Tim Duy's Fed Watch

Now We Wait

The Federal Reserve followed through largely as expected last week, adopting a very new policy regime:

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month....

...If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.

The Fed delivered open-ended quantitative easing.  The end of the program is to be a function of economic outcomes, not arbitrary dates.  They did not specify macroeconomic targets, such as a 7% unemployment rate, but I think few expected the Fed to lock themselves into such a specific number.  

There has already been much commentary on the decision (I was otherwise engaged that day, so the whirlwind passed me by).  See, for example, Mark Thoma, FT Alphaville, Gavyn Davies, FT Money Supply, Scott Sumner, and Econbrowser.  I would add that this policy shift indicates that Federal Reserve Chairman Ben Bernanke has repudiated at least two of his earlier views.

The first is his belief that the stock of bond purchases was more important than the flow.  Obviously, the focus is now on the flow of purchases, reflecting the importance of managing expectations in the implementation of policy.  The shift to a flow-based policy removes the unnecessary uncertainty surrounding the intent of policymakers that was associated with previous, stock-based policy.  

Second, notice that with his new found focus on the importance of weak labor market conditions, Bernanke returns to his former self.  It has long been something of a mystery of what happened to the Bernanke who offered advised to the Bank of Japan back when he was a Federal Reserve Governor.  Bernanke even felt it necessary to defend himself against attacks that he had abandoned previous positions:

So the very critical difference between the Japanese situation 15 years ago and the U.S. situation today is that Japan was in deflation,and, clearly, when you’re in deflation and in recession, then both sides of your mandates, so to speak, are demanding additional accommodation. In this case, it’s—we are not in deflation, we have an inflation rate that’s close to our objective. Now, why don’t we do more? Well, first I would again reiterate that we are doing a great deal; policy is extraordinarily accommodative...I guess the question is, does it make sense to actively seek a higher inflation rate in order to achieve a slightly increased reduction—a slightly increased pace of reduction in the unemployment rate? 

Back in April, Bernanke stressed that the key factor that eliminated the need for additional QE was the lack of a deflationary threat.  Bernanke has apparently abandoned that view, and now pursues an even more aggressive QE program than imagined in the spring on the basis of labor market conditions.  Bernanke appears to have now come full circle on the role of monetary policy in alleviating economic distress.  A long, strange trip, to be sure.  And one wonders if he would have made it back full circle without the persistent critiques of the certain elements of the blogging community to push him along.

Now, of course, the question is will it work?  This is, of course, an experiment.  I tend to think that monetary policy would be much more effective if backed by a rational fiscal policy, but at the moment central banks in both the US and Europe left to do the job by themselves.  I would add that the central bank action comes at a critical time, with a weakening global economy clearly starting to drag on US activity.  Which brings us to a quick data review.

First off, note that exports growth continues to decelerate:

The impact has already been evident in manufacturing surveys:

 

And likely in the core manufacturing data as well:

 

Interestingly, I have seen little commentary on the sharp decline in core manufacturing growth, but on the topic see Barry Ritholtz.  The surprise decline in industrial production (partly attributed to the hurricane), could be a warning that something more serious is brewing:

I would say on net that the consumer remains subdued.  Stripping out autos and gas, retail sales barely budged in August:

That said, consumer confidence was stronger, helping to close the anomalous gap between confidence on consumer spending growth:

But gas prices continue to rise, which may bite into confidence in future months:

Higher gas prices will put some upward pressure on headline inflation, which otherwise remains subdued:

Higher gas prices and the associated impact on inflation could provide the first test of the Fed's commitment to open-ended QE.  The experience of the past few years, in which higher gas prices have been a drag on the economy rather than trigger broader inflation, should have served as a sufficient lesson for the Fed to not reverse course at the tiniest whiff of rising prices.

Finally, initial unemployment claims continue to move sideways, also helped along by the hurricane:

No evidence of significant labor market improvement yet.  

Bottom Line:  The Federal Reserve ushered in a new policy regime last week.  But will it work?  That part remains to be seen.  While the appropriate monetary policy given the Fed's expectation of inflation below their target and persistent weakness in the labor market, they are still fighting the effects of uncooperative fiscal policymakers.  For now, the best bet is slow and steady underlying growth, with the drag of the external sector offsetting some of the early improvement in housing.  Should gas prices continue to rise, the Fed will quickly find their resolve tested.  My expectation is that they do not fold easily; rising headline inflation will not trigger a rapid policy reversal as higher gas prices will place an offsetting weight on final demand. I would like to say that the Fed acted in time to prevent a broader slowdown, but the manufacturing data gives me pause. While I certainly see nothing that convinces me that further slowing is inevitable, the ongoing global weakness and the fiscal cliff provide me with plenty of uncertainty heading into the final months of 2012. 

The Wait Should be Finally Over

Tomorrow should bring QE3 from the Federal Reserve.  I am reminded on the length of this debate from a piece I wrote in February:

Calculated Risk reads this passage in a recent speech by San Francisco Federal Reserve President John Williams:

This is a situation in which there’s no conflict between maximum employment and price stability. With regard to both of the Fed’s mandates, it’s vital that we keep the monetary policy throttle wide open. 

and concludes:

QE3 is coming.

Dallas Federal Reserve President Richard Fisher states:

“In my view, it’s not going to happen,” he said. “It’s a fantasy. Wall Street keeps dangling QE3 out there [but] I just don’t see it happening.”

I guess we are going to see who knows more about monetary policy - CR or Fisher.  My instinct tells me CR, but Fisher seems just a little too certain to dismiss entirely.

Not dismissing Fisher entirely meant expecting QE later than sooner.  But, ultimately, barring a massive surprise, I think we will learn tomorrow that CR does in fact know more about monetary policy than Fisher.  Then again, who doesn't?

I have been a bit busy this week, so I have been a little under the radar.  With respect to the meeting tomorrow, I agree with Robin Harding at the FT on this point:

For me, the question of what the Fed will do is far less interesting – and far less in doubt – than how the Fed will do it. This will not be a pro forma repeat of previous actions. As Mr Bernanke’s speech shows, the Fed is trying to address grave concerns about the labour market. The crucial issue is whether and how they tie any action to the state of the economy.

I don't anticipate a lump sum QE announcement.  I anticipate an open-ended commitment to regular purchases of securities, Treasuries and/or MBS, that can be scaled up or down in response to the economy.  Wall Street may be initially disappointed by the lack of a big number, but over time I think markets will come to appreciate the greater impact offered by a regular commitment based upon economic outcomes rather than the arbitrary amounts and time lines of previous QE efforts.  

As Harding says, how they tie the policy to the economy is key.  It is probably too much to expect an explicit nominal GDP target.  Nor do I think we will get Chicago Federal Reserve President Paul Evan's suggestion of an explicit unemployment target coupled with higher inflation tolerance.  Harding suggests:

“The committee intends to purchase a further $xbn of Treasury and agency mortgage-backed securities per quarter until incoming information points to a substantial and sustainable strengthening in the pace of the economic recovery.”

Sounds good, although as I have trouble expecting the Fed to undertake open ended QE in the absence of direct reference to both parts of the dual mandate, a possible variant :

“The committee intends to purchase a further $xbn of Treasury and agency mortgage-backed securities per quarter until incoming information points to a substantial improvement in labor utilization rates in the context of price stability.”

You get the idea.

Bottom Line:  QE3 is expected, but more important is the message that comes with it.  To be most effective, the Fed needs to link open-ended policy explicitly to the economy, thereby removing the uncertainty associated with the previous arbitrary programs.  I think anything less should be viewed as a dissappointment. 

Another Jobs Disappointment

The August employment report certainly reminded me that forecasting monthly changes in nonfarm payrolls is a dangerous game.  A game I will certainly play again, but dangerous nonetheless.  I think there is little doubt that this report is not in the "substantial and sustainable" category, which thus points to additional Fed action next month.

Nonfarm payrolls posted a 96k gain for the month, well below consensus expectations and the low-end of my 110k-290k range (198k midpoint).  The numbers for the previous two months were revised downwards.  And while the 12-month trend remained virtually unchanged, the 6-month trend is weaker than last summer:

And while I am sure it will not dissuade fears that inflation is just around the corner, hourly wages actually slipped a penny for both all employees and production/non-supervisory workers.  The latter category, for which we have a longer time series, continues to plumb the depths of wage growth:

Also note that the index of aggregate weekly hours has largely leveled off this year, in contrast with steady growth in 2011:

Roughly half the net job growth was attributable to health care and social services, manufacturing and government both dragged down the headline, while professional services gained 28k despite a disconcerting loss of 4.9k temp workers.  In short, more of the same general lackluster numbers that on average have typified the labor market "recovery."

The population survey was also hardly inspiring.  The unemployment rate managed to edge down on the back of an exodus of 348k workers from the labor force.  Consequently, the participation rate ticked back down:

The ranks of both the employed and unemployed fell.  Employed part-time for economic reasons fell only marginally, basically steady since the beginning of this year:

Long-term unemployment, an issue specifically noted by Federal Reserve Chairman Ben Bernanke, fell as a proportion of total unemployment, yet still remains very, very high:

Improvements in the long-term unemployment situation have been hard to come by, to say the least.

Bottom Line:  Where does this leave us for next week's FOMC meeting?  Given Bernanke's description of the labor market situation as "grave" and the complete lack of improvement in the most recent report, given Bernanke's meager defense of the potential costs of balance sheet operations (see Joe Gagnon), given the ongoing European saga (Europe still headed for a deeper recession as more austerity will likely occur in both Spain and Italy despite the ECB) and its impacts on US manufacturing (see Intel today), given the uncertain situation in China, given the increasingly vocal support of Fed doves and marginalization of Fed hawks, given that time is running out for Bernanke with the nontrivial possibility of a Romney win, and given that recent positive data is largely limited to consumer spending, it is hard to come to any conclusion other than to expect additional easing next week.  Quantitative easing and/or enhanced verbal guidance, although at this point I imagine they need to go hand-in-hand.  In fact, if they don't ease this time, I think we will need to conduct a fundamental reassessment about what exactly is happening on Constitution Ave.

Quick Employment Report Preview

Everyone has their eyes on tomorrow's employment report, considered to be especially important as it could clear any final hurdles to additional Federal Reserve easing at the next meeting.  Can this week's data give us any hints of the outcome?  

The week began with the ISM manufacturing report, with the headline number ticking down just a notch:

Many of the underlying details were also little changed, with some notable exceptions.  The inventory component climbed 4 points while the prices paid component rose 14.5 points, suggesting that firms are being hit by both weaker demand and higher costs.  Not a great combination for profit margins.  The production measure slid 4.1 points, pushing it into negative territory: 

And the import component also slid into negative territory, suggesting additional domestic weakness in the sector:

In short, softer, but not devastatingly so.  Generally consistent with Fed easing in the past.  On the other side of the coin, the ISM non-manufacturing report came in higher, and, notable as far as the employment report is concerned, the employment component rose 4.5 points:

Also on the generally positive side was the gain in the ADP payrolls numbers, with private employees rising by 201k in August.  Finally, initial claims were somewhat lower than in August.  You can take these bits and pieces to create a quick model of the monthly change in nonfarm payrolls as a function of the ISM employment index (NMFEI), the monthly change in the ADP report, and the monthly change in initial claims:

The model forecasts a nonfarm payroll gain of 198k for August.  To be sure, the standard error of 88k is large in terms of payroll forecasts; I wouldn't be surprised by anything between 110k and 290k.  That said, the current consensus is 125k with a range of 70k to 177k, which seems low to me.  So when Bill McBride concludes:

Overall it seems like the August report will be somewhat stronger than expected.

I find myself in agreement.  

Bottom Line:  The range of consensus forecasts for the August employment report look to be on the low side of what we should expect.  If the consensus is correct, then the odds of the Fed easing further this month will swell; 125k or lower seems too low to rapidly alleviate what Federal Reserve Chairman Ben Bernanke describes as a "grave" employment situation.  But something closer to the top of the consensus range and above could throw a wrench in expectations for the next Fed meeting.   

Quick Data Notes

Just a couple of data notes floating around my computer.  First, based on dismal new orders for nondefense, nonaircraft capital goods, I am not expecting an upside surprise in tomorrow's ISM report:

In the past, such weakness has been met with Fed easing.  Also supporting Fed easing was the read on PCE inflation:

Headed south, exactly the opposite of the expectations of the Fed hawks.  Note that recent trends in core-inflation tend to confirm the decline in headline:

In such a context, I am not particularly worried about the rise in gas prices, which has tended to weigh on spending rather than trigger runaway inflation:

Overall, we look to be heading decisively below the FOMC's expected price path:

Even if the Fed put no weight on the employment mandate, they should be easing on the basis of the price stability mandate alone.  The employment mandate could really be viewed as simply icing on the cake to justify an expansion of the balance sheet.

Initial claims continue to move sideways, much like we saw last summer:

Last year, claims didn't turn south until the fall.  Presumably, this is the kind of thing that prompts some policymakers to want to wait for more data before easing further. It is not clear that Federal Reserve Chairman Ben Bernanke is willing to wait much longer.  Friday's employment report could be decisive in determining the outcome of the next FOMC meeting.  A very weak report should ramp up the odds that the Fed takes action later this month. 

On a brighter note, consumer spending was up for in July, a good start for the quarter:

The hawks will take this as evidence not to take further action; the doves will take this as evidence that the underlying economy continues to track along a suboptimal path, and the failure of growth to accelerate beyond that path in an environment of falling inflation is reason to take further action.  Simply put, the economy could be doing better in the context of the dual mandate.

Bottom Line:  The manufacturing data suffers from the weight of the global slowdown. In general, the remaining data confirms neither runaway growth nor imminent collapse.  Instead, more of the same low growth that we have become accustomed to.  That same low growth looks consistent with inflation drifting below the Fed's mandate, providing the Fed with plenty of justification to act.  This is especially case given the downside risks posed by the global environment and fiscal policy.  Of course, that was the case three meetings ago.  But each meeting has brought us closer and closer to a new round of easing, and we may finally have crossed the line.  

Did the Republicans Force Bernanke's Hand?

To what extent is the Fed responding to political pressures?  Of course, Federal Reserve officials like to believe they are above the fray, and vehemently deny that political considerations play any role in their decision-making process. They must be above the fray, otherwise the cherished independence would be broken.

I know this is what I am supposed to believe.  Doesn't every Fed watcher?  Yet I can't help but think that it would be naive to believe that any institution in Washington is above politics.  It is simply not that kind of town.  The degree that you have the illusion of independence depends upon your ability to have a substantial block of fiscal policymakers that believe you are doing your job.  And not "your job" as you define it, but as they define it, whether or not their definition makes any sense.  Such is Washington.

Which brings me to Pedra da Costa's Reuters piece this morning:

Increasing political encroachment on the Federal Reserve, particularly from the Republican Party, could threaten the central bank's hard-won independence and undermine confidence in the nearly 100-year old institution.

That was the pervasive sentiment among economists gathered at the Fed's annual monetary policy symposium in Jackson Hole, Wyoming. Against the dramatic backdrop of the Grand Teton mountain, many said a closely-contested presidential race has turned the monetary authority into a political football.

It has always been feared that political independence would be threatened from the left, with the ultimate result of hyperinflation.  Not so anymore:

"I do fear for it a bit if the election comes out that way, especially if some of the more radical voices, that happen to be Republican voices nowadays, get reelected," said Alan Blinder, Princeton economics professor and a former Fed vice chairman, adding that historically opposition to the U.S. central bank had come predominately from the left.

"There's a lot of hostility," said Blinder, who was appointed to the Fed by former president Bill Clinton.

Of course, some believe that political pressure is already having an impact:

For some observers, that pressure is already affecting the Fed's behavior, preventing it from pushing more aggressively for stronger economic growth following the sharp blowback received back in 2010, when policymakers announced their last large scale bond purchase program.

If in fact this is true, then Federal Reserve Chairman Ben Bernanke made a disastrous tactical error.  By not responding even more aggressively, as he now appears to be headed, he opened the Fed up to additional attacks because monetary policy looked ineffective at supporting the economy.  As they say, the best defense is a good offense.  If the economy looked to be returning to the pre-recession path of nominal GDP, the Fed's detractors from both the left and the right would have less ammunition for criticizing monetary policymakers.

That, however, is not the world we are living in.  Instead, we are now in a world in which the ideas gaining traction within the Republican party include an audit of the Fed, the elimination of the dual mandate in favor of only an inflation target, and, incredibly, a return to a gold standard.  Moreover, even if such efforts ultimately prove fruitless, we have seen that the confirmation process for Fed governors turn increasingly political.  It would not take much to believe that a Republican-controlled Senate with Mitt Romney as President would seek to pack the Fed with clones of Dallas Federal Reserve President Richard Fischer.  

In essence, the time for more monetary accommodation may be growing short.  Bernanke must assess a nontrivial possibility of a Romney Administration, the candidate who has already promised to fire the Fed chair.  Obviously, Bernanke then has no reason to forestall additional easing in hopes of retaining his job in a Romney Administration.  Bernanke must also assess the nontrivial possibility that the odds of political pressure on the Fed only increases, and that pressure will continue to come from the right.  If such events do unfold, the odds are that policy will turn tighter earlier than it should, with what he likely believes would be disastrous consequences to the economy.

In other words, if the Federal Reserve is to deliver more easing, it needs to be sooner than later.  It will only become harder in the days ahead.  

Bottom Line:  Based on the current mode in Washington, it is difficult to believe that political pressure from the right on the Federal Reserve does anything but intensify.  Interestingly, to the extent that the Fed is not immune to political pressure, one could argue we are at a point where such pressure induces the Fed to do more, not less.  Rather than resisting taking more action because he fears the political consequences, Bernanke might look into the future and conclude he can wait no longer as Congress is unlikely to react to his calls for fiscal help while the "hard money" crowd continues to make gains within the Republican party.  While I think the state of the economy should have forced the Fed's hand long before now, the possibility that they might only get one more bite at the apple should be extra inducement to act.  

Employment Data Ahead

While the ISM manufacturing report is on the board for Tuesday, the big event for this week is the August employment report.  Of course, it is a matter of debate as to what extent the data is important for the next Fed meeting.  Many are taking Federal Reserve Chairman Ben Bernanke's description of labor markets as "grave" as a indication that more action is imminent.  Atlanta Federal Reserve Chairman Dennis Lockhart, a generally middle-of-the-road policymaker, seems to believe the data are still important.  Via the Wall Street Journal:

"It's a close call" when it comes answering the question of whether the Fed should provide more aid to the economy, Federal Reserve Bank of Atlanta President Dennis Lockhart said. He spoke on the sidelines of the Kansas City Fed's annual research conference here.

Mr. Lockhart said that as he tries to determine what, if any, further stimulus should come from the Fed, he was weighing action against the broader trend of economic activity.

"I'm increasingly of the view that we are on a track that you would, to simplify it, would say is about a 2% growth track with fluctuating job growth. But overall, not a strong enough pace to bring down unemployment to anything close to a notion of full employment in a reasonable time," Mr. Lockhart said.

The policy maker said the fundamental question is whether new Fed stimulus could alter this path. "That's a very tough question. I am not highly confident in the ability of simply monetary action to jump-shift the economy onto a different track," Mr. Lockhart said.

This is the key question - can monetary policy jump the economy to another path?  More likely than not, this is the question that has prevented additional action to date.  Indeed, it is really the only question that makes any sense given the persistent failure of monetary policymakers to meet either the employment or inflation parts of their dual mandate.  Interestingly, Lockhart played down Bernanke's speech:

When it comes to additional stimulus, Mr. Bernanke argued "it could help. I think, one, meaning the press or pundits, or observers, can overinterpret the speech as being, as indicating, his preference for further action," Mr. Lockhart said. "I don't think [Mr. Bernanke] signaled or indicated a particular direction.

It seems Lockhart agrees with my hesitation in embracing Bernanke's speech as a clear indication of the Fed's next policy move.  What is promising, in my opinion, is the recognition that if the Fed is going to act, they need to act in a way that will shift the existing paradigm:

If the Fed were to act, Mr. Lockhart said half-measures would not get the job done. While he didn't state what the steps could be, he said stimulus, if chosen, should be "a package. When I say package that means two or three things done at the same time to create maximum possible gains."

Not only does this speak to open-ended quantitative easing, but also communication tools, such as extending the period of expected low rates and quantitative targets for policy.  

Also in the news was St. Louis Federal Reserve James Bullard.  He would like to wait for more data, but sees which way the wind is blowing:

Mr. Bullard said “it’s clear we have an easing bias,” but he also noted recent data have improved. He said he’d also like to see how the August employment report–due next Friday–turns out before deciding what’s appropriate for the Fed.

Mr. Bullard said he’s willing to be patient and collect more data before acting. But he also said given the current consensus on the committee, “I’d be open to some action”–as long as it was a “relatively smaller move.” He explained the trajectory of recent data doesn’t “justify the large policy moves” associated with bond-buying programs that expanded the central bank’s balance sheet.

The comments on the size of any additional move are interesting in context of his next quote:

If the Fed were to adopt at some point a new asset-buying program, he said he’d prefer that it be open-ended and adjusted on a meeting-by-meeting basis, as opposed to adopting a preset size and end date for the purchases. A flexible bond-buying effort would be “the natural way” to go, and “maybe this way will be the charm if we decided to go that way,” Mr. Bullard said.

I am not sure if market participants have fully come to terms with the concept of open-end quantitative easing.  There may be some disappointment if market participants expect a new program will come with a big number, which is my interpretation of Bullard's comment on "large policy moves."  Most likely, it will be a small number - something like a commitment to expand the balance sheet by $10 billion a week until conditions justify tightening.  A stronger version would be to tie the steady expansion to specific macroeconomic objectives.  An even stronger version would be to commit to the program even in the event of inflation in excess of the current 2% target.  But my point here is that we should be prepared for an open-ended program to come attached with a number that may be small compared with QE1 and QE2.

FYI - in contrast to Bullard, I think an open-ended program would be a large policy move, even if the numbers appeared small.

Bullard also claims to be more sympathetic to charging interest on reserves, a negative interest rate.  I don't know that this idea has much other traction at this point.  

Bottom Line:  If we believe Lockhart, Bernanke's speech was less of a signal than the general consensus would believe.  But if we believe Bullard, the FOMC is moving in the direction of additional easing in any event.  Greater than 50% odds, but still a close call?  Sounds about right.  The employment report could ramp the odds up to 80%, or push us back to the break even point.  If they do move, I am expecting an open-ended quantitative easing coupled with a communication tools.  Note that an open-ended program is not likely to include a big number.  The point of the open-ended program, however, is that it can get big, very big, if needed.