Tim Duy's Fed Watch

A Little Less Dovish...

In the midst of an internal debate over policy communication, Chicago Federal Reserve President Charles Evans pulled back on his 3 percent inflation threshold in a speech yesterday.  Arguably, as the only policymaker suggesting guidance well above the Fed's stated 2 percent target, Evans was the last true dove at the Fed.  With Evan's falling in line with his colleagues, it looks like the last sliver of hope that the Fed would tolerate slightly higher inflation to accelerate the reduction of real burden has now been dashed.

There is a lot of interesting material in Evan's speech, but here I focus only on his basic outlook and the implications for policy.  Regarding growth:

That said, monetary policymakers must formulate policy for today. In the United States, forecasts by both private analysts and FOMC participants see real GDP growth in 2012 coming in at a bit under 2 percent. Growth is expected to move moderately higher in 2013, but only to a pace that is just somewhat above potential. Such growth would likely generate only a small decline in the unemployment rate.

Of course, he added earlier that this forecast is vulnerable to the possible of an austerity bomb in 2013, but for the moment assume that issue is resolved:

Having said all that, most forecasters are predicting that the pace of growth will pick up as we move through next year and into 2014. Underlying these projections is an assumption that fiscal disaster will be avoided—and with this, that some important uncertainties restraining growth should come off the table. Also, deleveraging will run its course, and as it does, the economy’s more-typical cyclical recovery dynamics will take over. As the FOMC indicated in its policy moves last September, the current highly accommodative stance for monetary policy will be kept in place for some time to come.

He then praises recent policy actions:

Tying the length of time over which our purchases will be made to economic conditions is an important step. Because it clarifies how our policy decisions are conditional on progress made toward our dual mandate goals, markets can be more confident that we will provide the monetary accommodation necessary to close the large resource gaps that currently exist; additionally, markets can be more certain that we will not wait too long to tighten if inflation were to become an important concern.

And then tackles a big question:

The natural question at this point is to ask: What constitutes substantial improvement in labor markets? Personally, I think we would need to see several things. The first would be increases in payrolls of at least 200,000 per month for a period of around six months. We also would need to see a faster pace of GDP growth than we have now — something noticeably above the economy’s potential rate of growth.

From Evan's perspective, these conditions would be sufficient to end the expansion of the balance sheet, although interest rates will remain near zero beyond that point.  When should rates rise?

Of course, we will not maintain low rates indefinitely. For some time, I have advocated the use of specific, numerical thresholds to describe the economic conditions that would have to occur before it might be appropriate to begin raising rates.

On the employment mandate:

In the past, I have said we should hold the fed funds rate near zero at least as long as the unemployment rate is above 7 percent and as long as inflation is below 3 percent. I now think the 7 percent threshold is too conservative....This logic is supported by a number of macro-model simulations I have seen, which indicate that we can keep the funds rate near zero until the unemployment rate hits at least 6-1/2 percent and still generate only minimal inflation risks. 

So he shifts to a 6.5 percent threshold for unemployment, and later argues that even this might be a bit conservative as his models don't foresee much inflation pressure before 6 percent.  See also Federal reserve Janet Yellen's recent speech; Evans' view is consistent with the optimal path forecasts.  On one hand this is somewhat of a shift to the dovish side on the inflation forecast, suggesting that inflation will not accelerate as quickly as some might expect.  What about the threshold for the rate of inflation itself?

With regard to the inflation safeguard, I have previously discussed how the 3 percent threshold is a symmetric and reasonable treatment of our 2 percent target. This is consistent with the usual fluctuations in inflation and the range of uncertainty over its forecasts. But I am aware that the 3 percent threshold makes many people anxious. The simulations I mentioned earlier suggest that setting a lower inflation safeguard is not likely to impinge too much on the policy stimulus generated by a 6-1/2 percent unemployment rate threshold. Indeed, we’re much more likely to reach the 6-1/2 percent unemployment threshold before inflation begins to approach even a modest number like 2-1/2 percent. 

 So, given the recent policy actions and analyses I mentioned, I have reassessed my previous 7/3 proposal. I now think a threshold of 6-1/2 percent for the unemployment rate and an inflation safeguard of 2-1/2 percent, measured in terms of the outlook for total PCE (Personal Consumption Expenditures Pride Index) inflation over the next two to three years, would be appropriate.

Notice that he really doesn't have a reason to shift his threshold; he doesn't even expect to hit the inflation threshold before hitting the employment threshold.  His reason for essentially is that the 3 percent threshold makes people "anxious."  Anxious about what?  Anything that is perceived to be a threat to the Fed's credibility.

Does this shift on Evans' part really change anything?  Probably not.  He was always an outlier among Fed policymakers, with a tolerance for inflation as high as 3 percent making him a true dove.  But he was never going to get any additional traction on that front from his colleagues.  The 2 percent target is set in stone, and it is too much to expect the Fed will tolerate any meaningful deviations from that target.  Of course, it is questionable that 3 percent is a meaningful deviation to begin with, but that is question is almost irrelevant at this point.   

Bottom Line:  By shifting his threshold on inflation, Evan's concedes to the political realities within the Fed.  There was never much support for anything like tolerance for 3 percent inflation; for most policymakers, I suspect anything above 2.25 percent would be considered a threat to credibility.  By falling in line with the rest of the FOMC, Evan abandons his role as a true dove, someone willing to tolerate substantially higher inflation.  He is a dove now in the modern sense - a policymaker with a lower inflation forecast that allows for a longer period of easier policy.

Meanwhile, in Japan...

Back in September, I wrote:

What I expect to happen is this:  The Bank of Japan will be forced into outright monetization at some point; a soft default in the form of higher inflation will occur.  And dramatically higher inflation, I fear.  Japan has not had inflation for two decades.  I suspect they will experience all that pent-up inflation in the scope of a couple of years.

Sure enough, the battle begins.  Almost lost in the holiday weekend, from Reuters last week:

Japan's main opposition Liberal Democratic Party (LDP) said on Wednesday that on its return to power it would set a 2 percent inflation target with an eye to revising the law governing the Bank of Japan so as to boost cooperation between the government and the central bank...

...In its campaign platform unveiled on Wednesday, the LDP called for bold monetary easing through cooperation between the government and the central bank on debt management, but it made no mention of Abe's calls for the BOJ to buy debt to finance infrastructure projects.

The response from the Bank of Japan was swift:

But BOJ Governor Masaaki Shirakawa dismissed many of Abe's proposals, including the possible revision of the Bank of Japan law, a step critics say is aimed at clipping the central bank's independence and forcing it to print money to finance public debt that is already double the size of Japan's economy.

"Central bank independence is a system created upon bitter lessons learned from the long economic and financial history in Japan and overseas countries," Shirakawa told a news conference....

...Shirakawa was adamant the central bank would not directly underwrite government debt because bond yields would spike and hurt the economy.

"No advanced country has adopted such a policy," he said.

Shirakawa is correct.  Modern central banks may have lost some control over inflation at times, but I don't think any has engaged in outright monetization of government debt.  Yet despite Shirakawa's insistence to the contrary, I still think that is exactly where Japan is headed.  More central bank history in the making.

Stop The Holiday Shopping Media Circus

I feel as if every December I need to mentally prepare myself for the onslaught of inane media coverage of the holiday shopping season. This year, however, we seem to have a few more voices of reason and common sense. Barry Ritholtz, a long-time veteran of the Black Friday Media Wars, sees signs of hope:

Over the years, I have been rather annoyed (perhaps too much) at the annual foolishness over Black Friday forecasts. Each year, we hear breathless predictions of ridiculous increases in consumer spending — holiday shopping rises 16% this season! — which turn out to be wildly over-optimistic, and are never confirmed by the actual data....

....This year, the idea seems to have spread into the mainstream: Lots of coverage about it, with a few choice quotes from you know who tossed in for good measure.

Ritholtz provides a host of links on the subject, but a recent entrant is missing. Neil Irwin at the Washington Post delivers the truth about Black Friday:

Black Friday is here, and if you happen to derive pleasure from streaming around big box stores or mega malls as part of a teeming horde, well, who am I to judge another person’s sources of enjoyment.

Let’s just not pretend that it means anything...

...sales over Thanksgiving weekend tell us virtually nothing about retail sales for the full holiday season—let alone anything meaningful about the economy as a whole.

So if it is a meaningless event from an economic perspective, what explains the media obsession?

For the media, it is a ready-made story. It takes place at a time that there is little other news, and it is known in advance, so editors and TV news directors can plan in advance for coverage. And there’s no doubt that video of people stampeding through the doors of a Wal-Mart in hot pursuit of a new Wii makes for great television. That is even putting aside more cynical possibilities, such as that media depend on retail advertising and thus have a vested interest in creating a sense of hype and anticipation around an orgy of consumerism.

Nothing more than another media manufactured trend. Bookmark the Irwin piece and refer back to it each morning before you get sucked into the inevitable Bloomberg stories detailing the ups and downs of the holiday season. And remember that everyone will be looking for a quick sound bite to leverage off the holiday mania. Sarah Kliff Suzy Khimm includes one such bite in a piece on the latest Reuters/Michigan Consumer Sentiment numbers:

...the latest round of economic indicators suggest that economic gloom is finally starting to set in with the general public, and the austerity crisis may have something to do with it. The Reuters/University of Michigan Consumer Sentiment Index fell 2.2 points from the preliminary reading early in November to the final reading after the election...They’re still more optimistic about the current state of the economy, but consumers have become more pessimistic about what’s ahead—a change that IHS Global Insight chalks up to “increased awareness by many Americans of the fiscal cliff.”

“If the political rhetoric and finger pointing reaches a fever pitch similar to that of the debt ceiling crisis in the summer of 2011 then consumer confidence is likely to take a very serious hit, and this holiday season will not be very cheerful,” the IHS analysis concludes.

Aside from the pointlessness of attempting to gain deep understanding about the economy from a minor blip in the confidence numbers, before you start huddling in the corner for fear of imminent economic collapse, please refer back to last summer's dive in confidence numbers:

While the budget talks did undermine confidence last summer, the impact on spending was essentially nil. I doubt very much that US households will focus much on the fiscal cliff until the new year, choosing instead to focus on holiday parties, egg nog, and gift giving. And if they do give some thought to the cliff, they won't change their spending measurably; they have already set their budgets for the year. That will only happen if going over the fiscal cliff undermines the job market, something that would not be evident until much deeper into 2013. For now, consumer sentiment is only catching back up to where we would expect it to be given the pace of spending. Nothing more, nothing less. For economic trends more relevant to the path of spending, see Neil Irwin's reasons to be thankful this season.

Bottom Line: Black Friday hype - just say no.

Why We Can't Take Inflation Hawks Seriously

Peter Coy at Bloomberg reports on the Shadow Open Market Committee. Not surprisingly, the SOMC fears an outbreak of inflation is just around the corner.

Conservative economists are paying attention to the man behind the curtain and not liking what they see. At a meeting in a Manhattan hotel on Nov. 20, the so-called Shadow Open Market Committee criticized Federal Reserve Chairman Ben Bernanke for an ultra-easy monetary policy that will, in their opinion, lead ultimately to dangerously higher inflation.

It is almost comical that those who profess to be experts on monetary policy appear to almost never listen to what Federal Reserve officials say. Case in point:

Marvin Goodfriend, an economist at Carnegie Mellon University, said the Federal Reserve “appears to be walking away” from a commitment it made last January to keep the inflation rate at or near 2 percent. In September, when it announced a new round of bond buying to bring down unemployment, the Fed made no mention of the 2 percent target, merely saying it would pursue its growth target “in a context of price stability.”

Made no mention of the 2 percent target? Really? Let's go to the tape:

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that inflation over the medium term likely would run at or below its 2 percent objective.

I think they were pretty clear about the 2 percent target, which is the Fed's definition of price stability. If Goodfriend can't remember this, he should bookmark the appropriate page on the Board's website:

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate.

The only way this isn't clear is if you are deliberately ignoring what the Fed is saying. The SOMC also fears any policy that allows inflation to drift even temporarily above 2 percent:

Jeffrey Lacker, the hawkish president of the Federal Reserve Bank of Richmond, was the Shadow Open Market Committee’s invited keynote speaker. He shared the committee members’ concerns about letting inflation drift much above the 2 percent target in the name of growth, even for a short while.

“At the very least, the precedent set by an opportunistic attempt to raise inflation temporarily is likely to cloud our credibility for decades to come,” Lacker said.

First, actual inflation outcomes would be expected to fall in a symmetric pattern around 2 percent. When Lacker argues against allowing even a temporary drift above 2 percent, he is effectively saying that 2 percent is a ceiling, not a target, so that on average, inflation will be less than 2 percent over time (all the errors would be on the low side of the target). Thus, he is actually trying to enforce a price stability standard stricter than the current standard. Second, this whole discussion is something of a strawman to begin with. Realistically, only Chicago Federal Reserve Chairman Charles Evans supports any meaningful drift over 2 percent. Even Minneapolis Federal Reserve President Narayana Kocherlakota, much lauded for his move to the dovish side of the FOMC, sets an upward bound of just 2.25 percent before the Fed should consider a policy shift. And Federal Reserve Vice Chair Janet Yellen, also a well-noted dove, describes an optimal path for policy that foresees inflation just barely kissing 2.25 percent at best. In short, within the Fed there is very little support for any inflation drift that would "cloud our credibility for decades to come." This is simply a nonsensical fear on Lacker's part.

Next, we have the argument that we will never see inflation coming because of the Fed's large scale asset purchase program:

Mickey Levy, chief economist for Bank of America and an SOMC member, said that the Fed “has neutralized the bond vigilantes” by keeping rates low. In other words, even if bond traders are worried that inflation will heat up, they don’t dare bet that way by driving interest rates higher, because the Fed will swat them away by pushing rates back down. “The adage ‘Don’t fight the Fed’? It’s in full force,” Levy said.

Do people forget that both the BLS and the BEA publish monthly reports on prices? That the Fed would not incorporate this data into their decision making process? That the Fed cannot control inflation expectations as measured by the TIPS market, the very same expectations the Fed uses as a policy guide?

There will still be plenty of data and market indicators even within the context of bond purchases. Here is my expected sequence of events: If growth or inflation accelerates to the point that the Fed will be expected to change policy, bond market participants will bid down the price of Treasuries holding constant a given pace of asset purchases (that "all else equal" thing). The Fed will then have a choice - either prepare to tighten as the market expects, or accelerate the pace of asset purchases to hold rates down. If they choose the second route, the bond sell-off will accelerate as participants begin to suspect the Fed is not committed to the 2 percent target. That would be the signal the Fed is clearly moving in the wrong direction. And you should expect inflation to move higher. In other words, the Fed's bond purchase program does not by itself eliminate inflation signals should such signals emerge. The bond vigilantes have not been neutralized by the Fed; they have been neutralized by reality.

Finally, back to the 2 percent target:

The Shadow Open Market Committee meeting wrapped up just before Bernanke spoke a few blocks away at a meeting of the Economic Club of New York. Harvard University economist Martin Feldstein, who attended the SOMC symposium, was given the privilege of asking Bernanke questions at the Economic Club luncheon. He did not choose to ask the chairman whether the Fed was walking away from its 2 percent inflation target.

Right after the luncheon, though, Bloomberg TV’s Mark Crumpton asked Feldstein, who was President Ronald Reagan’s chief economic adviser, if he was concerned that the Fed hadn’t been talking about the 2 percent target lately. “Absolutely,” Feldstein said. “It’s very important for the Fed to reaffirm those goals.”

Notice that Feldstein claims the Fed is not discussing the target moments after Bernanke spoke. But what did Bernanke actually say? To the tape:

But with longer-term inflation expectations remaining stable, the ebbs and flows in commodity prices have had only transitory effects on inflation. Indeed, since the recovery began about three years ago, consumer price inflation, as measured by the personal consumption expenditures (PCE) price index, has averaged almost exactly 2 percent, which is the FOMC's longer-run objective for inflation. Because ongoing slack in labor and product markets should continue to restrain wage and price increases, and with the public's inflation expectations continuing to be well anchored, inflation over the next few years is likely to remain close to or a little below the Committee's objective.

How has the Fed not been talking about the 2 percet target? They repeatedly emphasize the target. Bernanke does so virtually every time he speaks. Cleveland Federal Reserve President Sandra Pianalto basically says the 2 percent target is so concrete that there should no longer be a distinction between hawks and doves. How can Feldstein sit through Bernanke's speech and completely miss the part that addresses Feldstein's concerns? How can he not say "the Fed talks about 2 percent every chance they get"? The only explanation: He simply does not want to recognize any information that departs from his pre-conceived view of the world.

Bottom Line: Inflation hawks continue to operate in a parallel universe.

 

Posted with Blogsy

Thanksgiving

Best wishes to all....

Easy Holiday Shopping

One stop holiday shopping in Central Oregon.

Industrial Production Stalls

Sober Look is questioning just how temporary will be the impact of Hurricane Sandy on the data.  I tend to think about this in somewhat different terms.   I am fairly confident that the impact of Sandy on the national data will be almost entirely transient.  I am less confident that we are identifying underlying trends in the data as we dismiss any weaker than expected numbers as artifacts of Sandy.  At the moment, however, I think this issue is largely confined to manufacturing data.

As is well known at this point, industrial production slipped 0.4% in October, but the Federal Reserve estimated that Sandy contributed to a 1 percentage point decline in production.  The manufacturing side of the ledger, almost three-quarters of the index, was flat after accounting for Sandy, which is pretty much par for the course of the last year:

 

Obviously, the flat trend in manufacturing was in place well before Sandy, and could get much worse if the core durable goods new orders data is any indicator:

Seeing the trend in place makes me a little less comforted by the fact that the October slide can be attributed to Sandy.  What if we see another slide in November?  Will that too be attributed to Sandy, or is there something more than meets the eye?  Should we be worried about recession?  I think that answer depends on whether or not you view the manufacturing drag as largely caused by domestic or international factors.  If it is largely external, I think it slows the US economy but does not tip us into recession.  We experience something closer to 2007/8, with the housing rebound taking the place (albeit weakly) of the tech boom.  A domestic event, would be more significant.  

So which is it?  The Wall Street Journal reports this morning:

U.S. companies are scaling back investment plans at the fastest pace since the recession, signaling more trouble for the economic recovery.

Half of the nation's 40 biggest publicly traded corporate spenders have announced plans to curtail capital expenditures this year or next, according to a review by The Wall Street Journal of securities filings and conference calls.

But why is capital spending weak?

At the same time, exports are slowing or falling to such critical markets as China and the euro zone as the global economy downshifts, creating another drag on firms' expansion plans...Corporate executives say they are slowing or delaying big projects to protect profits amid easing demand and rising uncertainty. Uncertainty around the U.S. elections and federal budget policies also appear among the factors driving the investment pullback since midyear....Companies fear that failure to resolve the fiscal cliff will tip the economy back into recession by sapping consumer spending, damaging investor confidence and eating into corporate profits.

Firms see the real impact of an external slowdown, and they fear the consequences of fiscal austerity.  But which firms?  

Snapon Inc., which makes equipment for auto technicians, reports healthy investment among the 800,000 small businesses it serves across the U.S. "Their confidence is fair and reasonable," said Snap-on CEO Nicholas Pinchuk. "As you move up to bigger companies, their foresight becomes broader and their confidence starts to erode."

This should not be surprising; large firms with significant international exposure are feeling the heat from Europe, China, etc.  Already impacted by this weakness, they are especially sensitive to the potential impact from the fiscal cliff.  This contrasts greatly with the evolving domestic side of the equation:

The slowdown in capital spending contrasts with a rebound in U.S. consumer spending and confidence, which has returned to a five-year high. Meanwhile, the latest survey by the Business Roundtable, which tracks expectations for sales and investment among its big-company CEOs, found the worst sentiment about the economic outlook in three years.

Consumer confidence has rebounded in recent months, and now looks consistent with the current pace of spending.  Job growth continues while the unemployment rate continues to track down.  The impact of Sandy on retail sales was relatively small, and note that the September number was revised up.   And, importantly, it is hard to deny the upward progress in housing markets:

It would be a historical anamoly to experience a recession when housing is on the upswing, and I am challenged to believed that trade channels are by themselves sufficient to defy that history and trigger a domestic recession. 

That said, I understand completely firms' lack of confidence.  Particularly for larger, international firms, the impact of slowing growth overseas is real, and going over the fiscal cliff will only make their problems worse.  Indeed, a rapid turn to austerity is the kind of domestic event that could turn history on its head and induce a recession despite a housing recovery.  

At the moment, however, consumers seem far less concerned about the fiscal cliff than their corporate counterparts.  Perhaps this is an artifact of the lack of partisan bickering since the election.  Or maybe households rationally believe that since Congress has worked this out in the past, they will work it out now.  But whatever the case, housesholds are not expecting Congress to disrupt their holiday spending plans.  Let's hope that remains the case.

 Bottom Line:  The external sector is having an impact on manufacturing, and this was evident in the data well before Sandy, so we can't just ignore data weakness in that sector.  The impact is greatest on just where you would expect - large multinationals.  But the domestic economy still appears to be chugging along, with the housing market picking up the slack from manufacturing.  On net, that suggests no great acceleration in aggregate activity in the near-term, especially when combined with more fiscal austerity.  At the same time, however, the US should be able to escape the international turmoil without a recession.  So what is the near term risk?  Aside from the usual suspect (oil price surge from Mideast war, etc.), the fiscal cliff is still at the top of the list.

Fiscal Madness

What is it about fiscal policy that brings out the crazy?  Because it all seems pretty simple.  Joe Weisenthal hits the nail on the head:

The U.S. recovery has been remarkable on a comparative basis precisely for one reason: Because despite all of the rhetoric, the U.S. has completely avoided the austerity madness that's gripped much of the world.

Weisenthal points us to Ryan Avent and Josh Lehner, both showing in different ways the better post-recession outcomes experienced by the US compared to other economies.  Paul Krugman extends the argument by comparing the divergent path of Eurozone and US unemployment rates.  The key difference in policy - the US pursued a more aggressive fiscal policy and didn't pull back too quickly.  I don't think you can emphasize this point enough.   

Which brings us to the fiscal cliff (or slope, which is more accurate and avoids creating the false impression that all is lost come January 1).  The tax increases and spending cuts in place promise to repeat the mistakes of the UK and the Eurozone by pivoting too fast and too hard into the realm of fiscal austerity.  A solution to the fiscal cliff means smoothing the path to fiscal consolidation (optimally, with no austerity in the near term, but I don't see that as an outcome).  The proximate cause of Weisenthal's ire is former Federal Reserve Chairman Alan Greenspan, who says:

All of the simple low hanging fruits have been picked and the presumption that we are going to resolve the big issue on spending by making a few little twitches here and there I think is a little naive. If we get out of this with a moderate recession, I would say that the price is very cheap. The presumption that we will solve this problem without paying I think is grossly inappropriate...I think the markets are getting very shaky. And they are getting shaky because I think fiscal policy is out of control. And I think the markets will crater if we run into any evidence that we cannot solve this problem.

As Weisenthal notes, this is a completely backwards analysis.  Let's make this clear:  If you think fiscal policy is out of control, you should welcome the fiscal cliff.  From the CBO:

 

If markets are shaky, they are shaky because participants recognize the recessionary impact of this level of fiscal austerity and they don't like it.  Market participants want Congress and the President to do exactly what Greenspan claims is impossible, minimize the impact of spending cuts.  

It is truly time for Greenspan to simply fade away; he no longer has anything useful to add to the discussion.  Of anything.  Who should join him is Dallas Federal Reserve President Richard Fisher.  Fisher laid further claim to the title of "Worst Monetary Policymaker Ever" in a speech last week, first by describing Congress as "parasitic wastrels."  It should be obvious that this is not exactly speech conducive to maintaining an independent central bank.  He continues with this tirade:

The jig is up. Our fiscal authorities have mortgaged the material assets of our grandchildren to the nth degree. We are at risk of losing our political heritage of reaching across the aisle to work for the common good. In the minds of many, our government’s fiscal misfeasance threatens the world’s respect for America as the beacon of democracy...So my only comment today regarding the recent federal elections is this: Pray that the president and the Congress will at last tackle the fiscal imbroglio they and their predecessors created and only they can undo. 

The rise in neo-Nazi's in Greece is a democratic outcome of austerity?  Again, Fisher just doesn't get it.  He seems to believe that the challenge upon us is to radically cut spending.  Again, this is absolutely not the challenge upon us.  In the middle of this tirade he launched into another:

Only the Congress of the United States can now save us from fiscal perdition. The Federal Reserve cannot. The Federal Reserve has been carrying the ball for the fiscal authorities by holding down interest rates in an attempt to stoke the recovery while the fiscal authorities wrestle themselves off the mat. But there are limits to what a monetary authority can do. For the central bank also plays a fiduciary role for the American people and, given our franchise as the globe’s premier reserve currency, the world. We dare not become the central bank counterpart to Congress by adopting a Buzz Lightyear approach of “To infinity and beyond!” by endlessly purchasing U.S. Treasuries and agency debt so as to encumber future generations of central bankers with Hobson’s choices when it comes to undoing what seems contemporarily appropriate.

Fisher appears to be under the delusion that the economy is suffering from the effects of large deficits (which require "fiscal authorities to wrestle themselves off the mat"), and the Federal Reserve is the sole support of those deficits.  He continues to look at the world as if the US economy was operating well above potential, and that only the Fed stands in the way of 10% interest rates.  Of course, if this were true, unemployment would not by near 8%, wage growth would not be scraping the floor, and inflation would not be hovering below the Fed's 2% target.  Fisher is not dissuaded by these little facts. 

And, by the way, despite Fisher's argument to the contrary, being the counterpart to Congress is exactly what the Fed will do as long as the economy is unable to exit the zero bound in the absence of fiscal stimulus.  

Why are Greenspan and Fisher so horribly wrong?  Because they belong to a group that has worried incessantly that large deficits would bring economically ruinous high interest rates and, unless held at bay by the Federal Reserve, runaway inflation.  Such worries have been repeatedly proved unfounded, but Greenspan and Fisher have no other intellectual framework to fall back on.  When you only have a hammer, everything is a nail.  For them, any question of fiscal policy always needs to be twisted into their version of the world, even when the opposite is so completely obvious to just about everyone else at this point.

Finally, despite the ongoing evidence that fiscal austerity has failed and now pushed the Eurozone back into recession, we get this from European Central Bank President Mario Draghi (via FT Alphaville):

In my joint work with the Presidents of the European Council, the European Commission and the Eurogroup, we have identified four pillars on which to build a stable and prosperous Europe: a banking union with a single supervisor; a fiscal union that can effectively prevent and correct unsustainable budgets; an economic union that can guarantee sufficient competitiveness to sustain high employment; and a political union that can deeply engage euro area citizens.

Sounds good, right?  But pay close attention to his definition of a fiscal union.  It remains nothing more than an austerity union, a mechanism to control deficit spending.  But a fiscal union is so much more.  It transfers resources across regions.  It serves as an insurer for all regions.  And it frees the central bank from having to be the lender of last resort to individual regions.  For Draghi, however, a fiscal union is just a mechanism to control spending.  And controlling spending has done little more than push the Eurozone deeper into recession.  Draghi might have prevented financial collapse, but the price he extracted ensures ongoing recession nonetheless. 

Bottom Line:  We need to find a cure for the crazy that some fall into whenever the topic is fiscal policy.

Yellen Supports Explicit Guideposts

Today Federal Reserve Vice Chair Janet Yellen discussed the evolution of policy communications.  As might be expected from Yellen, there was a dovish tone to the speech.  She provides a very nice overview of the Fed's changing communication strategy before shifting to her preferred path for the future.  Along the way, she reiterates her estimated optimal path for monetary policy:

The notable feature of the optimal path is that inflation glides to its long-run target from above while unemployment does the opposite.  These path are achieved by holding down interest rates longer than the level implied by a Taylor-type rule. Yellen explains that it is challenging to communicate such a rule, particularly in the current circumstances:

The fact that simple rules aren't as useful in current circumstances as they would be for the FOMC at other times poses a significant challenge for FOMC communications, especially since private-sector Fed watchers have frequently relied on such rules to understand and predict the Committee's decisions on the federal funds rate...

...Now, however, the federal funds rate may well diverge for a number of years from the prescriptions of simple rules. Moreover, the FOMC announced an open-ended asset purchase program in September, and there is no historical record for the public to use in forming expectations on how the FOMC is likely to use this tool. Thus, the current situation makes it very important that the FOMC provide private-sector forecasters with the information they need to predict how the likely path of policy will change in response to changes in the outlook...

How can the Fed augment the current communication strategy of an expected time frame for exceptionally low rates coupled with broad economic objectives to be met prior to changing policy?  First, more explicit forecasts:

One logical possibility would be for the Committee to publish forecasts akin to those I've presented in figure 1. That is, the Committee could provide the public with its projections for inflation and the unemployment rate together with what it views as appropriate paths both for the federal funds rate and its asset holdings, conditional on its current outlook for the economy. 

Yellen notes, however, that the Fed's institutional structure relies on 19 forecasts, which is challenging to synthesize into a single forecast. Research in this area is ongoing.  She then supports the basic approach advocated by Chicago Federal Reserve President Charles Evans and Minneapolis Federal Reserve President Narayana Kocherlakota:

Another alternative that deserves serious consideration would be for the Committee to provide an explanation of how the calendar date guidance included in the statement--currently mid-2015--relates to the outlook for the economy, which can and surely will change over time. Going further, the Committee might eliminate the calendar date entirely and replace it with guidance on the economic conditions that would need to prevail before liftoff of the federal funds rate might be judged appropriate. Several of my FOMC colleagues have advocated such an approach, and I am also strongly supportive. The idea is to define a zone of combinations of the unemployment rate and inflation within which the FOMC would continue to hold the federal funds rate in its current, near-zero range.

While I like explicit targets in theory, I have been concerned that monetary policy is too complex to summarize in two numbers, thus making it a communications nightmare rather than a dream.  Perhaps I am too pessimistic.  Yellen offers a response:

Under such an approach, liftoff would not be automatic once a threshold is reached; that decision would require further Committee deliberation and judgment.

Not a fixed target that requires action, just consideration of action.   Whether the rest of the FOMC follows suit with this approach is another question, but the winds are definitely blowing in that direction. On average then, this is relatively dovish.  The Fed is heading toward a policy direction that would explicitly allow for inflation somewhat above target and unemployment below target as long as inflation expectations remained anchored.  One would think this should put upward pressure on near term inflation.  But Ryan Avent notes the opposite is occuring:

But since mid-October, there has been an unmistakable reversal in the inflation-expectations trend. Based on 5-year breakevens, all of the September spurt has been erased. And 2-year breakevens are back at July levels. Given my optimism over the Fed's September moves and the apparent strength of underlying fundamentals in the economy, I would like to disregard this trend, but one should be very reluctant to abandon guideposts that have served one well just because they've moved in an inconvenient way.

Graphically:

Avent has a point here (with the caveat that TIPS-based inflation expectations might be less than perfect). He also expressed concern about a broader array of assets:

Other proxies for demand—equity prices, bond yields, and the level of the dollar—have also moved, albeit modestly, in worrying ways. The S&P 500 is down a bit over 5% from its September high, the 10-year Treasury yield has fallen more than 20 basis points since October, and the trade-weighted dollar, which plunged after the Fed's September meeting, has been strengthening since the middle of last month.

I would add that Yellen's speech did not even generate a knee-jerk response in the stock market today.  I remember a time not long ago when any hint of dovishness was good for a 1% rally.  Which, combined with Avent's thoughts, leaves me wondering if open-ended QE is the last of the Fed's monetary tools.  We now know the Fed will continuously exchange cash for Treasury or mortgage bonds until the Fed's economic objectives are met.  Uncertainty about the course of monetary policy as been largely eliminated.  There is not likely to be a premature policy reversal.  What if the pace of the economy does not accelerate, sustaining a large, persistent output gap and a low inflation environment?  The Fed could increase the pace of purchases, but would this really change expectations?  Can we get more "open-ended?"  

Bottom Line:  Yellen delivers a dovish speech, siding with Evans and Kocherlakota who had previously advocated explicit inflation and unemployment guidelines for policy change.  The Fed is moving in this direction, promising to further lock-in a program of aggressive large scale asset purchases.  But is this the end of the road for policy?  "Open-ended" sounds much like "unlimited."  And unlimited sounds like the end of the road.  If the economy stumbles, will the Fed pull a new trick out of its policy bag, or is that bag finally empty?  And if that bag is empty, then we will need to turn to fiscal policy if the economy stumbles.  This is worrisome given the expected path of fiscal policy - tighter, just degrees of tighter. Which means for the moment we just cross our fingers and hope the economy gains traction on the back of housing and accelerates as 2013 progresses. 

Consumer Sentiment Back on Track

The preliminary Reuters/University of Michigan consumer sentiment number for November rose to its highest level since 2007.  Does this foreshadow a faster pace of consumer spending?  I think it is too early make such predictions.  Remember, sentiment has been rising since the middle of 2011, but consumer spending has sagged.  So far this year, consumer sentiment has mostly played a game of catch-up.

In the middle of 2010, real household spending diverged from consumer sentiment.  This year, the two series re-converged:

Consumer sentiment so far has simply returned to levels consistent with the pace of spending.  Further gains, however, would be consistent with faster spending.  Something to keep an eye on as an upside risk in 2013.