Tim Duy's Fed Watch

Fall Tapering in the Air

Today is a "taper-on" day as financial market participants reacted to the initial claims report by sending Treasury yields up over 2.8% before they settled back to just a few basis points below that mark.  If you didn't believe tapering was coming as early as September, and by December at the latest, the initial claims report was something of a wake-up call.  Claims moved decisively lower in the last few weeks:

and are pushing into a range consistent with stronger job growth:

One might respond that other data has been lackluster.  Industrial production, for example, is edging forward at an anemic pace:

Retail sales were up in recent months, but like industrial production, given the noticeable slowing trend since late last year, it is difficult to call the growth gangbusters:

Moreover, the Philly Fed report, while not a disaster, disappointed on the downside.  On the upside, builder confidence rose in August despite the increase in interest rates.  The Fed will interpret this as a sign that higher rates have yet to meaningfully derail the housing recovery.

How might all of these pieces fit together for the Fed?  They might decide that there is no evidence the economy is falling off a cliff, thus there is no reason to abandon their baseline forecast.  Moreover, declining initial claims will support the contention that labor markets are poised to strengthen further in the months ahead, leading them to discount the softness in the most recent employment report.  A solid report for August will be given greater weight than a weak report for July.  And when it comes to tapering, progress in reaching "stronger and sustainable" labor markets is the most important benchmark.

What about inflation?  St. Louis Federal Reserve President reiterated his belief that the Fed needs to be wary about the inflation numbers.  From Bloomberg:

“The committee would not normally remove policy accommodation in an environment where inflation is below target and is projected to remain there,” said Bullard, who votes on policy this year, in prepared remarks in Louisville, Kentucky. The Fed’s inflation goal is 2 percent.

I suppose the key word here is "normally."  We live in anything but "normal" times for central banking.  That said, today's CPI report gives the smallest hint of a possibility that the inflation outlook is set to change:

I wonder if the stage is being set for another Bullard dissent in the near future.  One ccould argue that the small uptick in year-over-year core is a sign that inflation is bottoming, consistent with the Fed's expectations (note I include the Fed's target for reference).  Assuming the PCE numbers are similar, would I hang my hat on this number?  Probably not.  Would FOMC members, in the context of ongoing declines in initial claims?  I wouldn't bet against it.  Remember, though, my bias: I think that fundamentally they are looking to exit asset purchases and refocus attention on the federal funds rates as the first step in policy normalization.  Thus I believe that although they might say things like "the decision is data dependent" and "the data is mixed," they will tend to focus on the positive aspects of the data as justification for moving forward with tapering sooner than later.  

Regardless of the date of the tapering, however, the initial claims report reiterated that the writing is on the wall.  Tapering is happening, and as long as that idea is still sinking in, I suspect the Federal Reserve is going to have a hard time keeping a lid on interest rates despite their best efforts to push back the timing of the first rate increase.  I think there are still market participants who have yet to adjust their expectations that QE is not forever, and that expectation delivered unusually low term premiums. Hence rates remain under pressure until everyone comes to the acceptance that end of asset purchases is arguably a paradigm shift.  

And, speaking of paradigm shifts, note that long-time deflationist David Rosenberg is changing his tune.  Via Joe Weisenthal:

it's VERY strongly worth noting that David Rosenberg has written a note and slide dek[sic] today (which we published at Business Insider) wherein he departs from the deflation camp.

Are we at the low water mark for inflation? Maybe, and if the Fed even suspects this is the case, they will be even more eager to end asset purchases and normalize policy.

Bottom Line:  The realization continues to grow that whether it is September or October or December, the end of asset purchases is now in sight.  

Is Inflation a Consideration?

The decision of the Fed to define a time line for tapering given the low inflation numbers has been something of a puzzle.  Cleveland Federal Reserve President Sandra Pianalto provides  a concise explanation of that puzzle in her speech today:

Last fall, the FOMC initiated a third round of asset purchases. In this program, which is often referred to as “QE3,” we are purchasing $85 billion of Treasury securities and mortgage-backed securities per month. This policy was designed to drive some near-term momentum in the economy with the specific goal of achieving a substantial improvement in the outlook for the labor market.

Labor market data comes in every month and is subject to different interpretations. In my view, there has been meaningful improvement in both current labor market conditions and in the outlook for the labor market since the FOMC launched the current asset purchase program. Employment growth has been stronger than I was expecting, and the unemployment rate today is more than half a percent lower than I projected it to be last September.

In light of this progress, and if the labor market remains on the stronger path that it has followed since last fall, then I would be prepared to scale back the monthly pace of asset purchases.

Thus, according to Pianalto, QE3 was never about inflation, but instead was always about the labor market.  And, by her assessment, they can roll out the "Mission Accomplished" banner.  In short, the improvement in the labor market - or, more specifically, the stability of the labor market in light of fiscal contraction - is a driving force in the tapering decision.  Hence why officials are not willing to end speculation on a September taper despite no evidence that inflation is trending back toward the Fed's target in a timely fashion.  Inflation management, it would seem, is a problem that many policymakers simply think is a task best left for interest rate policy.

Crazy Fedspeak

There are two interviews of note hitting the wires today.  One is with Richmond Atlanta Federal Reserve President Dennis Lockhart, in which he leaves open the possibility of a September beginning to the tapering process.  Via the Wall Street Journal:

Dennis Lockhart, in an interview with Market News International, published Tuesday, said that while a move to ease back on monetary stimulus could come in September, the move could come at any time before the end of the year. Mr. Lockhart, who is not a voting member of the Fed’s monetary policy setting committee, also cautioned that should gross domestic growth and job creation in the second half of the year disappoint, “I, for one, would be quite prepared to delay or even reconsider” removing the asset purchase program.

This is crazy.  By the September meeting we have at best only the earliest data with which to judge the second half of the year.  If you really need to evaluate the second half of the year, you need to wait until October at the earliest.  September should be out of the question.  But it clearly isn't.

The next paragraph:

Mr. Lockhart said he was hoping for a bigger non-farms payroll figure in July — 162,000 — indicating that if the figure were to rise to between 180,000 to 200,000 and growth pick up, then the Fed would be in a position to taper.

This is equally crazy.  Is Lockhart really saying that 18,000 jobs - out of an economy with 136 million jobs - is meaningful from a policy perspective?  And notice the low expectations.  We don't even need 200,000 jobs any more to justify pulling back accommodation.

I was wondering if Lockhart is being taken out of context.  He generally has a very balanced, considered view.  But then we see the comments of Chicago Federal Reserve President and noted dove Charles Evans.  Again, via the Wall Street Journal:

During a breakfast briefing with reporters Mr. Evans said, “I clearly would not rule that out,” when asked if the Fed might begin throttling back on its asset purchases at theFederal Reserve‘s Sept. 17-18 policy meeting....

...The Fed is “quite likely to reduce the flow purchase rate starting later this year,” Mr. Evans said. “I couldn’t tell you exactly which month that will be.”

Hence why we can't take September off the table.  If Evans thinks it is possible, then it must be very possible, despite only another month's data between now and then.

Both appear to find the 7% mark significant:

“Considering the cumulative improvement in economic conditions since September 2012, Our asset purchases likely will end with the unemployment rate somewhere in the range of 7%,” Mr. Evans said, adding he expects this to happen sometime in 2014.

and

Mr. Lockhart said he expects the unemployment rate to fall to 7% in mid-2014.

This I don't understand unless they expect labor force participation to surge.  We have six months left in 2013 to reduce the unemployment rate by 0.4 percentage points.  Less than a percentage point a month:

7% just doesn't seem like a high bar to cross by then end of 2013.  Evans also highlights an argument to begin tapering sooner than later:

“Markets have begun to digest a world in which asset purchases are finite,” he said. He added that just because purchases might be scaled back, that doesn’t mean the Fed will raise interest rates, in fact, he said he sees rates remaining unchanged as long as inflation in kept in check, which could push unemployment below 7%.

The initial shock of tapering is behind us, giving the Fed more room to actually initiate the tapering.  Tapering is the first step on the path to normalizing policy.  The second step is making sure everyone is focused back on interest rates:

“Once we cross 6.5% [unemployment] we would be more closely monitoring” the information that informs the Fed funds rate, he said....

...“Suppose inflation were 1.5%. That’s much too low for our 2% target. Further accommodation would be called for,” he said, adding that he could even envision unemployment rates dropping “below 6% in certain environments.” 

The more they believe they can hold rates in check even if they begin to tapering, then the more likely that tapering will be. 

Bottom Line:  I think the Fed very much wants to taper in September, and hence why I am wary to believe we need to see some significant acceleration in the data to push them in that direction.  

Bits and Pieces

Just a handful of observations from the day:

1.) Dallas Federal Reserve President Richard Fisher offered-up one of his typically colorful speeches.  As should surprise no one, he is in favor of tapering at the next FOMC meeting.  His choice of words was interesting:

The challenge now facing the FOMC is that of deciding when to begin dialing back (or as the financial press is fond of reporting: “tapering”) the amount of additional security purchases. In his press conference following our June FOMC meeting, speaking on behalf of the Committee, Chairman Bernanke made clear the parameters for dialing back and eventually ending the QE program. Should the economy continue to improve along the lines then envisioned by Committee, the market could anticipate our slowing the rate of purchases later this year, with an eye toward curtailing new purchases as the unemployment rate broaches 7 percent and prospects for solid job gains remain promising...

...Having stated this quite clearly, and with the unemployment rate having come down to 7.4 percent, I would say that the Committee is now closer to execution mode, pondering the right time to begin reducing its purchases, assuming there is no intervening reversal in economic momentum in coming months.

It sounds as if Fisher takes seriously Bernanke's 7% marker regarding the end of balance sheet expansion.  Also note that he is not saying that he thinks the FOMC should taper.  He is saying they "are closer to execution mode," which sounds like an opinion from an insider.  Moreover, he is also suggesting that the data doesn't need to get better to taper; it just doesn't need to get any worse.

Then again, perhaps Fisher is just taking away the parts of the FOMC meeting that support his own position.  After all, he has long desired to curtail asset purchases and can now finally see that time is soon at hand.

2.) The lackluster employment report was surrounded by more encouraging data.  First, the manufacturing PMI came in ahead of expectations, and today we learned that its nonmanufacturing cousin did as well:

Evidence that activity is picking up as the impact of fiscal contraction wanes?  Or just a one-month bounce?  Could be either, but the Fed will get another look at these numbers before the September meeting, so they don't have to decide just yet.

3.) St. Louis Federal Reserve President James Bullard made a very important point that I should have highlighted Friday before I forgot:  Having a press conference only every other FOMC meeting is quite frankly ridiculous.  Bullard, via Reuters:

"September versus December, as if there was no meeting in October," he said, referring to two upcoming meetings that will be followed by press conferences with Fed Chairman Ben Bernanke...

..."I want the committee to have a press conference at every meeting, so that every meeting looks, ex ante, identical. And this would give the committee the freedom to make a move or not make a move at a particular meeting," said Bullard, a voting member of the committee this year.

We are all acting as if the Fed could not possibly make a policy move in October because there is no press conference.  Are we really down to only four policy-eligible meetings a year?   If that's truly the case, why even bother having a meeting?   And while we are at it, why not release the projections at every meeting as well?  I hope Bullard grabs this one by the tail and doesn't let go.  Either have an identical meeting every six weeks, or give us all a rest and just admit that there is no point to having more than four meetings a year.  

 4.) The Liberty Street Economics blog has a post on the recent bond market selloff, in which the authors conclude:

Our findings, reported in the chart below, suggest that nearly all of the recent increase in yields can be explained by a rising term premium. 

Federal Reserve Chairman Ben Bernanke's June press conference perhaps popped a small bond bubble in represented by an unusally low term premium.  This might explain why rates remain stuboornly above 2.5% despite a seemingly more dovish stance among Fed speakers since that press conference.  It might simply be difficult to unwind that increase in the term premium.

To give credit where credit is due, Joe Gagnon pointed out the term premium issue in an email, but I never had a chance to follow up.

5.) Since you are all thoughtful readers, I know that you all are following Bill McBride's Septaper posts which stand in opposition to my posts.  At least this is what I concluded from the Wall Street Journal this morning.  One thing is for sure - either McBride is taking the FOMC forecasts to literally, or I am not taking them literally enough.  Or, if October is an option, maybe a little of both.  

That's it; I think I should probably work on getting the kids into bed.

Septaper or not?

In addition to other activities, I spent a fair amount of the weekend puzzling over how we ended up at this tapering debate in the first place.  After all, the data hasn't been terrible, but it hasn't been exactly blockbuster either.  To be sure, we started the month with some promising data, but the employment report turned out to be yet another of the lackluster reports to which we have become accustomed.  In short, nonfarm payrolls continue to grind upward:

The twelve months haven't seen any huge disappointments, but also only one blowout month.  Moreover, underemployment indicators are not improving at any rapid pace:

Plenty of slack on the labor market.  Likewise, inflation isn't exactly trending toward the Fed's target:

None of this is new, and none of this prevented Federal Reserve Chairman Ben Bernanke from outlining a QE exit path on June 19th of this year.  But why outline that path in the first place?  I suspect it comes down to this sentence from the FOMC statement:

In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives.

Bernanke seemed firmly committed to a 7% unemployment rate as a trigger for ending asset purchases - that apparently represents progress toward meeting economic objectives.  Indeed, at that current rate of decline, we will be hitting that target very early in 2014:

If 7% unemployment is actually a relevant level, best to start tapering sooner than later.  Moreover, the unemployment decline is occurring in the context of a GDP path that is generally following expectations:

GDP growth decelerated as expected with fiscal contraction; if the forecast continues to hold true, expect GDP to accelerate in the second half of the year.  So, from the Fed's point of view, one could see where they are making substantial progress toward their objectives (the unemployment rate) in the context of a forecast that is generally consistent with expectations.  Moreover, there is also the additional context that the costs of QE may be rising in the form of financial instabilities.  

But what about inflation, or lack there of?  Well, notice that the Fed is arguably in something of a tight spot.  If you have a Phillips Curve view, then unemployment is quickly approaching a level in which upward pressure on inflation would be expected.  And the Fed would certainly want to begin removing accommodation prior to seeing that pressure emerge.  And time to remove that pressure is growing short, at least as indicated by the path of unemployment.  So you can see where September becomes something of  an important time if you want to gradually back away from asset purchases.  The longer you wait, the longer you risk having to go cold turkey on asset purchases.

And if you thought Bernanke set off some fireworks by discussing tapering in June, imagine the reaction if the Fed was to pull the plug on asset purchases at the last minute with some blowout data coming in the door as the impact of fiscal contraction fades.  

Moreover, you can also now see another problem.  It makes sense to confirm the waning impact of fiscal policy prior to tapering.  But we really won't see that data until deeper into the fourth quarter, at which time we can expect to be right on top of the 7% unemployment mark.  Again, does the Fed want to be in the position of having to suddenly pull the plug on QE?

But, but, but, you say, look back at those underemployment indicators.  Surely inflation is not a realistic threat at 7% unemployment, or even 6.5%.  The Fed has already covered this, however, in its forward guidance about interest rates:

In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. 

If need be, the Fed can address underemployment by holding rates near zero for longer than expected.  In affect holding the level of accommodation constant for now, but adjusting the mix to ease the eventual transistion to higher rates.  And perhaps to alleviate some financial distortions specific to quantitative easing as well.

So I think, at least in the context of the above, Bernanke's push for tapering become more understandable.  But will they follow through on tapering September as expected, or push it back until later in the year?  You can make an argument from the rise in rates, the data, and the Fedpeak that they will push it back.   But you can also make the argument that they may as well get the ball rolling now because the adjustment to a new regime has already occurred.

Note that despite the data and the Fe speak, rates remain stubbornly high relative to the pre-June 19th period. On that date, Bernanke firmly reset expectations.  Unless the Fed is willing to accelerate the pace of asset purchases, it is difficult to see the Fed reversing June 19th.  So that leaves the Fed in the position of either tapering in the near future, which is largely expected and thus should not have a significant impact on rates or delaying the tapering and running the risk of an abrupt end to QE without having a significant impact on rates.  After all, if they pass on September, then it is easy to see an entrenchment of expectations that December is the date.  Indeed, if financial market participants suspect that a delay now means a faster reduction of accommodation later, a pass in September could have the perverse result of sending rates higher rather than lower.

Bottom Line:  There is considerable uncertainty around a September date to begin taper.  Fedspeak and recent data have left me much less certain.  But I can see how the steady decline in the unemployment rate combined with a Phillips Curve view of the world puts the Fed in the uncomfortable position of possibly having to reduce accommodation prior to a being fully certain if their forecast is accurate.  Delay in the context of an accurate forecast could leave them tightening much more aggressively than currently expected.  Hence why I tend to see the bar to tapering as low, but the bar to ending zero rates as high.  Moreover, the cost to tapering is arguably now low because the increase in rates is already behind us; September or December isn't meaningful in the big picture anymore.  Overall, I still tend to lean toward September over December, with the lack of a press conference being the reason to not settle on October.  

Early 3Q Data Lifts Off

The FOMC meeting concluded largely as anticipated, with a tempered downgrade of the economic assessment from "moderate" to "modest" and a new warning about the dangers of low inflation.  Of course, given the weak first half evidence in the GDP report, "modest" seems like an appropriate adjective.  In addition, the Fed highlighted the recent rise in mortgage rates, signalling their concern about negative feedback effects.  Treasuries gained the news, wiping out earlier losses.

That said, there was no sense that the general forecast had changed dramatically.  The Fed still expects activity to pick up in the second half of this year, and likely still expects that that pickup will be sufficient to require the withdrawal of accommodation, beginning in the next few meetings, with September still the consensus.  They will be looking for data that supports that expectation.  It is mostly likely the case that strong data for July and forward will be more important than weak data from June and back.

With that in mind, the early data is looking good for tapering sooner than later.  Treasuries reversed yesterday's gains this morning on the combined strength of the ISM manufacturing and initial claims reports.  Manufacturing received a boost in July:

Moreover, the underlying components were solid as well.  New orders rebounded:

Production surged:

And employment gained:

It looks like something lit a fire under the manufacturing sector last month.  In addition, initial claims surprised positively:

I would say the general downward trend of the last year remains intact.  More positive employment news came yesterday with the ADP report showing a private sector job gain of 200k for July.  While Calculated Risk is correct that the ADP report is not particularly useful in predicting the initial release of the nonfarm payrolls numbers (which could be all over the place), Joe Weisenthal is correct in that it does track the underlying trend of the labor market, and signals that recent strength continued to hold.  Moreover, regarding tapering, employment is probably still the most important data.  

Bottom Line:  Early signs look good that the first half doldrums are easing.  But early signs are just that, early.  For example, tomorrow we get the employment report, which can be notorious volatile.  Moreover, we still have a wealth of data between now and the next FOMC meeting.  But if early data is any indication where the economy is heading, the FOMC will shift further toward reducing monetary accomodation between now and the next meeting.