Tim Duy's Fed Watch

While We Wait...

While we wait for the second quarter GDP report and the outcome of the FOMC meeting, you can amuse yourself watching  Lakshman Achuthan of the Economic Cycle Research Institute desperately clinging to his call that a recession started in the middle of 2012:

 A reminder of the high-frequency data employed in recession dating:

[Click to enlarge]

I am not saying its the most exciting data, but it still isn't a recession.  Achuthan is apparently clinging to a thin reed of hope that every major data series is revised substantially downward.  Given the low expectations for the second quarter GDP report, personally I would hold out hope for a surprise negative print.  I still don't think the NBER would see such an outcome as anything more than a one quarter aberration, but I suspect it is Achuthan's best hope at this point.

Hawks and Doves, Again

Neil Irwin argues that the classification of Fed policymakers into hawks and doves is too simplistic, and, of course, he is correct.  He concludes:

In other words, maybe instead of classifying central bankers by the variety of bird they most resemble, we should instead judge them on their ability to adapt their thinking to circumstance.

That said, I doubt we are going to change this convention anytime in the near future.  We can, however, better define the terms to at least reduce the negative connotations associated with either identifier.  I use the terms to refer to a policymaker's judgment as to the appropriate level of monetary accommodation given the current and expected economic situation.  A "dovish" policymaker tends to view the economy as likely needing more monetary accommodation than a "hawkish" policymaker.  Similarly, if I say the risk is that tomorrow's FOMC statement will sound "dovish," it means that it will suggest a greater amount of monetary accommodation relative to the last FOMC statement.  I think this is a refinement of my thoughts the last time I tackled this subject:

I tend to think of the distinction in terms of the policymaker's inflation forecast.  A hawk is a policymaker who perceives a greater upside risk to the inflation forecast and thus anticipates policy will turn tighter sooner than later.  On the other side, doves tend to see less upside risk to the inflation forecast, or even downside risk, and thus do not anticipate a tighter policy in the near term.

As Irwin points out, a policymaker might not be hawkish because of the current inflation risk, but because of risk of financial instability.  Thus, it is more appropriate to use the terms to refer to a policy outlook rather than the specific reason (such as inflation, deflation, financial instability, etc.) for that outlook.

The key is that the terms hawks or doves refer to a perception about the appropriate path of monetary policy, and it is possible - and desirable - that the perceive path changes as the economy changes.  In other words, a policymaker could be "dovish" at one point in the business cycle, and "hawkish" at another.  If the FOMC turns "hawkish" in the near future, we can expect less accommodation (or even tighter policy), which is what we would expect if the economy were accelerating.  

This definition does not imply that "hawks" or "doves" have different inflation targets, which I think is an outdated classification.  On that basis, there are no such things as hawks or doves - the FOMC has already quantified their objective of 2% annual PCE inflation over the longer run.  Even the Evan's rule is not technically at odds with that objective; it merely allows the Fed to reach that objective from above, making clear that actual inflation will likely be within a range around 2%.  In other words, the target is not a ceiling.

So when we learn that the doves, and specifically Vice Chair Janet Yellen, have been better forecasters than the hawks, we should not conclude that those favoring a higher inflation target have been correct.  We should conclude that those who favored additional monetary accommodation on the basis of their forecasts were correct.  Those who favored relatively less accommodation based on their forecasts were incorrect.

The hawks/doves distinction has returned with the great debate over who should take the helm of the Federal Reserve when current-chairman Ben Bernanke steps down.  Sadly, there is an effort to paint Janet Yellen in a negative light because she is a "dove" and thus will favor higher inflation, the debasing of the currency, cats and dogs living together, etc.  This is the negative connotation associated with the outdated definition of hawks and doves.  The attack on Yellen takes an ugly turn in the Wall Street Journal:

Janet Yellen, the current Fed vice chairman, has emerged as the favorite of the Democratic left. As an economist with long experience at the Fed, she doesn't lack for professional credentials. But her cause has been taken up by the liberal diversity police as a gender issue because she'd be the first female Fed chairman.

Nancy Pelosi has bellowed her support, and Christina Romer, who was chief White House economist for the first two years of Mr. Obama's Presidency, has all but said it would be a defeat for women if Ms. Yellen doesn't get the Fed job. That led our friends at the New York Sun to wonder if they had somehow missed the creation of "the female dollar" given that they thought the Fed's main task is to preserve the value of the currency.

Ms. Yellen is also seen, in and outside the Fed, as a leading monetary dove. That isn't limited to her backing for Mr. Bernanke's monetary interventions since the 2008 panic. We've followed Ms. Yellen for 20 years and can't recall a key juncture when her default policy wasn't to keep spiking the punchbowl. Many Democrats think the Fed needs to keep interest rates at near zero through the 2016 election, and Ms. Yellen is their woman.

I suppose we are supposed to infer that all women are at heart dovish policymakers bent on debasing the US currency.  I think Kansas City Federal Reserve President Esther George would disagree.  And I am not sure how you read this passage without realizing the case against Yellen is, at its core, nothing more than sexism.  Moreover, I am not sure how you read this column and not realize the ignorance of the author.  Regarding the punchbowl comment, Neil Irwin, unsurprisingly, has a better recollection of the past twenty years:

For example, Janet Yellen, the current Fed vice-chair, is viewed in markets as an uber-dove because she has been a strong advocate of the Fed’s unconventional monetary easing to try to help the job market. But it wasn’t always so. Larry Meyer served as a Fed governor with Yellen in the 1990s. In 1996, the two of them had concluded that the Fed needed to raise interest rates to fight the threat of inflation. They went to Alan Greenspan and told him of their concerns, threatening to dissent at a future meeting unless there was  a rate increase. They lost the argument, but it is a sign that while Yellen may be a dove right now, the same would not be true in all states of the world.

I also have followed Yellen for the better part of 20 years and never for a moment considered her a dove relative to the old, outdated definition.  If anything, I would have considered her a hawk relative to the current 2% target.  Recall that she was an early advocate of numerical targets.  From 2005:

...I find myself still pretty comfortable with the numerical objective I had recommended almost a decade ago. More specifically, I would now favor a 1.5 percent numerical objective for inflation as measured using the core personal consumption expenditures (PCE) price index, which, given the recent average differences in measurement bias, corresponds to a 2 percent objective for the core CPI. If the stability of my own views on the appropriate numerical inflation objective is representative, it seems likely that the FOMC’s numerical inflation objective would probably change fairly little over time due to economic factors.

If you assume that core and headline rates converge to the same over time, than at one time Yellen favored what could be considered a relatively more hawkish stance regarding the appropriate rate of inflation.  The next year she suggested that even lower inflation was acceptable:

I see an inflation rate between 1 and 2 percent, as measured by the core personal consumption expenditures price index, as an appropriate price stability objective for the Fed. 

But what she has not changed her view on achieving that outcome within the structure of the dual mandate:

However, I also think it is critically important that a numerical inflation objective not weaken our commitment to a dual mandate that includes full employment. Therefore, I would see the numerical objective as a long-run goal, and would want the Committee to have a flexible timeframe within which to maintain it. We’ve done a good job under Chairman Greenspan of promoting both price stability and full employment. I believe that a numerical long-run objective for inflation will enhance our ability to maintain that success even in the face of the significant challenges that may come up.

Yellen doesn't view an inflation target as being inconsistent with achieving full employment.  And guess what?  She has been right.  The current pursuit of full employment certainly has not fueled inflation.  But if it did, if the 2% target was in jeopardy, I am confident Yellen would act accordingly.  Indeed, I think she would surprise those who deride her as a "dove."

Bottom Line:  The classification of policymakers into hawks and doves is unfortunate given the negative connotation associated with doves in particular.  It is even more unfortuate that Yellen has been identified as a dove innumerable times in the press and blogs (myself included).  I don't know that we can easily abandon the terminolgy, but we very much need to work to eliminate any negative connotations to the terms.  

FOMC Week

With the FOMC widely expected to hold the pace of its asset purchase program steady, the real action will be in the statement.  Two issues bear watching, the economic outlook and and the forward guidance. The risk is that one or both are more dovish than the last FOMC statement.  But, interestingly, being more dovish does not necessarily imply a delay to asset purchase tapering; it could also mean that the Fed leaves a September tapering in place, while using forward guidance to ease policy policy by signaling an even more extended period of low rates.

At this risk of oversimplifying the last FOMC statement, narrow the Fed's June outlook to:

Information received since the Federal Open Market Committee met in May suggests that economic activity has been expanding at a moderate pace...

... The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished since the fall.

Putting inflation aside for a moment, the Fed can move in a dovish direction by downgrading from "moderate" to "modest."  As Calculated Risk notes, much here hinges on the Fed's interpretation of what is largely expected to be a weak GDP report (released the same day as the FOMC statement), on the order of 1% or less for the second quarter.  I tend to think the Fed will largely dismiss the report as an artifact of fiscal contraction and other one-off events.  Indeed, in his recent Congressional testimony, Federal Reserve Chairman Ben Bernanke indicated that the Fed's forecast had not changed significantly since the last FOMC meeting despite knowing that the second quarter GDP would be lackluster.  Has he had a change of heart since then?

Another possible hint on the outlook could be the consistency of the last two Beige Books.  From the June Beige Book:

Overall economic activity increased at a modest to moderate pace since the previous report across all Federal Reserve Districts except the Dallas District, which reported strong economic growth.

The language was similar in July:

Reports from the twelve Federal Reserve Districts indicate that overall economic activity continued to increase at a modest to moderate pace since the previous survey. 

Arguably a downgrade, but I doubt policy is likely to shift on a minor pullback in activity in just one Federal Reserve District.  Still, given that the data flow has certainly not been better than expected, even if they do not downgrade the basic assessment, they could suggest that the risks to the outlook are more balanced (rather than "diminished" as in June).  With this in mind, recall that Bernanke's assessment of the risk appeared more balanced in his Congressional testimony, which suggests this week's FOMC statement will indicate the same.

Regarding inflation, the Fed last concluded:

The Committee also anticipates that inflation over the medium term likely will run at or below its 2 percent objective.

This assessment is not likely to change.  Possible, though I think unlikely, would be a change to this sentence:

Partly reflecting transitory influences, inflation has been running below the Committee's longer-run objective, but longer-term inflation expectations have remained stable.

A decidedly dovish shift would be to remove the reference to "transitory influences."  Even more dovish would be to suggest that inflation expectations are trending down, but I very much doubt the Fed will go that far.   

In addition to shifting their assessment of the economy, the Fed may choose to tighten up it's forward guidance.  Considering that Fed speakers, including Bernanke, have indicated that, given the inflation outlook, interest rates will remain unchanged even after the unemployment rate hits 6.5%, it seems possible that the FOMC could shift the unemployment threshold down to 6%. They could also formalize Bernanke's 7% unemployment for ending quantitative easing.  What they won't do is increase the 2.5% inflation threshold; indeed, that one I view more as a trigger than a threshold in any event.

It may be the case that, barring a sharp deterioration in the economy, we will find that changes in the economic assessment should be interpreted as changes in the expected timing of the first rate hike rather than the pace of the exit from quantitative easing.  This may be the case even if the forward guidance is left unchanged.  The Fed seems to desire a shift in the mix of policy while maintaining the current level of accommodation, and they may use the statement to signal such an intention.  

Moreover, arguably there is little harm at this point to sticking with a plan to end asset purchases by the middle of next year.  Bernanke already shifted expectations in such a way that interest rates jumped to a new range around 2.5%.  In order to reverse that increase, I suspect the Fed would need to do more than just suggest a delay in the tapering.  I suspect they would need to surprise markets with an increase in the pace of purchases.  But I don't see much appetite at the FOMC for such a move other than perhaps St. Louis Federal Reserve President James Bullard.  Thus, FOMC members could decide that they still want out of QE and just use forward guidance to control the pace of any further rate gains.  

Bottom Line:  This will be a very interesting FOMC meeting even if the statement is left largely unchanged.  That alone reveals that the Fed is moving ahead with their plan to taper undeterred by any soft spots in the data.  After all, wouldn't this just be another midyear slowdown in the data flow?  A move to a more dovish statement, either in the economic assessment or fine-tuning the forward guidance, however, does not necessarily mean any change in the plan to end asset purchases.  It could all be about the timing of the first rate hike at this point.  The plan to end asset purchases may have had more to do with market functioning than economic activity in the first place.  And that debate is really over regardless of when the Fed actually tapers.  Whether September or December or early next year is probably no longer very important; the date of the first rate hike, however, is still very important.

Negative Feedback Loops?

Earlier this week, we were greeted with news that new homes sales posted a solid increase in June:

Calculated Risk has more here and here, with the conclusion that is was "a solid report even with the downward revisions to previous months."  More interesting, though, is that the gains came amid a spike in mortgage rates.  This could be taken as evidence that the rate rise has had only minimal impacts on housing markets, thus clearing the way for the Fed to scale back asset purchases sooner than later.

That said, today we learned this, via Bloomberg:

Rising mortgage rates contributed to increased cancellations and a dropoff in traffic in June, according to Fort Worth, Texas-based D.R. Horton....

....Homebuyers are “shocked and disturbed” rates have moved up so fast, D.R. Horton Chief Executive Officer Donald Tomnitz said on a conference call.

But not everyone in the industry is singing the same tune:

Richard Dugas, PulteGroup’s chief executive officer, said on a conference call today that the higher mortgage rates haven’t hurt demand and buyer traffic remained consistent throughout the quarter and into July.

“We’re in the camp that if higher rates reflect improving economic conditions we’d expect a housing recovery to remain on track,” Dugas said. “As an industry, we can sell more houses if more people have jobs, even with modestly higher rates.”

On the margin, some buyers were certainly impacted by the sharp gain in rates, but rates are only one part of the buying decision - factors like job growth also matter.  The initial sticker shock might only be temporary.  And perhaps even higher rates are necessary to make a significant dent in the housing market.  From Bloomberg:

As Jed Kolko, Trulia’s chief economist wrote yesterday, homebuyers say rising rates is their top worry when looking to buy, even more so than rising prices or finding a home they like. But as Kolko points out, people’s actions aren’t matching their words so far. Despite the higher rates, applications for purchase mortgages rose in June, as did asking prices for homes. Trulia’s data suggest that mortgage rates around 6 percent would be a tipping point that cause a majority of people to reconsider buying.

Overall, I would say the negative anecdotal housing evidence is too limited at this point to have a policy impact.  And note the positive anecdotal evidence from the latest Beige Book:

Residential real estate activity increased at a moderate to strong pace in most Districts. Most Districts reported increases in home sales. Cleveland noted that June sales of single-family homes were down compared with earlier in the spring but up from last year. Boston, New York, Minneapolis, Kansas City, Dallas, and San Francisco noted strong residential real estate markets. Home prices increased throughout the majority of the reporting Districts. Boston, New York, Richmond, Atlanta, Minneapolis, Kansas City, and Dallas noted low or declining home inventories and upward pressures on home prices in some areas. Residential construction activity also improved moderately across the Districts, and contacts in New York, Philadelphia, Chicago, Minneapolis, Dallas, and San Francisco reported faster growth in multi-family construction, in particular.

Moreover, it is not clear that taking some steam off the housing market was not an intent of some policymakers.  San Francisco Federal Reserve President John Williams was quoted recently saying:

“The outsized response” in the yields of 10-year Treasuries in recent weeks may have stemmed from complacency and “froth” in the market, Williams said. Some investors expected the Fed to keep quantitative easing and zero interest rates in place for longer than officials were anticipating.

“The market reaction to me probably is a sign that there was complacency and excesses going on,” Williams said. “It’s a good thing that maybe came to an end, or maybe was lessened.”

But earlier in the article he said:

Federal Reserve Bank of San Francisco President John Williams, who has never dissented from a policy decision, said “it’s still too early” for the Fed to begin trimming its bond-buying, warning of risks to the economy from low inflation and government budget cuts.

“We need to be sure that the economy can maintain its momentum in the face of ongoing fiscal contraction,” Williams said in a speech today in Rohnert Park, California. “It is also prudent to wait a bit and make sure that inflation doesn’t keep coming in below expectations, possibly signaling a more persistent decline in inflation.”

I find a lot of inconsistency in Fedspeak of late.  If the economy needs continued support, why even begin the tapering discussion?  And if the economy needs continuing support, then the rate rise represents a real tightening of monetary conditions, not just a lessening of accommodation, so how can Fed officials cheer-lead the rate rise?  We saw something similar from Federal Reserve Chairman Ben Bernanke:

The second reason for increases in rates is probably the unwinding of leveraged and perhaps excessively risky positions in the market. It's probably a good thing to hav e that happen, although the tightening that's associated with that is unwelcome. But at least the benefit of that is that some concerns about building financial risks are mitigated in that way and probably make some FOMC participants comfortable with this tool going forward.

In my opinion, we no longer know the Fed's reaction function.  The reaction function does not appear to be entirely dependent on unemployment and inflation.  There was never any reason to adjust QE on that basis, that's why Bernanke's post-FOMC comments caught everyone by surprise.  If you take the economy off the table, then the Fed appears to have a financial stability variable now built into their reaction function. Perhaps that variable reflects concerns about leverage, perhaps, as Izabella Kamiska suggests, it reflects liquidity issues.  Maybe they were worried about lighting a fire beneath Housing Bubble 2.0.  We just don't know; we just know that they are not entirely dissatisfied with rising rates despite the potential for negative feedback on the economy.

Bottom Line:  Still too early to conclude the extent of the negative feedback of the recent rise in rates.  Moreover, it is not clear to what extent Fed officials are unhappy with that feedback.  Less so than we might suppose if they now have a financial stability variable in their reaction function.  If so, policy efforts will center less on reversing the rate increase than in moderating the pace of increases. 

Shock and Awe(ful)

Yesterday's hot story from Ezra Klein that Larry Summers was the lead candidate for the top spot at the Federal Reserve was greeted with shock and awe(ful).  I wish I could say that I was surprised, but at the end of last month I tweeted:

I often think we have prematurely declared Janet Yellen the front runner. We forget that politics will be in play. http://t.co/ghIPnl0kjj

My concerns were only reinforced when news broke last week of the campaign against current Vice Chair Janet Yellen.  From Ezra Klein:

The favored parlor game of the political-economic complex right now is guessing who will replace Ben Bernanke as chairman of the Federal Reserve. The clear front-runner is Federal Reserve Vice Chairman Janet Yellen. But she’s by no means a sure thing.

One important reason she’s not — and I don’t know another way to say this — is sexism, as evidenced by the whispering campaign that’s emerged against her.

Yesterday, Klein declared Summers the front-runner:

People dismissed Summers’s chances a month or two ago, but he’s increasingly viewed as the leading candidate today — and opinions on this, for reasons I don’t fully understand (though I suspect have to do with a bunch of elite trial balloons going up at the same time), have really hardened in the last 72 hours.

Klein lists a variety of reasons in favor of Summers, most important of which I think is that President Obama and his staff know and like Summers, while Yellen is a virtual unknown in White House circles.  This is also the message of Washington Post reporter Zachary Goldfarb's tweet yesterday:

Larry Summers visited White House 14 times in past 2yrs. Janet Yellen visited once, records show. pic.twitter.com/ufFuVbrH7V

— Zachary A. Goldfarb (@Goldfarb) July 23, 2013

Reaction was swift and fierce from some quarters of the blogosphere.  Cardiff Garcia begins with a defense of Summers:

...Some of the mistakes of his past, such as his role in deregulating derivatives (the Brooksley Born episode) or the Harvard interest rate blowup, don’t really tell us much about his capacity to guide macroeconomic stabilisation policy.

His more recent mistakes, specifically his failure to better advise Obama on the stimulus (should have been bigger) and housing policy (should have done more for people in foreclosure and underwater homeowners), included political considerations that are hard to untangle from his actual views.

before launching into his reasons for supporting Yellen, beginning with the most important:

The simplest reason is that she is more conventionally qualified for the job, boasting a much longer entry in her CV as a monetary policymaker. 

Like him or hate him, Summers lacks Yellen's depth of exposure to monetary policy.  If relative experience with monetary policy is a requirement for the job, Yellen clearly has the upper hand.  Felix Salmon, not exactly a fan of Summers to begin with, sums up the situation:

...if Obama picks Summers, it won’t be on the merits; instead, it will be on the grounds that Obama likes Summers, and is in awe of his intelligence. (Summers is, to put it mildly, not good at charming those he considers to be his inferiors, but he’s surprisingly excellent at cultivating people with real power.)

Salmon then launches into an attack on Summers:

What’s more, the move would be a calculated snub to bien pensant opinion. Never mind the utter shambles that Summers made of Harvard, or the way he treated Cornell West, or his tone-deaf speech about women’s aptitude, or the pollution memo, or the Shleifer affair, or the way he shut down Brooksley Born at the CFTC, or his role in repealing Glass-Steagal, or his generally toxic combination of ego and temper — so long as POTUS likes Larry, and/or so long as Summers is good at working key Obama advisors like Geithner, Lew, and Rubin, that’s all that matters.

Evidently, Salmon holds a grudge a bit longer than Garcia.  Now, if only President Obama would shift his focus from Summers and Yellen to Ben Stein, then we would see some real fireworks from Salmon.

 Mark Thoma has a more succint reaction:

Larry Summers is the Front-Runner?  WTF?

Perhaps not all is lost.  Back to Klein:

That’s not to say Summers is anywhere near a sure thing. His confirmation would be far tougher than Yellen’s, as Republicans will make him answer for the stimulus and the bailouts, and progressive Democrats have a list of grievances going back to financial deregulation in the Clinton-era. There’s also the simple fact that appointing Yellen would break a significant glass ceiling — and do so in an administration that hasn’t always been great about appointing women to top economic positions. And Summers continues to be a polarizing figure: Those who like him love him, but those who don’t like him really don’t like him.

That said, one gets the feeling that this is not a sudden decision.  Instead it is one that has been building for weeks, at least since June 29, when I began to get nervous about the assumption of Yellen as a front-runner.  I suspect that if the position has hardened within the White House as Klein suggests, it is because Obama has made his choice and it is time for everyone to get on board.

I have to say that if Yellen is not the pick, I will be disappointed.  I think she the best qualified candidate for the job, and agree with the pro-Yellen arguments of Garcia, Salmon, and Bill McBride.  I am very concerned about Summer's disposition to be a de-regulator, especially after we see that the Federal Reserve, in its infinite wisdom, gave permission for investment banks to openly manipulate commodity markets.  Does anyone see Summers pushing back at that kind of regulation, or getting on board?  I don't think that he is the kind of person to take the words of Adam Smith to heart:

The interest of the dealers, however, in any particular branch of trade or manufactures, is always in some respects different from, and even opposite to, that of the public. To widen the market and to narrow the competition, is always the interest of the dealers. To widen the market may frequently be agreeable enough to the interest of the public; but to narrow the competition must always be against it, and can serve only to enable the dealers, by raising their profits above what they naturally would be, to levy, for their own benefit, an absurd tax upon the rest of their fellow-citizens. The proposal of any new law or regulation of commerce which comes from this order ought always to be listened to with great precaution, and ought never to be adopted till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention. It comes from an order of men whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it. 

Bottom Line:  Nothing is certain until the announcement is made and the Senate takes its turn, but it is looking like the White House is pushing to make Larry Summers the next Federal Reserve Chairman.  The curse of the Vice Chair would then live on.

Changing the Mix, Not Level, of Accommodation

Brad DeLong says that I confuse him, but nicely places the blame on Federal Reserve Chairman Ben Bernanke.  And, truth be told, I have to admit to some confusion, as it it difficult to see how we arrived at this whole tapering debate in the first place.  The data simply doesn't lead you to it.  So how did the Fed get here?

It is difficult to say the path of activity has meaningfully accelerated.  For all of the drama that can surround the quarterly GDP report, the economy has been growing at a pretty steady pace since the recession ended:

And the improvement in the job market in recent months is really less than meets the eye.  The twelve-month moving average of job growth is pretty stable and arguably lackluster:

To be sure, with a hand from declining labor force participation, the unemployment rate is also on a steady downward march:

But at 7.6 percent still too high, as too are measures of underemployment.  Moreover, one would think that the recent path of inflation would in and of itself end any discussion of tapering:

It looks as though we started the tapering discussion solely on the expectation that the data would soon improve as the impact of fiscal contraction waned.  Yet that seems very premature given the levels of inflation and unemployment.  There really doesn't seem to be a reason that we needed to have this discussion now rather than at least until after we saw third quarter GDP.  

So, again I ask why are we having this discussion?  The plot thickens further as Bernanke has altered the nature of the discussion recently.  The proposed taper is no longer about reducing policy accommodation.  From the Reuters transcript of Bernanke's House testimony:

You talked about the weakness of the economy, I think that's evidence that we need to provide continued accommodation even if we begin to change over time the mix of tools that we use in providing that accommodation.

Bernanke is talking as if the goal is to change the mix of monetary policy but not the level of accommodation, essentially trading some reduced accommodation from ending asset purchases for additional accommodation by extending the forward guidance on interest rates.  But why?  If the level of accommodation is the same, does the mix matter?  

That's an interesting question - does the Fed have research saying the mix matters, and why?  I can see two reasons.  One is that somehow asset purchases have a more negative distortionary impact.  Another is that there exists an internal bias in the FOMC against expanding the balance sheet.  Arguably, some elements of both where on display in Bernanke's testimony today:

The second reason for increases in rates is probably the unwinding of leveraged and perhaps excessively risky positions in the market. It's probably a good thing to have that happen, although the tightening that's associated with that is unwelcome. But at least the benefit of that is that some concerns about building financial risks are mitigated in that way and probably make some FOMC participants comfortable with this tool going forward.

Some FOMC participants are not comfortable with asset purchases because the fear financial instability.  And maybe they should, but at first blush I am hard pressed to say why shifting the accommodation to interest rates doesn't simply trigger another instability elsewhere.  But what I believe is not important; what is important is that some FOMC members believe it, likely enough that reaching consensus is increasingly difficult as the last minutes suggest.

As that discomfort grows, so too does the risk of premature policy withdrawal.  So Bernanke needs to find a way to appease both factions within the FOMC, those that want to end asset purchases and those that worry that the exact opposite, an increase in asset purchases, is needed.   The solution is this "let's change the policy mix" argument.  Give the hawks a bone by giving a time line to ending asset purchases but take it away by waffling on the Evan's rule to push back the timing of the first rate hike.

The trouble is that handing off policy from asset purchases to interest rates is not as simple as it seems.  One is a current action, the other is a promise about the future.  As is often said, talk is cheap.  Actions speak louder than words.  Forward guidance is not as powerful as asset purchases in shaping expectations, thus investors,regardless of the promise of a longer period of low short term rates, repriced debt when asset purchases were clearly revealed as temporary .

In other words, if Bernanke had a plan to change the mix of accommodation without changing the level, that plan failed to some degree as financial conditions tightened.  To what extent this has a feedback effect that forces the Fed to delay tapering is unknown, but I suspect whatever economic damage may occur is already on the way.  For instance, even if higher rates don't undermine housing purchases, they will reduced refinancing activity, something that may have become more important as home prices rise and equity levels increase.  But without getting the hawks on board with an expansion of asset purchases, it is difficult to see how Bernanke talks rates back down to 2 percent.  Again, talk is cheap.  The data would need to start deteriorating much faster to given Bernanke's word additional purchase.

Bottom Line:  Trying to reconcile the tapering talk with the data is not easy.  I think that's why many analysts missed the direction the Fed was heading.  It was somewhat incomprehensible based on the Fed's previous guidance.  It could be the effort to change the policy mix but not the level of accommodation was Bernanke's attempt to gain consensus within the FOMC and maintain accomodation, but he may have underestimated the importance of asset purchases in holding rates low.  

Cascades Peaks

Classic Cascades view of a string of peaks

Peak on the right is North Sister.  Snow-covered peaks in the distance are Mt. Jefferson and Mt. Hood.  Mt. Adams was also visible, but the phone couldn't quite pick it up.

Bernanke Takes a Dovish Stance

Federal Reserve Chairman Ben Bernanke traveled to the House today to deliver his final Monetary Report to Congress.  While he reiterated many of his previous comments surrounding quantitative easing and interest rates, Bernanke leaned on the dovish side of the equation in his testimony and Q&A.  Bernanke continues to emphasize the distinction between asset purchases and interest rates as well as the data dependent nature of both.  Overall, like his comments last week, Bernanke leaves me less confident of a September taper.  Such uncertainty, I think, is one of his objectives.  

At the onset of his testimony, Bernanke suggests that economic activity is broadly consistent with the Fed's forecast:

The economic recovery has continued at a moderate pace in recent quarters despite the strong headwinds created by federal fiscal policy.

But he quickly raises a red flag:

Housing activity and prices seem likely to continue to recover, notwithstanding the recent increases in mortgage rates, but it will be important to monitor developments in this sector carefully.

The Fed is understandably wary that the recent rise in rates will undermine the housing recovery, but also recognizes that rates are just one factor determining the demand for housing.  See again FT Alphaville on this topic.  Bernanke's assessment of the labor market is also mixed:

Conditions in the labor market are improving gradually...Despite these gains, the jobs situation is far from satisfactory, as the unemployment rate remains well above its longer-run normal level, and rates of underemployment and long-term unemployment are still much too high.

Then comes the decidedly dovish inflation outlook:

Meanwhile, consumer price inflation has been running below the Committee's longer-run objective of 2 percent. 

And once again he dismisses the data:

This softness reflects in part some factors that are likely to be transitory. Moreover, measures of longer-term inflation expectations have generally remained stable, which should help move inflation back up toward 2 percent.

But then he raises the specter of deflation:

However, the Committee is certainly aware that very low inflation poses risks to economic performance--for example, by raising the real cost of capital investment--and increases the risk of outright deflation. Consequently, we will monitor this situation closely as well, and we will act as needed to ensure that inflation moves back toward our 2 percent objective over time. 

If I had to say what surprised me the most over the past few months, it is that the tapering debate has proceeded so far and so long given below target and declining inflation rates.  They are clearly placing considerable importance on a Phillips Curve view of the world in which they anticipate that falling unemployment will soon exert more upward pressure on inflation, otherwise they would have raised the pace of asset purchases at the last meeting rather than signal the end of quantitative easing.

Bernanke then muddles the risk to the forecasts.  He first reiterates the message of the last FOMC statement:

The pickup in economic growth projected by most Committee participants partly reflects their view that federal fiscal policy will exert somewhat less drag over time, as the effects of the tax increases and the spending sequestration diminish. The Committee also believes that risks to the economy have diminished since the fall, reflecting some easing of financial stresses in Europe, the gains in housing and labor markets that I mentioned earlier, the better budgetary positions of state and local governments, and stronger household and business balance sheets. 

That's a lot of good news.  But he rains on the parade:

That said, the risks remain that tight federal fiscal policy will restrain economic growth over the next few quarters by more than we currently expect, or that the debate concerning other fiscal policy issues, such as the status of the debt ceiling, will evolve in a way that could hamper the recovery. More generally, with the recovery still proceeding at only a moderate pace, the economy remains vulnerable to unanticipated shocks, including the possibility that global economic growth may be slower than currently anticipated. 

Interesting emphasis on the downside risks, particularly given that during the Q&A Bernanke said that recent data had not yet altered his basic outlook.  Definitely sounds like he wants to take some of the certainty out of the path of asset purchases even if the current outlook is unchanged.  This speaks to an effort to disabuse market participants of the notion that policy is calendar based.

Regarding policy, Bernanke continues to distinguish the Fed's policy tools and reiterate that policy remains accommodative even after the end of asset purchases:

We are relying on near-zero short-term interest rates, together with our forward guidance that rates will continue to be exceptionally low--our second tool--to help maintain a high degree of monetary accommodation for an extended period after asset purchases end, even as the economic recovery strengthens and unemployment declines toward more-normal levels. In appropriate combination, these two tools can provide the high level of policy accommodation needed to promote a stronger economic recovery with price stability.

Bernanke also repeats his performance in his last FOMC press conference:

If the incoming data were to be broadly consistent with these projections, we anticipated that it would be appropriate to begin to moderate the monthly pace of purchases later this year.

I do wish policy was more based on data being  more "narrowly" consistent with the projections; "broadly" consistent leaves a lot of wiggle room.  Note that Bernanke did suggest that so far the data remains within the range of broadly consistent.  That 7% trigger comes back into play:

And if the subsequent data continued to confirm this pattern of ongoing economic improvement and normalizing inflation, we expected to continue to reduce the pace of purchases in measured steps through the first half of next year, ending them around midyear. At that point, if the economy had evolved along the lines we anticipated, the recovery would have gained further momentum, unemployment would be in the vicinity of 7 percent, and inflation would be moving toward our 2 percent objective. Such outcomes would be fully consistent with the goals of the asset purchase program that we established in September. 

I don't think we know where that 7% number came from; St. Louis Federal Reserve President James Bullard claims it is not official policy and it doesn't show up in the minutes.  But 7% it is.

Dovishly, Bernanke recognizes that financial conditions have tightened recently:

 On the other hand, if the outlook for employment were to become relatively less favorable, if inflation did not appear to be moving back toward 2 percent, or if financial conditions--which have tightened recently--were judged to be insufficiently accommodative to allow us to attain our mandated objectives, the current pace of purchases could be maintained for longer.

The Fed was definitely surprised that rates reset following the last FOMC meeting.  Indeed, even though rates fell today, the decline is a minimal few basis points compared to the rise since the spring.  It seems that the Fed thought they were doing everyone a favor by signalling well in advance that policy was likely to shift by the end of the year, presumably so that markets would not be surprised and push up rates quickly.  Policymakers, however, appear to have forgotten - again, for something like the third time in the last four years - that even talking about tighter policy is the same thing as tighter policy.  Did they just sabotage their own desire to wind down asset purchases?  Time will tell.

Bernanke pounds home this now familiar idea:

As I noted, the second tool the Committee is using to support the recovery is forward guidance regarding the path of the federal funds rate. The Committee has said it intends to maintain a high degree of monetary accommodation for a considerable time after the asset purchase program ends and the economic recovery strengthens. 

And emphasizes thresholds are not triggers:

As I have observed on several occasions, the phrase "at least as long as" is a key component of the policy rate guidance. These words indicate that the specific numbers for unemployment and inflation in the guidance are thresholds, not triggers. Reaching one of the thresholds would not automatically result in an increase in the federal funds rate target; rather, it would lead the Committee to consider whether the outlook for the labor market, inflation, and the broader economy justified such an increase.

And then he questions the conditions around the unemployment threshold:

For example, if a substantial part of the reductions in measured unemployment were judged to reflect cyclical declines in labor force participation rather than gains in employment, the Committee would be unlikely to view a decline in unemployment to 6-1/2 percent as a sufficient reason to raise its target for the federal funds rate. Likewise, the Committee would be unlikely to raise the funds rate if inflation remained persistently below our longer-run objective. 

Why does the same concern about labor force participation not hold for quantitative easing?  If raising rates due to falling labor force participation is premature tightening, then why isn't ending quantitative easing also premature?  And does anyone every wonder about these thresholds are in the first place?  They seem to be the loosest of guidelines.

Regardless, Bernanke accomplished what he set out to do: Push back against the idea that the Fed will raise rates anytime soon.  And he goes further:

Moreover, so long as the economy remains short of maximum employment, inflation remains near our longer-run objective, and inflation expectations remain well anchored, increases in the target for the federal funds rate, once they begin, are likely to be gradual.

The message is that policy will remain accommodative long after quantitative easing ends.

Bottom Line:  Bernanke continues to inject uncertainty regarding the path of asset purchases, while at the same time creating more certainty about the path of interest rates.  Altogether, part of his ongoing efforts to minimize the tightening that occurred in the run-up and aftermathath to the last FOMC meeting.  But at the same time, he said the data remain broadly consistent with the path he outlined at the meeting, suggesting that the general policy path he outlined in June remains in play, which means beginning to wind down asset purchases later this year.  

Time To Move On

Looking back at the last month, it seems evident that we moved through a policy inflection point.  Eventually, improving economic activity would prompt the Federal Reserve to begin normalizing policy.  To be sure, the process is not likely to be quick, but it will happen. As labor markets improved, housing prices rose, and asset prices climbed, policymakers would start to believe that the costs of quantitative easing would be rising relative to the benefits.   Thus the first stop on that journey to normalized policy would be to scale back the pace of asset purchases.

At this point, market participants have largely absorbed the news the quantitative easing would be phased out in the months ahead.  Once this became evident, US Treasury securities were no longer a one way bet, and thus the willingness to hold bonds at a sub-2% rate decreased somewhat.  As should have been no surprise to anyone, Federal Reserve officials included, rates thus backed up, eventually settling in a range around 2.5%.  Similarly, equities stumbled but then regained their footing.  That, I think, marks the end of the tapering debate.  

How could the debate be over before tapering even begins?  I think Joe Weisenthal has the answer:

Maybe the Fed will start slowing its pace of bond purchases in December. More likely it will be September. It doesn't make much of a difference.

But really the story now, with respect to the Fed, is when the first interest rate hike will be...

Other than bragging rights, September or December isn't really important anymore. And to be sure, I am still interested in the political intrique behind Bernanke's move to lay out the tapering.  How much did he influence that discussion?  And where he get the 7% unemployment trigger?  But I suspect the market moving news surrounding the taper - that quantitative easing is not forever, not even for another year -  is behind us.  At this point, any impact of the data on the pace of tapering is really not that important.  What is important, however, is the impact of data on the lift-off from the zero bound.  

Indeed, an emphasis on rates is exactly what we can expect from Federal Reserve Chairman Ben Bernanke's testimony this week.  He will reiterate the message of last week, that quantitative easing and interest rates are two separate policies.  An end to quantitative easing does not imply that the date of the first rate increase has been moved forward.  

Thus, the message will be that you shouldn't be expecting a rate increase in 2014 because the Federal Reserve changed its reaction.  Bernanke will tell you they did not change the reaction function, and if need be, they may feel compelled to prove it by shifting the unemployment threshold down from 6.5%.  Any case for a 2014 rate hike would rest on the premise that the economy takes a dramatically more positive turn than policymakers expect.  And note that this would comes as a surprise to Fed officials, who tend to worry not that their forecasts are too pessimistic, but too optimistic. 

So what takes us to a 2014 rate hike?  At the risk of oversimplifying, I am looking at four main factors.  First is that impact of fiscal contraction definitively fades in the second half of this year.  Second is that the housing market does not stumble in the face of higher mortgage rates.  Third is that the labor market continues to expand such that we see real improvement in measures of underemployment.  And fourth is that inflation soon reverses course and trends back to 2%.

That to me seems like a a lot of things have to go right in very short order.  I am reasonably confident that the effects of fiscal contraction will fade, and that the housing markets will continue to improve.  On the latter point, note that interest rates are only one factor driving housing activity.  Please see Calculate Risk and FT Alphaville for more information.  As far as the other two points are concerned, I am wary of believing that even after taking fiscal policy and housing off the table, growth will be strong enough to drive the kinds of changes in labor markets and inflation dynamics that would induce the Federal Reserve to being normalizing interest rates in 2014.  

Bottom Line:  Whether or not the taper happens in September or December, financial market participants have already digested the news that quantitative easing in not forever.  For the most part, incoming data is now about timing the next milestone in the process of policy normalization, the first rate hike.  Expect policymakers to continue to push back on expectations that 2014 will bring a rate hike.  Indeed, it seems a lot has to go right in the data to make that happen.

Friday Afternoon Fed Blogging

We gained a lot of insight into Fed policy this week, and not all of it was pretty.  Some thoughts as Friday comes to a close:

1.) The Fed is deeply divided.  The minutes of the last FOMC meeting clearly revealed that the FOMC is splitting into deeply divided factions.  Those factions were on display today with the comments of St. Louis Federal Reserve President James Bullard and Philadelphia Federal Reserve President Charles Plosser.  Bullard pushed hard on the policy implications of the inflation data.  From the Wall Street Journal:

“If [inflation] drops any further from here, we are going to have to take it very seriously,” Federal Reserve Bank of St. Louis President James Bullard said in an interview with the Wall Street Journal. Price pressures are at the “lower bound” of where they should be, and “I’m a little nervous” about this situation, the official said.

...Mr. Bullard said the “simplest” way the Fed could counter under-target inflation is by extending its current bond buying stimulus program for longer than currently planned, and take off the table for now any move toward shrinking the monthly size of the effort.

As his dissent made clear, Bullard clearly feels that talk of tapering is clearly premature.  On the other side is Plosser, who not only wants to end asset purchases this year, but also change the Evan's rule from thresholds to triggers:

The second step is for the FOMC to commit to its forward guidance on the fed funds rate path, that is, to begin treating the 6.5 percent unemployment rate and the 2.5 percent inflation rate in the guidance as triggers rather than thresholds.

The growing division makes it increasingly difficult to think of "the Fed" as a single entity with regards to policy intentions.

2.) Bernanke is pulling the strings.  Someone brokered a truce at the FOMC meeting that allowed Federal Reserve Chairman Ben Bernanke to lay out the path to ending asset purchases.  That someone must have been Bernanke, indicating that he wanted to introduce the idea that asset purchases would most likely soon be curtailed.  This suggests that Bernanke is pro-tapering.

3.) Bernanke tipped his hand big time.  Bernanke claimed in his press conference that his comments represented the views of the FOMC.  But as I noted earlier this week, the minutes make no reference to his 7% unemployment trigger for ending asset purchases.  So where did that number come from?  Must have been Bernanke revealing his own preference.  This was confirmed today by Bullard:

In the interview, Mr. Bullard said that when Mr. Bernanke said the bond buying program will likely end when a 7% jobless rate is achieved, he was not stating official FOMC policy.

“The committee itself has not voted on or approved any threshold for the [bond buying] program. It’s not clear we would,” Mr. Bullard said, adding that central bankers will discuss this matter further at future gatherings.

Ouch - so how much of what Bernanke says in a press conference is consensus policy, and how much is his own position?  Not clear any more.  But the plot thickens.  From Plosser's speech:

In the June press conference, Chairman Bernanke added some clarification and more specifics regarding the forward guidance for the latest round of asset purchases, which are adding $85 billion a month to our balance sheet...He indicated that if the incoming data are broadly aligned with this central tendency outlook, the Committee anticipates it would moderate the pace of monthly purchases later this year, perhaps ending them around mid-2014. The Chairman indicated that at that point, the unemployment rate is likely to be near 7 percent. If this plan unfolds as described, this latest round of large-scale asset purchases would exceed $1 trillion and the Fed's balance sheet would grow to more than $4 trillion.

So what are the economic conditions that would lead the Committee to slow the pace at which we are expanding the balance sheet? ..The Chairman noted that the asset purchase program is expected to end before the Committee begins raising the fed funds rate. So, ending the program by mid-2014, when the unemployment rate is anticipated to be around 7 percent, would be consistent with this.

Notice how carefully Plosser differentiates between the Committee and the Chairman.  It sounds as if Plosser also attributes the 7% number to the Chairman, not the Committee.  Not that Plosser is unhappy with the number:

My forecast has the unemployment rate approaching 7 percent by the end of this year and 6.5 percent before the end of 2014...consistent with my forecast and with the Committee's forward guidance, I favor starting to reduce the pace of purchases and ending the asset purchase program by year-end.

Plosser is happy to take the 7% number because it justifies his desire to end asset purchases by the end of this year.  If Bernanke unilaterally set policy, the policy he set was one that favored the hawks.

Now for a big question:  Did Bernanke set the 7% unemployment trigger as FOMC policy because he is pulled toward the more hawkish of the FOMC factions?   If the 7% was not consensus FOMC policy, I think he tipped his hand.   

4.) Is there a fight brewing?  Let's go back to Bullard's comment:

“The committee itself has not voted on or approved any threshold for the [bond buying] program. It’s not clear we would,” Mr. Bullard said, adding that central bankers will discuss this matter further at future gatherings.

What exactly will be discussed?  The 7% trigger, or the unilateral policy action on the part of Bernanke?  Bullard sounds like a very unhappy camper - how hard is he going to push on Bernanke in the Chairman's final days?

Bottom Line:  It is increasingly important that we get some real clarity on the Chairman's 7% unemployment trigger.  I think it might help more clearly define where he sits on the policy spectrum. That might be on a more hawkish side that we tend to believe.  And with the FOMC increasingly divided, should we be expecting a real power struggle within the Fed in the waning days of the Bernanke era?