Tim Duy's Fed Watch

When Can We All Admit the Euro is an Economic Failure?

The last month of data flow from Europe is nothing short of depressing.  It seems that the history of the Eurocrisis can be summed up as a repeated effort to snatch failure from the jaws of defeat.  The Euro and the policy framework that supports it is now clearly inconsistent with anything but sustained recession.

Consider a handful of recent reports.  First, unemployment continues to reach new highs.  From Bloomberg:

Unemployment in the 17-nation euro area was 12 percent in February and the January figure was revised up to the same level from 11.9 percent estimated earlier, the European Union’s statistics office in Luxembourg said today...The European Commission predicts unemployment rates of 12.2 percent this year and 12.1 percent in 2014. ECB President Mario Draghi said on March 7 that “it is of particular importance at this juncture to address the current high long-term and youth unemployment.”

I don't think that 12.2 percent forecast will hold.  Greece remains a complete disaster.  Via Aljazeera:

Greece's unemployment rate reached a new record of 27.2 percent in January, new data has showed, reflecting the depth of the country's recession after years of austerity imposed under its international bailout.

The latest figure rose from a revised 25.7 percent in December, the country's statistics service ELSTAT said on Thursday...Unemployment among youth aged between 15 and 24 stood at 59.3 percent in January, up from 51 percent in the same month in 2012.

Meanwhile, the Troika continues to demand further job cuts in return for a drip feed of bailouts that have arguably done little other than ensure Greece remains in recession:

An inspection team of international lenders has finished its review of Greece's reform progress, paving the way for another 10 billion euros aid payment, a source with knowledge of the talks said on Saturday....Under Greece's current bailout plan agreed in November, Athens must overall cut 150,000 public sector jobs from 2010 to 2015, about a fifth of the total, through hiring curbs, retirements and dismissals.

As a consequence, the stage is being set for another political crisis in Greece.  Ekathimeri reports:

The head of the main leftist opposition SYRIZA, Alexis Tsipras, called on Saturday for the shaky coalition government to step down and pave the way for new elections, claiming that this was “the only way out” for a country seemingly condemned to endless austerity...

...“The situation has reached the absolute limit,” the leftist leader told supporters. “At this moment, there is no other way out for the country than the resignation of the government and the staging of new elections so a new administration can emerge with the mandate and support of the majority of society to implement an alternative plan to exit the crisis.” Tsipras admitted that his plan entailed risks but was preferable to “certain failure.”

Is the price of staying in the Euro finally now too high?  Meanwhile, Ambrose Evans-Pritchard reminds us that both Cyprus have gone from bad to worse:

On cue, Angela Merkel's Christian Democrat base in the Bundestag has warned that there can be no increase in the EU-IMF rescue package for Cyprus.

The Cypriot people alone must carry the extra cost of up to €5.5bn beyond what was already agreed in the €17.5bn deal in March.

"Should that not be possible, the assent of the German Bundestag next week is out of the question," said Christian von Stetten, a key member of the finance committee.

And Evans-Pritchard repeats a point that cannot be repeated enough:

If the eurozone refuses to offer any further help, there must surely be a greater temptation to withdraw from the euro and default on sovereign debt in a classic restructuring deal with the IMF.

That is what the IMF is there to do. Such restructurings have been done countless times across the world over the last 50 years. It is traumatic, but countries usually recover after a couple of years.

Currency depreciation is a critical element of traditional IMF restructurings.  The inability of troubled Eurozone economies to depreciate remains a key impediment to their return to growth; there is simply no cushion to offset the never-ending austerity.  Speaking of never-ending austerity, Evans-Pritchard reviews the situation in Portugal:

So Cyprus is very far from being solved, and so is Portugal. A fresh Troika leak, this time to the Pink Sheet, has confirmed what anybody following Portugal already suspected. The country is stuck in a debt-compound trap. The economic slump is proving much deeper than forecast. The deficit has been rising not falling, in spite of austerity cuts.

And, increasing, it is not just periphery.  From Reuters:

Manufacturing across Europe's major economies endured another month of mostly deep decline in March, dragging down even former bright spots, surveys showed on Tuesday....

Factories in Germany and Ireland, the relative stars of February's PMIs, fell back into decline last month. Everywhere else, the industrial rot extended.

Spanish manufacturing declined at its fastest pace since October, which followed news the government will revise its economic forecasts for 2013 to show a 1 percent contraction, from a 0.5 percent decline previously.

In France, factory activity retreated for a 13th month and car registrations there dived 16.4 percent in March, further underlining the malaise sweeping through the euro zone's second-biggest economy.

"The euro zone's March manufacturing PMIs ... (banishes) the recovery scenario projected by the European Central Bank further beyond the realm of likely probabilities," said Lena Komileva from G+ Economics in London.

The ongoing deterioration in Europe is evident to everyone except European policymakers.  Clive Crook wonders at European Commission President Jose Barroso's outlook:

Barroso's optimism on Europe's economic recovery, if you can call it a recovery, was harder to understand. This week the IMF's Christine Lagarde talked of a three-speed world: "countries that are doing well, those that are on the mend, and those that still have some distance to travel.” (In other words, fast growth in many emerging economies, slow growth in the U.S., and no growth in Europe.) The euro area's economy is still shrinking. Yet Barroso still thinks (or says he thinks) that policy has been mostly well-judged and the union will emerge stronger from its ordeal.

He noted early on that Europe's public debts still aren't high by U.S or Japanese standards. True -- and that's the point. The EU is insisting on austerity in its weakest economies even though, in the aggregate, its fiscal problem is manageable. The failure to create effective burden-sharing arrangements -- some form of limited fiscal union to work alongside its monetary union -- has been the euro area's biggest error, not counting the creation of the euro itself. And the consequences are crushing countries such as Spain and Barroso's own Portugal.

Note that fiscal union is not the same as an austerity union.  The former allows for internal transfer of the type Crook describes.  The latter is simply a joint commitment to austerity.  But austerity is the only policy possible within the European framework.  Calculated Risk caught German Finance Minister Wolfgang Schauble wallowing in self-delusion:

"Nobody in Europe sees this contradiction between fiscal policy consolidation and growth,” Schauble said. “We have a growth-friendly process of consolidation, and we have sustainable growth, however you want to word it.”

With no depreciation for crisis-stricken economies, no fiscal stimulus, and tight credit conditions through half of Europe as banking consolidates within national boundaries, what exactly is the road forward for Europe?  I just don't see it.

Bottom Line:  How high does unemployment need to rise, how much output needs to be lost, how much poverty must be endured before European policymakers realize that the framework supporting the Euro politcally is an economic failure?

 

FOMC Minutes Signal End to QE

I usually enjoy the day FOMC minutes are released.  It is one of the few releases those of us on the West Coast can read at the same time as everyone else without having to get up in what seems like the middle of the night.  So I experienced a mix of surprise and disappointment when I arrived at the office and learned that everyone else had already read the release.  

As is now well known, the minutes were inadvertently released early.  Robin Harding tells the story:

According to two sources in Congress, the accidental release came from Brian Gross, a special assistant to the Board of Governors who works on government relations...

...“A Fed staffer inadvertently sent an email with the minutes to a group of contacts,” said the Fed. “That group of people was mostly Congressional staffers and trade association members in Washington.”

The distribution list, thought to contain about 100 people, is one that the Fed regularly uses to send out releases.

Sounds like an honest mistake - yes, not all mistakes are of the Zero Hedge "it must be a conspiracy" variety.  It happens.  In any event, the minutes gave a clear indication that FOMC members were leaning toward pulling the plug on asset purchases by the end of this year (emphasis added):

..Members stressed that any changes to the purchase program should be conditional on continuing assessments both of labor market and inflation developments and of the efficacy and costs of asset purchases. In light of the current review of benefits and costs, one member judged that the pace of purchases should ideally be slowed immediately. A few members felt that the risks and costs of purchases, along with the improved outlook since last fall, would likely make a reduction in the pace of purchases appropriate around midyear, with purchases ending later this year. Several others thought that if the outlook for labor market conditions improved as anticipated, it would probably be appropriate to slow purchases later in the year and to stop them by year-end. Two members indicated that purchases might well continue at the current pace at least through the end of the year. It was also noted that were the outlook to deteriorate, the pace of purchases could be increased....

It seems the center of gravity at the FOMC has shifted toward contentment with the current pace of progress in the labor markets. This seems somewhat odd to me; it is as if they were more interested in putting a floor under the recovery rather than trying to accelerate the pace of activity.  The desire to pull the plug on the program as soon as possible also seems odd considering that the majority of policy makers find it to be effective:

In their discussion of this topic, meeting participants generally judged the macroeconomic benefits of the current purchase program to outweigh the likely costs and risks, but they agreed that an ongoing assessment of the benefits and costs was necessary. Pointing to academic and Federal Reserve staff research, most participants saw asset purchases as having a meaningful effect in easing financial conditions and so supporting economic growth. Some expressed the view that these effects had likely been stronger during the Federal Reserve's initial large-scale asset purchases because that program also helped support market functioning during the financial crisis. Other participants, however, saw little evidence that the efficacy of asset purchases had declined over time, and a couple of these suggested that the effectiveness of purchases might even have increased more recently, as the easing of credit constraints allowed more borrowers to take advantage of lower interest rates. One participant emphasized the role of recent asset purchases in keeping inflation from declining further below the Committee's longer-run goal. A few participants felt that MBS purchases provided more support to the economy than purchases of longer-term Treasury securities because they stimulated the housing sector directly; however, a few preferred to focus any purchases in the Treasury market to avoid allocating credit to a specific sector of the economy.

Surely this suggests that some positive fraction of the current activity is attributable to quantitative easing and thus we can expect that some of that activity to fade when the program is brought to an end.  Thus even if the economy accelerates further over the course of this year, ending QE will take some wind out of its sails.  And taking the wind out of the sails means risking not achieving escape velocity with respect to the zero bound.  They might not believe they are actually removing accommodation when QE ends, but they will not be adding to that accommodation.  And the first derivative must be important, otherwise there is no point in discussing changing the pace of asset purchases.

I am heartened a bit to see this:

It was noted that, in addition to the standard channels through which monetary policy affects the economy, asset purchases could help signal the Committee's commitment to accommodative monetary policy, thereby making the forward guidance about the federal funds rate more effective. 

I have long believed that the Fed failed to appreciate the signalling component of quantitative easing.  Indeed, I could be convinced it was the most effective channel of transmission.  I am glad to see that policymakers are starting to see that as well.

Bottom Line:  The Fed seems content with the current pace of activity.  Content enough to believe they can pull the plug on quantitative easing this year.  I remain concerned that ending QE will slow forward momentum, thus the Fed is running the risk that they the economy will not achieve sufficient velocity to escape the zero bound. The actual timing is still data dependent, but I am wondering if we should change our framework from "how good does the data need to be end QE" to "how bad does the data need to be to continue QE?"  

Handicapping Labor Data

We know the Fed intends to taper off quantitative easing.  We know the timing is dependent on progress in achieving a stronger and sustainable recovery in the labor market.  Courtesy of San Francisco President John Williams, we have also know the time they expect to be confident of that recovery - this summer, which could be as early as the June FOMC meeting.  Thus June is the earliest we could expect the Fed will begin scaling back the pace of asset purchases, with the expectation that quantitative easing will draw to a close by the end of this year.

June is earlier than I had anticipated.  I had expected the Fed would want to be confident that the economy would not experience one of its Spring/Summer swoons.  One would think fiscal tightening this year would magnify that concern.  Via Bloomberg:

“We could very well in the summertime start seeing the effects of the fiscal tax increase and spending cut slow us down again,” said Joseph Gagnon, a senior fellow at the Peterson Institute for International Economics in Washington and a former Fed economist.

Moreover, given that inflation remains under the 2 percent target and it is likely that significant slack in the labor market will remain deep into 2014, there does not appear to be any need to rush into scaling back quantitative easing.  Considering data lags, it would seem prudent for the Fed to wait until the fall or even winter before easing back on purchases.

To be sure, policymakers would probably argue that they could revert to a more aggressive pace of purchases should the data turn south.  But even so, that is not likely the desired path.  I don't think they would want to increase the pace of purchases just two months after a decrease.  I would expect they would want to be sure that they did not have to reverse course.  

But that does not seem to be the case.  Instead, it is evident that FOMC members anticipate ending asset purchases this year.  This I find somewhat puzzling, as they seem to have reached a consensus that they need to be scaling back the asset purchase program on the basis of their own forecast, but that forecast itself anticipates that unemployment - what Vice Chair Janet Yellen described as the “the best single indicator of current labour market conditions”- will remains unacceptably high in the 6.8 to 7.3% range at the end of 2014.  Indeed, arguably the Fed has fallen back into the trap of placing an implicit calendar date for the end of quantitative easing, rather than leaving the timing data dependent.  It seems they want to end the program by the end of 2013, and are desperately hoping the data cooperates.

Assuming their intention is to end the program this year, to what extent will they color the data in such a way as to ensure it cooperates?  For instance, it seems evident that the March employment report should call into question plans to slow the pace of quantitative this summer.  Again, from Bloomberg:

“There’s a very strong message to the Fed here, which is that it’s too early to even think about exiting from easy policy,” said Ethan Harris, co-head of global economics research at Bank of America Corp. in New York. “This report suggests that they’re missing on both of their mandates: Inflation is too low and the labor market is too weak.”

This should be correct.  The sub-100k nonfarm gain should raise red flags about the strength and sustainability of the labor market improvement.  If the Fed holds true to the assertion that policy is data dependent, this should be correct as well:

“It helps that we’ve removed one source of uncertainty which is, how will the Fed react?” said Julia Coronado, chief economist for North America at BNP Paribas in New York. “Instead of asking how bad things need to get for the Fed to do more, it’s how good do they need to be before they stop helping.”

But at the same time, I am watching for signals that policymakers downplay this report or any other similarly weak reports.  And lo and behold, today John Williams has an interview with the Wall Street Journal:

The economy could be on a strong enough footing by the second half of the year for the Federal Reserve to begin winding down its bond-buying programs, John Williams, president of the Federal Reserve Bank of San Francisco, said in an interview with The Wall Street Journal.

Mr. Williams said this has long been his view and a disappointing jobs report Friday wouldn’t alter his thinking too much. The Labor Department said Friday that employers added just 88,000 jobs in March, after expanding by more than 200,000 in three of the previous four months.

“We just have to get away from overreacting to one piece of data,” he said.

To be sure, the usual caveat is included:

Of course, his forecast is conditional on how the economy actually performs. “We just have to keep watching all of the economic indicators,” he said.

But how closely is the Fed watching the indicators?  Or have they already effectively made a decision on the timing of QE's demise?  Be wary that the minutes will have a hawkish tone.

Of course, continue to watch for data that support the case for easing as early as June.  With that in mind, February JOLTS report was released this morning.  An update of the Yellen charts:

Although the JOLTS data is of second-order importance, notice that the quits rate was revised up for January, a signal that existing employees are more confident of labor market prospects.  Put it in the "stronger and sustainable" category.

Bottom Line:  I had expected that the data flow would argue for the Fed to postpone tapering off QE purchases until late this year.  The Fed seems to have a different view, thinking that the data flow argues for ending QE by the end of this year.  My expectation is that the Fed is being overly optimistic and will find that summer is too early to being tapering off QE.  That seems to be the message from the bond market as well; yields aren't exactly soaring.  But the ease by which SF Fed President John Williams is willing to dismiss the most recent jobs report suggests data may be less important than we have been led to believe.  

Labor Market Hits Air Pocket

My first thought on the employment report is that, at its core, it was more of the same.  For the last two years, nonfarm payrolls growth has shifted between promising and disappointing on the drop of a hat.  Underneath the drama, the labor market continues to grind forward at a suboptimal pace - a pace that allows for a slow decline in the unemployment rate, but also suggests more policy action is necessary.

My second thought is that San Fransisco Federal Reserve President John Williams was likely far too optimistic in his assessment that the Fed could begin tapering off QE as early as this summer.  That is only three months away, and I have trouble seeing how policymakers could be sufficiently confident in the pace and sustainability of the recovery to justify taking their foot off the gas after just three more months of data.  

Headline nonfarm payrolls gained by just 88k, with a 95k in the private sector offset by a 7k loss on the public side of the ledger.  To be sure, some of the sting was eased by upward revisions to the previous two months, but I think that is cold comfort at this point.  Instead, anyway you slice it this report does not signal that momentum is building in the labor market.  Notice that the twelve-month average is slowing declining, and stands at 159k/month, down from 202k/month last March:

Arguably, momentum has faded over the past year. Put in context of the Yellen batch of indicators, there is little reason to believe that the Fed should shift policy gears anytime soon [click on charts to enlarge]:

Other indicators were generally consistent with the tenor of the headline establishment number:

Wages, the labor force participation rate, and the employment to population ratio all slipped.  On a positive note, aggregate weekly (private sector) hours gained, consistent with what I believe is a more steady underlying improvement in the labor market than suggested by the month-to-month volatility of the headline numbers.  There was little evidence of an acceleration in the pace of improvement in measures of underemployment:

Underemployment measures suggest substantial slack in labor markets - plenty of slack to justify ongoing QE at the current pace for most of the year at least, even if the next six reports showed nonfarm payroll growth of 200k+.  It makes me wonder what Williams was thinking pushing for the end of QE to begin this summer.  Are FOMC members more eager to pull the plug on QE than public statements would suggest?  Have they been spending too much time with their European counterparts?  Something to mull over.

In any event, bond markets continue to suggest that any Fed officials who want to pull the plug on QE this summer are getting ahead of themselves.  The 10-year Treasury yield fell to 1.69% this morning - not exactly a ringing endorsement of the pace of recovery.

Bottom Line:  Another in a long line of employment reports that suggests the much hoped-for acceleration in job growth remains out of reach.  Nothing to suggest the Federal Reserve needs to slow the pace of asset purchases in the near future.  Williams' expectation that tapering off of purchases as early as this summer remains puzzling.

Pause Coming?

Initial jobless claims spiked last week:

As Calculated Risk notes, this could reflect the impact of the sequester.  We might also be repeating the pattern of the last two years in which claims decline and then disappoint by plateauing for six months. If that is the case, then we should expect to see less improvement in nonfarm payrolls in the months ahead. If so, San Francisco Federal Reserve President would probably need to push back his expectation that large scale asset purchases are tapered off beginning this summer.  Note too that 10-year Treasury rates slipped another three basis points this morning to 1.78 percent.  Bond markets do not seem to be signaling that the economy is accelerating at a pace sufficient to justify the Fed taking their foot off the gas this summer.

Hawkish Dove

Tim Duy:

Hawkish Dove, by Tim Duy: The generally dovish San Francisco Federal Reserve President John Williams sounded relatively hawkish in today's speech. The money quote:

I expect that continued asset purchases will be appropriate well into the second half of this year. In making this assessment, I don’t have a specific unemployment or job-gain threshold in mind for cutting back or ending these purchases. Instead, I’m looking for convincing evidence of sustained, ongoing improvement in the labor market and economy. The latest economic news has been encouraging. But it will take more solid evidence to convince me that it’s time to trim our asset purchases. An important rule in both forecasting and policymaking is not to overreact to what may turn out to be just a blip in the data. But, assuming my economic forecast holds true, I expect we will meet the test for substantial improvement in the outlook for the labor market by this summer. If that happens, we could start tapering our purchases then. If all goes as hoped, we could end the purchase program sometime late this year.

Based on William's current forecast, he expects the Fed will begin tapering off asset purchases this summer, perhaps the June FOMC meeting. He is apparently more optimistic than me, as this puts him at least three months ahead of my expectations - I had not anticipated slowing the pace of purchases until late in the year. Of course, the reality will be data dependent, with the next three employment reports being particularly important. As a recap, three of the last four reports have shown nonfarm payroll growth at or above 200k:

Will Friday's March release make it four for five? Mixed signals from labor market indicators to date make it a tough call. While the downward trend in initial unemployment claims is generally supportive of a solid report, the numbers popped in the second and third weeks of March:

Could the recent increase be the first signs of fiscal contraction working through the economy, or just noise? We get another release tomorrow. The employment number in the ISM manufacturing report was stronger, while the corresponding number from the nonmanufacturing counterpart was weaker. And the ADP release came in below expectations at a 158k gain in private sector jobs, suggesting a weaker report. Altogether, I would tend to expect a number on the low side of the current expectation of 192k gain, but don't see a lot to swing me dramatically away from that number - a number that is more consistent with William's story than not.

That said, I am cautious about extrapolating too much of the recent momentum forward. To be sure, the first quarter is shaping up to be better than the Fed anticipated, with Macroeconomic Advisors tracking forecast showing 3.6% growth. This could be giving Fed officials hope that this year's fiscal contraction is a nonevent. I am not yet convinced that we have dodged that bullet; rumor has it that sales-tax states had a weak March, possibly a delayed reaction to the end of the payroll tax credit. But more important is that the bond market is certainly not acting as if the economy is performing well enough to justify a shift in Fed policy. Notice that today the 10-year yield slumped to 1.81%, a low for the year. It seems as if bond market participants have become less confident of the recovery during the first quarter, even as Williams has become more confident.

Bottom Line: Williams placed a marker for the date that the Fed begins its exit from quantitative easing - summer, assuming that his current forecast holds. I am not so sure the bond market agrees with that assessment.