Tim Duy's Fed Watch

I Don't See How This Can Continue

The European unemployment numbers are out.  The story from the Financial Times:

Unemployment in the 17 euro countries climbed to 10.4 per cent in December, with the November rate revised upwards to the same rate, setting a fresh record since the introduction of the single currency in 1999. So-called “peripheral” members such as Spain and Greece recorded the highest rates, of 22.9 per cent and 19.2 per cent respectively.

By contrast, national data from Germany, the eurozone’s bulwark, showed joblessness declined in January to 6.7 per cent, the lowest level since reunification in 1991.

And a picture is worth a thousand words:

Perhaps France and Italy can hang on while relative wage deflation increases competitiveness with Germany, but conditions in the periphery look downright dire.  And note that years of austerity have done little to help Greece and Ireland.  I don't see the same medicine working in Spain or Portugal either.  It is no wonder that Greece is looking for very substantial reductions in its debt, and it seems inevitable that Portugal will come to the same conclusion sooner or later.  The great disparity in unemployment rates is another factor that leaves me pessimistic on the ultimate outcome of the Euro experiment.  We need real fiscal transfers, and soon.  More carrot with stick.

For now, however, market participants are focused on the salutary effects of the ECB's LRTO (not to mention expectations for another round of QE from the Fed).  Have these efforts eased conditions enough to allow for a Portuguese restructuring or even Greece's exit from the Euro?  Or have market participants and European policymakers been drawn into a dangerous path of complacency?  Thinking aloud, do current market conditions embolden German politicians to think they can finally cut Greece loose with little or no consequences to the rest of Europe?  Would this indeed be the case?  I have trouble believing in the "orderly exit" story, but perhaps the can has been kicked far enough down the road that it can happen.

Europe Needs a Real Fiscal Union

The rhetoric is heating up as we head into Monday's European Union's summit.  On one hand, we see rumors circulating that a deal in the Greek debt talks is in the works.  Via the Wall Street Journal:

But in Athens, the mood Saturday was upbeat. "We really are one step away from a final agreement [on the debt deal]," Finance Minister Evangelos Venizelos told reporters following a day of hectic talks in the Greek capital. "Next week we will be in a position to complete this procedure along with the talks we are holding on the new loan program."

Note, however, that these negotiations are just one piece of the puzzle.  Via the New York Times:

Though a debt agreement may spur Greece’s next bailout installment, the deeper loss being inflicted on bondholders carries the risk that many investors, in particular hedge funds that in recent months have loaded up on cheap Greek bonds in hopes of a payday this March, will refuse to participate in the deal.

Greece will try to impose the terms on all investors by writing collective-action clauses into the contracts of its old bonds. By doing this, the hope is that the holdouts, estimated to sit on 10 percent to 15 percent of the 206 billion euros ($272 billion) in outstanding securities, will exchange their old bonds for new bonds — preferring the new discounted bonds to their old ones, which may become worthless.

Some hedge funds that have bought at rock-bottom prices may decide to pursue legal action, although such a process could take years with small certainty of success.

Also undecided is what the European Central Bank, which owns 55 billion euros of Greek bonds, will do. Despite public pressure that it, along with investors, accept a loss on its bonds, the bank has not budged.

It seems to me more accurate to state that one portion of the debt deal may be in place, but in the interest of unity on the eve of the EU summit, we will pretend that the issues of holdouts and the ECB are not relevant.  In any event, given the steady deterioration of the Greek economy, I find it unlikely that this is the last word in the debt story.

More interesting, however, is German demands that Greece cede its budgetary authority to the Troika.  Athens of course was a bit perturbed by the escalation of demands.  Via the Financial Times:

The Greek finance minister has lashed out against a German proposal for its budget to be controlled by a eurozone commissioner as a condition for receiving a second €130bn bail-out, saying the country was already prepared to “implement tough but necessary decisions”...

...The German plan, widely circulated in Athens and dubbed “the document of shame” by a local newspaper, would require Greece to pass legislation making debt repayments a budget priority, and would also give the new commissioner a veto over large-scale spending.

Perhaps the Greeks are not moving ahead swiftly enough with reforms, but consider that they are stuck between a rock and a hard place - anything positive in the long-run looks to be devastating in the short run.  For example:

One main sticking point has been demands by EU and International Monetary Fund negotiators for a 25 per cent cut in the €750 minimum monthly wage and the abolition of an annual bonus paid as 13th and 14th salaries – measures that would improve competitiveness and bring Greece in line with minimum wages in Spain and Portugal.

George Koutromanis, labour minister, argued that the measure would reduce output by about 1.5 percentage points of gross domestic product and prolong the country’s recession, now in its fifth year.

Greece needs more carrots to move forward; Germany offers only the stick.  Speaking of which, Germany subsequently responded to Athens indignation.  Via the Wall Street Journal:

Germany's finance minister issued an unusually blunt warning that the euro zone might refuse to grant Greece a fresh bailout, pushing Athens into default unless it persuades Europe it can overhaul its state and economy...

...Europe is "prepared to support Greece" with the new loan package, Mr. Schäuble said, but he warned: "Unless Greece implements the necessary decisions and doesn't just announce them ... there's no amount of money that can solve the problem."

The options for Greece are narrowing quickly - either willingly accept German rule, or exit the Euro.  And perhaps plans for the latter are already well established.  Via The Examiner (hat tip Ed Harrison):

Greece plans an orderly exit out of the Eurozone according to two sources close to Mr. Papademos, Greek Prime Minister, who spoke on condition of anonymity earlier today.

The sources confirmed that plans are ready to return to a legacy currency given the current circumstances and that such exit would be dealt with, quote “in as orderly a fashion as possible” unquote.

I am starting to wonder if Greece is going through the motions to get one more tranche of aid before they come to the conclusion that they must exit the Eurozone.  Absent real transfers from Germany, staying in the Eurozone now means crushing recession under German rule.  Exiting just means crushing recession.  Germany, however, is playing a dangerous game testing Greek nationalism.  Either outcome is bad for Greece, but I suspect pushing Greece out of the Euro is ultimately bad for Germany as well.

Meanwhile, other nations need to pay attention to how this all plays out, because austerity is just not working anywhere.  Take Spain for example, where unemployment is at a depression-like level of 23%.  A clear symbol of the failure of European economic policy, to be sure.  Spain gets a pass, however, as for now it is playing the German game.  Via the Wall Street Journal:

In an interview this week with Spain's El Pais newspaper, German Chancellor Angela Merkel noted Spain's high unemployment rate, and said her country was willing to help the region's fiscally frail countries, but that they must take steps to solve their own problems.

Soraya Sáenz de Santamaría, spokeswoman for Spain's new government, repeated that a sweeping overhaul of Spanish labor laws is coming in weeks. "To all those millions of people who are looking for a job, I want to tell them...we are speeding up the reforms that are necessary to turn this situation around," she told journalists after the weekly cabinet meeting.

The story is that high dismissal costs deter hiring.  To be sure, a real issue.  I would note, however, that this did not seem to be a problem a few years back when the construction boom fostered unemployment rates below 10%.  While structural reforms are important, so to is demand.  And where will that demand come from in the short run?  

Even more pressing is the issue of Portugal, which will almost certainly need another bailout.  Moreover, the 15.2% rate of 10 year debt calls into question the EU claim that the Greek PSI was an isolated event.  Via Business Insider:

While on some level it is crucial for the country to sustain the idea that it is meeting its debt obligations until it has more aid in the bag, the truth might be that the gig is up; it's just unlikely that Portugal will continue to meet its debt and deficit goals amid mounting pressures, even if it complies with the troika plan.

This is much the same psychological development that took place in Greece last summer, as EU politicians realized that a managed default might be the best way to return Greek debt levels to sustainability.

Note that swift passage of an even watered-down commitment to EU-wide fiscal austerity may not be as easy as it sounds.  Perhaps the Irish are no longer willing to suffer in silence, via the Financial Times:

The Irish government faces intense pressure to hold a referendum on the eurozone fiscal treaty after a poll that showed almost three quarters of the public want a vote on the agreement.

Months of uncertainty lie ahead.  That said, perhaps their is some hope that Europe leaders will actually move where they need to go - true fiscal union.  On the eve of the summit, we learned that EU leaders are starting to see the writing on the wall.  Via the New York Times:

Bowing to mounting evidence that  austerity alone cannot solve the debt crisis, European leaders are expected to conclude  this week that what the debt-laden, sclerotic countries of the Continent need are a dose of economic growth.

A draft of the European Union summit meeting communiqué calls for ‘‘growth-friendly consolidation and job-friendly growth,’’ an indication that European leaders  have come to realize that austerity measures, like those being put in countries like Greece and Italy,  risk stoking a recession and plunging fragile economies into a  downward spiral.

But the devil is in the details:

The difficulty, however, is that reaching such a conclusion is not the same as making it happen.

Instead, leaders will discuss long-term structural reforms and better use of E.U. subsidies, while avoiding mention of the one thing that could change the climate: a fiscal stimulus from Germany, the euro currency zone’s undisputed powerhouse.

Easy to say, tough to do given Europe's political makeup.  At what point will Germany be willing to justify fiscal transfers to the rest of Europe.  For now, the EU appears able to come up with little more than token sums of cash to support growth.  According to Reuters:

The summit is expected to announce that up to 20 billion euros ($26.4 billion) of unused funds from the EU's 2007-2013 budget will be redirected toward job creation, especially among the young, and will commit to freeing up bank lending to small- and medium-sized companies.

A paltry sum when placed in context of 23 million unemployed in Europe. 

Bottom Line:  The European Central Bank's LTRO dramatically eased financial market tensions throughout Europe, revealing the important role of a lender of last resort.  But underneath those tensions exist some very real and deep economic and political fractures in the European economy.  And unless those fractures are quickly healed via a real fiscal union - not just an agreement to balance budgets, but a union in which rich countries transfer, not lend, resources to poor - the Euro experiment will be torn asunder.

ZIRP and Interest Income

Edward Harrison at Credit Writedowns describes the Fed's zero interest rate policy as "toxic," noting that it is a transfer from savers and fixed-income investors to borrowers.  On net, this is stimulative if the spending propensities of the latter exceeds that of the former, but the willingness of the borrowers to spend is constrained by weak household balance sheets.  The Fed is thus pushing on a string, and possibly even making matters worse by reducing the income flow to households.  Harrison points to the following chart to illustrate the severity of the problem:

If the Obama Administration takes advantage of low interest rates and is able to push forward with refinancing efforts for underwater borrowers, then we can expect an at least temporary economic boost of potentially substantial magnitude.  See Joe Gagnon for estimates.  I would expect more modest outcomes, as the Administration has proved itself capable of half-hearted efforts in the past.  Anything, however, would be helpful at this point.

My question is how much of the zero interest rate environment is attributable to Fed policy directly?  Or, in other words, is the Fed really just following the economy down?  It seems that the banking system is awash with cash - note the trend of total checkable deposits:

Considering the lack of take-up on the other side of the savings/borrowing equation, I have trouble seeing that interest rates would go to anywhere but down to rock bottom levels.  And I certainly have trouble seeing that the Fed would improve conditions by raising interest rates.  

That said, I fully agree with Harrison when he predicts:

But remember, households are still over-levered and interest rates cannot be stimulative since they are zero percent. When the next recession hits and the yield curve is still flat as a pancake, bad things are going to happen. That’s why I have to remind you how toxic this policy is.

We have witnessed lower interest rates with each recession since the mid-1980's, which begs the question of what happens when the next recession hits and the economy is still locked on the zero bound.  Bad things, I think.  From this I conclude that the Federal Reserve is clearly not taking the zero bound seriously enough.  This is even more evident when one recognizes the central tendency for the Fed Funds rate forecast over the longer term is 4.0 to 4.5%, while six FOMC participants see the rate unchanged through 2014!  Seems like a serious disconnect between where the economy is and where it should be.  It is simply tough to disagree with Brad DeLong, who, upon reading Jim Hamilton, concludes the Federal Reserve is just plain wrong in its implementation of policy.

Maybe the next round of QE will do the trick, but I remain skeptical.  Policy has consistently fallen short of that necessary to decisively propel the economy off the zero bound.  Such policies have, in my opinion, fallen victim to fears of inflation.  The Federal Reserve appears committed to a 2% target under any circumstances, with even a temporary increase considered unacceptable.  

In short, I see the Fed's policy as toxic not so much because interest rates are locked at the zero bound, but because the Fed sees no urgency in rectifying the situation.  I think this will be proven to be a serious policy failure when the next recession arrives, and I wish the Fed would make a clear objective to lift the economy off the zero bound, rather than issue a forecast that, when coupled with lack of immediate policy action, represents acceptance of the zero bound.  As far as what the Fed can do to accomplish such an objective, in addition to loosening the inflation target, I tend to think they need to shift their policy framework to regular, permament additions to the balance sheet until the economy is well beyond the zero bound rather than emphasize the temporary nature of the entire monetary policy agenda.

Notes on the Fed Meeting

Just a quick note today – I am swamped with classes and travel this week, and sadly cannot really do justice to the wealth of information provided today by the Fed.

The basics are well known at this point.  The Fed extended its expectation for low rate out through the end of 2014, with the new hawk on the FOMC, Richmond Fed President Jeffrey Lacker, dissenting.  The growth and inflation forecasts for 2012 were downgraded, while the unemployment forecast was upgraded slightly.   Individual forecasts of the path of the Federal Funds rate were revealed, with six participants anticipating interest rate hikes in 2012 or 2013, in contrast to the broader expectation for low rates through 2014.  The Fed now has an explicit inflation target of 2%.  No new QE at this time.

Some initial thoughts: 

First, the forecast for unemployment and inflation, combined with the restatement of the dual mandate with an explicit inflation target, scream for additional QE at this time.  This is especially so when you realize the range of 2014 inflation forecasts remains centered on something south of the 2% target.   Simply put, the Fed is clearly falling short of both mandates at this point.  We need to be patient for the minutes where we can expect to learn more about QE options, and I agree with Calculated Risk that the Chairman paved the way for additional QE, assuming of course that the economy does not show immediate signs of improvement.  Still, the delay is frustrating given the forecasts.  That said, I think in the last minutes it was clear the Fed was moving in stages, and the communication stage is now complete.  Now we can focus on the next round of QE.  In addition, most participants would not see a need for immediate action given the improvement in the data flow combined with still stable inflation expectations.

Second, the unemployment forecast appears vulnerable given how quickly the rate decreased in recent months.  If the rate of job growth necessary to keep with labor force growth is significantly less than the 125k-150k estimates often used, then I would expect even tepid growth would send the unemployment rate lower than the Fed’s forecast.   The Fed is likely expecting a rebound in the labor force participation rates, but is that likely given the tepid growth forecasts?  And how much of a decline of unemployment over the next month or two would prompt Bernanke to put a hold on QE3?

 Third, I don’t read too much into the divide between the hawks and the doves regarding the timing of a rate increase.  That timing is based on each participant’s individual forecasts, with the hawks likely having somewhat more optimistic forecasts for growth and employment compared to the doves.  If forecasts disappoint, then the hawks will not be in a position to push for a more aggressive path of tightening.  Likewise, the doves will modify their position relative to how their forecasts evolve.  Which is why I am looking at that unemployment rate forecast – it seems the most vulnerable. 

Bottom Line:  The Fed is poised for additional easing, but the next round of QE is not quite a certainty yet.  But I think we would need to see some significant upside surprises in the data in the near term to put plans for additional easing on hold.  Watch the unemployment rate.  We are already at 8.5%, the upper end of the Fed’s forecast.  The lower end is just 8.2% - not far away, and something that is plausible at early as next week.  The Fed’s forecast just doesn’t feel right given the 0.6 percentage point decline over the past four months. 

Japan, Revisted

I haven't had a chance to comment on the recent debate regarding Japan's lost decades, so I am coming to the party a bit late.   A view is forming that the situation is not as dire as many believe.  Paul Krugman notes:

This picture suggests that the Japanese economy was indeed depressed for about 16 years, and deeply so after the slump of the late 1990s. But it may have returned to more or less potential output on the eve of the current crisis.

Just to be clear, this is not a picture of policy success; it is, in fact, a picture of enormous waste. But the condition wasn’t permanent.

Yes, the lost years surely indicate a policy failure. But arguably there is some success.  On one hand, we can see this as vindication of massive deficit spending.  But is this really success?  Because on the other hand, there is no end in sight of such deficit spending.  On Japan's 2012 budget, via the FT:

Even by current grim international fiscal standards, Japan’s budget for the year from April 1 makes scary reading.

For the fourth year in a row, government revenue from bond issuance is set to exceed that from all taxes. Outstanding government debt is expected to hit an extraordinary Y937tn.

I don't intend to go down the "Japan's bond market is about to collapse" path.   But what I am wondering about is Krugman's description of the condition as not permanent. Do we need to see a reversal of debt to GDP ratios to declare victory?  Well, even on that metric it looks like there was some hope heading into the recent downturn:

But such hopes have since been dashed.  

Where does this leave me?  Yes, fiscal policy can work - it can back fill missing demand.  But we haven't seen enough activity in Japan to really jump start the economy to a point that fiscal policy is no longer an economic necessity.  And I am not sure we can expect such a jump start without more explicit help from the central bank.  In which case, Japan has not truly "recovered."  Thus, we cannot yet conclude their condition is not permanent.

In short, before we can declare recovery in Japan, we need to define what a successful recovery should look like. Is it just about returning to potential output (adjusted, in this case, for demographics), or should it be recovery to the point that deficit spending is no longer necessary to support that output?

Is Europe About to Unravel?

Even the illusion of political unity in Europe appears to be dissolving before our eyes.  This, of course, should come as no surprise to anyone watching the European crisis unfold.  The key problem always was the internal imbalances, a problem for which European policymakers have never offered a credible solution.  They simply don't have such a solution in the context of a system of fixed exchange rates.  I believe that currency devaluation is the only option that will change relative competitiveness in any reasonable timeframe and restore internal balance. But that option is unavailable for Euro members. 

Lacking currency devaluation as a tool to resolve imbalances, European policymakers turned to fiscal austerity.  That plan has failed, pushing nation after nation into ever deepening recession.  With Greece going on its fifth year of recession, I imagine by now that Portugal, Spain, and even Italy now see the writing on the wall for themselves.  Sadly, however, the alternative is exiting the Euro, which almost certainly means financial chaos for the Continent as a whole.  

The Eurozone is like a roach motel.  You can get in, but you can't get out.

Still, peripheral nations can only accept so much pain before the costs of being in the Euro outweigh the costs of leaving.  And Italy is now sending Berlin a clear warning that such an endgame is approaching.  Via the Financial Times:

Italy’s prime minister has pleaded for Germany and other creditor countries to do more to help lower his country’s borrowing costs, warning there would be a “powerful backlash” among voters in the eurozone’s struggling periphery if they did not...

..Rome would push the German government to realise it was in “its own enlightened self-interest” to lend more of its fiscal weight to lowering borrowing costs of Italy and other highly indebted governments. The single currency had brought “huge benefits …and maybe [to] Germany even more than others,” he said....

...The stance could put Mr Monti, whose appointment to replace Silvio Berlusconi was cheered by German chancellor Angela Merkel, on a collision course with Berlin. 

What can Germany do?  Germany could do lots of things to help - running a massive budget deficit to drive consumption and inflation higher comes to mind.  Monti, however, is looking for something a little more reasonable, real help on interest rates via Eurobonds and a German commitment to a larger rescue fund.  Arguably small concessions given the magnitude of the problem, but Germany resists.  He also holds out hope for additional ECB aid:

But he said he believed the ECB should feel more secure to move once a new fiscal discipline treaty is agreed at an Brussels summit at the end of the month. 

Perhaps he hopes for too much:  A deep rift between politicians and the ECB looks to be growing.  A stunning development, again via the Financial Times:

The European Central Bank has harshly criticised negotiators working on a new treaty to enshrine fiscal discipline in the eurozone, saying that recent revisions to the draft amounted to “a substantial watering down” of the pact’s strictures intended to force down debt levels within the single currency.

Jörg Asmussen, a member of the ECB’s executive board, wrote to negotiators that new provisions in the treaty that would allow highly indebted eurozone countries to breach budget deficit limits “in periods of severe economic downturn” amounted to an “escape clause” that could lead to “easy circumvention of the rule”.

“These revisions in my view clearly run against the spirit of the initial general agreement on an ambitious fiscal compact,” Mr Asmussen wrote in a letter on the ECB’s behalf, dated Thursday.

The original compact would of course be watered down - it was never credible to begin with, as it called for a level of fiscal austerity across the Eurozone compatible only with Depression.  The ECB is looking for just such an outcome:

In proposed treaty language accompanying the letter, Mr Asmussen suggested that eurozone countries should only be allowed to breach the deficit limit – which is defined in the text as 0.5 per cent of economic output – in times of “natural catastrophes and serious emergency situations outside the control” of eurozone governments.

How far with the ECB push the issue?  Will they back away from further bond purchases?  Edward Harrison and Martin Feldstein have more here and here.  I would add that it pays to remember the ECB plays for keeps, and is not above outright extortion to get what it wants.  

Meanwhile, via Naked Capitalism, Wolf Richter informs us of another rift growing in the Eurozone rescue efforts, this time in the disaster that is Greece:

But now the Troika itself is in disarray. It surfaced today at an IMF press briefing in Washington: the IMF no longer supports austerity as a guiding principle. Athens News quoted a senior IMF source, who was speaking on condition of anonymity. Frustration was practically palpable:

Horizontal austerity measures are constantly being adopted that are leading nowhere, whilst further wage and pension cuts are unjustified because the only way to improve competitiveness is through growth-creating market liberalization, the opening of closed professions, and productive investments.

The three Troika inspectors—Poul Thomsen from the IMF, Mathias Morse from the EU, and Klaus Mazouch from the ECB—are supposed to head to Greece next week to inspect its books; the budget deficit is once again higher than the revised limit that Greece had vowed to abide by. And they’re supposed to negotiate additional “structural reforms.” But there probably won’t be three inspectors, according to senior IMF sources. Missing: Poul Thomsen. The IMF has had enough.

Finally, note that last week's S&P downgrade came down especially hard on Portugal.  That bailout is headed toward another round of private sector involvement.  Only a matter of time.  

Bottom Line:  In Europe, the unstoppable force of austerity is colliding with the immovable object that is reality.  Expect fireworks.

How's That Austerity Working?

From a Wall Street Journal article on the collapse of the Greek debt talks:

The negotiations have been tortuous. After first insisting no default by any euro-zone country would be possible, leaders agreed in July to seek a deal to cut about 10% from the face value of Greece's bonds in private hands. By October, Greece's prospects had deteriorated, and euro-zone governments and the IIF agreed to pursue a deal to cut the face value in half. Since October, Greece's economy, which is entering its fifth year of recession, has weakened further, worsening the state of its government finances. That means a bigger gap in Greece's budget that must be filled either by more debt relief or more new lending from official creditors.

How can this downward spiral end with anything other than a technical default?  It can't, which is why the debt talks collapsed.  The cuts necessary to bring Greek debt down to anything even remotely sustainable is much greater than the supposed 50% haircut agreed to last October.  And that 50% headline number is now a source of heartburn for European politicians.  Via the FT:

Charles Dallara, the IIF’s managing director, told the Financial Times on Sunday that he believed an agreement in principle needed to be completed by the end of this week if the restructuring deal was to be finalised in time for a €14.4bn Greek bond redemption due on March 20.

Though he said Greek officials were negotiating in good faith, he was critical of other eurozone negotiators, saying they were not living up to the outlines of the haircut deal reached at a tense October EU summit. “[Ms Merkel and Mr Sarkozy] and all the European heads of state said they wanted a deal with a 50 per cent [haircut] and a voluntary agreement,” Mr Dallara said. “Some of their own collaborators are not following that decision.”...

...Greek debt managers had agreed with bondholders on a coupon just below 5 per cent but creditors last week proposed a much lower interest rate.

Germany has proposed a 2-3 per cent coupon that would increase bondholders’ losses from 60 per cent to more than 80 per cent in net present value terms.

It looks like Merkel and Sarkozy are trying to pull the old bait and switch on creditors.  The difference between a 60% and an 80% cut is meaningful, and sufficient to drive some debtholders, such as hedge funds that picked the stuff up on the cheap, to think they are better off to take the chance on their CDS counterparties rather than submit to a "voluntary" restructuring of the magnitude necessary to bring real relief to Greece's fiscal situation.

One has to say this about European policymakers - they sure keep it interesting.  

Meanwhile, German Chancellor Angela Merkel appears to have learned nothing from the ongoing debt-deflation dynamics throughout much of Europe.  Responding to the S&P downgrades, via the FT:  

Ms Merkel said the downgrade made implementation of steps towards fiscal union – to be codified in an inter-governmental treaty which could be signed by the end of January – urgent. She called on leaders to resist softening up the so-called fiscal compact “here, there and everywhere” as details were hammered out.

Even after German GDP turned negative in the final quarter of last year, Merkel can find no other option than fiscal austerity.  Perhaps some hope from France:

François Fillon, prime minister, at the weekend ruled out more austerity measures, saying the government’s efforts were aimed at boosting growth.

Then perhaps, maybe not:

But he also said in an interview with Journal du Dimanche, a Sunday newspaper: “We will do everything to get it [the triple A] back.” 

Does France have any choice but additional austerity?  What would happen politically if the core refused to embrace what it pushed upon the periphery?  Spain appears ready to double-down on the austerity path, even as a slowing economy pushes the budget deficit over 8% of GDP:

Mariano Rajoy, the centre-right prime minister who took power in Spain last month, has responded to Friday’s credit downgrade from Standard & Poor’s by saying that his government will persevere with austerity and economic reforms, cutting the budget deficit, modernising labour laws and restructuring the banking sector.

Good luck with that - it has worked so well in Greece.

Bottom Line:  The actions of the European Central Bank greatly eased the immediate financial pressures in the Eurozone.  But the underlying problem of internal imbalances remain, and the European response is still  not addressing those imbalances.  Instead, the commitment to the fixed exchange rate combined with Germany's failure to recognize that their current account surplus must turn to deficit if they ever hope to be repaid promises to lock the Eurozone on the path of ongoing recession.

Output Gaps and Inflation

Regarding, again, the size of the output gap, this remark is found in the most recent Fed minutes:

However, a couple of participants noted that the rate of inflation over the past year had not fallen as much as would be expected if the gap in resource utilization were large, suggesting that the level of potential output was lower than some current estimates.

I think this has less to do with the size of the output gap and more to do with downward nominal wage rigidities.  Note that wages are still rising, although the pace of wage growth for production and nonsupervisory workers is still falling: 

Perhaps a better example is the relatively new series, wages for all workers: 

Overall private wage growth bottomed out in 2009 and held around 1.75%, perhaps just beginning to rise in recent months.  

Despite very high unemployment and underemployment, wage growth is still positive.  It tends to be very difficult to induce workers to take wages cuts (think also how the newly unemployed will resist taking new jobs with a substantially lower pay), which in-turn helps put a downside to inflation.  In other words, one would expect the relationship between the output gap (or, similarly, high unemployment) and inflation to flatten as inflation rates fall toward zero.  

This is also covered by Paul Krugman here and here.

Also note that rising wages doesn't necessarily imply higher inflation.  Between the two is productivity growth.  To account for the latter, we can look at unit labor costs: 

Not exactly a lot of inflationary pressures stemming from unit labor cost growth.  Presumably, high real wages could come by redistributing productivity gains to workers in the context of low inflation.  For that to happen, however, I think we will need a lot more upward pressure on the labor market than we are seeing right now.

 

More on the Output Gap

Only time for a quick post between classes today...

Hoisted from the comments from my last piece, Steve notes:

In an interview with Bloomberg last week, Bullard explicitly said he expected the economy to follow a new output trend out of the base of the recession rather than a recovery to a trend from the previous peak. The written media didn't pick up on these quotes; rather they focused his comments that explicit inflation targeting is near.

I missed that interview, but found it here.  And yes, St. Louis Federal Reserve President James Bullard does say that estimates of the output gap are too high and will be revised downward. He says the outcomes of the last expansion were not related to economic fundamentals and thus we should not expect to be able to return to those levels of output and, presumably, employment.  He does not aim to return to the pre-recession trend of output growth and is instead ready to manage the economy along the new path.  Bullard does admit, however, that he has gotten little traction for his view.

On the other end of the spectrum, San Fransisco Federal Reserve President John Williams offers an interview to the Wall Street Journal, and sounds dovish even after the most recent employment report:

 In a follow-up email exchange, Mr. Williams wrote that the report didn't fundamentally alter his views on the economy.

"My view of it is inflation is going to be for a sustained period below target," he said. "Unemployment is going to be sustained above a reasonable estimate of the natural rate of unemployment, which is closer to 6.5% than the 8.5% that we have now. That does make an argument that we should have more stimulus."

There is a caveat, however:

Mr. Williams also hedges, though, adding that it "really depends in how much confidence you have in that forecast. And also there are costs to taking greater policy action. There are always trade-offs that have to be weighed."

This is frustrating, because if there is indeed an argument further stimulus, what is holding the Fed back?  Why hedge by questioning the forecast?  And what are the costs?  Presumably the cost is higher inflation, but Williams already says he expects inflation to be below target.  So why pull your punches?

I am starting to wonder if the whole "we can do more" meme from the dovish side of the FOMC has more to do with just offering a counterweight to the hawks who seem to see an imminent need for tightening rather than a push for an actual policy change.  

QE3 or Not?

Last week - before the most recent employment report - the Wall Street Journal offered up the odds of another round of quantitative easing:

“Primary dealers,” those 21 lucky banks that answered the Old Bridge Troll’s questions correctly and were granted the right to do business directly with the Fed, see QE3 coming and don’t see the Fed raising rates for at least two years.

That’s according to the results of a new survey of primary dealers by the New York Fed.

Primary dealers, on average, assign a 45% chance of a Fed interest-rate increase in the second quarter of 2014. Before that, the chances of a rate increase are never higher than 15%.

High expectations are not a surprise given the propensity of some officials to make remarks like these from New York Federal Reserve President William Dudley:

However, because the outlook for unemployment is unacceptably high relative to our dual mandate and the outlook for inflation is moderate, I believe it is also appropriate to continue to evaluate whether we could provide additional accommodation in a manner that produces more benefits than costs, regardless of whether action in housing is undertaken or not.

It's no secret some Fed officials have been looking into additional purchases of mortgage-backed assets to support the economy via the housing market.  And once they started talking about it, market participants began to assume it was imminent.  Moreover, the idea of additional easing popped up in the most recent minutes:

A number of members indicated that current and prospective economic conditions could well warrant additional policy accommodation, but they believed that any additional actions would be more effective if accompanied by enhanced communication about the Committee's longer-run economic goals and policy framework.

So now we have a timeline - first, enhanced communication.  Second, additional easing.  Seems straight forward, especially now that inflation looks to be trending downward, alleviating the panic that appeared to seize FOMC members in the first part of 2011.

But after the first part of 2011 comes a string of relatively solid data, at least as solid as one gets in this recovery.  That data culminates with the decidedly not-terrible employment report.  How long could it be before monetary policymakers started to question the need for additional easing?

Just a single day.  On Saturday, St. Louis Federal Reserve President started to toss cold water on the idea of additional easing.  Via MarketWatch:

 “I don’t think it [QE] is very likely right now because the tone of the data has been very strong right now,” Bullard told reporters after a speech at the American Economic Association meeting....

...Bullard said he was encouraged by the December employment report that showed a drop in the unemployment rate to near a three-year low of 8.5%.

“I thought the jobs report was encouraging. Hopefully it is harbinger of more robust activity,” he said.

Bullard said he thinks Wall Street is too gloomy about the outlook.

“I think forecasters are a bit too pessimistic about the U.S. economy,” he said. “The recession has been over for fair amount of time. It is a logical point in the recovery where you would expect somewhat more rapid growth and somewhat better jobs market, so we’ll see if that is what happens.”

The logical point to see more rapid growth is in the quarters immediately following a significant contraction, not two years later.  But putting that aside for the moment, I think it is easy for the Federal Reserve to read the recent data as signs the Great Depressing is beginning to unwind.  Consider recent behavior of monthly private nonfarm payrolls:

Just eyeballing the chart, it looks like payroll growth is settling into a trend consistent with something around what we would think of as potential growth, except that growth may be a little slower than in the pre-recession period and is occurring along an equilibrium path below the pre-recession path.  And that growth is translating into a falling unemployment rate:

At this rate, we could be approaching 7% by next year, which would then put unemployment below the Fed's forecast for 2014.  By my standards still an unacceptably slow pace given that decelerating inflation provides room for additional easing, but I can easily see where FOMC members decided the risk of additional easing outweigh the benefits.  

Now, in my mind, this would guarantee that the Fed would not be really unwinding the Great Depression as much as managing a the economy along a new trend.  Unwinding the Great Depression, I think, means fully reversing the drop in the employment to population ratio: 

Note that in the previous recession, the employment to population ratio edged up, but fell short of regaining the previous peak.  Imagine the same occurring this time.   Complicating a complete unwind is the economy's dependence on asset bubbles to support high levels of employment: 

It seems that the loss of net wealth equal to 100% of GDP must be a depressing effect on spending.  My sense is that we are unlikely to craft another widespread asset bubble and thus we will be missing a piece of demand that was critical to supporting the economy. How I think you might compensate for this lost demand is for the Fed to explicitly raise the inflation target and stimulate growth such that nominal wages rise sufficiently to quickly erode the real value of debt.  If the Fed doesn't allow that to happen, instead sticking with the 2% target, then I suspect they will reduce accommodation long before the economy would regain the pre-recession equilibrium path.  In other words, the Fed manages the economy along the new equilibrium path, and makes no pretense of trying to achieve pre-recession employment targets.  

Could the Fed credibly commit to a higher inflation target and make actionable such a commitment?  I think they can, but would need to announce they are making some permanent additions to the money stock and ease the expectation that the balance sheet expansion will be fully unwound at the first possible moment.  In other words, to convince the public that you intend to raise the level of the price path relative to the existing path, you need to be willing to allow for the permanent increase in the money supply that would allow that to happen.  Barring that, they can target the dollar directly and do what they won't do - buy foreign currency or foreign debt.  But this is now a more academic than practical discussion.  The Fed has a target.  Period.  End of story.

Bottom Line:  Bullard reminds us that QE3 is not a certainty.  True, inflation is easing and in aggregate the labor market remains weak, even if recent numbers are coming in a bit stronger.  Arguably plenty of room for additional easing, which is why I have tended to think the Fed would eventually take additional action (that and the never-ending European mess).  But the Fed hasn't shown an eagerness to ease further despite what they saw as a very slow reduction in unemployment - and it is reasonable to assume that forecast is getting a little bit brighter.  Under such conditions, one or two months of "positive" employment news could fully derail the QE3 train.  I increasingly think it depends on what the Fed's ultimate objective is - to unwind the Great Recession and attempt to restore pre-recession employment to population ratios, or just manage along a new output path.  I used to think the former was the Fed's objective, but now am questioning that belief.