Tim Duy's Fed Watch

Fedspeak on Both Sides of the Atlantic

Federal Reserve Chairman Ben Bernanke and New York Fed President William Dudley both took to the podium yesterday.  Dudley spoke directly to the current intersection between the economic outlook and monetary policy, while Bernanke took on the topic of monetary policy in a global context.  Despite coming from different directions, both were supportive of current policy.

Dudley first, as it seems journalists are seeing the speech with somewhat different eyes.  Jonathon Spicer at Reuters walked away with:

New York Fed President William Dudley, a close ally of Fed Chairman Ben Bernanke, gave a strong and comprehensive speech defending the very easy monetary policies that he said were gaining traction and must not yet be adjusted.

Spicer concludes from the speech, accurately I think, that it is consistent with expectations that the Fed will continue large scale asset purchases at the current pace for the foreseeable future (most of this year, by my expectations).  Notable was Dudley's view of the labor market.  From the speech:

So how are we doing relative to our objective of a substantial improvement in the labor market outlook?...The unemployment rate is modestly lower and private non-farm payroll growth a bit higher...other important indicators including the employment-to-population ratio and job-finding rates are essentially unchanged...This suggests that the labor market is far from healthy.

Moreover, our policy is based on the outlook for the labor market, not the level of employment or unemployment today. In this context I note that the recent improvement in payroll employment growth, which gets much of the attention, is out-sized relative to the growth rate of economic activity that supports it. We have seen this movie before...As a result, it is premature to conclude that we will soon see a substantial improvement in the labor market outlook.

The implication for policy:

Currently we are falling well short of our employment objective and the restrictive stance of federal fiscal policy is a factor. On inflation, we are also falling short, but by a considerably smaller margin. As a consequence, we need to keep monetary policy very accommodative.

I do not claim that there are no costs or risks associated with our unconventional monetary policy regime. But I see greater cost and risk in moving prematurely to a policy setting that might not prove sufficiently accommodative to ensure a sustainable, strengthening recovery...

Seems to be a clear indication that he is not inclined to alter the pace of asset purchases in the near future.  At a minimum, Dudley is looking for evidence that the recent acceleration in job growth is sustainable (in concert with improvement across a broad range of indicators), and I think that will come only after another six months of nfp numbers consistently 200k+.

Other journalists took a different focus.  The headline of Victoria McGrane's Wall Street Journal piece is:

Fed Banker Backs Dialing Down Easy Money

Something of a hawkish tone, no?  From the article:

A member of the Federal Reserve's inner circle Monday promoted a plan for the central bank to scale back the pace of its bond-buying program as the jobs market improves, though he stressed that a decision on how to proceed is far from imminent.

Similarly, Robin Harding's Financial Times piece is titled:

Dudley gives first hints of slowing QE3

Again, something of a hawkish take.  Harding's lead-in:

One of the Federal Reserve’s biggest backers of easy monetary policy said he supported the slowdown of the central bank’s asset purchases once the US economy had enough momentum.

I think these headlines imply that the end of quantitative easing is closer than conventional wisdom holds.  I don't think that should be a takeaway.  But these articles focus on another takeaway, that the Fed is coalescing around a plan to taper-off asset purchases, not end cold-turkey.  From Harding's piece:

The comments by Bill Dudley amount to the first official hint that the pace of a reduction in the asset purchase programme – known as QE3 – is likely to be gradual, and may soothe market worries about the impact of reduced purchases by the Fed.

 Back to the speech:

In my view, we should calibrate the total amount of purchases to that needed to deliver a substantial improvement in labor market conditions, by allowing the flow rate of purchases to respond to material changes in the labor market outlook...At some point, I expect that I will see sufficient evidence of economic momentum to cause me to favor gradually dialing back the pace of asset purchases.

Given the current outlook, FOMC members do not anticipate increasing the size of asset purchases.  The discussion will thus naturally turn toward the other direction - when and how should we end asset purchases?  I think Harding is correct to conclude that a consensus is building within the Fed to taper-off purchases gradually, but only after the sufficient progress is made on the labor market front.  But be wary of losing focus on the latter point.  Even if the Fed know how they want to end the asset purchase program, that time is still far off given the current forecasts.

Dudley added an interesting footnote to the last sentence I quoted above:

Assuming that the improvement in the outlook is not endogenous to the chosen policy setting to the extent that it would disappear if purchases were slowed.

This suggests that it is not enough that the labor market makes sufficient progress to justify changing policy.  The Fed also has to be confident that the progress is self-sustaining in the absence of quantitative easing.  It seems to me that this raises the bar for slowing asset purchases.

Separately, Bernanke took on the issue of the so-called currency wars.  After a history of exchange rate policy during the Great Depression, Bernanke concludes:

The lessons for the present are clear. Today most advanced industrial economies remain, to varying extents, in the grip of slow recoveries from the Great Recession. With inflation generally contained, central banks in these countries are providing accommodative monetary policies to support growth. Do these policies constitute competitive devaluations? To the contrary, because monetary policy is accommodative in the great majority of advanced industrial economies, one would not expect large and persistent changes in the configuration of exchange rates among these countries. The benefits of monetary accommodation in the advanced economies are not created in any significant way by changes in exchange rates; they come instead from the support for domestic aggregate demand in each country or region. Moreover, because stronger growth in each economy confers beneficial spillovers to trading partners, these policies are not "beggar-thy-neighbor" but rather are positive-sum, "enrich-thy-neighbor" actions.

Obviously, Bernanke rejects the currency war story, at least as far as it applies to developed nations.  What about less-developed economies?  The story is a bit more complicated.  Bernanke notes that developing nations may be relying on an export-based growth strategy and may have underdeveloped financial sectors that leave them vulnerable to capital inflows.  Bernanke responds that trade-weighted exchange rates are little changed since 2008, and that stronger developed nation growth helps exporters in developing nations.  In addition, with regards to capital flows:

It is true that interest rate differentials associated with differences in national monetary policies can promote cross-border capital flows as investors seek higher returns. But my reading of recent research makes me skeptical that these policy differences are the dominant force behind capital flows to emerging market economies; differences in growth prospects across countries and swings in investor risk sentiment seem to have played a larger role. Moreover, the fact that some emerging market economies have policies that depress the values of their currencies may create an expectation of future appreciation that in and of itself induces speculative inflows.

Notice that at the end he hits the ball back to the currency manipulators?  Furthermore, he advocates considering capital controls:

Of course, heavy capital inflows and their volatility pose challenges to emerging market policymakers, whatever their source. Policymakers do have some tools to address these concerns. In recent years, emerging market nations have implemented macroprudential measures aimed at strengthening their financial systems and reducing overheating in specific sectors, such as property markets. Policymakers have also experimented with various forms of capital controls. Such controls raise concerns about effectiveness, cost of implementation, and possible microeconomic distortions. Nevertheless, the International Monetary Fund has suggested that, in carefully circumscribed circumstances, capital controls may be a useful tool.

Again, Bernanke is pushing the conversation back onto his critics.  Developing nations have tools to address their concerns.  Use them.

Bottom Line:  The Fed is not thinking about expanding the pace of asset purchases.  Instead, they are thinking about when and how to end those purchases.  Policymakers anticipate a gradual end to the program, and they want to communicate their intentions well ahead of the actual timing of the policy change.  So expect them to continue to walk a fine line between acknowledging the exit strategy while making clear the exit is not imminent.  Finally, Bernanke continues to brush off critics, both home and abroad.

 

Do Capital Controls Mean Cyprus Has Already Left the Eurozone?

Cyprus is in a struggle to save itself, at least the European definition of "save itself," and remain a Eurozone member.  But will Cyrpus even use the same euro as the rest of Europe when all is said and done?

After all, banks remain closed in Cyprus, which means a euro in a Cypriot bank has very little value.  If you can't spend it, is it really a euro?  And even when banks reopen, it is assumed that capital controls will be imposed to prevent euros from leaving the island.  So a French euro will be able to purchase goods and services in Germany, but a Cypriot euro will not. It seems then that a Cypriot euro is unambiguously worth less than a French euro.  

Thus, there will be two Euros in circulation (if not already).  This is the thesis of blogger Guntrum B. Wolff (ht Ed Harrison):

The most important characteristic of a monetary union is the ability to move money without any restrictions from any bank to any other bank in the entire currency area. If this is restricted, the value of a euro in a Cypriot bank becomes significantly inferior to the value of a euro in any other bank in the euro area. Effectively, it means that a Cypriot euro is not a euro anymore. By agreeing to this measure, the ECB has de-facto introduced a new currency in Cyprus.

I think this might be right.  If I can spend my dollar in Oregon but not in California, it is really the same dollar?  I think not.  

Is this how the Eurozone experiment will end?  Not with a formal "exit," but with a return to banking dominated by national boundaries and enforced by capital controls?  No longer a true common currency, but a dozen currencies sharing the same name, each with a different value?  

There will be another banking crisis in Europe (just as a bank will fail in some US state) and depositors are now aware that they are fair game in any crisis response, so capital flight will intensify at an earlier stage in the crisis.  As may have been noted, European policymakers find rapid crisis resolution to be something of a challenge, thus accelerated capital flight will necessitate a more rapid imposition of capital controls in the future - and with each round of capital controls, a new sub-euro will be born.

Bottom Line:  Europe's response to the Cyprus situation will have long-lasting impacts on the Eurozone experiment itself, none of the good.  Indeed, the imposition of capital controls should lead one to wonder if the "solution" to Cyprus is effectively an exit from the Eurozone is everything but name.  And don't forget that the crisis also threatens to destabilize the region geopolitcally.  I don't think that "disaster" is too strong a word in this case.

The Recovery is Real

 A lot of ink has been spilled over the past three years fretting about the fragility of the economy.  But the reality is largely the opposite.  The economy has proved to be very resilient.  We have weathered external demand shocks, external financial crises, and even fiscal contraction, and all the while economic activity continued to grind higher.  Looking back, it seems that the biggest risk the economy faced was the Fed's start/stop approach to quantitative easing.  That problem appears solved with open-ended QE linked to economic guideposts.

At the risk of sounding overly optimistic, I am going to go out on a limb:  The recovery is here to stay.  Not "stay" as in "permanent."  I am not predicting the end of the business cycle.  But "stay" until some point after the Federal Reserve begins to raise interest rates, which I don't expect until 2015. This doesn't mean you need to be happy about the pace of growth.  But it does mean that a US recession in the next three years should be pretty far down on your list of concerns.  

Consider a handful of recent data.  Last year's slowdown in manufacturing activity has proved temporary:

Remember, this was the data that ECRI claimed was a smoking gun in their hypothesis that the US economy slipped into recession in the middle of last year.  Retail sales continued to gain in February despite the end of the payroll tax break:

Sure, you might complain about weak consumer confidence, but I think it best to pay more attention to what household do.  The housing market is unambiguously improving, which by itself should ease any recession concerns:

Note recent reports that the housing market is catching even producers off-guard, constraining supply.  Expect them to gear up over the year, setting the stage for a stronger activity in 2014.  With the issues of jobs in mind, note that jobless claims continue to grind lower:
 

Still too high, but moving in the right direction; I expect claims will fall to 300k by then end of this year or early next year.  

I anticipate monetary policy will remain on hold for much of this year before the Federal Reserve turns to the issue of tapering off the pace of asset purchases.  Even then, rates will not increase until 2015;  inflation is simply too low and unemployment too high to justify a policy shift before that time. Interestingly, I am believe the biggest risk to my expectations is that the economy accelerates faster than expected, prompting the Federal Reserve to raise rates in late 2014.  

To be sure, I think that fiscal policy will weigh on growth in the first part of 2013.  And I think that the European crisis is far from solved (note today's PMI release, not to mention Cyprus).  And maybe China will slow further, undermining exports.  But as far as the implications for the US economy, I tend to see these events as bumps in the road.  They might cause air pockets for equity markets, but are of second or third order importance in the evolution of US activity.

Indeed, it seems to me that betting on a recession when the Fed is not tightening is clearly betting against history.  Moreover, historically the Fed has inverted the yield curve prior to a recession:

And yes, I realize this seems to imply that the US economy cannot have a recession because the yield curve is upward sloping - which of course it has to be when short rates are constrained by the lower bound.  But that still doesn't resolve the issue that recessions tend to occur only after a period of tighter policy.  As long as the Fed is able and willing to ease in the face of negative shocks - and they have seemed to be willing to do so and have  found a solution to the zero bound problem in quantitative easing - I would expect that monetary policy would largely offset most problems that comes down the pipeline.  

Case is point is the Asian Financial Crisis.  I remember predictions of US recession due to the trade shock, but that never occurred.  The Fed eased into the crisis, mitigating its impact.  The recession only occurred after the Fed revered course and tightened sufficiently to invert the yield curve.  Arguably last summer's European shock was the same.  The Fed met fire with fire, and recession fears faded. 

Could I imagine a shock the Federal Reserve could not offset sufficiently?  Something that just came on too strong, too fast?  Sure - I suspect a US debt default would be such a shock.  But I also put very low probability on such an occurrence.  As a general rule, the US economy is a like a large ship.  It may run into headwinds that slows its progress and I can argue it needs more coals in its furnace, but it doesn't turn on a dime.  Pretty much best just to stay out of its way until the Federal Reserve decides it turn the rudder.

Mostly now I concern myself with the pace of growth (still disappointing) and the eventual policy reversal.  Similar to Ryan Avent here, I am not convinced that the Fed will be successful in pulling the economy off the zero bound:

If recovery proceeds as the Fed anticipates, its interest-rate target will remain at near zero until at least 2015. Perhaps more worrying, the FOMC's best guess at the appropriate, long-run value of the fed funds rate is about 4%. That is strikingly low. In each of the past three recessions the Fed has responded by cutting the fed funds rate more than 4 percentage points. A fed funds rate at that level virtually guarantees that the next downturn will result in a relapse into ZLB territory. Unless the Fed suddenly becomes much more comfortable with unconventional policy, the unemployment rate will rise more than it otherwise would and recovery will be weaker as a result. And that's assuming that growth over the next few years actually is robust enough to allow the Fed to get rates back to 4%, which is not at all guaranteed.

My second concern is to what extent this expansion, like the last two, will be dependent on asset valuations.  What will this chart look like in two years?

Caution:  Pure speculation follows.  If this recovery is built on an asset bubble (and I am starting to entertain a possibility that I had previously discounted, that it could be a joint equity/housing bubble), then I suspect we will learn after the Fed tightens policy that we are not off the zero bound.  If so, I further suspect the next recovery will require the Fed to deliver a pure-helicopter drop of money. 

Bottom Line:  The US economy is less fragile than commonly believed; it has endured a series of shocks over the last three years without major incident.   I am claiming neither that equity prices won't stumble, nor that we should be happy with the pace of activity.  But I do think that a recession is unlikely before the Federal Reserve begins raising interest rates - something not likely to happen for two years.  While long-run predictions are dangerous, for the sake of argument add up to another two years for tighter policy to reverberate through the economy and you are looking at sometime around 2016/2017 when the next recession hits.  That's the timeframe I am currently thinking about.

If Communication Is Effective...

Today's FOMC statement and subsequent press conference by Federal Reserve Chairman Ben Bernanke reaffirmed the general view that the Fed will keep short-run interest rates locked down until 2015.  It should be expected that the same is not true for long-rates.  If communications are effective, we would expect long rates to rise well ahead of the date of the first increase in the federal funds target. 

Consider Bernanke's reference to 1994 in his recent speech:

We also have some historical experience with increases in rates during tightening cycles to consider. For example, in 1994, 10-year Treasury yields rose about 220 basis points over the course of a year, reflecting an unexpected quickening in the pace of economic growth and signs of building inflation pressures. This increase in long-term rates appears to have reflected a mix of a pronounced rise in the expected path of the policy interest rate and some increase in the term premium...our approach to communicating and implementing monetary policy provides the Federal Reserve with new tools that could potentially be used to mitigate the risk of sharp increases in interest rates. In 1994--the period discussed earlier in which sharp increases in interest rates strained financial markets--the FOMC's communication tools were very limited; indeed, it had just begun issuing public statements following policy moves. 

Fed officials are concerned that the exit strategy is not as disruptive for bond market participants as the 1994 episode.  Looking back at the last three major tightening periods:

In 1994, almost all of the increase in long rates occurred during the tightening itself.  In the subsequent episodes, long rates increased only 66bp (99-00) and 60bp (04-06) during the tightening episodes themselves.  Long rates bottomed well ahead of the Fed rate increase, in late 1998 with the Asian Financial Crisis and with the Fed's last rate cut in 2003.  At those times, financial market participants began to anticipate that the Fed would soon change course and begin implementing tighter strategy.  

Better communication in the latter two periods compared to 1994 helped foster a smoother implementation of policy.  And communication tools have only improved since the 04-06 tightening.  Consequently, we should expect that much of the increase in long-rates will occur before the Fed pulls the trigger on short-rates.  That lead-in will prevent the Fed's exit from being as disruptive as many people seem to fear.

Fed Holds

The two-day FOMC meeting concluded with policy unchanged, as expected.  The statement itself was little changed as well.  The Fed acknowledged the improved flow of data since the last meeting, noted tighter fiscal policy, and reaffirmed its view that inflation is likely to remain at or below the 2 percent target.  The Fed removed a statement referring to easing global strains, presumably a reflection of the challenges in Cyprus at the moment.  Asset purchases continue at their current rate.  

A more interesting change can be seen in the Fed's statement regarding the future of the asset purchase program.  The relative paragraph from the January statement:

The Committee will closely monitor incoming information on economic and financial developments in coming months. If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until such improvement is achieved in a context of price stability. In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases.

was changed to this (emphasis added):

The Committee will closely monitor incoming information on economic and financial developments in coming months.  The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.  In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives.

The addition of the final clause appears to be a bow to policymakers who are concerned that the pace of easing might need to be curtailed in the nearer future. I assume this issue will once again be highlighted in the minutes.  It appears to give the Fed room to alter the pace of purchases as the unemployment rate tends toward the 6.5 percent threshold even if, for example, jobs continue to grow in the 150k-200k range.  

That said, I expect asset purchases to continue at this pace for most of this year (if not into next year).  Moreover, most policymakers expect this as well.  Note the relatively minimal changes to the projections:

While the expected unemployment rate was revised downward, the Fed expects it to remain unacceptably high.  Moreover, the top end of the expected inflation rate was revised downward for this year.  The combination of high unemployment and low inflation argue for sustained easing.  Indeed, the combination could argue that policy needs to be even more accommodative. Note also that the unemployment rate is expected to exceed 6.5% through 2015, putting that year as timing of the first rate hike,  And, unsurprisingly, that is the expectation of vast majority of meeting participants.  

In short, with unemployment this high and inflation this low, the benefits of continued easing exceed any potential costs.  And with this in mind, note that Federal Reserve Chairman Ben Bernanke, in the press conference, stated that he did not see anything unusual in current equity valuations, another indication that he believes that concerns about financial market distortions are overblown.

Bottom Line:  Policy is on hold.  On hold for a long time.  Unless activity accelerates substantially, asset purchases will continue at the current rate through most of this year (if not until well into next year), while short-term interest rates will remain locked down near zero until 2015.  Beware of reading too much into the comments of the more hawkish monetary policymakers; they still represent a minority view.  

The War on Common Sense Continues

This weekend, European policymakers opened up a new front in their ongoing war on common sense.  The details of the Cyprus bailout included a bail-in of bank depositors, small and large alike.  As should have been expected, chaos ensued as Cypriots rushed to ATMs in a desperate attempt to withdraw their savings, the initial stages of what is likely to become a run on the nation's banks.  Shocking, I know.  Who could have predicted that the populous would react poorly to an assault on depositors?

Everyone.  Everyone would have predicted this.  Everyone except, apparently, European policymakers.

The situation remains fluid, with even the final hit to depositors still unknown.  The Financial Times is reporting that authorities are considering altering the plan to shift the burden on the tax away from smaller depositors.  Moreover, at this point it is not clear is the parliment will concede to the measures despite a last minute push by ECB officials to affirm the deal before markets open Monday.  And the impact on other nations in the European periphery remains unknown.

At this point, I would imagine the damage is done, regardless of any modification of the plan.  Cypriots  know that their savings are now on the bargaining table.  To be sure, there will be repeated reassurances that this is a one-off event, but how trustworthy are such assurances?  Indeed, if Greece is any example, this will not be the last bailout, and thus plenty of time for the European policymakers to insist on another bite at the apple.  Perhaps if authorities completely backtrack on the plan could they stave off a bank run, but even on that I am not confident.  Trust is easy to lose and hard to earn.

The bigger question is what does this mean for the European financial system as a whole?  Will depositors across the Eurozone view Cyprus as a unique situation?  Or will Greek citizens come to believe that the next tranche of bailout funds might come with a new conditions to shore up government finances?  Will taxes on deposits be an element of any future bailouts?  If so, Italian and Spanish depositors might come to view their mattresses as safer than the bank.  

Perhaps expectations of a broader bank run are premature.  Early reports from Spain claim that no such run is in the making (of course, what else would they say?). But I suspect this is still a game-changing event, sure to make the financial system more unstable by aggravating the negative feedback loop that surrounds financial crises.  What else could be the case when you remove a basic safeguard against panic in the banking system?

I can only sample the amazing amount of excellent commentary in response to this new development.  Frances Coppola, in a must read piece, explains the economic consequences:

The effect of large and small depositors removing funds on that scale will be a brutal economic downturn as the money supply collapses. In particular, the dominant financial sector will suffer a severe contraction, putting thousands of jobs at risk and paralysing lending to Cypriot households and businesses. And that is IN ADDITION to the estimated 4.5% economic contraction that is already happening due to austerity measures imposed on Cyprus in 2012 to reduce its fiscal deficit, and the further measures required in this bailout. 

Yes, exactly how will this help Cyprus emerge from their recession?  If you guessed "it won't," you are correct.  But expect European policymakers to drone on about how their plan will restore confidence in the economy of Cyprus. Coppola also bemoans the culpability in the ECB:

The FT confirms the ECB's role in forcing through the deal. It says the ECB threatened to stop providing liquidity to Laiki, Cyprus's second-biggest bank, which would have caused an immediate disorderly collapse. I have written previously about the ECB's disgraceful behaviour. This is the worst example yet. 

Just two weeks ago I implored the ECB not to do anything stupid.  They didn't listen.  

Like me, Karl Whelan is challenged to see that this was a good choice:

Even if we get through the next week without panic, my gut feeling is that this decision is a bad one and the Europeans should have chosen from the other two options on the table.  Over the longer-term, I doubt if financial stability in the euro area (and the continued existence of the euro) is compatible with a policy framework that doesn’t protect the savings of ordinary depositors. 

Nick Rowe points out that savers in Cyprus are suffering disproportionately because they lack the ability to print their own currency:

The difference is that inflation from printing too much money is a tax on currency too. Cyprus cannot tax currency; it can only tax bank deposits.

Joseph Cotterill (another must read piece), identifies the reason to spread the pain to small depositors:

The spin that this is about spanking money-launderers is rubbish. The 9.9 per cent levy will be the cost of doing business for the average CIS corporate shell, as Pawelmorski notes. More to the point, someone clearly balked at increasing the rate above 10 per cent for big-ticket depositors — because why else distribute pain to small holders to make up for it. Someone has an eye on Cyprus somehow maintaining a future as an offshore banking centre.

Too big a hit to large depositors would end any hope that Cyprus could hold onto its biggest industry.  The anonymously penned Some of it Was True blog wonders if there are any rules in European finance:

Probably of more lasting importance is the latest bout of rule-changing by the authorities. Debt unwindings are generally well-defined in law. First equity, then sub debt, then deposits and senior bonds together, and all treated equally. Most of these principles have been tweaked over the last few years, but the tweaks are getting steadily more aggressive. The ECB, holders of Athens-law and foreign law Greek debt all got different treatment; the Dutch didn’t restructure SNS Reeal paper, they confiscated it; the Irish banned lawsuits against the ultimate wind-down of Anglo Irish. This is scratching the surface compared with the rule-changes of the past but it’s getting steadily more creative.The referee has gone from being quasi-neutral arbiter, to pulling off his black shirt to reveal a Manchester United one underneath and awarding himself a series of penalties. While there’s clearly no point in market participants playing the shocked blushing virgin in the face of a situation where the consequences of following the legally-logical steps are socially unacceptable, the uncertainty generated creates costs too.

Edward Harrison (yet another must read) takes a fatalistic view of the news:

 It was inevitable that we would be in crisis again. The austerity world view of crisis resolution is completely at odds with the capacity of the euro zone’s institutional architecture to handle a crisis. And so, we keep doubling down on the same policy of austerity in exchange for reforms which has created the downward spiral to begin with. I wish I could be optimistic here. But I think it is going to get worse. I hope I’m wrong. And I certainly hope that periphery depositors still have enough faith in the euro to ride this one out. If the Cyprus panic metastasizes, it will get ugly. 

Peter Siegel at the FT places the blame on the Germans:

Unbeknown to the Cypriot delegation members as they entered the hulking Justus Lipsius summit building in Brussels on Friday night, their fate was already sealed: their German counterparts wanted about €7bn for the estimated €17bn bailout of their country to come from deposits in the country’s banks.

“They were hand in hand with Finns, who were much more dogmatic,” said one senior eurozone official involved in the 10-hour marathon talks that stretched until 3am on Saturday morning. “Had that not happened, full bail-in,” the official added, using the terminology for wiping out nearly all Cypriot bank accounts.

Felix Salmon see the German influence as bad for Euope and Germany itself:

The Cypriot parliament is probably not going to revolt this weekend, but any politician who votes for this bill is going to have a very, very hard time getting re-elected. This decision is important not only because of the precedent it sets with regard to bank depositors, but also because of the way in which it points up just how powerless all the Mediterranean countries (plus Ireland) have become. More than ever before, it’s Germany’s Europe. That’s bad for Cyprus — and it’s not even particularly good for Germany.

For their part, the Germans deny responsibility for actions against small depositors:

"It was the position of the German government and the International Monetary Fund that we must get a considerable part of the funds that are necessary for restructuring the banks from the banks owners and creditors - that means the investors," German Finance Minister Wolfgang Schaeuble told public broadcaster ARD in an interview.

"But we would obviously have respected the deposit guarantee for accounts up to 100,000," he said. "But those who did not want a bail-in were the Cypriot government, also the European Commission and the ECB, they decided on this solution and they now must explain this to the Cypriot people."

Bottom Line:  In the short-run, the implications for the European periphery might be limited.  But, in the long-run, it is hard to see the assault on Cypriot depositors as anything but a step backwards for financial stability in Europe.  This crisis remains far from over.

The Importance of Printing Your Own Currency

Quick post - running to the final classes of the term....

Jim Hamilton is defending his recent work calling into question the sustainability of the US debt load.  Brad DeLong takes a first shot at Hamilton's post here.  I take issue with this paragraph:

Whether a country is able to borrow in its own currency is completely irrelevant for the above calculation. Yes, it means the country likely won't technically default on the debt, and could always create new money to pay off the creditors. But as Reis (2013) and Leeper (2013) have recently explained, printing money does not generate any magical resources with which to resolve a real fiscal shortfall. The central bank could create some more inflation, but anticipated inflation does nothing to alter the above determination of the limits on government debt. Anticipated inflation would just cause the nominal interest rate R and the nominal growth rate g to both increase by the same amount, and therefore would do nothing to change the net growth rate r = R - g which is the key parameter in our equation for sustainability (see for example equation (2) in Econbrowser March 6 or equation (8) in our paper).

This ignores the possibility of financial repression - meaning that the government can force yields on its own debt lower, thereby ensuring that inflation, even anticipated inflation, decreases real interest rates.  Back to another post by DeLong:

...and (e) even if we start to tip over into an unsustainable debt-path scenario, we can handle it, because that is why God made financial repression.

Let me spell (e) out a little bit. If investors start to fear that the U.S. debt trajectory is truly unstable, the immediate consequence is a fall in the dollar and an export boom, with somewhat higher domestic inflation. Because the U.S. government regulates the financial system, it can set reserve requirements where it likes--it can thus use its reserve requirements to force banks to hold Treasuries, and if it doesn't like the interest rate at which banks are holding Treasuries, it can up reserve requirements some more.

No, financial repression is not ideal. But it is not a disaster like a collapse of confidence in the debt and the currency....

Arguably, we are currently witnessing a real-time example in Japan's Abenomics policy mix.  The Yen has depreciated significantly, consistent with expectations of inflation.  And there is even growing evidence that wages are responding as well.  From FT Alphaville:

One of the big determinants of whether ‘Abenomics’ manages to pull Japan from its deflationary spiral is through wage growth. Inflation can’t really kick off or arguably even begin without rising wages. One can argue about how important wage growth is, or where it fits in causality-wise — and we’ll come to that later. But it is — or will be — an important signal as to whether this three-pronged approach of the new-ish Japanese government is working.

And actually, it might be catching on. The FT’s Ben McLannahan wrote in early February that the decision by convenience store chain Lawson Inc to raise wages of two-thirds of its staff by 3 per cent could be quite significant..

According to Hamilton, if we have higher anticipated inflation, we should see higher nominal interest rates on government debt, thereby debt sustainability is deteriorating.  But alas:

Time and time again, Japan sticks out like a sore thumb that those preaching the unsustainability of government debt want to sweep under the rug with the "Japan is a special case" story (a country fixed effect).  But it seems more likely that Japan's economy is behaving exactly as you might expect given that it issues debt in its own currency.  In other words, Japan is just a normal case pushed to the extreme.  

A Solid Employment Report

The February employment report was solid - not a blockbuster report, but definitely solid.  And three of the last four employment reports have been solid as well, with payroll growth about 200k per month.  This will undoubtedly raise some chatter that the Federal Reserve's large scale asset purchase program will be tapered back soon than later.  I suspect such talk would be premature.  While the labor market currently has some momentum, we have seen such momentum fade in the past.  Moreover, we are still deep in the labor market hole, so to speak.  The Fed has time to see this play out, and, even if labor markets continue to improve at this pace, will most likely take that time, delaying any reduction of the pace of asset purchases until late this year.  

Headline job gains totaled 236k for February:

December was revised up, but January was revised down. The three-month average is 191k, while the twelve-month average is a more modest 164k, declining slowly over the year.  Note that during the last two years we have seen momentum on either side of the start of the year fade by spring or summer.  The Fed knows this as well, and thus will tend to question the resiliency of these numbers.  This is especially the case as the fiscal contraction is just beginning to work its way through the economy.  Note that government employment continues to be an overall drag on the numbers:

The sequester may aggravate this trend in the near term.  Calculated Risk is optimistic that layoffs at the state and local levels are mostly over; my conversations with municipalities in Oregon tend to be somewhat more pessimistic.  Even though revenues are stabilizing in some cases, costs continue to rise, squeezing budgets.  Anecdotal and regional evidence, so use with caution.

The unemployment rate edged down to 7.7%; at this rate of decline, we will be into next year before we see 6.5%.  And that's not a trigger for Fed action on interest rates - as long as inflation remains contained, 6.5% early next year suggests a rate hike in late 2014 or early 2015, consistent with current expectations.  Why the delay after hitting 6.5%?  Again, I think it reflects the depth of the hole.  Progress on some indicators remains woefully slow:

See also Robin Harding's cheat-sheet on Federal Reserve Vice Chair Janet Yellen's last speech.  

Hawkish monetary policymakers might try to gain some traction on wage gains:

Here again, the depth of the hole matters.  Wage growth has considerable room to climb before it becomes a worrisome inflation indicator.  And note that the all employees figure is not showing the same gains:

 

I would expect that the intensity of public comments by Federal Reserve policymakers increases as the year progresses.  The hawks will almost certainly get increasingly nervous, and like to be heard.  This will probably continue to show up in the minutes.  But the doves, and currently dovish-leaning center, recognize the importance of clear communications, and thus will feel compelled to respond even more vociferously than in the past.  In my opinion, this is not a great overall strategy, but unless Federal Reserve Chairman Ben Bernanke wants to exert more direct control over communications to get everyone on the same talking points, it is what we have.

Bottom Line:  A solid report, but we need a longer stream of solid reports before Fed chatter turns decisively toward tighter policy.

If Not For That Pesky Sequester

This morning's Wall Street Journal headline on the sequester included this quote:

"If they could get this fixed, the economy is poised to take off," Bank of America Corp. Chief Executive Brian Moynihan said in an interview.

I believe this is largely correct, albeit "take off" is perhaps a bit strong.  The US economy looks to have shaken off some of last year's doldrums, particularly in manufacturing and the housing recovery is set to accelerate further this year.  While clearly some external headwinds remain, notably the ongoing economic disaster that is Europe, I tend to think these will have only a second-order impact on the US economy. The immediate concern is obviously the impact of the sequester and earlier tax hikes, especially considering the evolving views of the impact of fiscal policy.  That said, while I find the timing of these policy changes unfortunate and believe they place an unnecessary speedbump in the recovery process, their impact should fade as the year progresses.  

Also bolstering the outlook is that the Federal Reserve is most likely to continue the large scale asset purchase program throughout much of this year.  That was the message of Federal Reserve Chairman Ben Bernanke this week as he minimized concerns that the risks of additional easing outweighed the benefits.  I expect a similar message tonight.  The initial impact of the sequestration will likely place enough downward pressure on the economy which, when coupled with still low inflation (low enough that additional easing would not be unreasonable), should be enough to keep the hawks at bay.

Earlier this week we learned that home sales continue to rise:

Yes, to be sure sales remain at very low levels.  But it is the direction that matters now, and the direction is positive.  In and of itself, the positive direction of housing is consistent with ongoing economic expansion (those ECRI guys are not likely to catch a break).  And while there has been some commentary calling into question the quality of the January numbers, I would counter with signals from the latest ISM manufacturing report indicate that at least the underlying trend of improvement held in February:

"Business seems to be on an uptick. The normal seasonal downturn for us has been much shorter and not as severe as in the past four years." (Furniture & Related Products)

"Demand indicators are robust. Supply is constrained. Pricing is escalating." (Wood Products)

Speaking of manufacturing, that too is looking more robust.  Core-manufacturing orders have staged a remarkable rebound in recent months:

 Likewise, the ISM numbers were generally positive.  Headline, and new orders, and production:

Moreover, even the external indicators were looking better.  Most important in my mind is the improvement in new import orders, a signal of solid underlying domestic demand:

Finally, while the employment index slipped slightly, it still holds in expansion territory:

Were it not for the sequester, and the already evident impact on defense spending, manufacturing would be experiencing even stronger performance.  

Changing tax laws created havoc in the personal income data, first boosting the December figure as taxpayers drew income and capital gains into the waning days of 2012 to avoid higher taxes and then dropping the January number on tax hikes, including the end of the payroll tax credit:

Still, courtesy of a drop in the saving rate as households adjusted to the tax hike, consumer spending continues to grind upward:

I anticipate the spending numbers to remain on the soft side in the near term as the impact of tighter fiscal policy continues to work its way through household budgets.  

None of this is meant to imply that economics conditions are rosy, just that the economy continues to move in the right direction and was likely poised for stronger growth in 2013 if not for tighter fiscal policy.  The anticipated impacts of tighter policy are expected to further widen the output gap:

 

And note that, still contrary to the expectations of those who believed Fed policy would send prices surging ever higher, inflation remains well under control, as would be consistent with an economy running below potential:

The challenge is not too much inflation; the challenge is too little inflation.  Despite the generally positive direction of the economy, there remains room for additional monetary and fiscal stimulus.  I doubt we get more of the former, and we are already seeing the opposite of the latter.  Not exactly the optimal policy mix.

And I would admit to uncertainty about the sustainability the recovery over the longer term; I am still not confident we can exit smoothly from the zero bound.  That, however, might not be a concern until 2016 or 2017 (assuming the Fed starts increasing rates in 2015).  As far as the hear and now is concerned, I anticipate that 2013 is setting the stage for a stronger 2014.  

Bottom Line:  Near term trends are positive, and would be more so if not for the sequester.  That said, I don't expect the near term to be sufficiently positive to derail the path of monetary policy.  Fed hawks will still defer to Bernanke for the foreseeable future.