Tim Duy's Fed Watch

Steady As She Goes

The BEA released revisions to Q1 GDP numbers today, taking growth down a hair from the original 2.5% to 2.4%.  Bloomberg is claiming that the downward revision to GDP and a rise in initial unemployment claims account for today's gain in equities.  The idea is that the weaker data will dissuade the Fed from slowing down the pace of asset purchases this year.  

It is of course dangerous to assign a cause to every fluctuation in asset prices.  In this case, I am hard pressed to see that today's data has any meaningful impact on policy.  If anything, a focus on the data over a longer period rather than the month-to-month or quarter-to-quarter movements should convince you that little has changed since 2010.  Gross domestic product and income in levels:

Gross domestic product and income year-over-year:

Abstracting from inventory changes, look at the remarkable consistency of real final sales growth:

And as far as initial claims are concerned, you must have pretty sharp eyesight to conclude that something fundamentally changed last week:

Also note the the Fed may discount soft GDP numbers in any event.  Recall the words of New York Federal Reserve President William Dudley:

“The important thing to recognize about the U.S. economy is that things are actually improving underneath the surface,” Dudley said in the interview. “We don’t really see that so much in the activity data yet because of the large amount of fiscal drag.” 

Policymakers are trying to look past the fiscal drag to see if it is bleeding through to the broader economy.  If not, they will conclude that growth is set to jump next year as the fiscal impact wanes.  And they want to be ahead of the jump with respect to QE.  Hence why the next few months of data are so important.

Bottom Line:  Today's data is not likely to have an impact on monetary policy.  

More Uncertainty?

I was reading this Business Insider report on an analyst's mea culpa on a bad trade when this jumped out:

Last week, we advised investors to add to their 7s/30s and 10s/30s yield curve steepening positions with the view that Chairman Bernanke would calm expectations for tapering by September this year – helping keep rates and volatility low. These curves have since flattened back to the levels at which we suggested investors enter steepeners. Given the uncertainty Bernanke injected into the market, we suggest investors pare down positions to more sustainable levels. At the same time, we keep to our core steepening view. [emphasis added]

I find it curious the analyst believes that Federal Reserve Chairman Ben Bernanke increased uncertainty.  I think it was just the opposite.  Prior to Bernanke's remarks, opinion on policy was scattered among some looking for the Fed to scale back asset purchases as early as June and as late as 2014.  Bernake narrowed that range to September as a likely date, and cleared the way for New York Federal Reserve President WIlliam Dudley and Boston Federal Reserve President Eric Rosengren to point us at September as well.  Overall, it looks like more, not less, certainty. 

Perhaps market participants are unhappy with the path Bernanke laid out, but that path is more obvious than it was a week ago.

September Looking Good

Boston Federal Reserve President Eric Rosengren, considered to be on the dovish side of the Federal Reserve, had this to say about the outlook for monetary policy:

However, I would also say that it may be undesirable to abruptly stop purchases, so it may make sense to consider a modest reduction in the pace of asset purchases if we see a few months more of gradual improvement in labor markets and improvement in the overall growth rate in the economy – consistent, by the way, with my forecast, which is somewhat more optimistic than that of many private forecasters.

A "few more months" I interpret as June, July, and August, which puts the beginning of tapering at the September FOMC meeting.  I think that Fed speakers are sending pretty clear signals to prepare for a September policy change.  

Some big names on Wall Street don't agree.  Vincent Reinhart at Morgan Stanley believes the data will push the Fed back to December.  The view at Goldman Sachs is reportedly similar.  To be sure, the data might cut in that direction, but I think that the bar to tapering might be lower than believed by those looking for a shift in December.  We may believe the Federal Reserve's dual mandate argues for a longer period of QE at its current pace, but I am thinking that for the Federal Reserve, the dual mandate has more to do with the lift-off date from ZIRP than the end of QE.  They have tended to argue for more or less QE on the basis of "stronger and sustainable" improvement in labor markets, and, given the obvious shift in tone among Fed speakers, I think we have reached that benchmark.  At this point, they are just looking for a little more confirmation, in their minds erring on the side of being "too easy." 

A lot of data will be coming in the door over the next week and a half, culminating in the all-important employment report on Friday, June 5.  I think even a moderately positive run of data will further cement a September shift.  And I think the Federal Reserve would place less weight on a weak employment report than a strong employment report.  The recent pattern of general upward revisions argues for a asymmetrical response.  Moreover, I sense they are wary of being trapped by one weak number - I don't think they would have expanded QE last September if they knew that job growth for August was 165k rather than the initially reported 96k.  They don't want to make that mistake again.

Bottom Line:  I think the Federal Reserve is leaning toward a September policy shift.  While it is as always data dependent, I think the data will need to be pretty weak to push the Fed to December.  

More Fed - It Never Ends

Bloomberg is carrying an interview with San Francisco President John Williams.  Williams reiterates the possibility that future policy moves may be up or down:

“Even if we do adjust downward our purchases, it doesn’t mean we’re now in some autopilot of moving in the same direction,” Williams, 50, said in an interview yesterday in San Francisco. “You could even imagine a scenario where we adjust it downward based on good data and then adjust it back” if the economy weakened.

Yes, the Fed can change policy in any direction.  But I reiterate what I said earlier:  I simply do not believe that they believe that such changes will be likely.  First, I don't think they will want to reduce the pace of purchases until they are sure they do not need to reverse course in the next meeting.  Second, I think they will want to end asset purchases well ahead of hitting the 6.5% unemployment threshold.  And I don't think they can do that if they are fooling around with the pace of purchases over the next year.  

That said, we will hear many officials repeat this same line.  Why?  Williams has the answer:

“Because we have this freedom to adjust, how will people interpret it?” he said. “This is uncharted territory.”

Once the Fed does decide to calibrate its bond-buying, its challenge will be to communicate that “these are just adjustments and not strong signals about things going forward,” he added.

The Fed is trying very hard to  ensure that market participants do not overreact to any one policy shift, with the most likely overreaction being to tank Treasury prices and spike yields. The Fed believes that the way to prevent this is to continuously remind everyone that any subsequent moves might be up or down, so don't assume a downward move in the pace of purchases implies anything about the necxt meeting.

But keep in mind that the Fed does not have a forecast that suggests policy will shift up and down randomly.  They have a forecast that the first cut to the pace of purchases will be the beginning of the end for quantitative easing and, in all reality, will start the clock on the first rate hike.  In other words, they can talk about moving policy up-and-down, but I can't imagine that they really expect such ups-and-downs to be the path of policy going forward.

In other news, New York Federal Reserve President William Dudley reiterates Federal Reserve Chairman Ben Bernanke's position:

“I don’t really understand very well how the tug-of-war between the fiscal drag and the improving economy are going to sort of work their way out,” Dudley said in an interview with Michael McKee airing today on Bloomberg Television. “Three or four months from now I think you’re going to have a much better sense of, is the economy healthy enough to overcome the fiscal drag or not.” 

Dudley adds something that I think is important:

“The important thing to recognize about the U.S. economy is that things are actually improving underneath the surface,” Dudley said in the interview. “We don’t really see that so much in the activity data yet because of the large amount of fiscal drag.”

Translation:  Fiscal drag will weigh down the GDP numbers.  Look underneath those numbers to building momentum in the economy.  I think this means there will be extra weight on the jobs data rather than the GDP data as an indicator of the impact of fiscal policy.  With that in mind, note that jobless claims reversed last week's spike:

I would say the downward path of claims remains intact despite the fiscal drag.  That is what will be meaningful for assessing "strong and  sustainable."

Bottom Line:  Assuming current data holds, the beginning of the end of QE is coming.  But not immediately.  Maybe three meetings out in September assuming that the impact of fiscal drag remains largely contained to the GDP data.  The Fed does not want us to jump to conclusions about future policy moves based on that initial shift.  But I am hard-pressed to see a forecast that would allow for up-and-down moves once the Fed pulls the trigger.  Up-and-down moves cannot be their expected policy path. 

Bernanke Saves the Day

There was some initial consternation yesterday after Federal Reserve Chairman Ben Bernanke gave the clarity we were hoping to see.  From Reuters:

"If we see continued improvement and we have confidence that that's going to be sustained then we could in the next few meetings ... take a step down in our pace of purchases," he said.

"Next few meetings" sounds like September at the eariliest.  Indeed, September or December are the most likely meetings given both have an associated press conference.  

For financial market participants, I would say this was a mixed message.  Bernanke is dovish if you expect the Fed to move in June, hawkish if December at the earliest.  But imagine the message that would have been delivered to financial markets had Bernanke not spoken ahead of the minutes of the April FOMC meeting:

 A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth; however, views differed about what evidence would be necessary and the likelihood of that outcome.

It seems to me that the threat of an imminent policy change would have been taken very poorly had Bernanke not already spoken yesterday morning.  So, in a sense, Bernanke saved traders from an even more tumultuous day.  Expect Bernanke to use the June press conference to lay the ground work for a reduction in the pace of purchases as early as September.  

From a different viewpoint, Bernanke might have just sandbagged his colleagues.  Recent comments from Federal officials suggest they reasonably believed they were close to cutting the pace of purchases, and it seems like they received this impression from the discussion in the last few FOMC meetings.  Hence, for example, why San Francisco Federal Reserve President John WIlliams felt comfortable suggesting an imminent reduction in the pace of purchases as recently as Monday of this week. Bernanke, however, sets everyone straight.  It's not going to happen this summer.  Maybe fall.

Notice also the communications challenge.  Even as participants coalesced around a policy shift as early as June, they did not have internal agreement on what would justify such a shift.  I am not sure how they communicate policy if there is no central view as to what should justify a particular policy.   One gets the feeling that the Federal Reserve treats "strong and sustained growth" like the Supreme Court treats pornography:  They will know it when the see it.

The communications plot thickens later in the minutes:

 A few members expressed concerns that investor expectations of the cumulative size of the asset purchase program appeared to have increased somewhat since it was launched last September despite a notable decline in the unemployment rate and other improvements in the labor market since then. In contrast, a few other members focused on evidence that market expectations about the total size of the program had changed little, on net, since the program was launched or had responded appropriately to incoming information. Members generally agreed on the need for the Committee to communicate clearly that the pace and ultimate size of its asset purchases would depend on the Committee's continued assessment of the outlook for the labor market and inflation in addition to its judgments regarding the efficacy and costs of additional purchases and the extent of progress toward its economic objectives. To highlight its willingness to adjust the flow of purchases in light of incoming information, the Committee included language in the statement to be released following the meeting that said the Committee was prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.

The second sentence in this paragraph is a little bit clunky.  But overall it sounds like there is concern among some officials that market participants are not sufficiently responding to incoming information.  In other words, the Fed expected that incoming information would trigger a continuous reassessment of the pace of asset purchases, but they are not seeing that continuous reassessment reflected in expectations.  Hence the reminder that policy is not a one way street.  

I am thinking this morning that the Fed is asking an awful lot from market participants; if policy officials cannot agree on what constitutes sufficient evidence to trigger a change in policy, how can officials expect such knowledge on the part of market participants?  

From all of this I am reminded of one important thing:  Staying on top of the likely path of monetary policy means tracking Bernanke.  Be wary of regional Federal Reserve presidents.  What seems to happen is this sequence of events:

1. Bernanke speaks.
2. We all reach a common assessment of the policy path
3. Bernanke drifts into the background amid a cacophony of Fed speakers.
4. Our view of the policy path begins to splinter as each Fed speaker has a different interpretation of the implication of the data flow for policy.
5. Bernanke speaks.
6. We all reach a common assessment of the policy path.
7. Repeat steps 3 through 6 above.

Bottom Line:  Assuming the recent pace of activity continues through the summer, it is reasonable to expect the first cut in the pace of QE to begin as early as September.   While the Fed will continue to say that they could adjust policy up or down, I don't believe that they really believe this.  I think they expect the first reduction in the pace of easing to be the first stage to ending quantitative easing; as such, it is not their intention to start the process until they firmly believe they will not have to backtrack.  A good reason to delay through the summer, in my opinion.  Finally, there is a very, very simple way to improve communications:  Bernanke needs to give more speeches directly pertaining to the policy path. 

And Then There is Bernanke

Lots of Fed chatter in the last week.  For openers, some background from Reuters:

It decided on May 1 to keep buying at an $85 billion monthly pace, and many economists say mixed economic data warrants keeping up the purchases through year-end.

But persistent warnings from more hawkish Fed officials had fanned talk that it might start to wind back soon.

The hawkish Fed officials would be Dallas Federal Reserve President Richard Fisher, Philadelphia Federal Reserve President Charles Plosser, and Richmond Federal Reserve President Jeffrey Lacker.  These are often colorful voices, but as a general rule are not voices that will hold much sway with regards to the pace of easing.  What is much more important is to what extent remaining policymakers are coming along to the same view.  In other words, these three can ruffle their feathers all they want, but that ruffling should not be interpreted as consensus movement within the FOMC.

For consensus movement, turn more toward New York Federal Reserve President William Dudley.  Great speech today, but I will narrow my focus with a few points I think are relevant for US policy.  While Dudley is clearly concerned about deflation, this is important:

Similarly, current circumstances in the two countries are different, with deflationary expectations still in the process of being dislodged in Japan.  The BoJ needs to push up inflation expectations, whereas in the U.S. the current level of inflation expectations is consistent with the long-term objective of the Fed.

This speaks to his concerns - or lack thereof - about the current US inflation numbers.  My sense is that he will dismiss those low numbers as long as expectations stay anchored at 2 percent.  Later he says:

Let me give a few examples of how my own thinking may evolve.  In terms of our asset purchase program, I believe we should be prepared to adjust the total amount of purchases to that needed to deliver a substantial improvement in the labor market outlook in the context of price stability.  In doing this, we might adjust the pace of purchases up or down as the labor market and inflation outlook changes in a material way. For me, the base case forecast is not the sole consideration—how confident we are about that outcome is also important.  

Here he brings inflation back as an issue in determining the pace of purchases.  But then in the next paragraph:

Because the outlook is uncertain, I cannot be sure which way—up or down—the next change will be.  But at some point, I expect to see sufficient evidence to make me more confident about the prospect for substantial improvement in the labor market outlook. At that time, in my view, it will be appropriate to reduce the pace at which we are adding accommodation through asset purchases.  Over the coming months, how well the economy fights its way through the significant fiscal drag currently in force will be an important aspect of this judgment. 

Which sounds as if inflation is not the primary determinant in the decision to taper.  The labor market is the primary determinant, which might be expected if he believes that low inflation numbers are not a relevant concern in the context of stable inflation expectations.  In such a context, Dudley wants to see to what extent the labor market will feel the fiscal drag.  In other words, be cautious about how far the low inflation story will travel in the FOMC.

To be sure, you can point to today's speech by St. Louis Federal Reserve President James Bullard as a reason that current inflation is relevant.  From Reuters:

"Inflation is pretty low in the U.S.," Bullard told reporters after delivering a lecture in Frankfurt. "I can't envision a good case to be made for tapering unless the inflation situation turns around and we are more confident than we are today that inflation is going to move back toward target," he said.

But is this the consensus view?  Robin Harding of the FT smartly tweets:

Re Bullard comments, low inflation has always been the main driver of QE for him. Entirely different for Bernanke, Yellen et al.

— Robin Harding (@RobinBHarding) May 21, 2013

I think Harding is right.  With inflation expectations stable, from the consensus FOMC viewpoint tapering will be much more dependent on the labor outlook than current inflation.

Other voices include Chicago Federal Reserve President Charles Evans who raises the prospect of a sharp end to quantitative easing.  From Reuters:

"Another approach, which doesn't get talked about that much, we could continue to go with $85 billion a month until we decide that absolutely we've seen enough improvement, and then bring it to a quick conclusion at that time," Evans told reporters after the speech.

"That would be a program going into the fall, I would think, because you can't really have that much confidence to bring it to an end" before that, he said. "I think at the moment the key issue is whether or not it is extremely likely that this (improvement) is going to be maintained over the next few months."

That last line is important - I think it means that if the labor market continues on its current pace through the rest of spring and into the summer (again, assessing the impact of fiscal contraction), then the tapering will begin in later summer or early fall.

In contrast, Minneapolis Federal Reserve President Narayana Kocherlakota argues that policy is still too restrictive:

The FOMC has responded to this challenge by providing a historically unprecedented amount of monetary accommodation. But the outlook for prices and employment is that they will remain too low over the next two to three years relative to the FOMC’s objectives. Despite its actions, the FOMC has still not lowered the real interest rate sufficiently in light of the changes in asset demand and asset supply that I’ve described.

And, at a minimum, he would not favor reducing the pace of stimulus:

...this kind of analysis suggests that, currently, the gains from tightening related to improving financial stability are both speculative and slight. In contrast, the losses from tightening—in terms of pushing employment and prices even further below the Federal Reserve’s goals—are both tangible and significant. I conclude that financial stability considerations provide little support for reducing accommodation at this time.

I don't think he would favor it in three months regardless of the labor data.  

So many voices, so many views.  Looking through the noise, I think there is strong interest in tapering QE now that we have a string of job reports pointing to substantial and sustainable improvement in labor markets, but, given the fiscal contraction, little willingness to pull the trigger on tapering until we see another two or three similar reports.  On net, I think disinflation concerns will move to the back-burner as long as inflation expectations are stable.  

Still, at the same time, the Fed wants to keep its options open, as they are very much cognizant that past efforts to pull back on easing have been premature.  Hence the talk that future moves could be up or down, which is really just plain confusing because why would the Fed even begin tapering if they thought there was a reasonable chance of having to reverse course the next month?  It is even more confusing given that some officials seem to care about inflation, but others labor markets. The former says more purchases, arguably the latter says less.  And I am not sure they have a consensus view of what would be the pace of tapering even if they all could agree on the forecast and relevant indicators. No wonder communications is a problem.  Back to Dudley:

An important challenge for us will be to think carefully about what combination of actions and communications will best ensure that when we do eventually judge that it is appropriate to begin normalizing policy, the initial tightening of financial market conditions is commensurate to what we desire. There is a risk is that market participants could overreact to any move in the process of normalization.

It seems that lacking a more clear, consistent framework for the exit from quantitative easing, the risk of miscommunication is high.  Hence, we are all looking toward tomorrow's speech by Federal Reserve Chairman Ben Bernanke to provide the clarity that appears very much needed. 

 

Dollar Up

The Dollar continues to gain despite the supposed "Great Debaser" Federal Reserve Chairman Ben Bernanke bringing us multiple rounds of quantitative easing:

Just sayin....

Confidence Boom?

The early read on the Thomson Reuters/University of Michigan Consumer Sentiment index jumped to 83.7 in May, up from 76.4 in April.  Just a quick reminder before we get too excited - sentiment has tended to be low relative to actual spending.  May's sentiment bounce just returns us to trend:

Better than collapsing confidence, but by itself not pointing to an imminent acceleration in consumer spending.  

Busy Data Day

Something of a busy data day.  Not all of it pleasant, but I suspect that the Fed will attempt to see through that unpleasantness.  Start with the surprise jump in initial unemployment claims:

I don't think the jump is out of line with recent volatility, nor does it suggests that the general downtrend is broken.  Next we have a disappointing read on housing starts, primarily due to a drop in the volatile multi-family sector:

I would take comfort in the opposite move in building permits, which will show up as future starts:

The regional manufacturing surveys continue to disappoint, with the Philly Fed survey the latest to fall short of expectations.  Calculated Risk has more, and notes that the incoming regional surveys suggest the next national ISM report will be weak.  Manufacturing looks likely then to continue bouncing along just above the expansion/contraction mark:

One wonders if manufacturing is really slowing, or  if this is a diffusion index issue.  We can't tell from the index if the expanding firms are growing very quickly or slowly.  We do know that they have been keeping their workers busy:

And we also know that while industrial production dipped in April, again there is nothing to suggest it is rolling over:

The CPI release revealed that inflation remains nonexistent.  Indeed, core-CPI tracked lower:

This is what I think the Fed would find as the most important indicator of the day.  One would think that low inflation should give the Fed pause in any consideration of tapering quantitative easing in the near future.  That said, again we seem to have Federal Reserve policymakers who are discounting the low inflation numbers.  San Francisco Federal Reserve President John Williams, in a speech today:

I expect that the decline in inflation will prove to be temporary, and that inflation will climb slowly, but stay below the Fed’s 2 percent longer-run target over the next few years.

Even though he believes that inflation will remain low for a few years (!), he still anticipates beginning the tapering process this summer:

...assuming my economic forecast holds true and various labor market indicators continue to register appreciable improvement in coming months, we could reduce somewhat the pace of our securities purchases, perhaps as early as this summer.  Then, if all goes as hoped, we could end the purchase program sometime late this year. 

He adds the usual caveat:

Of course, my forecast could be wrong, and we will adjust our purchases as appropriate depending on how the economy performs.

I think the lack of concern about low inflation is important.  We also saw this with noted-dove Chicago Federal Reserve President Charles Evans.  Low inflation is simply having less of an impact on policymakers than would be expected.

The other reason I pay attention to Williams is that I don't see him gravitating far from Federal Reserve Chairman Ben Bernanke.  We will hopefully learn more of Bernanke's intentions this weekend so that I can test that theory (what better day than a Saturday to provide some interesting guidance or foreshadow next week's release of the minutes of the last FOMC meeting?). UPDATE:  No, probably won't be a market moving speech.

Bottom Line:  I don't see much in today's data that would lead us to believe the economy is on a substantially different path.  But one part of that path is low inflation, which should be meaningful to the Federal Reserve.  The problem, however, is that as of yet policymakers seem rather apathetic to the low inflation readings.  Apparently even lower numbers are needed to capture their attention.

 

Lumping Everything into the Wealth Effect

After posting my review of Martin Feldstein's WSJ op-ed, I waded through Dallas Federal Reserve President Richard Fisher's latest speech and found this:

The former outcome is that envisioned by the theoreticians that lead the Fed: According to this plot, by driving rates to historical lows along the entire length of the yield curve, investors will rebalance their portfolios and reach out to riskier assets, providing the financial wherewithal for businesses to increase capital expenditures and reengage workers, expand payrolls and regenerate consumption. Rising prices of bonds, stocks and other financial instruments will bolster consumer confidence. The CliffsNotes account of this play has the widely heralded “wealth effect” paving the way for economic expansion, thus saving the day.

The latter outcome posits that the wealth effect is limited, for two possible reasons. One is that our continued purchases of Treasuries are having decreasing effects on private borrowing costs, given how low long-term Treasury rates already are.  Another is that the uncertainty resulting from fiscal tomfoolery is a serious obstacle to restoring full employment. Until job creators are properly incentivized by fiscal and regulatory policy to harness the cheap and abundant money we at the Fed have engineered, these funds will predominantly benefit those with the means to speculate, tilling the fields of finance for returns that are enabled by historically low rates but do not readily result in job expansion. Cheap capital inures to the benefit of the Warren Buffetts, who can discount lower hurdle rates to achieve their investors’ expectations, accumulating holdings without necessarily expanding employment or the wealth of the overall economy.

Is it just me, or is Fisher being explicitly derisive about the wealth effect?  And when did we start lumping all the channels of monetary policy into the "wealth effect"? The wealth effect is but one channel of monetary policy.  See something like this graphic from Frederick Mishkin's money and banking textbook:

While equity prices do operate through a number of channels, only one of those is the "wealth effect."  To his credit, Fisher has a more sophisticated view of those channels than Feldstein, who appears to limit the impact of QE to the strict definition of the wealth effect:

That drives up the price of equities, leading to more consumer spending.

But even if Fisher does see the bigger picture, should he really be lumping together all the channels of monetary policy into the "wealth effect?"  Doing so only feeds the bias against monetary easing by perpetuating the view it is about nothing more than creating an artificial boost of equity prices and benefiting speculators rather than stimulating the economy via a number of channels that subsequently enhance the profitability of firms and thus raises equity prices.

Of course, Fisher and Feldstein are deliberately trying to perpetuate a bias against quantitative easing.  And even after all these years, I still find it odd that Fisher appears to believe his job is to undermine the institution that provides his employment.