Tim Duy's Fed Watch

Epicurean Update

For those planning a trip to Portland, OR, I point out that Pazzo Ristorante offers a ridiculously rich, melt-in-your-mouth gnocchi paired with an ever changing ragu - tonight is goat.  The wait staff once told me the gnocchi are soaked in olive oil for 24 hours during preparation.  

I recommend the half order.

Also note they are serving on tap Pin Up Porter from Southern Oregon Brewing.  The food/beverage combination is worth a trip downtown.

Very High Bar for QE3

My first thoughts: The FOMC statement was consistent with my expectations, while Federal Reserve Ben Bernanke sounded slightly more hawkish than I anticipated.  The latter confirms the view I took two weeks ago – near term inflation gains were not sufficient to justify altering the current policy stance, but would derail any additional increases to the balance sheet beyond June.

The FOMC statement itself was largely straightforward.  Arguably a bit of a downgrade of the economy (as CR notes, the “firmer footing” language has disappeared) and a little more talk about inflation.  The new economic projections reflected these alterations, with growth forecasts brought down to pretty much the same range when the Fed initiated QE2, while near-term headline inflation forecasts are higher.

The initial phase of Bernanke’s press conference was also in line with my expectations.  He noted that the expectations for trend growth and the natural rate of unemployment were beyond the control of the Fed, while inflation was directly determined by monetary policy.  He explained the reasoning for a positive rate of inflation, explicitly pointing to the concern about deflation, defined as falling wages and prices.  This was, I believe, the last we heard about wages.

In response to the Q&A portion, he said the impending weak Q1 growth numbers are the result of transitory factors (defense spending, exports, weather), and “possibly less momentum.”  The latter phrase was a bit disconcerting and should suggest a predilection toward additional asset purchases beyond June, but apparently the FOMC intends to focus on the transitory nature of the numbers.  See again my earlier piece.  When questioned about the timing of any exit, Bernanke explained the relevant factors, including the sustainability of the recovery, the strength of the labor market, the direction of inflation, and resource slack.   Not surprisingly, he gave no timeline to tightening. 

Regarding the end of QE2, he reiterated the “stock” view of the balance sheet.  Essentially, the pace of accumulation is less important than the size of the balance sheet, and there were no plans to shrink assets.  Indeed, he suggested the first step toward tightening would be to stop reinvesting assets as they mature or are redeemed.  I thought he handled the Dollar questions well – throwing it back in the lap of Treasury Secretary Timothy Geithner and claiming, rightly in my opinion, that the best thing for the Dollar over time is that the Fed pursues policies that satisfy its dual mandate.

The most interesting comments came in response to questions about whether the Fed should do more to lower unemployment and if QE2 is effective, shouldn’t the program continue?  Here was a more hawkish Bernanke.  As I noted earlier, growth forecasts returned to the pre-QE2 range, which should be a red flag.  Unemployment remains high, with only moderate job creation.  Core-inflation remains low, while the impulse from commodity prices on headline inflation is expected to be temporary.  Finally, he claims that QE2 was in fact effective.  So why not do more?  Because the Fed needs “to pay attention to both sides of the mandate” and the “tradeoffs are less attractive.”  Much talk by Bernanke at this point about inflation expectations, and the importance of maintaining those expectations, and not much (none, I think), about the issue (or non-issue) of wage inflation. 

Apparently the threat of headline deflation off the table, Bernanke is not inclined to pursue sustained easing despite low core inflation and high unemployment.  Again, I am not entirely surprised, except that Bernanke appear to suggest we are much closer to an inflation tipping point than I would expect.  He could have tempered these comments with a more forceful discussion of labor costs, but did not.  It seems clear these comments were intended to calm the non-existent bond market vigilantes, but is it consistent with the outlook?  Arguably, no.  For what it’s worth, I think Bernanke appeared most uncomfortable during this portion of the conference. 

Bottom Line:  When I look at the revisions to the Fed’s outlook and listen to Bernanke, I get the sense that the basic Fed policy is summarized as follows:  “The economic situation continues to fall short of that consistent with the dual mandate, we have the tools to address that deviation, but will take no additional action because some people in the Middle East are seeking democracy.”

Quick Note on Inflation Expectations

The FOMC will render judgment on the economy today, followed by the inaugural post-meeting press conference by Federal Reserve Chairman Ben Bernanke.  Policy is expected to remain essentially unchanged, with the large-scale asset program continuing through June.  The FOMC statement will likely be similar to the last, maybe upgrading the state of the labor market but acknowledging weak first quarter data.  I am curious to what extent they have adjusted their full year GDP forecast.  Any downward adjustment would be further reason to maintain the current path of policy, and it is difficult to see reason for any upward revision.

The statement will likely maintain language on commodity prices, inflation, and inflation expectations – commodity prices are likely to have only a transitory impact on core-inflation, while expectations remain stable or anchored.  Rates will be kept low for “an extended period.”

I am hopeful that the Chairman’s press conference will be illuminating but ultimately something of a nonevent – that the general consensus on the direction of monetary policy is consistent with that of the gravitational center of the FOMC, and thus Bernanke’s comments will be largely non-disruptive. Or at least it should be, as I anticipate we will learn that it was correct to heavily discount the more hawkish sounding regional bank presidents.

The Wall Street Journal focuses on the inflation expectations issue here and here.  To be sure, I think the Fed is following this closely, but I think we should nuance the issue a little more carefully to account for a transmission mechanism from inflation expectations to actual inflation.  I expect Bernanke would tie a discussion of inflation expectations to a discussion of labor costs.  Vice Chair Janet Yellen did just that earlier this month:

In addition, the indirect effects of the commodity price surge could be amplified substantially if longer-run inflation expectations started drifting upward or if nominal wages began rising sharply as workers pressed employers to offset realized or prospective declines in their purchasing power…

 …Consequently, longer-term inflation expectations became unmoored, and nominal wages and prices spiraled upward as workers sought compensation for past price increases and as firms responded to accelerating labor costs with further increases in prices….

 …That said, in light of the experience of the 1970s, it is clear that we cannot be complacent about the stability of inflation expectations, and we must be prepared to take decisive action to keep these expectations stable. For example, if a continued run-up in commodity prices appeared to be sparking a wage-price spiral, then underlying inflation could begin trending upward at an unacceptable pace. Such circumstances would clearly call for policy firming to ensure that longer-term inflation expectations remain firmly anchored.

For a more immediate example of what this would look like, turn to recent stories from China like this:

China’s southern economic powerhouse Shenzhen said Thursday it would raise the minimum wage by 20 percent, following a similar move by Shanghai, as China continues to battle rising inflation and a labor shortage.

Sounds clearly like an economy in which inflation expectations have become unstable, to say the least.  It is difficult to see a parallel to the current US situation – we don’t have a labor shortage, without which there is minimal upward pressure on wages, rendering senseless fears a wage-price spiral is imminent.  I suspect Bernanke would agree with a similar line of argument, and it will be interesting if he explicitly cites unit labor costs.

Finally, the series of questions I would like asked:  “What specific outcomes or goals did you expect when you initiated QE2?  Have you reached those goals?  If you haven’t reached those goals, are you preparing for QE3?  Why or why not?”

 

 

On the Logic of Inflation Hawks

Richmond Federal Reserve President Jeffrey Lacker:

Businesses thus far have absorbed input price increases, presumably believing that competitors would not follow suit, which suggests that they believe that overall inflation will remain low. The responsibility of the Federal Open Market Committee (FOMC) is to validate these expectations by conducting monetary policy in such a way that inflation does not accelerate. That's not always an easy task at this point in a recovery. In the last cycle, the economy began to grow more rapidly at the end of 2003. Although energy prices showed growth spurts, unemployment had not yet begun to fall and the core inflation measure that excludes energy and food prices was still just 1-½ percent. As a result, many forecasters expected inflation to diminish, and the FOMC kept the funds rate at a very low level well into 2004. Instead of falling, overall inflation soon rose to 3 percent, where it stayed, on average, through the end of the expansion in 2007. Core inflation averaged 2-¼ percent over that horizon. With hindsight, I think it is fair to say that policymakers overestimated the extent to which high unemployment would keep inflation from accelerating, and as a result, waited too long to withdraw monetary stimulus. Four years of 3 percent inflation may not have been the worst of all possible outcomes, but I do not consider it a success. I hope we do better this time. In particular, I believe we need to heed the lesson of the last recovery that inflation is capable of rising even if the level of economic activity has not returned to its pre-recession trend.

Note that Lacker changes the goalpost – rather than focus on core-inflation, he shifts the focus to headline inflation of 3%.  Why?  Because otherwise he needs to face the fact that core-inflation averaged a mere 25bp above trend over the 2004-2007 period:

 

Consider that in context of the entire decade to that point:

 

One could just as easily make the argument that the Fed was allowed core-prices to catch up after a period of inflation that fell 25bp below the upper bound.  Lacker, however, does not see it that way.  Instead, he would prefer to hold unemployment rates high in order to prevent prices from returning to trend.  That’s dangerous thinking, especially if you believe that we should expect a period of higher inflation if output is to converge with potential.  With friends like these….

Also note the path of commodity prices during this past decade:

 
Lacker professes disappointment with inflation results, and would prefer that more people were unemployed to “do better this time.”  I would argue just the opposite:  Given the upward trend in commodity prices – something the Fed had little if any control over – I think the Fed did a pretty good job maintaining inflation expectations in a period of falling unemployment.  And I think it is odd that an insider doesn’t recognize this success. 

 

Q1 Growth Looking Weak – Will it Affect the Fed?

In my last post I argued the Fed will tend to look through an transitory inflation increase – especially any that can be traced back to commodity prices – as the economy marches toward potential output, and thus not rush into policy tightening.  The string of downgrades to Q1 growth, however, is a reminder there is no guarantee that march will continue in a timely fashion.  To what extent will the Fed tolerate growth that falls short of their forecasts?  What is the tipping point for QE3? 

Start with the most recent Fed economic projections from the January FOMC meeting.  Although Q1 is looking weaker than anticipated, I doubt the projections will change much, as most policymakers will try to look through any one number to the underlying trend.  The Fed is looking for Q4/Q4 growth in the 3.4-3.9 percent range this year.  The longer run projection is 2.5-2.8 percent, a common estimate of potential growth, so the Fed projects closing the output gap by roughly a percentage point this year.

The downgrades to Q1 forecasts arguably place that forecast in jeopardy.  Again, I don’t think the Fed will see it that way.  I think they will see it as noise, especially if they are not picking up a lot of anecdotal information otherwise – I anticipate today’s Beige Book release to signal the recovery continues, with concern about energy prices eating into consumer spending.  Moreover, notice this post from Calculate Risk with two interesting items.  The first is from Goldman Sachs analysts, who argue that high frequency data suggest the pace of activity accelerated throughout the quarter, and thus the second quarter will be stronger.  The second is a link to a WSJ article describing a shortage of rail cars.  Both stories suggest a weak Q1 showing is more of a statistical aberration than anything else.  Fed officials will be attracted to this line of reasoning.

I have argued that the pace of job creation suggests growth near or a little above trend, and thus myself have tended to discount a weak Q1 GDP report.  Interestingly, the IMF delivered an updated assessment of the world economy, forecasting US growth of 2.8 percent (annual average), just about potential output.  In contrast to the Fed, which expects growth to accelerate in 2012 and 2013, the IMF expects growth to be relatively unchanged for the next three years, which suggests little if any closure of the output gap and much higher unemployment than the Fed expects.

The Fed and IMF views are dramatically different.  At this point I would add the words of wisdom once offered by a close friend:  Always bet against the IMF.  I think this stemmed from frequent IMF announcements that the “crisis is contained,” which rarely turned out to be accurate, but always an opportunity to short some emerging market currency.  But, that aside, suppose the reality is looking more like the IMF view by the middle of this year, is there room for QE3?  This quote (via the WSJ) from New York Federal Reserve President William Dudley suggests not, or at least not immediately:

I’d be very surprised if we didn’t complete QE2 [referring to the Fed’s second round of quantitative easing]. After that, though, the hurdle for QE3 is higher… One reason we embarked on QE2 was we really were worried about the risk of deflation in the U.S… Now the risks of deflation are greatly diminished. So one of the motivations behind QE2 is no longer in place.

The deflation threat was key reason the Fed stepped up the asset purchase program.  Now no one is talking about deflation.  And unless commodity prices just collapse, nor will they by midyear.  Why?  I suspect we will still be experiencing some of the pass through from the recent commodity price hikes for the next few months, which will be enough to keep Fed hawks riled up.   Even if the economy is limping along near potential, jog growth should be steady if not exciting.  I suspect that a touch of inflation coupled with growth, albeit lackluster, would make it difficult to clear the bar for QE3. 

One could imagine that situation changing in early to mid-2012 as the transitory effects on inflation fade.  And, of course, assuming the IMF is right and the Fed is wrong.  If the Fed’s forecast is accurate, by early next year they will be looking to tighten. 

Finally, a final interesting quote from Dudley:

It’s important to recognize that even with these commodity price pressures, other measures of inflation are very quiescent… There is no sign of any second round effect. Wages are rising very slowly and unit labor costs are running very very flat.

Watch wages it you are worried the Fed is getting behind the inflation curve, and notice Dudley points specifically to unit labor costs.  The core of the Fed will resist panic unless unit labor costs start spiraling upward.  Then they will panic.

Bottom line:  Weak Q1 GDP is not likely to upset the Fed’s basic outlook.  At best it is another nail in the coffin for any argument to pull the plug early on QE2.  But even if growth comes in below the Fed’s forecast this year, the hurdle for QE3 is high.  I think monetary policymakers would need to see clear evidence that the risks are turning back toward deflation. And unless growth is far weaker than expected, such evidence is unlikely to return until late this year or early next year.

Back to Basics

It is worthwhile to construct a simple framework to place into context the various Federal Reserve views on the state of the economy.  Via that framework, we can at least keep clear whose bread is buttered on which side.

Begin with a basic AS-AD model:

 I illustrated sort-run aggregate supply as kinked, with the horizontal portion reflecting sufficient excess capacity that prices hold constant across a range of output.  This is not strictly necessary for a simple framework, but reflects the general impression that the threat of deflation was quickly replaced with inflation concerns.  Also, I understand that a model in levels is not exactly ideal for considering inflation dynamics, but I also think we can see through to the general implications for inflation and policy.  Consider an increase in aggregate demand:

 

Whatever you think of the nature of the recovery, there appears to be general agreement that some recovery is in place, what the Fed describes as “firmer footing.”  The pace of job creation in the last six months appears consistent growth a little above trend.  I think we can consider this improvement as a general increase in aggregate demand.

Note what occurs once demand rises sufficiently to pull output past the “kink” in the short run aggregate supply curve – there is suddenly room for upward pressure on prices. This appears consistnet with the general shift in risk away from deflation toward inflation. The situation could be somewhat more complicated if supply issues, particularly for oil, are putting upward pressure on the long run aggregate supply curve at the same time, but for the reasons given below this also does not need to impact our long run inflation story. 

Importantly, we need to expect such pressure to continue as the price level rises until output reaches potential.  In short, the rising prices can coexist with large output gaps.  How does this translate into likely the likely path of inflation?  The way I think about it is that prices return to their prerecession trend:

 

This implies that reestablishing long-run equilibrium entails a period of relatively higher inflation.  And that inflation will create significant unease among a certain group of policymakers (and investors, for that matter).  Dallas Federal Reserve President Richard Fisher:

We know from anecdotal soundings that American businesses, like businesses in other countries, are doing their utmost to offset with higher prices the surging costs of inputs such as fuel, other commodities and materials, and components, parts and processes sourced from abroad. My gut tells me that this will result in some unpleasant general price inflation numbers in the next few reporting periods…

I am not sure that we can reestablish potential output without enduring this uncomfortable period.  Policymakers and investors need to look through this period to the other side; they need to be thinking about where inflation expectations will be once that equilibrium is reestablished.  Federal Reserve Governor Janet Yellen:

…in light of the experience of the 1970s, it is clear that we cannot be complacent about the stability of inflation expectations, and we must be prepared to take decisive action to keep these expectations stable. For example, if a continued run-up in commodity prices appeared to be sparking a wage-price spiral, then underlying inflation could begin trending upward at an unacceptable pace.

Note specifically the issue of a wage-price spiral.  Those who argue that the current dynamics will lead to only a temporary inflation increase believe slack labor markets greatly reduce the risk of wage gains – inflationary or not!  Without wage inflation playing a supporting role, it is difficult to see that any increase in inflationary expectations can be sustained.  Even inflation hawks seem to recognize this.  Back to Fisher:

Given that we still have significant excess capacity of unemployed workers, extremely subdued wage growth, strong productivity growth and weak domestic demand, one might reasonably posit that the general inflationary pressures we are experiencing presently are transitory…

What we should expect is that inflation accelerates for a period of time as the economy shifts back toward potential, at which time, assuming monetary policy is appropriately moderated in the background, we would expect inflation to decelerate back around the Fed’s target of around 2%.  Inflation followed by disinflation.

The next debate is the issue of how soon the Fed needs to act to ensure that policy is appropriately moderated.   Broadly speaking, there are two views on this point, and it basically comes down to an empirical question – has the rate of structural unemployment risen?   If not, we are far from potential output as there is plenty of involuntarily un- and underemployed labor to be reintegrated back into the economy, in which case we have little reason to expect that wage gains will accelerate rapidly and thus threaten a wage price-spiral.  But, as Yellen notes, we should be mindful of this issue, and be open to the possibility that structural unemployment has risen.

Indeed, perhaps the economy undergoes an alteration in the few years such that a significant portion of the population lack a required skill set.  Construction workers, for example, given that housing demand is likely to look different in the future.  A rise in structural unemployment can be graphically illustrated as a leftward shift of potential output:

 Under such conditions, the economy is closer than we imagine to potential output, and thus the risk of overshooting and triggering a wage-price spiral is quite high.  This seems to be what Fisher has in mind when he follows up the previous earlier quote with:

…Nonetheless, adding still more liquidity, or not withdrawing in a timely manner what we already provided in abundance, would do nothing to quell emerging inflationary pressures and might well compound them, proving doubly injurious to savers and the earnings of those who do have jobs...

and:

Now, we at the Fed are nearing a tipping point. Just as we pressed on in doing our duty through extraordinary, exigent measures, we must now discipline ourselves to just as persistently normalize our operations in a timely way.

Fisher appears to take a potential increase in structural unemployment as fact.  As Brad DeLong points out, Minneapolis Federal Reserve President Narayan Kocherlakota estimates that structural unemployment has risen as much as 3%, which would put the natural rate at 8%.  David Altig suggests an increase as much as 1.7%.   Again, this is an empirical question, and I would argue that rising joblessness across a broad range of sectors coupled with nonexistent wage pressures suggest that structural unemployment has not increased much at all, and even if it has, we still need to recognize the likelihood that a strengthening economy will increase labor force participation such that unemployment will cotinue to fall at a slow pace.  Moreover, this was the anecdotal story via the most recent 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...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.

I would also note this is the view of consumers themselves, from the Reuters/University of Michigan survey March press release:

Just one-in-four consumers expected their financial position to improve during the year ahead, returning to near the lowest level ever recorded of 20%. Scarce income gains as well as rising food and gas inflation were responsible for these dismal financial expectations. Only 38% of all households expected income increases in the year ahead, the smallest proportion ever recorded. Just 11% of all households expected inflation-adjusted income gains during the year ahead, barely above the all-time low of 8% in 1980.

Overall, incoming data appear consistent with a view that we are far from a point at which a wage-price spiral should be a concern.  If so, then tightening policy in response to either higher commodity prices and general economic improvement risks confusing a relative price change or an return to potential output as in and of themselves capable of triggering a wage-price spiral.  Instead, the economy would be then needlessly mired at suboptimal point, in which case disiniflationary expectations may once again assert themselves.  New York Federal Reserve President William Dudley reflects upon this issue and concludes:

“We’re probably going to have excess slack in the U.S. labor market at least through the end of 2012, and that’s one reason that colored my view that we shouldn’t be overly enthusiastic about tightening monetary policy too early,” Dudley told a forum in Tokyo today.

Interestingly, Fisher recognizes that the data gives no indication of an impending wage-price spiral, but that data apparently has no impact on his thought process.  He instead goes to the rest of the world:

There is the risk that we might breach our duty to hold inflation at bay. Inflationary impulses are gaining ground in the rest of the world. At the core of the euro zone, Germany, where unemployment is actually lower than before the crisis, wage inflation is pressing up against 3 percent. Retail price inflation in the United Kingdom now exceeds 5 percent, despite very high unemployment. Reported inflation now exceeds 4.5 percent in China, 6 percent in Brazil and 8 percent in India.

It is far from clear that Europe as a whole needs tighter policy (the opposite is more likely), so Fisher drills down to Germany, but doesn’t seem to recognize that the he undermines his own argument as unemployment is nowhere near the pre-crisis level in the US.  Moreover, notice his horror that wages in Germany may rise 3%.  3% - it is an apocalypse!  How much of this could be accounted for by productivity growth?  What is happening to unit labor costs?  Then he proceeds through a litany of inflation rates in the rest of the world as if these should be meaningful to US policy. I guess he needs them to be relevant since the US data to support his view is lacking.   It is this attitude that concerns me; that the actions of the past three years must lead to runaway inflation is taken as an article of faith by some, rather than a topic of serious research and analysis.

Bottom line:  We can track the path of the prices and output and explore the positions of Fed officials within a fairly simple framework.  That framework suggests that the economy will experience a temporary period of accelerating inflation as it returns to potential (we should be so lucky, quite frankly).  There doesn’t seem to be much debate at what speed this will occur; Fed officials appear comfortable with growth expectations around 3.7% this year.  What does seem to be an issue of debate is the size of the unemployment gap.  If we are close to the natural rate of output, excess monetary stimulus is close to triggering the fabled wage-price spiral.  If far away, there is plenty of excess capacity and thus no need to tighten quickly.  Indeed, tightening policy too soon would only entrench disinflationary expectations.  Fed officials appear to be splitting along these two basic views of the world, with one side seeing recent price increases as consistent with their inflationary nightmares.  I tend toward the other, which I also think will be the dominate view at the FOMC.  But keep an eye on the wage/compensation type data – the FOMC doves are doing the same.

Meltzer, Part II

David Altig gives Allan Meltzer a more charitable read than I did:

Generally speaking, the Meltzer strategy offers what I perceive to be two critical criteria for a viable exit plan. One is that the winding down of the mortgage-backed securities (MBS) and long-term Treasury securities on the Fed's balance sheet should be conducted in a way that avoids market disruption and distortion as much as possible. The second is, of course, that the excess reserves held in the banking system—the liability side of the Federal Reserve’s balance sheet—have to be removed or "locked up" as needed to avoid an inflationary expansion of broad money and credit.

I take Altig seriously, but believe he is giving Meltzer far too much credit. 

First off, there is nothing in the Meltzer plan that keeps the excess reserves “locked up.”  Instead, Meltzer claims that simply moving a portion of the assets and corresponding liabilities off the Fed’s balance sheet onto another bank’s balance sheet somehow magically changes the monetary situation.  From the Wall Street Journal:

The Fed's current operating balance sheet would be back to a more manageable range of about $1 trillion. This proposal removes some of the risk of inflation by removing some of the bank reserves that threaten to fuel it.

This seems pretty clear – Meltzer suggests that bank reserves that are not “officially” part of the balance sheet are no longer available to fuel inflationary pressures.  Why?  If we split the Fed in half, call one part the “official” Fed, and the other part the “bad” Fed, does the aggregate size of the balance sheet change?  Does the aggregate amount of excess reserves change?  I don’t see how. 

Altig, in the above quote, shows a preference for an orderly plan to wind down the balance sheet.  I agree, but think there needs to be flexibility to wind down quickly should the need arise.  Meltzer’s plan does not offer that flexibility:

The Fed would make a commitment not to sell any of the bad bank's mortgage-backed securities and Treasurys until they mature. Almost half of the Fed's currently held assets, more than $1 trillion, have 10 or more years until maturity, so all of them would be off the table as far as financing inflation during the gradual economic recovery.

Again, Meltzer implies that if he simply changes the location of the assets, that if they are not “official Fed assets,” they magical change from inflationary to inert.  Moreover, he ensures that the assets are not available for immediate sale should it become necessary, thereby depriving the Fed of one tool to rapidly drain reserves. 

What I suspect is that Meltzer does not trust the Fed to reduce the balance sheet and thus seeks to create a mechanism that forces it to do so.  He thinks this reduces the inflationary risk; I would say just the opposite.

Altig then nails down the fatal flaw of the Meltzer plan:

Which brings me to a point that I don't quite follow about the Meltzer plan: If reserve assets are removed from the banking system, what are the corresponding offsets on the balance sheets of private banks?

The potential problem is that the excess reserves held by private banks do not have to stay at the Federal Reserve – they are free to leave and becoming new lending.  Something needs to occur to draw them into the Fed, or any quasi-Fed bad bank.  If you want to take away one asset, cash, you need to give them another.  It is not an issue of Altig not being able to “follow the Meltzer plan.”  Again, he is giving Meltzer too much credit.  Meltzer simply does not address this issue.  In contrast, Altig does address this issue, and his post contains numerous example of mechanisms, either directly or indirectly through links, to draw excess reserves into the Fed.  For example:

My guess is you end up with something like term deposits or their economic equivalent—nonnegotiable sterilization bonds, for instance. And if you match the maturities of those deposits with the maturities of the MBS and long-term security portfolio, it becomes pretty clear that the debate is really less about tactics and more about some pretty familiar, but difficult, issues: When is it time to stand pat on policy, and when is it time to reverse course?

Exactly.  Meltzer offers nothing new, just another voice that saying the Fed needs to act sooner than later.  Otherwise, he is empty of new ideas.  The Federal Reserve staff have already devised a number of actual and potential tools to drain reserves, all of which can be done without creating a “bad” bank.  Meltzer offers up an accounting slight of hand that fails to address the key issue of what will prevent private banks from lending out the excess reserves rather than parking them at the Fed.  That hole – the crux of the issue – is filled by Altig. 

Misguided Meltzer

After scouring the Wall Street Journal for stories by competent journalists, I found myself in the op-ed section.  Apparently I feel compelled to make the same mistakes over and over.  In any event, I found Allan Meltzer’s latest inflation warning staring me in the face.  Most of the piece is not new territory, but it has an interesting twist at the end.

Meltzer begins with the same, tired lament:

Federal Reserve Chairman Ben Bernanke sees little risk of inflation because he doesn't look in the right places. Inflation is a general increase in prices, but increases always occur at different rates. Right now, labor costs are not rising but other costs, such as the prices of raw materials, have been and are continuing to increase. Businesses will pass some of these costs to their customers. Health-care costs also are continuing to rise.

Inflation is not a general increase in prices.  That is a one-time price increase, or a shift in relative prices.  Inflation is a continuous increase in the price level, which, to be perpetuated, needs to be matched by increasing wages – something Meltzer admits is not happening.  Without an increase in wages, the current gains in headline inflation will prove to be transitory.  Meltzer then brings up the boogieman of the 1970s:

Mr. Bernanke tells us that inflation won't be a problem as long as unemployment remains at an unacceptable level. But considerable research shows that this reasoning is badly flawed. During the inflation of the 1970s, for example, the discredited "Phillips Curve"—which suggested that high unemployment and rising prices shouldn't go together—persistently underestimated inflation and misled the Fed into pursuing an ever more expansive policy. If the Fed looked, it would find many other countries that experienced high inflation and high unemployment together.

Yes, inflation can coexist with high unemployment, but only in the presence of accelerating wage growth.  This combination existed in the 1970s, but not now.  Look at the historical record.  The path of unit labor cost growth prior to 1980 is very different from that experienced since 1980.  Until unit labor costs start accelerating, fears of a return to the 1970s are misplaced.  Next Meltzer tries to redefine the CPI:

Those who doubt that the United States is headed for inflation remind us that increases in the consumer price index (CPI), and the "core" CPI that omits food and energy prices, remain modest. But the CPI and the core CPI are currently misleading because 40% of the CPI and 25% of the core CPI represent housing prices and are heavily dependent on statistical estimates of what homeowners would pay to rent their homes. Most of us never see these prices and do not pay them the same way we pay for food, gasoline and health insurance.

First, Meltzer does not even understand when the data is actually poised to work in his favor.  Apartment vacancy rates are falling, suggesting that rents, and thus housing component of CPI, are set to rise.  Perhaps Meltzer would be happy to use the housing prices that people actually pay, but those are falling, which is not exactly consistent with his argument.  Notice also that Meltzer wants to narrow the CPI down to only those items going up in price.  Why not to those items going down in price?  He continues:

Furthermore, the Fed treats gasoline and oil price increases as a transitory blip. That's almost certainly correct about the effect of Arab unrest or the Japanese tsunami. But much of the rise in oil prices came before these events and was in response to the strengthening world economy. Prices will likely continue to rise as the world economy grows. Meanwhile, world grain prices have been driven up by the foolish U.S. ethanol program. When ethanol raises corn prices, prices for substitutes like wheat and rice rise also. There is no sign that Congress will repeal the ethanol program.

Meltzer conveniently ignores that rising commodity prices have simply reversed the losses sustained during the recession.  Apparently he would be happier if the Fed induced a recession to offset that terrible improvement in the global economy.  On top of which he wants the Fed to “fix” the relative price changes induced by Congress.  Good luck with that.

Then Meltzer finishes with a twist, his grand proposal to save us from inflation:

One of the Fed's recent errors was increasing the money supply by buying more than $1 trillion of mortgage-backed securities as part of its "quantitative easing" policy. Its hefty balance sheet now threatens to finance further inflationary increases in the money supply. How can it be unwound in an orderly way?

One idea is for the Fed to create its own version of a "bad bank." The Fed should promptly put the $180 billion of its long-term government debt and more than $1 trillion of its mortgage-backed securities into a separate entity. The long-term government debt and mortgage-backed securities would be the new bank's assets…

…The Fed would make a commitment not to sell any of the bad bank's mortgage-backed securities and Treasurys until they mature…

Yes, that’s right – Meltzer’s solution to the inflation threat is to tie the hands of the Federal Reserve so that they cannot liquidate the balance sheet if necessary.  More:

…Almost half of the Fed's currently held assets, more than $1 trillion, have 10 or more years until maturity, so all of them would be off the table as far as financing inflation during the gradual economic recovery. As the mortgages mature and are paid off, the bad bank's assets decline. The reduction in the bad bank's assets means that its liabilities, the excess reserves, would also decline—though that would be years away.

No, if the Fed cannot sell the assets, then they are not “off the table,” they are the centerpiece of the table.  If you are worried about inflation, you don’t want to entrench a system that ensures that excess reserves would decline “years away.”  You want the exact opposite – to drain the reserves right now.

Rather than admitting that the Fed has not induced a monetary collapse, that the world has not ended, that Treasury rates are mired below 4%, that he is simply wrong, Meltzer offers a completely backwards policy proposal.  A short step from there to complete irrelevance.

More Hawkish Rhetoric

And so it continues.  Via Jon Hilsenrath at the Wall Street Journal:

James Bullard, president of the Federal Reserve Bank of St. Louis, said he would push at the Fed’s upcoming two-day policy meeting (April 26 and April 27) to reduce the central bank’s quantitative easing program by $100 billion, but held out little hope of being successful.

“I don’t always get my way on the committee,” he noted in an interview with the Wall Street Journal. Most Fed officials want to carry the program through to its end in June. “Any changes that we’re going to make we’re going to have to make at this meeting,” he added.

Bullard’s position is not news.  At least he admits the Fed is not likely to follow his suggestion, so I give him credit for providing proper guidance.  Still, his logic is interesting:

Mr. Bullard was elaborating on comments he made last week about the Fed’s $600 billion program of U.S. Treasury securities purchases. When the Fed launched the program last November it had lower forecasts for growth and inflation, he said.

“We got a stronger economy and we got higher inflation and higher inflation expectations than we expected at the time,” he said. “The logical thing to do is to pull back.”

Bullard seems to be saying that we need to end the program early because it is working.  The majority of the majority will view it otherwise - don't mess with something that is working.  Consider also the Fed’s projections last November and at the end of January:

 

The longer run projections were virtually unchanged.  For 2011, the GDP forecast is about 0.4 percentage points higher than the November forecast – an improvement, to be sure, but nothing to write home about.  The high end of the core-PCE range was pulled down – in other words, the Fed was less confident on the inflation outlook in the immediate wake of QE2.  The unemployment rate is likely to come down sooner than anticipated – but this is arguably because of lack of re-entry to the labor force.  Labor force participation remains stubbornly low.

In essence, we can argue that we are moving a little faster toward the long run projections than prior to QE2.  Evidence that the program is working as intended, but not more so than intended. Bullard may be hinting that internal forecasts suggest dramatically better growth, but the Fed’s forecast was already better than private sector forecasts, and those will likely come down a tad with a weak first quarter.  Indeed, at best I see the path of data has the potential to generate the Fed’s forecast.  Still, I would add that the labor market is not yet signaling growth vastly above potential growth, which means the Fed’s forecast still imply more trend reversion than seems likely or than the private sector expects.

Regarding higher inflation, he could be referring to headline inflation, but that means he is confusing a relative price change with a general price change.  Monetary policymakers should not be confused about this distinction.

Moreover, I am not sure there is room to be unhappy with inflation expectations. They seem to have moved back to exactly where they should be:

 

You could point to surveys that signal rising near term inflation expectations among consumers, but ask them if they can get higher wages to compensate.  Wait, someone has.  From the Reuters/University of Michigan survey March press release:

Just one-in-four consumers expected their financial position to improve during the year ahead, returning to near the lowest level ever recorded of 20%. Scarce income gains as well as rising food and gas inflation were responsible for these dismal financial expectations. Only 38% of all households expected income increases in the year ahead, the smallest proportion ever recorded. Just 11% of all households expected inflation-adjusted income gains during the year ahead, barely above the all-time low of 8% in 1980.

If I remember correctly, the early 1980s ushered in a period of disinflation, not inflation.

Bullard explains further:

 “It is tumultuous times for monetary policy and that is why you’re hearing more from the Fed,” he said. “A tightening cycle is the hardest thing for a central bank to do. There is a lot of risk that you might fall behind the curve and wind up with a lot of inflation. On the other hand you hate to choke off a fledgling recovery. And so there is a lot of debate about it.”

He asserts there is a lot of risk of inflationary outcomes, but doesn’t explain why.  Most importantly, I would like him to explain why we should expect significant risk of falling behind the curve in an environment where wages gains are minimal at best.  Given that we need to get job growth up and unemployment down sufficiently to drive wage growth beyond what can be compensated by productivity, something of a lengthy process to say the least, it doesn’t seem likely the Fed will fall behind the curve anytime soon.

The interview concludes:

In the past, the Fed hasn’t explained itself well. “We’re trying to do a better job of communicating.”

I can’t resist:  They need to try harder. 

 

The Good, The Bad, and the Fed

The data flow can be characterized as generally good from a growth perspective and generally bad from a levels perspective.  Fed policymakers who focus on the former will tend toward removing policy accommodation sooner than later.  Those who focus on the latter tend toward the opposite.  I think the key decision makers, notably Federal Reserve Chairman Ben Bernanke, will be in the second group, leading the Fed to finish up with the current asset purchase program as scheduled before moving to the sidelines.

Start with the good.  The March employment report tells a story not unlike the February report, but without the ability to dismiss it as simply an artifact of weather related disruptions in January.  Private sector job growth continues to compensate for weakness on the government side, sustaining net overall job growth at a monthly average of 159k during the first quarter.  This was a tad better than the 139k average of the final quarter of last year and consistent with declining initial unemployment claims.  Overall, nonfarm payrolls data suggest the economy fell into a more sustainable growth path at the end of last year, near trend growth, perhaps a little above as the first quarter came to a close.

If we focus on the underlying trends, rather than getting bogged down in volatile month-to-month or quarter-to-quarter numbers, it looks as though the cyclical tide has turned.  The manufacturing surveys, including the most recent ISM report on manufacturing, remain well into solid territory.  It can be argued that the March dip in auto sales forewarns of the negative impact of higher energy prices, but also should be taken in context of a solid gain in February.  Also, note the rising confidence among CEO’s:

Optimism among U.S. chief executive officers surpassed the highest level reached before the recession as more business leaders projected increased sales, investment and hiring, a survey showed.

The Business Roundtable’s economic outlook index increased to 113 in the first quarter, the highest point since records began in 2002, from 101 in the previous three months, the Washington-based group said today. Readings greater than 50 coincide with an economic expansion. The previous peak was 104 in the first three months of 2005.

…Fifty-two percent of CEOs said they will add to payrolls, up from 45 percent in the fourth quarter and the largest share on record. Some 62 percent said they plan to spend more on equipment, up from 59 percent.

…The chief executives in the Business Roundtable survey forecast U.S. economic growth of 2.9 percent this year compared with the 2.5 percent projection in the previous survey.

All generally good news, and the growth forecast is consistent with trend growth.  Hold onto the number, though – we will need it later.

Finally, keep an eye on inventories –which were depleted at the beginning of this year:

If firms were experiencing a sharp drop in demand, and thus an increase in unexpected inventories, I find it challenging to believe they would continue to add workers in February and March.  Instead, firms are probably trying to make up lost inventory ground, which will support the sustainability of the recovery going forward. 

In sum, the economy looks to be on, as the Fed describes, “firmer footing.”  Definitely good.  But definitely not without warts.  Housing, for example – a market that just won’t heal in light of a very big structural change toward tighter underwriting conditions.  Yet the biggest wart is simply that the pace of growth appears to ensure the economy operates far below potential for far too long.  This is the “bad.”  As a consequence, unemployment is retreating slowly. Arguably, we wouldn't mind if unemployment increased a bit if growth was sufficiently strong to draw a mass of persons back into the labor force.  But labor force participation fell to 64.2 percent and held there for three months:

 

Likewise, the employment to population ratio shows no indication of rebounding to prerecession levels anytime soon.  At this rate of recovery, I am generally worried that the next decade will prove to be once again “jobless,” that nonfarm payrolls will once again remain stagnant by the time we are near the trough of the next recession.  Maybe this is what inevitably becomes of aging economies.

The palpable weakness of the labor market reveals itself in stagnant wage growth.  Average hourly earnings gained just a penny in February, and nothing in March.  Workers might be feeling the effect of headline inflation, but apparently have absolutely no power to respond with anything but belt tightening.  The lack of wage growth is simply the biggest hole in the inflation story, as it suggests that underlying inflation inertia is practically nonexistent.  That this is not obvious to all monetary policymakers is somewhat shocking.  spencer at Angry Bear puts it succinctly:

The combination of expanding hours and very weak wage gains generated an increase in average weekly earnings. But the year over year increase in average weekly earnings is only 2.87% this month versus 2.98% in February. With weekly earnings only growing at under a 3% rate it is hard to see how firms can pass higher commodity prices through to consumers.

The inflation hawks seem to be ignoring the point that higher prices or inflation is most likely to generate weak consumption, not sustained higher inflation. Managers and analysts appear to be far too optimistic about firms ability to raise prices.

spencer is referring to the contingent of Fed speakers who appear to be organizing in favor of an imminent tightening of policy.  This directly impacts expectations of market participants.  From the Wall Street Journal:

..Several officials, such as Mr. Kocherlakota, have given individual interviews to news organizations, adding up to hundreds of newswire headlines that have jarred some traders. Many of the most vocal—as is often the case—have been inflation hawks, who tend to favor higher interest rates to beat back rising consumer prices.

"People in the market have been getting freaked out," said Michael Feroli, chief U.S. economist with J.P. Morgan. "There is this view that Washington has sent out some memo to coordinate everyone to start talking hawkishly." He said he's skeptical of that view.

Feroli is right to be skeptical:

The Fed regional bank presidents generally speak for themselves, not the central bank as a whole, and typically don't coordinate their messages with each other or the Fed board in Washington.

Some Fed officials have been frustrated in recent years with a tendency of colleagues, often regional bank presidents, to stake out policy positions in public rather than within the closed-door Federal Open Market Committee, where the decisions are made.

It would not be a surprise if market participants were likewise rattled by the contents of the March 15 FOMC meeting minutes, to be released today, as the hawks may have been vocal at the meeting.  Still, the hawkish rhetoric will likely not yield much policy traction.  New York Fed President William Dudley, widely believed to be a key decision maker, sent a clear message about the direction of policy:

To sum up, economic conditions have improved in the past year. Yet, the recovery is still tenuous. And, we are still far from the mark with regard to the Fed's dual mandate. In particular, the unemployment rate is much too high.

Thinking ahead, unemployment may only be one hurdle.  When unemployment is on a solid downtrend, Fed officials may turn to labor costs before tightening the screws.

Another point – note that Fed’s GDP forecast for this year is 3.4 to 3.9%.  This is up to a full percentage point above that expected by CEOs (refer to above).  And, at the moment, I would argue the labor market data is consistent with sustained growth maybe a bit above the potential growth range of 2.5 to 2.8%.  Thus, growth looks to be falling short of the Fed’s forecasts, arguing for sustained policy accommodation.

Finally, we need to consider the likely position of Federal Reserve Chairman Ben Bernanke.  It is difficult to believe that an academic so knowledgeable about the history of the Great Depression would be eager to repeat the mistakes of 1937.  Nor would he be likely to confuse a change in relative prices with an outbreak of accelerating inflation.  Nor would he fail to recognize the importance of wages in setting in motion accelerating inflation.  Nor would he ignore the depth of the labor market hole.  And, I would hope, that he is already beginning to see the possibility of another jobless decade unless we can quickly and definitively surpass the previous employment peak (never too early to think about the outcome of the next recession, even while riding the current wave upward).  All of which suggests he will not be leading the charge toward tightening anytime soon.

Bottom Line: Monetary tightening will come.  At least, we all hope it will.  I shudder at the prospect of being stuck here for another three years.  But I think it premature to expect that tightening anytime soon.  The core of the Fed will keep focused on the pace of growth relative to the depth of the recovery.  The current recovery may be sustainable, but continues to fall short of that necessary to propel output and employment to prerecession trends.  And clearly short of that necessary to induce more rapid wage gains.  The data simply are not there to justify a monetary policy shift at this juncture.