Tim Duy's Fed Watch

Ultimately, It's About the Inflation Target

Ryan Avent reports from Chicago on the willingness to believe the Fed is powerless to produce additional inflation:

Why is Mr Hall—why are so many economists—willing to conclude that the Fed is helpless rather than just excessively cautious? I don't get it; it seems to me that very smart economists have all but concluded that the Fed's unwillingness to allow inflation to rise is the primary cause of sustained, high unemployment. And yet...this is not the message resounding through macro sessions. Instead, there are interesting but perhaps irrelevant attempts to model the funny dynamics of a macro challenge that actually boils down to the political economy constraints (or intellectual constraints) facing the central bank. Let's focus our attention on that, for heaven's sake.

Avent is correct.  It does seem that most economists believe that at the zero bound, allowing inflation expectations to rise is an effective - perhaps the only effective - mechanism for the central bank to accelerate activity.  Moreover, if, as Avent says, we believe the Fed can prevent deflationary expectations, then they can certainly create inflationary expectations.  The fact that they don't would then be something of a mystery, as certainly we don't see Federal Reserve Chairman Ben Bernanke as intellectually deficient on this issue.  He can clearly do the math as well as anyone.

An answer to this conundrum is evident in the Fed's forecasts (dark blue is the central tendency):

The disconnect between the unemployment and inflation forecasts is clear.  The Fed has a dual mandate, and, according to its forecasts, it cannot meet both of the mandates in the near to medium terms under the expected policy path.  So a choice needs to be made.  And the Fed has chosen to focus on meeting the inflation side of the mandate  (note, headline PCE inflation in the long-run, which is why I focused on that measure in a piece last week).  No mystery.  No reason for vast intellectual expenditures.  Price stability means 2% inflation, and if we can't meet the unemployment target within that mandate, so be it.  

In other words, they are certainly capable of inducing higher inflation.  They just don't because, in their view, 2% is a firm target, and the costs of exceeding that target, or, more importantly, changing that target, are effectively assumed to be infinite and thus by definition exceed any expected benefits.  

Now, you could argue, that it really isn't this simple, since the "price stability" objective is not legally defined at 2% (Notice also that 2% is really the upper limit.  On average, it appears that monetary policymakers would actually like something closer to 1.8%).  There is a real question here that I don't believe the Fed has adequately answered - why should the definition of price stability be 2% rather than 3%? 

So what is the constraint - political, intellectual, or irrational - that forces the Fed to adopt a 2% inflation target, and then choose to act as if that target was written in stone?  I imagine policymakers would respond to the first point by claiming that price stability really means zero percent inflation, and that they choose 2% because we overestimate inflation and need some cushion from the lower bound problem. Fine, but what if you are already in the liquidity trap?  For the second part, they would argue that the economy would be less stable in the absence of a firm target.  My reply is that this might be correct for the eight decades a century that you are not in a liquidity trap, but what about the other two decades you are in a liquidity trap? Is a target calibrated during normal economic conditions then supporting suboptimal outcomes in a liquidity trap?

I expect to get some relief in at least the near term inflation forecasts at the conclusion of the next FOMC meeting, a decrease of the lower boundary of the central tendency which then helps clear the way for additional Fed easing.  Core inflation has clearly been rapidly decelerating in recent months:

If you believe, as the Fed appears to, that core-inflation provides useful information on the direction of headline inflation, then the message is clear - headline inflation is likely to drift lower, and the economy needs more stimulus.  What the Fed will deliver, however, will still be within the bounds of the 2% inflation target, and thus still falls short of the increase in expected inflation that the Fed should really be delivering. 

 

 

A Few Quick Charts on Consumer Spending

In my last piece, I noted that excessive optimism or pessimism essentially cancelled each other out over the course of 2011 when tracking the overall economy.  The same held true of consumption spending as well:

 
Since the recession ended, consumer spending has been tracking a slightly slower growth trend than prior to the recession.  Again, there looks to have been a long-lasting shock to the path of consumer spending.  Interesting changes have occurred underneath the surface, however.  The path of spending on services is markedly lower:

This was the subject of a Wall Street Journal article last November:

Increasingly, that means service businesses find it harder to get their share of consumer spending, which is prompting many business owners to scale back. At The Wall Street Journal's CEO Council conference this month, Alan Krueger, chairman of the president's Council of Economic Advisers, highlighted the service sector's central role for jobs growth. "Services account for about half of GDP, and over half of jobs," Mr. Krueger said. "Particularly discretionary services…people have been putting off getting their cars repaired because of concerns about jobs and income growth."

This is certainly something weighing on job growth.  That said, consumers are not foregoing all spending.  The Wall Street Journal pieces ends with:

Small cutbacks are a big reason Massimo Liguori, owner of Salon Massimo in Connecticut, closed down one of his two locations...In turn, Mr. Liguori said he now goes out to dinner with his wife twice a month or so, compared with at least once a weekend previously. "What happens is you start becoming skeptical of the future," he said...Still, a sense of austerity didn't prevent him from buying a $49,000 Lexus sport-utility vehicle. "A car is different because I put my family in that," he said.

Which brings us to the upturn in durable goods spending:

 
The rebound in auto sales clearly is supporting this trend.  How much of this is pent-up demand that has already been satisfied?  How much support will we get from auto sales in 2012?  Hopefully enough to match last year's growth, but MarketWatch recently pointed to a troubling sign:

But there’s also some negative news buried in the Conference Board release, and that’s a big drop in the percentage planning to buy an automobile in the next six months. At 9.8%, it’s the worst since October 2010.

One can always discount a single data point, but the decline fits a broader story: Americans needed to buy cars after the Great Recession because theirs were simply getting too long in the tooth.

But this replacement-cycle impact, which has been a tailwind for the likes of General Motors and Ford Motor Co., was bound to end at some point.

Has much of the auto rebound already taken place?  How much more can we expect given the vehicle miles driven continues to decline, suggesting existing vehicles will last even longer?  Something to think about as we ponder the strength of the economy this year.

Finally, the path of nondurable goods spending has been erratic:

 
Certainly, the upturn in gas prices played a role in tempering the pace of growth in nondurable spending this year:

The trend of nondruable goods spending is tracking the pre-recession trend.  So, at this point, we are seeing overall consumption supported by a rebound in durable goods spending that offsets a deterioration in the path of spending on services.  The bounce in durable goods spending will come to an end at some point, as 16 million units is likely an upper bound for auto sales.  Will service spending accelerate to compensate?  Or will we see a new normal, with a constrained consumer spending at a path and rate below those prior to the recession?  I am sympathetic to that outcome, with a corresponding increase in export growth to foster rebalancing of the economy (of course dependent upon growth in the rest of the world, something in question at this point).

But that still is not a story that rapidly returns the economy to potential output.  Which brings me back to a familiar place - putting aside the threats to the economy, it is easy to see a positive growth path for the economy, but more difficult to see a rapid closure of the output gap.  

Still Cautious Heading Into 2012

I have been hesitant to embrace the recent positive data flow - once bitten, twice shy perhaps.  Something about the current dynamics that seems a little too familiar.  Indeed, I felt something of relief when FT Alphaville came to a similar conclusion in the waning days of 2011.  Cardiff Garcia reports on a Nomura research note that details a new bias in the seasonal adjustment process, noting:

Up next, writes Nomura, you can expect exaggeratedly strong readings from the Chicago PMI later this month and the next ISM manufacturing survey at the start of January.

I imagine it is premature to call the readings "exaggerated," but both did surprise on the upside, as much data has of late.  Read the whole piece - it is worth the time.

Indeed, flirtations with either excessive optimism or excessive pessimism were not richly rewarded last year, as on average the economy simply edged upward in pretty unremarkable fashion:

 
It seems reasonable to expect the same in 2012, at least as a baseline - a slow "recovery" that is really more of an adjustment to what appears to be the economy's new equilibrium path, one that is decisively subpar to the pre-recession trend.  I don't believe that such an adjustment is necessary, as in my view it simply reflects a shortfall of aggregate demand.  That said, the longer the cyclical downturn grinds on, the more likely it is that we will indeed see a new equilibrium path.  A greater percentage of the cyclical unemployment will become structural unemployment or permanent shifts in the labor force participation rate.  In addition, investments will go unmade as firms hoard cash.  And, increasingly, policymakers will manage policy along the new equilibrium path, forgetting entirely the pre-recession path.

More than not, this is already the case.  To be sure, some FOMC members are moving toward QE3, setting the stage for additional asset purchases, perhaps in the spring now that inflation concerns have eased somewhat. Still, the pace of policy change is agonizingly slow.  From 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. A few others continued to judge that maintaining the current degree of policy accommodation beyond the near term would likely be inappropriate given their outlook for economic activity and inflation, or questioned the efficacy of additional monetary policy actions in light of the nonmonetary headwinds restraining the recovery. For this meeting, almost all members were willing to support maintaining the existing policy stance while emphasizing the importance of carefully monitoring economic developments given the uncertainties and risks attending the outlook. One member preferred to undertake additional accommodation at this meeting and dissented from the policy decision.

"Could well" warrant, but might not.  Other than Chicago Federal Reserve President Charles Evans, FOMC members have been hesitant to act further despite the gaping and persistent output gap.  It would seem that they are more willing to manage the economy along it current path, allowing unemployment to slowly decrease gradually - job gains or labor market exodus - rather than risk another percentage point of inflation.  And with the PCE price index essentially now returned to pre-recession trend, there has been little enthusiasm to embrace such a risk:

But again only Evans appears willing to accept higher inflation.  Perhaps policy change will accelerate now that Presidents Kocherlakota, Fisher, and Plosser are rotated off the FOMC, but note that this was always a minority block.  Had the majority wished to advance policy more aggressively, they could have.  The majority simply was not motivated enough to fight such a battle.  And while they would act should the economy falter, that action will be delayed if the incoming data once again reflects Nomora's upward seasonal bias, regardless of the underlying trend.  

In short, while the FOMC has been edging toward additional action - and will likely do something after first enhancing communication procedures with additional rate forecast - they have not done so with the urgency called for by the anemic recovery.     

While a repeat of last year is a reasonable baseline, I remain more concerned with downside rather than upside risks.  Europe is still on the ropes, in my opinion.  The ECB has bought some time with its LTRO, but the still high yields on long-term Italian debt suggest that that southern European nation is suffering from something closer to a solvency crisis than a liquidity crisis.  And the austerity push is far from over, as, unsurprisingly, peripheral European nations will continue to miss budget targets, with Spain being the latest example.  In my view, the European periphery will have trouble breaking the debt-deflation dynamic in the absence of currency devaluation.  Such devaluation is a key mechanism to resolving balance of payments crisis, allowing for a rapid increase in competitiveness and stoking inflation that reduces the real burden of domestic-denominated debt.  No such option is available to European nations, locked in as they are to the Euro.   Consequently, I see 2012 as another year of challenge as Europe struggles to hold the Euro together by pressuring troubled nations into ever-greater austerity.  

In addition to Europe, I remain concerned that US politics will usher in an ill-timed fiscal contraction.  The payroll tax credit was extended for just another two months, and Stan Collender is warning that there may not be an easy path to an extension.  And I continue to think that spending would be vulnerable to any sudden hit to income, especially when disposable personal income isn't exactly surging forward: 

Finally, the festering Iran situation is a wildcard, with posturing by both the US and Iran looking increasingly like a game of chicken, and both sides looking to provoke the other into a rash action.  Of course, if any escalation of hostilities triggers an actual supply disruption that spikes oil back to $150 or higher, we would expect the global economy to lurch downward.  Note, however, this is a perennial concern, and one that will not fade until we find an alternative to fossil fuels.  Something we simply learn to live with, it seems.

Bottom Line:  I want to believe the recent improvement in the tenor of economic data signals that activity is set to accelerate substantially in 2012.  But the ups and downs on the past two years smoothed out to nothing exciting or catastrophic, just a moderate path of activity that remains woefully insufficient to return the US economy to its pre-recession trend. For now, I will stick to that middle ground, while remaining watchful of the all-too-many downside risks that leave me just a little bit sleepless each night.