Tim Duy's Fed Watch

What Comes After the Evans Rule?

Since the last FOMC meeting, market participants have grown cautious about the near term path of monetary policy, sending two year rates higher even as the Fed lowers their expectation of the policy path.  Is this entirely justified by the economic data, or is another explanation at work?  I suggest that the Evans rule has turned hawkish and will increasingly be a challenge for Federal Reserve policy.  In short, the nature of forward guidance is very much a question for 2014.

I believe it was David Andolfatto who first recognized the hawkish nature of the Evans Rule:

As Chairman Bernanke stressed in his press conference, the new policy does not imply that the Fed will necessarily raise its policy rate should the unemployment rate fall below the 6.5% threshold...But surely, if the unemployment rate crosses this threshold, the perceived probability of an imminent rate hike is likely to spike up. Absent the unemployment rate threshold, the market would likely expect the policy rate to instead remain low for a longer period of time. This is the hawkish nature of the Evans rule. 

Take this in light of Across the Curve's commentary today:

Several participants with whom I have spoken have expressed concern about the unemployment rate and how much it will drop when those jobless whose benefits expired drop out of the work force. That will be a participation rate event but since the FOMC did not tamper with threshold some are concerned about a big drop in the rate.

As I noted yesterday, there was some disappointment that the Fed did not change the thresholds.  The Fed wants it both ways - they want the impact of changing the threshold without actually changing the threshold.  Hence this sentence appears in the statement:

The Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal.

The Fed does want to be bound by rules; they want discretion.  That is exactly what this sentence is meant to provide.  Why don't they want rules?  Because they don't know what the rule should be.  Remember Federal Reserve Chairman Ben Bernanke's press conference - he thinks the decline in the labor force participation rate is largely structural and that current wage growth is sufficient to deliver a 2% inflation rate.  He doesn't doesn't sound like he wants his hands tied by some rule, because he doesn't know where to draw the line. 6.5 percent is easy.  Is 5.5 percent?

Indeed, those who want the Fed to have rules should pay attention to San Francisco President John Williams:

That said, I expect that the explicit link between future policy actions and specific numerical thresholds, as in the recent FOMC statements, will not be a regular aspect of forward guidance, at least when the federal funds rate is not constrained by the zero lower bound. This guidance has proven to be a powerful tool in current circumstances, when conventional policy stimulus has been limited by the zero lower bound. But such communication is difficult to get right and comes with the risk of oversimplifying and confusing rather than adding clarity. Therefore, in normal times, a more nuanced approach to policy communication will likely be warranted. I see forward guidance typically being of a more qualitative nature, highlighting the key economic factors that affect future policy actions.

This isn't the description of a rule.  "Nuance" is equal to "discretion."  Rules?  We don't need no stinkin' rules!  Rules are just an artifact of the zero bound.  Once the economy is off the zero bound, Williams is looking to revert to business as normal - loose, discretionary forward guidance, nothing that locks down policy like the Evans rule.

The Fed is faced with a problem here.  There is a high probability of smashing through the 6.5% threshold by midyear, rendering the Evans rule pointless.  But what replaces the Evans rule?  They do not want to lower the threshold unless they were absolutely positive they would not hike rates before that point.  But they are not absolutely positive, so they hesitate.  At the same time, they do not want the markets to front-run policy.  But without a rule, and with a very clear desire to end their other non-conventional tool, asset purchases, can they control expectations?  Once we hit 6.5%, we are in a zone in which the Fed is NOT committed to zero interest rates.  We enter a zone where the null hypothesis must be that the Fed is biased towards raising rates simply because they are not willing to commit to a rule that suggests otherwise.   

Another way to think about this is now that they set a rule, markets will evaluate policy against that rule.  It is not easy to just pretend the rule never existed and slip back into discretionary policy.

In the absence of rules, we are looking at the possibility of a volatile year in bond markets as participants attempt to front-run the Fed, and in response the Fed tries to front-run the markets.  This is exactly what happened with quantitative easing.  Because it was not rule-based but instead discretionary (whatever definition of "stronger and sustainable" the Fed believes is appropriate at the moment), expectations for future policy, and with it interest rates, shifted throughout the year.  Once we pass through 6.5 percent unemployment, we are right back there.  Although we all know the Fed has said they expect to hold rates at zero for an extended period, they haven't promised to do so.  Without that promise, challenges should be expected.  The stronger the data, the bigger the challenge.

Bottom Line:  The end of the Evan's rule is fast approaching.  The Fed does not have a backup plan other than talk.  Are there new rules ahead?  Or is it all discretion?  And could you get a divided Fed to agree to new dovish rules in any event?  They don't seem eager to change the thresholds.  How much stress will force their hand?  Might be tough times for Fed communications ahead. 

Inflation, Wages, and Policy

As something of a addendum to my last piece, I wanted to follow up on the take-down of the inflation story by Ethan Harris of BAML as reported by Sam Ro at Business Insider.  Harris' argument is that there is plenty of slack in the labor market, so there is no reason to worry that wage growth-fueled inflation is just around the corner.  Fair enough; I have always said that the ultimate test of the theory that labor markets were tight would be higher wages.  The part I wanted to follow up on was this quote:

Moreover, even if wages do inch higher, we are a long way from the normal 3 or 4% rate that could start to create serious pricing pressure.

I think this overlooks an important point - the Federal Reserve has historically tightened policy at or before wage growth turns upward and the policy peak occurs when wage growth is hovering in the 4-4.5 percent range:

 In other words, we don't need to see wage growth high enough to create price pressures to trigger tighter monetary policy.  Typically, the Fed is tightening policy ahead of higher wage growth.  This, I think, is one reason to question the Fed's stated policy path and also explains why the Fed would be hesitant to embrace a lower unemployment threshold.  The fact that wages are rising while unemployment remains high is probably something of a puzzle to them, and lends credence to the stories that the labor market is currently affected by severe structural issues even though they see the same measures of labor market slack that Harris identifies.  

So it is not that the Fed is currently behind the curve, but that the upturn in wage growth will make them worry that they will need to act to prevent them from falling behind the curve.  It is also another reason why they want to extract themselves from QE as soon as possible; they want to be prepared to act quickly should they find they took an overly dovish view of the labor market.  I think there is a lot of uncertainty regarding unemployment/wage/inflation dynamics at the moment, and that uncertainty is not making the Fed happy given the size of the balance sheet.

Also consider also Federal Reserve Chairman Ben Bernanke's justification for expecting inflation to trend toward the Fed's 2 percent target.  From his press conference (emphasis added):

First, there are some special factors, such as health-care costs and some other things, that have been unusually low and might be reversed. Secondly, if you look at the fundamentals for inflation, including inflation expectations, whether measured by financial markets or surveys; if you look at growth, which we now anticipate will be picking up both in the U.S. and internationally; if you look at wages, which have been growing at 2 percent and a little bit higher according to many indicators—all of these things suggest that inflation will gradually pick up.

In short, although as Harris states we would not expect significant price pressures until wage growth accelerates further, wage growth is already at a rate that biases the Federal Reserve toward tighter policy (or, at a minimum, less accommodative policy).  Even the current meager wage growth rate is used as justification to ignore the inflation trend and initiate a plan to end asset purchases. What then might be the possibilities for policy from even slightly higher wage growth? 

On Challenging the Fed

At first blush, the Federal Reserve looked to have pulled off an almost seamless hand-off of accommodation from quantitative easing to forward guidance at the last FOMC meeting.  The announcement of the long-awaited taper was met with a subdued bond market reaction while stocks soared.  Since then, however, bond yields have climbed, breaching the three percent mark at the end of last week.  Mortgage rates have been pulled along for the ride, and if they continue higher, the sustainability of the housing recovery will again be questioned.  As discussed earlier by Matt Boesler at Business Insider, this very much looks like a challenge to the Federal Reserve's forward guidance.  Or is it?  It is not really a "challenge" if it simply reflects expectations of what a data-dependent policymaker would do in the face of a stronger than expected economy.  I think a little of both is happening.

Policymakers will be alert to signs that recent gains in rates look to be driven by expectations that the Fed will hike rates sooner than suggested by the Fed's own forward guidance.  Relying on the separation principle so well defined by Gavyn Davies, the Fed would be less concerned with rate increases driven by a higher term premium.  Using the two year Treasury rate as a proxy for the forward path of short rates, however, it looks clear that market participants are fundamentally reassessing Fed policy:

Note too that recent movements are not in response to higher expected inflation, and thus represent rising real rates:

What is somewhat remarkable about higher short-term rates is that at their December meeting the Fed lowered the expected path of interest rates.  The average of rate expectations for year end 2015 was 106bp, down from 125bp in September.  In effect, the Fed and the market are moving in different directions.  

What could account for the difference?  Of most concern to the Fed is that market participants simply do not believe the Federal Reserve is committed to a sustained low rate path.  But what has changed to make markets doubt the Fed?  To answer this, consider that the low rate story was driven by a combination of faith in the optimal control framework championed by incoming Federal Reserve Chair Janet Yellen and the belief that the decline in the unemployment rate was overstating the improvement in the labor market.  I tend to think that Federal Reserve Chairman Ben Bernanke threw cold water on both ideas in his final press conference.  

In the press conference, Robin Harding jumps on the Fed's tapering decision in light of the optimal control framework:

ROBIN HARDING. Robin Harding from the Financial Times. Mr. Chairman, your inflation forecasts never get back to 2 percent in the time horizon that you cover here, out to 2016. Given that, why should we believe the Fed has a symmetric inflation target? And, in particular, why should we believe you’re following an optimal policy—optimal control policy, as you’ve said in the past—given that that would imply inflation going a bit above target at some point? Thank you.

CHAIRMAN BERNANKE. Well, again, these are individual estimates, there are big standard errors implicitly around them and so on. We do think that inflation will gradually move back to 2 percent, and we allow for the possibility, as you know, in our guidance that it could go as high as 2½ percent. Even though inflation has been quite low in 2013, let me give you the case for why inflation might rise...

After explaining why the Fed expects inflation to move higher, Bernanke adds:

CHAIRMAN BERNANKE. Well, even under optimal control, it would take a while for inflation—inflation is quite—can be quite inertial. It can take quite a time to move. And the responsiveness of inflation to increasing economic activity is quite low. So—and particularly given an environment where we have falling oil prices and other factors that are contributing downward forces on inflation, it’s difficult to get inflation to move quickly to target. But we are, again, committed to doing what’s necessary to get inflation back to target over the next couple of years.

In other words, don't believe all those nice little charts Yellen has been touting that show inflation smoothly rising above two percent.  We are not trying to recreate those charts, so don't expect us to maintain accommodation even if inflation is below two percent.  And, by the way, we aren't really trying to drive inflation above two percent, we are just making clear that we will not panic if inflation is up to 50bp above target. Moreover, a symmetric target also means that we will not panic if inflation is 50bp below target, and it is easy to see how we get to that minimum level.  

I don't really believe they will not panic if inflation crosses two percent.  I think that, given the size of the balance sheet, they will panic.  In my mind, the decision to taper only reinforces my belief that the Fed is more comfortable with inflation below two percent than above it.  The target is not symmetric.

Regarding unemployment, read carefully:

MURREY JACOBSON. Hi. Murrey Jacobson with the NewsHour. On the question of longer-term unemployment and the drop in labor force participation, how much do you see that as the result of structural changes going on in the economy at this point? And to what extent do you think government can help alleviate that in this environment? 

CHAIRMAN BERNANKE. I think a lot of the declines in the participation rate are, in fact, demographic or structural, reflecting sociological trends. Many of the changes that we’re seeing now, we were also seeing to some degree even before the crisis, and we have a number of staffers here at the Fed who have studied participation rates and the like. So I think a lot of the unemployment decline that we’ve seen, contrary to sometimes what you hear, I think a lot of it really does come from jobs as opposed to declining participation. 

That being said, there certainly is a portion of the decline in participation, which is related to people dropping out of the labor force because they are discouraged, because their skills have become obsolete, because they’ve lost attachment to the labor force, and so on. The Fed can address that, to some extent, if—you know, if we’re able to get the economy closer to full employment, then some people who are discouraged or who have been unemployed for a long time might find that they have opportunities to rejoin the labor market. 

But I think, fundamentally, that training our workforce to fit the needs of 21st-century industry in the world that we have today is the job of both the private educational sector and the government educational sector...

With each passing month, the Fed is moving closer and closer to the belief that the decline in unemployment is not to be dismissed as simply a cyclical decline in labor force participation that will soon be reversed.  Indeed, I suspect this is why the Fed is not likely to lower the unemployment threshold anytime soon.  And if the Fed is now taking the unemployment rate decline at face value, consider the implications for policy given the path of unemployment:

It doesn't take much to believe that policymakers will find themselves hiking interest rates sooner than anticipated as they increasingly believe that a rise of labor force participation is not coming - and it doesn't sound like Bernanke expects to see much of a rise.  Do others?  Does Yellen?

In short, it is easy to see why financial market participants would be rethinking the path of short-term rates given that the Fed is dismissing the low inflation numbers and embracing the structural explanations for declining labor force participation.  Furthermore, there was some expectation that the Fed would change the unemployment thresholds as an "action" to cement the forward guidance and to counter the "action" of reducing the pace of asset purchases.  The Fed disappointed on that front. The old adage "actions speak louder than words" comes to mind.  It comes back to the problem the Fed faced this summer - how essential is the tool of quantitative easing in controlling the path of short-term interest rates?  Can the Fed effectively promise an interest rate path that is not consistent with past behavior without the "action" tool of asset purchases to put muscle into their words?

If the Fed believes that market participants are fundamentally misreading their intentions, they will want to push back against the current rise in short term rates.  They will try to do so verbally at first; I believe they will be very resistant to reversing the taper or lower the unemployment threshold.  Those are tools that I anticipate the Fed will use only if they believe they have completely lost control of the expectations for short rates.

Another possibility, however, is that the Fed validates the rise in rates by pointing to signs of stronger growth.  After all, the Fed's forecast is data dependent - it is not truly a challenge to the Fed's forward guidance if economic conditions change such that a different path of short term rates is appropriate.  Almost certainly you should expect the hawks to embrace this explanation.  More interesting, and with the possibility of creating significantly more volatility in bond markets, is the situation in which doves also embrace the "stronger growth" explanation for higher short-term yields.  This, I suspect, would lead market participants to further reject the current forward guidance.

As a final possibility, consider that the recent market movements may simply reflect trading in thin holiday markets, in which case the current "markets challenging the Fed" theme would be expected to disappear quickly in the new year.

Bottom Line:  The Fed's stated expected rate path looks overly dovish relative to policymakers' growing belief that the declining unemployment rate should be taken at face value and their dismissal of low inflation when making the decision to taper.  Consequently, short rates are moving higher, taking long rates with them.  The interpretation of these moves is complicated by stronger economic data, suggesting not that the Fed is being challenged, but that a data dependent Fed will find its current expectations inconsistent with actual path of the economy.  I tend to think some of both factors are at play - that any lingering doubts about the Fed's commitment are only aggravated by better data.  How doves react to rising rates is critical.  They will cement the shifting expectations if they embrace the rise as an expected response to stronger data.

 

The Beginning of the End for Quantitative Easing

In his final press conference, Federal Reserve Chairman Ben Bernanke announced and explained the plan to end the quantitative easing, beginning with a $10 billion reduction in the pace of asset purchases.  This policy action is something of a fitting end to Bernanke's tenure, as it marks the exit from the unconventional efforts that characterized monetary policy during the crisis.  And at first blush, Bernanke and his colleagues managed the process deftly in comparison to Bernanke's ill-fated press conference in June as stock markets surged to new highs while Treasury yields edged down.  Attention will now shift to the timing of the first rate hike, still not expected to arrive until 2015.

It has been long known that the Federal Reserve desperately wanted to end the asset purchase program; the issue for months has been timing the first step in that direction in coordination with market acceptance that tapering is not tightening.  To that end, the Fed has leaned heavily on forward guidance to entrench expectations of the path of short term interest rates to cap the rise in long-term rates.  We knew that the time for such a move was soon at hand, with analysts largely split on the exact date between the next three meetings, with no forecast coming with much conviction (I thought they would wait until after the New Year). 

To justify tapering, the Fed cited progress toward goals.  From the statement:

In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions, the Committee decided to modestly reduce the pace of its asset purchases.

The last labor report and its reported decline in the unemployment rate, were the final straw. Moreover, they have greater confidence in the sustainability in the pace of job gains.  First, fiscal policy is on a less contractionary path:

Fiscal policy is restraining economic growth, although the extent of restraint may be diminishing.

Second, FOMC members see the risks as largely balanced rather than tilted to the downside

The Committee expects that, with appropriate policy accommodation, economic growth will pick up from its recent pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate. The Committee sees the risks to the outlook for the economy and the labor market as having become more nearly balanced.

The Federal Reserve essentially disregarded the trajectory of inflation in this decision, falling back on stable inflation expectations and their forecasts to support the policy shift. 

The Fed did not, as some expected, cut the thresholds, instead choosing to enhance the forward guidance to emphasize the expectation that rates would remain low:

The Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal.

Policy makers do not seem to be inclined to change the threshold.  If they can accomplish the same expectations for rates without changing the threshold, they retain flexibility and the ability to change the threshold at some point in the future if needed.

There was no hint of lowering interest on reserves.  Bernanke might not believe this would have much impact.  During the press conference, he said that credit was not tight.  Instead, willingness and ability to borrow were the cause of weak lending.  Basically, he might see this as a demand side problem, and lower interest on reserves is a supply side tool.  

We learned that, assuming growth is more or less in line with the Fed's forecasts, we can pencil in a $10 billion reduction at subsequent meetings until the program is wound down at the end of 2014.  To be sure, Bernanke emphasized the data dependent nature of the program, but it was clear that this is the expectation of the FOMC members.

We also learned that the Fed does not view quantitative easing as a natural extension of policy when rates hit zero, but instead it is a separate, supplemental policy.  Quantitative easing works via lowering the term premium, but in normal times this impact can be mimicked with forward guidance.  Moreover, quantitative easing comes along with some additional costs, including uncertainty of managing policy via the term premium and managing a greatly expanded balance sheet.  The Fed would like to wind down the asset purchase program before the costs outweigh the benefits, and note the benefits have fallen now that they have held rates down via forward guidance.

Bottom Line: Another historic moment for a Federal Reserve that has had its share of historic moments in the past several years.  Most likely, we can now move past the issue of tapering and asset purchases.  Barring a dramatic change in the data, I doubt the Fed will reverse course.  The issue now is to what extent incoming data impact our expectations of the first rate hike.

FOMC Meeting Something of a Nailbiter

Tapering will be on the table at this week's FOMC meeting, but will the Fed take the first step to ending the asset purchase program or let it ride into the new year?  Wall Street analysts, economists, and pundits are all over the map on the tapering question, via Supeed Reddy at the Wall Street Journal.  My own position is that while the Fed wants to taper, they will pass on this opportunity - although I admit I don't hold that position with any great conviction.  The data flow in my opinion, is rather ambiguous in regards to tapering.  Given that ambiguity, other factors will comes into play.  One factor is the potential for disrupting bond markets during a traditionally illiquid month.  We know from this summer's experience that the Federal Reserve is very sensitive to market functioning.  Another factor is the institutional shake-up underway at the Fed.  There is a potential continuity risk in changing policy now given the number of new faces among the voting members next year.  In the absence of a dire rush to taper, it is reasonable to think the Fed will defer judgement until the crop of officials who will actually be carrying out the asset purchase wind down are all seated at the table.

Regarding the ambiguity of the data, I am hard-pressed to say that the economy has changed radically since September.  To be sure, the employment data is arguably firmer, but this really speaks more to the tendency of Fed officials to be overly sensitive to the last data point than any real change in the underlying pace of activity.  Compare the 12-month and 3-month trends in nonfarm payroll growth:

 

Job growth has been cycling around the 180-200k mark for 2 years.  And even that cycle is suspect, partly an artifact of the impact of the recession on the seasonal adjustment procedures.  Those impacts may be lessening (as they should over time) as indicated by the smaller fluctuations around the 12-month average. In short, the Fed has tended to define "stronger and sustainable" on the basis of the last two or three months of data, which thus opens the door again to tapering.  It seem, however, that looking at the underlying trend the job market is neither more nor less "stronger and sustainable" now than any other time in the last two years.

Beyond employment data, broad industrial activity is rising at a relatively tepid pace:

Seems to be bouncing around 3% year-over-year.  Nothing to suggest a dramatic change in pace since 2011.  If anything, perhaps a bit weaker.  As far as household spending is concerned, consider growth of retail sales excluding volatile auto and gasoline components:

Growth seems to have settled into the 4% year-over-year range.  Broad household spending after inflation has also settled into a pattern of tepid growth:

 

Likewise, if you think of underlying growth as close to the average of GDP and GDI growth, that too is reasonably stable:

If you take anything but the most near-term look at the data, there is little to suggest much has changed one way or another.  It's no real surprise that the Beige Book continues to describe activity as "modest to moderate."  Move alone, nothing to see here, folks.  But if monetary policymakers focus on the most recent few months of data, then they can argue that what they are seeing is "stronger and sustainable."

Where they might see more promise is that the forecast for fiscal policy in 2014 is brighter.  The budget deal is consistent with reduced fiscal drag next year while eliminating the possibility of another budget crisis.  Indeed, I think a good story can be told that 2014 is an inflection point for economic activity.  Still, we have told that story before, and with that lessen in mind it seems too early to declare "sustainable" without some actual 2014 data to work with.  Where the Fed might find more traction is with beginning tapering on the basis of progress toward goals with a focus on unemployment:

 

That said, if one of the goals is price stability, that pesky dual mandate thing is rearing its ugly head with the falling inflation numbers:

 

I would say the Fed needs to abandon low-inflation concerns if they taper with these numbers, instead falling back on stable inflation expectations and a forecast of rising inflation.  That forecast, however, really hasn't worked out yet.  

Overall, "stronger and sustainable" and "progress toward goals" are in the eye's of the beholder.  Same too with "progress toward goals."  It depends the goal.  No wonder then that Fed officials appear so ridiculously noncommittal with regards to tapering.  And no wonder then that market participants are also noncommittal over the outcome of this next meeting.

Given that ambiguity, the Fed may have a difficult time communicating any policy changes.  Does the tiny taper suggest a more hawkish Fed considering the path of inflation?  Or a more dovish Fed considering the path of unemployment?  With no strong market expectations, the Fed may worry that any action they take would be misinterpreted in the thin holiday trading.  Perhaps they believe that Federal Reserve Chairman Ben Bernanke could smooth out any issues during the press conference, but there is no certainty in that prediction.  It's not like he cleared much up with the June press conference.  The importance of communication is even more important given that the nature of tapering itself is on the table - no longer are we guaranteed a data-dependent policy as the calendar-dependent suggestion is on the table.  Hence there is a good case to be made for leaving policy broadly unchanged with the exception of modification to the forward guidance while setting the stage for a policy shift next year.

Finally, another reason to hold policy steady is the institutional changes raining down on the Federal Reserve.  Next year we see a new chair, and new vice chair, a new governor, a new president, and a change in the FOMC that brings two hawkish voices into voting positions.  Presumably, policymakers should be concerned that the policies they enact today will be consistent with the desires of the policymakers of two months from now.  This is especially the case when policy is at an inflection point as it is now.  In the absence of pressing need, it is thus easy to make the case that policy changes should be deferred to the next group of policymakers.  Now, clearly the Fed would not let such an issue dissuade it from acting during a financial crisis, or in the face of incipient inflation risks.  But neither of those are on the table right now, so there is no pressing need to act.  Of course, some might argue that given the impending changes, this is this Fed's last opportunity to leave its mark on policy - completely the opposite conclusion.  More ambiguity.

Bottom Line:  Unless you are living in a cave, you shouldn't be surprised if the Fed decides to taper this week.  At the same time, you shouldn't be surprised if they do not taper.  Even if they don't at this meeting, they soon will.

Bullard Offers Up The Tiny Taper

The employment report put the December taper squarely on the table.  But what about inflation?  Does low inflation take the December taper off the table?  That is the question I asked last week, and Gavyn Davies at the FT follows up on the theme.  Davies draws attention to this line from the FOMC statement:

In judging when to moderate the pace of asset purchases, the Committee will, at its coming meetings, assess whether incoming information continues to support the Committee's expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective.

As Davies notes, surely low inflation must create a headache for central bankers desperately seeking to taper.  In the US, not only is inflation not trending back up to the Fed's objective, it is actually trending away from the objective.  St. Louis Federal Reserve President James Bullard acknowledges the difficult position the Fed finds itself in:

While labor market outcomes have been considerably better than those predicted at the time of the September 2012 decision, Bullard noted that inflation has surprised to the downside.  “There is no widely accepted reason why inflation is running as low as it is in the face of extraordinarily accommodative policy from the Fed,” he said.

They don't know why inflation is falling, only that it is.  What should they do with respect to policy?  Bullard offers a solution:

“A small taper might recognize labor market improvement while still providing the Committee the opportunity to carefully monitor inflation during the first half of 2014,” Bullard said.  “Should inflation not return toward target, the Committee could pause tapering at subsequent meetings,” he added.

The tiny taper is back.  What makes this extraordinary is that Bullard is an inflation hawk in the sense that he typically defends the inflation target from above or below.  He is believed responsible for this addition to the FOMC statement:

The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance...

Seems like he is easing back on his low inflation concerns, perhaps thinking that inflation *must* turn upward soon considering the decline in the unemployment rate.  

Note, though, that he offers up the tiny taper in the context of leaving the asset purchase progam data dependent.  Other policymakers, however, want to shift the QE to a calendar dependent program.  This I suspect Bullard would only be willing to accept if inflation was on a clear upward trajectory.  

Bullard also discussed options for forward guidance:

He discussed three possible options for altering forward guidance, including lowering the unemployment threshold.  However, Bullard cautioned, this “puts the credibility of the thresholds approach at risk.”  He said another option would be to establish an inflation floor at 1.5 percent, which would be symmetric with the current forward guidance on inflation and which could be helpful if inflation continues to behave in an unusual manner.  The third option would be to state verbally that the FOMC is unlikely to raise rates even after the 6.5 percent unemployment threshold is crossed, which Chairman Ben Bernanke has already done.  This option is “less complicated and possibly just as effective,” Bullard said.

There seems to be a general resistance to changing the unemployment threshold, in part I suspect because there is lingering concern that the Phillip's Curve will rear its head before unemployment hits 5.5% or even 6%.  And I would think that the erratic behavior of inflation is exactly why they would avoid tying their hands with an inflation floor.  After all, arguably the "erratic" behavior of unemployment has already given them enough of a headache.  I tend to think the FOMC will come around to the third option of verbally reinforcing the existing thresholds.  It is indeed less complicated, as Bullard notes.

 Bottom Line:  The Federal Reserve wants to taper.  Wants very badly to taper, in my opinion.  The recent employment reports seem to be giving a green light, and I suspect they are coming around to the idea that the decline in the labor force participation rate is largely permanent at this point, which will only increase their angst about the asset purchase program.  But inflation is a thorn in their sides.  The Fed will need to do a 180-degree turn on its current inflation concerns.  If they dismiss the inflation concern in their drive to taper, I suspect they will lean on the stable inflation expectations and Phillips Curves arguments to justify a forecast that has inflation quickly reversing course and trending to target.  I still tend to believe the Fed will delay tapering until 2014.  Whether December or January or later, policy is close to an inflection point with a shift from more to less accommodation in the works.

Stronger and Sustainable, but...

The employment report produced a modest upside surprise with a gain of 203k jobs in November, remarkably close to my estimate of 211k from yesterday, which I might as well enjoy because it will never happen again.  In addition, the unemployment rate fell to 7% while the labor force participation rates ticked up 0.2 percentage points.  Smells like a tapering report.  And with that in mind the market reaction to the news should please Fed official, as bond markets were flat while stocks gained.  That too should be something of a green light to taper.  I can't help but think, however, that today was something of a goldilocks days for markets, because while the labor report was solid, both headline and core inflation are still headed south.  How will the Fed react to the inflation numbers?  That seems to be the real question.

In my opinion, the employment report confirms what I said yesterday:  The trend of improvement in labor markets remains intact.  Indeed, on a twelve-month basis nfp growth is very, very steady:

 

In the context of the Yellen charts, the steady nfp growth is contributing to a similarly steady decline in the unemployment rate, while the the hiring and quit rates are barely edging higher:

 

The drop in the unemployment rate reveals the challenges with the Fed's forward guidance.  As Victoria McGrane at the WSJ notes, Federal Reserve Chairman Ben Bernanke gave a clear signal earlier this year that the Fed expected its bond buying plan to be wound down by the time the unemployment rate hit 7%.  We haven't even started the taper yet.  I tend to think the 7% marker was the single biggest communications failure on the part of the Fed, and contributed greatly to the bond market volatility earlier this year.  Of course, it is an error the Fed will never admit to.

The steady recent gains in job growth coupled with the decline in the unemployment rate certainly put tapering on the table at the next FOMC meeting.  But a policy move at that point seems premature.  The issue of tapering is currently wrapped up with a host of issues as noted by Jon Hilsenrath at the WSJ:

Fed officials are likely to debate at their December 17-18 meeting whether to go ahead and pull back on the bond-buying program then or wait until the January 28-29 meeting, Ben Bernanke’s last as Fed chairman, or even later. Waiting until January will give them a little more time to confirm their increasing optimism about the economy and more time to finalize their exit strategy from the bond program and prepare markets for how they’ll proceed. They still have lots of questions to answer about the overall thrust of their policies and how they communicate their plans. Some officials want to put a cap on the overall amount of bonds they plan to buy, rather than leave it open-ended. They’ve also been debating for several months whether to once again alter their guidance to the public about when they’ll raise short-term interest rates. 

I tend to believe that they will want to firm up their communications stance prior to tapering, so I have tended to push my tapering expectations into next year.  Moreover, the Personal Income and Outlays report leave me cautious about a December taper.  The data don't suggest an acceleration of household spending activity: 

More worrisome is that inflation continues to fall: 

And some of the improvement we saw earlier this year has faded:

It seems premature to expect tapering while inflation is still trending down.  Indeed, Chicago Federal Reserve President Charles Evans expressed some caution today:

The official, a voting member of the monetary policy setting Federal Open Market Committee, also said he was “nervous about inflation developments” describing the data as being “substantially” short of the Fed’s 2% target.

He said the Fed had to be prepared to defend the target from above and below.

I suspect Minneapolis Federal Reserve President Narayana Kocherlakota and St. Louis Federal Reserve President James Bullard with have similar concerns.  If ultimately everything hinges on price stability over the long-run, the inflation decline should be very disconcerting to the entire FOMC.

Altogether, we have the makings of a very contentious FOMC meeting.  Consider the issues at hand:

• The Fed will update their forecasts, which will have an impact on their policy stance.
• Do they focus on "stronger and sustainable," "progress toward goals," "dual-mandate", or "cost vs. efficacy" when assessing the large scale asset purchase program?
• Taper or not?  When they taper, do they switch from data-dependent policy to a calendar-dependent policy?
• How do they balance the labor market improvement versus the inflation rate deterioration?  
• Leave the current thresholds in place?  If so, do they enhance forward guidance?  Do they put in place an inflation floor?
• Cut the interest rate paid on reserves?

I don't sense broad agreement among FOMC participants on any of these issues.  And all of these issues appear to be tied together in the context of an overall strategy for monetary policy, which means agreement and action on just one item leaves open the door for future conflict and communication failures.  It seems too much to expect the December meeting to produce sufficient agreement to justify changing policy; instead, it seems like the best we should expect is that they lay the groundwork to next year's policy path.

Bottom Line:  The employment report raises the odds of a December taper.  But does the inflation report lower the odds by the same amount?  Seems like that is a recipe for bond market stability.  Overall, I tend to believe the range of contentious issues yet to be decided on leaves the odds of tapering below 50%.   You kind of have to throw-out half the dual mandate, or make an argument that tapering is about labor markets only, to pull the trigger on tapering with inflation still trending down.  That seems like it should be a problem for the FOMC.

Ahead of the Employment Report

Another first Friday, another employment report.  Although the general expectation is that the Fed holds its currently policy in place, there is speculation that the monetary policymakers could pull the trigger on tapering this month if we see another employment report that could be deemed sufficient to declare the labor recovery "stronger and sustainable."  After all, it is not unreasonable to expect that, after tomorrow, three of the four most recent readings on the labor market revealed job growth in excess of 200k per month.  

That said, caution would be warranted before taking an overly optimistic position based on these data.  The gains may not be sustainable if US growth slows in the final quarter of the year as expected (indeed, the third quarter spurt is less than meets the eye).  Moreover, Fed officials must be somewhat wary of reading too much into the data given the pattern of fall/winter strength seen in recent years.  With these considerations in mind, it seems that sufficient certainty to justify tapering would not be evident until late in the first quarter of next year.  This assumes, of course, the Fed doesn't pull a different rabbit out of its hat - progress toward goals or cost/benefit analysis - to justify tapering sooner than anticipated.

Forecasting the employment report is a notoriously hazardous activity.  One quick and dirty method is a regression based on the ADP report, the ISM nonmanufacturing employment Index, and initial unemployment claims:

 The one-step ahead forecasts since 2004 closely match the actual data:

 

The model predicts payroll growth of 211k for November, somewhat higher than concensus of 180k. But of course there are still occasions of particularly large errors.  And this type of analysis is conditioned on the revised data.  Tomorrow we get the preliminary report - the market moving report.  It seems that no one cares much if you correctly anticipate the revised data; by the time that is released, the focus is on the next preliminary numbers.  Overall, my takeaway is that is that this kind of model tells us that we should expect job growth consistent with that seen in past months.  I don't read much into the specific forecast.

The Fed might be sensitive to the most recent report, which is why fears of imminent tapering will arise if the number surprises strongly to the upside.  Still, one number should not make a policy decision.  Indeed San Francisco Federal Reserve President John WIlliams seemed to have a relatively high bar for tapering in an interview with Reuter's Ann Saphir:

As for the Fed's massive asset-purchase program, Williams said the Fed should only reduce it once it is "completely confident that the economy is on the right track."

I have difficulty imagining that one number could leave the Federal Reserve "completely confident" about the pace of activity.  The Beige Book, for example, gives no hints that the pace of activity has changed much at all.  Like October, the economy was described as "modest to moderate" with no inflation to be seen despite continuing concerns about the supply of "qualified workers":

Hiring showed a modest increase or was unchanged across Districts. Difficulty with finding qualified workers, especially for high-skilled positions, was frequently reported. Upward pressure on wages and overall price inflation were contained. Contacts in many Districts voiced concern about future cost increases attributable to the Affordable Care Act and other types of federal regulation. 

I still find talk of tapering frustrating in the context of the FOMC forecast.  Inflation is well below target and there is no imminent threat of it accelerating to the 2.5% threshold.  Unemployment remains unacceptably high.  And their forecasts are likely to show that a return to potential output remains years away.  One reason they seem to be focused on tapering is the expectation that the fiscal drag will ease in 2014, thus eliminating the need for QE.  But that would seem to be a missed opportunity to give the economy a turbo boost to more quickly meet the Fed's policy objectives.  What exactly is the pressing need to end the asset purchase program?

The need, I still suspect, could be found in the Fed's double-secret analysis of the costs/efficacy of QE.  I would appreciate an entire speech on this topic, complete with a list of specific, quantified costs and benefits so that we can track understand the calculus underlying the Fed decision making.

Until we see that calculus, we need to fall back on the data dependent nature of all the Fed's programs.  And if that data didn't support tapering in September, I am hard-pressed to say that enough stronger data has arrived to change that decision.  I really hope I don't have to eat those words tomorrow!

In any event, the Fed would like us to shift our attention from tapering to interest rates.  Indeed, it very well might be the case that the big tapering market move is behind us, and the Fed can now taper with little implication for financial markets.  Thus would set the stage for the sort-of-normalization of policy.  Williams was pushing in this direction:

"My view would be that we would not be raising the funds rate even if the unemployment rate was below 6.5 percent as long as inflation continued to be low, for some time," Williams said. "We need to be communicating more about the post-6.5-percent world now, because it could be with us much sooner than we expect, and I don't want market participants to be surprised."

The interview does not indicate that Williams is pushing to change the unemployment threshold.  This seems more consistent with my view that the FOMC is more interested in strengthening the "threshold not trigger" language in the statement.  What happen's after the unemployment rate hits 6.5% is going to be interesting; at that point, if they don't want to change the thresholds, I expect they have to get rid of the thresholds altogether.  The unemployment threshold itself would be nonsensical at a 6.4% unemployment rate.

If there are any substantive policy changes in the FOMC, I expect they will be in the nature of the forward guidance.  I think they want to confirm they have a firm hold on the short end of the yield before they taper.  There is the possibility that they drop the rate of interest on reserves.  Williams again:

Williams said he also supported cutting the interest paid to banks on the excess reserves they keep at the central bank as a way to signal the Fed's commitment to low rates. "I think it would make sense," he said, although he acknowledged that policymakers have considered, and rejected, the idea several times over the years.

As Williams notes, this idea comes in and out of fashion at the Fed.  Policymakers apparently don't view it as having the potential for a huge boost, but they seem to be viewing it as less risky than previously thought.  

Finally, one other thing of note from the William's interview:

...once the Fed decides the economy is strong enough for the Fed to reduce its $85 billion in monthly bond purchases, it should announce an end date and a purchase total for the program, Williams said.

This follows in the thinking of hawk Philadelphia Fed President Charles Plosser, who argued that the Fed cap the size of the program to enhance it's credibility (not sure how this works; ultimately credibility is built on meeting the Fed's objectives, which are not currently in danger, and least in the direction Plosser seems to believe).  If this kind of proposal does gain favor, note that it represents a shift from a data dependent policy to another time dependent policy.  Once some threshold is reached, the program shifts into automatic.  Didn't the Fed just spend the summer convincing us that policy was not time dependent?  Why change now?  If they do change, why should we believe the same change will not occur with rate policy?  Just food for thought.

Bottom Line: Another month, another employment report.  With the fiscal shutdown in the rear-view mirror, Fed officials are turning their attention back to policy normalization.   They want to taper, but remain wary of pulling the trigger on tapering too quickly.  I tend to believe that, on balance, the FOMC needs to see a few more months of data given the uncertainty about the path of GDP before they were completely comfortable tapering.  That said, one can make a reasonably solid argument for tapering if the November employment report adds to the recent string of 200k+ payroll gains.  My expectation is that even a positive report will not trigger a taper with month; instead, the statement is most likely to evolve to reflect a new emphasis on forward guidance.  But I can't rule out a tapering surprise.