get monetary policy back to a more normal profile. He explained he saw the Fed as “possibly finishing the program a little bit shy of where we intended initially, and then go on pause for a while.”

Bullard’s comments need more clarification:

Bullard differs somewhat from that camp in that he’s been a QE2 supporter and was one of its primary advocates before it was launched. His comments Monday suggest a philosophical difference. While many in the Fed see QE2 as an extension of normal monetary policy, Bullard takes that view a step further, and would like the Fed to use bond buying in a fashion similar to the way it used to approach short-term rates. The Fed didn’t always move in a straight line with rate adjustments then, and sometimes paused to take in new data.

Bullard has been suggesting for quite some time that the Fed should use small adjustments in its bond buying program to manage expectations, and this is likely his last chance to see that idea actually implemented.  Note that it was not implemented last year; the Fed opted for the announcement of a large scale program with a $600 billion target.  The only possible reason to bring an early halt to the program given the early stage of the recovery and, as Bernanke notes, an environment of stable inflations expectations, is to hand Bullard a policy “win.”  I just don’t see that happening.  But if it does, there would be no question about Bullard’s stature within the Fed.

What could upset Bernanke’s optimism?  Commodity prices, of course.  If commodity prices work their way deep into inflation expectations in an environment of improving final demand, the Fed will be pushed to reverse policy.  And if inflation truly took hold, forget about fine-tuning and tapering; think outright reversal.  That, however, I think is less likely than the recessionary implications of a sharp run up in commodity prices, the odds of which seem more likely by the day.  For now, Bernanke can only sit on the sidelines and see how it plays out. 

Bottom Line:  If the Fed continues to drive by the rear view mirror, they will happily bring the current $600 program to conclusion as expected.  Assuming the data continues to hold, and momentum builds  in the job market, they will shift to "normalizing" policy, with rate hike possible early next year.  But if they turn their attention to the front windshield, they will see the commodity price truck starting to slide out of control.  But until the slide turns into an outright wreck, they just will not know which way to swerve.