Tim Duy's Fed Watch

And The Taper Continues

The FOMC meeting came and went with the expected result - the tapering process continued on schedule, undeterred by the current emerging market turmoil.  Of course, the Fed doesn't want to be seen as reacting to every gyration financial markets.  But even more importantly, the Fed wants out of the asset purchase business on the belief that a.) tapering is not tightening and b.) even if it was tightening, they could compensate via forward guidance.  The global stumble, however, is challenging that thinking.  Regardless of financial markets or US data, the Fed was not likely to launch into a new policy direction on the eve of incoming Chair Janet Yellen's coronation.  It's her show now.

The statement acknowledged the better tone of the data:

Information received since the Federal Open Market Committee met in December indicates that growth in economic activity picked up in recent quarters.

while at the same time giving a nod to weak job growth in December:

Labor market indicators were mixed but on balance showed further improvement.

Inflation is low, but that is offset by stable expectations:

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

Upside and downside risks are equally weighted:

The Committee sees the risks to the outlook for the economy and the labor market as having become more nearly balanced.

Low inflation is an issue they are assessing, but it is not sufficiently worrisome to alter the pace of the taper:

In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in February, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $30 billion per month rather than $35 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $35 billion per month rather than $40 billion per month.

At these rates, inflation is only a deterrent against higher interest rates, not tapering.  

Despite the plunge in the unemployment rate, the combination of the Evans rule and enhanced forward guidance remains unchanged:

The Committee continues to anticipate, 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.

I think we can be confident that much of the conversation centered around forward guidance, but there was not quite a pressing need to end or alter the Evans rule with unemployment still above 6.5%.  Moreover, any change to the forward guidance needs to be owned by Janet Yellen, and she will not have that opportunity for another six weeks.  Which will not be just her first meeting as chair, but also her first press conference as chair.  Trial by fire.

The Fed did not, as some supposed they might, react to sliding overseas markets.  This, combined with the tempered reaction to weak job growth and the absolute abandonment of the inflation target, speaks to the Fed's determination to end asset purchases.  We will need to see the emerging market downturn lapping up more directly on US shores before the Fed reacts.  The downturn in US equities is not yet enough.  Not only does the Fed not react to every dip in the market, they probably would not be surprised by a correction in any event.  The are inclined to believe that while not a bubble, stock prices were getting a little ahead of earnings.

Recent market action is very revealing, in my opinion.  First and foremost is that fears that without the Fed "no one will buy US debt" have proved to be completely unfounded.  Everyone knows that the Fed is eager to end asset purchases this year, and yet magically there are enough buyers to keep 10 year rates locked below 3%.  Without much, much faster growth and a real threat of inflation, we are stuck in a low interest rate world.  Get used to it.  Indeed, even when the Fed starts raising interest rates, I expect most of the impact will be in the center of the yield curve.  We need to jump to a higher equilibrium path to boost long rates sustainably higher.

Also evident is that regardless of the Fed's intentions, tapering is tightening, at least on a global scale.  To be sure, emerging markets are under pressure from a number of directions.  The yen's decline over the past year was eventually going to pressure emerging market currencies.  Commodity prices are softer than expected.  Remember just a few years ago when the global commodity super-cycle would propel prices ever higher?  That story appears to have come to an end.  The ongoing adjustment in the Chinese economy is not helping matters either.  Arguably, the Fed is only the icing on the cake.

But it is a cake of their own making.  Ambrose Evans-Pritchard reminds us that emerging markets spent years leaning into the Fed's low rate policies instead of leaning against.  Now they are caught in the classic currency crisis trap - they try to raise rates to stem currency declines, but higher rates crush the local economy and, by extension, equity markets, which aggravates the currency decline.  The process continues until the economy settles into a lower equilibrium.  It isn't pretty.  Never is.

Funny thing is that what the Fed sees as no tightening is evolving into a global tightening now as central banks rush to raise rates.  Consequently, money surges into the global safe asset - US Treasuries.  And, interestingly, I think that you can argue that this is much, much more disconcerting than last year's taper tantrum.  This seems to me to be a pretty clear global disinflationary shock.  And it isn't like inflation was on a runaway train to begin with.   

Bottom Line:  The Fed wants out of quantitative easing.  Policymakers want to normalize policy by bringing it back to interest rates.  That sets a high bar to delaying the tapering process.  Moreover, the leadership transition at the Federal Reserve also left policy on autopilot from December until March, raising the bar even further.  That seemed to sink in today.  They lack of offsetting on the part of emerging markets to easy Fed policy is now exacerbating the impact of tapering, creating a more significant monetary tightening than expected by the Fed.  It is not clear when this alters the path of Fed policy.  But what seems more clear is that the US is about to be hit by another disinflationary shock.  That deserves careful attention, because inflation, I think, is at this moment the most important variable to watch as far as Fed policy is concerned.  The Fed is pushing forward with tapering on only the forecast of future inflation.  That forecast appears under threat.  

The Week That Was

Plenty of data and Fedspeak to chew on last week, the sum total of which I think point in the same general direction.  Economic activity is on average improving modestly, the Federal Reserve will push through with another round of tapering next week, and low inflation continues to hold back the threat of rate hikes.

After stripping out the auto component, retail sales were solid in December:

 

I think we are at or nearing the point where auto sales will generally move sideways and thus induce some additional volatility in the headline number.  Consequently, it will be increasingly important to focus on core sales ("core" meaning less autos and gas).  Looking at the three-month change, we see a modest acceleration in the back half of 2013:

 

Likewise, industrial production accelerated in the final months of 2013:

 

The initial read on consumer sentiment was modestly disappointing but not a cause for worry.  In general, consumer sentiment has been weaker than what would be suggested by the pace of spending since the recovery began:

 

Housing starts stumbled in December after surging the previous month:

Housing activity continues to grind higher, with plenty of room left to climb.  Increasingly, the gains seem likely to be coming from the single family side of the equation; multifamily has already experienced a solid rebound:

None of the above is meant to imply that we are experiencing runaway growth.  Instead, the Beige Book probably sets the right tenor:

Reports from the twelve Federal Reserve Districts suggest economic activity continued to expand across most regions and sectors from late November through the end of the year. Nine Districts indicated the local economy was expanding at a moderate pace; among these, the Atlanta and Chicago Districts saw conditions improve compared with the previous reporting period. Boston and Philadelphia cited modest growth, while Kansas City reported the economy held steady in December. The economic outlook is positive in most Districts, with some reports citing expectations of "more of the same" and some expecting a pickup in growth.

The JOLTS report showed an uptick in the quits rate, something that will likely warm the heart of incoming Federal Reserve Chair Janet Yellen:

 

It's another quadrant of that chart that is showing improvement, which probably gives Fed officials confidence that they are moving in the right direction by slowly ending the asset purchase program.  That said, inflation prevents the Fed from putting their foot on the brakes:

Until we see meaningfully higher inflation numbers, the Fed will be hesitant to deviate from their current expected rate trajectory.   Putting aside any financial stability concerns, I am thinking the risk is that unemployment drops to closer to 5.5% when inflation starts to pick up, and policymakers respond with a steeper rate increase fearing they are behind the curve.

Dallas Federal Reserve President Richard Fisher offered-up another colorful speech stressing financial stability concerns.  He also revealed he wanted to see the Fed cut asset purchases by $20 billion a month:

 I was pleased with the decision to finally begin tapering our bond purchases, though I would have preferred to pull back our purchases by double the announced amount. But the important thing for me is that the committee began the process of slowing down the ballooning of our balance sheet, which at year-end exceeded $4 trillion. And we began—and I use that word deliberately, for we have more to do on this front—to clarify our intentions for managing the overnight money rate.

For all the concerns that the hawks will be persistent policy dissenters, Fisher does not appear to be a likely dissent just yet.  For him, it is important just to know the program will end this year.

On the other side of the coin is Minneapolis Federal Reserve President Narayana Kocherlakota.  In an interview with Robin Harding at the Financial Times, Kocherlakota makes clear his disappointment with the current policy trajectory:

“We’re running the risk of being content with inflation running consistently below our target. That’s inappropriate,” said Narayana Kocherlakota, who votes on Fed monetary policy this year, in an interview with the Financial Times. “Right now we’re sitting with an outlook for inflation that even by 2016 . . . is not getting back to 2 per cent.”

Importantly, he offers an alternative to the defunct Evans rule:

“We would say we intend to keep the Fed funds rate extraordinarily low in that interval between 6.5 and 5.5 per cent as long as the medium-term outlook for inflation stays sufficiently close to 2 per cent,” he said. “I definitely feel it is important to be numerical about it. Words are always subject, I think, to multiple interpretations.”

The idea of an "interval" gives some insight into the general consensus at the Fed.  There does not seem to be considerable support for changing the threshold to 5.5%. Kocherlakota knows this and hopes that he can disguise changing the threshold by calling it an interval.  But once you cross 6.5%, the idea of an interval is irrelevant.  5.5% becomes the focus, just as if the threshold has been changed.

Moreover, notice also the change in the inflation threshold from 2.5% to "sufficiently close" to 2%.  My sense is that such a change would be interpreted hawkishly.  But I think also reveals why policymakers are opposed to changing the unemployment threshold.  I am thinking that below 6.5% unemployment, they are less willing to tolerate 2.5% inflation because they worry about falling behind the curve.  

I think it is easier to see Kocherlakota dissenting than any of the hawks.  It is clear that policy is moving fundamentally in the wrong direction in his opinion:

Mr Kocherlakota said he would not refight the Fed’s decision to taper asset purchases by about $10bn a month. “My point is simply we need to do more. If the committee chose to do that through more asset purchases that’d be fine with me. But we have to be doing more.”

The hawks might want a more rapid end to asset purchases, but at least for them policy is heading in the right direction.

 San Francisco Federal Reserve President John Williams questioned the role of asset purchases as part of the Federal Reserve toolkit.  Victoria McGrane at the Wall Street Journal has the story here. Williams highlights the uncertain impacts of quantitative easing:

Mr. Williams, who has been supportive of the Fed’s three rounds of bond purchases, said the measures “have proven a potent but blunt tool, with uncertain effects on financial markets and the economy.” The Fed’s bond-buying program, also known as quantitative easing, or QE, aims to lower long-term interest rates in hopes that will spur borrowing, hiring and investment.

Surveying the body of research on such bond purchases, Mr. Williams found that studies consistently find that the purchases have a significant impact on long-term bond yields but it’s harder to tell if they’re doing much to help the overall economy.

“Estimating the effects of large-scale asset purchases on the economy – as opposed to financial markets – is inherently much harder to do and is subject to greater uncertainty,” he said.

WIlliams also acknowledges the difficulties of implementing forward guidance:

“Experience has shown that it is impossible to convey the full reach of factors that influence the future course of policy. As a result, forward guidance ends up being overly simplified and prone to misinterpretation,” Mr. Williams said in his paper. What’s more, markets may not believe promises about policy made several years in advance since the policymakers making those statements could leave, he noted.

Again, isn't the Evans rule something of an oversimplification that has resulted in confusion?  Perhaps a simpler target is needed:

A new framework such as nominal GDP-targeting could, in theory, could work better at communicating the Fed’s policy plans than the current approach, he said, but it might have costs as well.

And then comes the third rail of central banking:

Finally, Mr. Williams also said new research should address whether the Fed and other central banks with a 2% inflation target should aim higher. “[D]oes the 2 percent inflation target … provide a sufficient cushion to allow monetary policy to successfully stabilize the economy and inflation in the future?” he asked in his paper.

All of which sums up to:  We are still learning from the crisis and thus we will see consideration of even more innovations to central banking going forward.

And last but not least, Federal Reserve Chairman Ben Bernanke made another victory lap at the inaugural event of the new Hutchins Center on Monetary Policy at the Brookings institute (also where Williams presented).  For those of you with four hours to set aside, video is here.

Bottom Line:  The US economy is grinding forward.  Policymakers are generally comfortable with the pace of tapering at $10 billion per meeting.  That could be reconsidered if we see sustained weakness in future data, but I don't think that should be the base case.  Not everyone is happy at the Fed, however, and arguably the center has shifted toward the hawks as the doves are clearly not pleased that both asset purchases are ending and the Evans rule does not have an heir apparent.  I think it is reasonable to believe the primary conflict at the next FOMC meeting is not over asset purchases, but on the communications strategy.  The direction and nature of "enhanced forward guidance" is becoming a contentious issue now that the unemployment rate is just a breath away from the 6.5% threshold.

 

Lockhart Greenlights Tapering

Atlanta Federal Reserve President Dennis Lockhart presented his 2014 forecast in a speech today.  In short, he expects modestly better growth, ongoing improvement in labor markets, and inflation to gradually rise to the Fed's target.  Pretty much the standard 2014 outlook, and with the usual caveats:  There is still much progress to be made in labor markets, and inflation is currently on the low side.  And, assuming all goes according to plan:

If all goes as expected, there is a policy transition under way from a QE world, so to speak, to a post-QE world. As I said, that decision was made in December.

Some of his more interesting comments come in the post-speech conversation with journalists.  Michael Derby at the Wall Street Journal has the story.  While the December employment number was a disappointment, it is not itself likely to deter policymakers from tapering plans:

...Mr. Lockhart told reporters what happened in the job market last month has not shaken his monetary policy outlook. “I don’t think we should overreact to one month” and should bear in mind employment data frequently undergoes notable revisions, he said.

 Lockhart's views on stock prices are intriguing: 

In response to audience questions, Mr. Lockhart rejected the idea that big gains in stock prices over the course of the last year mean the equities market has lost its moorings. When taking stock of what has happened, “I don’t see it as a bubble,” the official said, although he added he would like to see company earnings validate the advances the market has experienced. The official also said “we are watching very carefully to make sure we don’t get into bubble territory.”

He seems to be implying that he believes stock prices are reasonable only if earnings rise.  Which is the same thing as saying he really doesn't believe that stock prices are exactly reasonable.  They are just not sufficiently unreasonable to define as a "bubble."  Combined with the careful "watching," one could interpret Lockhart as saying that the Federal Reserve believes stock markets are starting to get ahead of themselves.  They are watching the financial stability issue like hawks...no pun intended.

Regarding the Evans rule, Lockhart admits what already should be evident to everyone:

...The Fed says that it will not raise short term interest rates until the jobless rate falls well under 6.5% so long as inflation remains contained. Mr. Lockhart said the fast approach to that level–unemployment was at 6.7% in December, from 7% the prior month– threatens to complicate the central bank’s message.

Rate hike guidance was supposed to be “easy” to understand, but given what’s happening, it will now require central bankers to have to explain more why they aren’t raising rates when the threshold is crossed, Mr. Lockhart said. He noted the Fed may need to revisit the guidance and refine it to deal with the current “challenges in communications,” and that may mean the central bank may need to make the jobless threshold less connected to the jobless rate.

The Evan's rule is defunct.  Like I said yesterday, the Federal Reserve thought the Evans rule would be easy to understand, but the rapid drop in unemployment has greatly complicated their communications strategy.  I like the part about making the jobless threshold less connected to the jobless rate.  That is pretty much already the case.  It seems increasingly evident that Fed communications strategy is at a major inflection point.  Do they replace the Evans rule with fresh, specific numerical based guidance?  Do they continue to specify labor market indicators?  Does the statement get more or less wordy?  And shouldn't these changes happen at the December meeting, rather than after unemployment plunges below 6.5%?

Moreover, wouldn't the Fed's communication strategy be easier if they just dropped mention of the employment mandate and focused on the inflation target?  As Lockhard notes in his speech:

Over the past 12 months, inflation has averaged only 0.9 percent. Indeed, the broad patterns in the price data suggest we have been on a disinflationary trend for about two years, as shown in this slide.

Continued disinflation could pose risks to economic performance. This slide shows the trend of one key measure of inflation (the personal consumption expenditures inflation index) over the last four years. At the Fed, we follow a number of inflation indices, and they show basically the same picture.

The inflation situation shown here seems disconnected from the recent growth momentum and the outlook that it will continue.

As I mentioned earlier, I think inflation will stabilize and begin to move back in the direction of the FOMC's 2 percent objective as the economy gathers momentum. So I'm interpreting the soft inflation numbers as a risk signal. Through the lens of prices, the economy could be weaker than we currently believe.

The inflation rate alone gives them license to hold rates near zero without the complications of devining the message of the decline in the labor force participation rate.  And he also suggests that low inflation is a signal that economic growth is weaker than commonly believed, again suggesting that there is no reason to rate rates.  

So why not just focus on the inflation rate?  I suspect because the Federal Reserve envisions the possibility that they may raise interest rates even if inflation is low.  It's not the base case by any means (no rate hike until 2015 in the absence of real evidence of inflation is the base case), but it is something they don't want to ignore as well.  An alternative situation is if unemployment declines further and the Fed fears they will fall behind the curve if they don't tighten.  Another situation is that the Fed fears they will need to tighten policy to stifle potential bubbles.  Indeed, the latter possibility probably already leads the Fed to hesitate before lowering the unemployment threshold.

In short, I think the Fed is looking to maintain maximum discretion with regards to rate policy; to the extent they want to find a new rule, it will almost certainly be a rule that, like the Evans rule, they were sure they would not want to break.  In other words, they would like to find a rule that is clearly time consistent and easy to communicate.  But as markets bubble and unemployment drops further, I think it is increasingly difficult for them to find such a rule.  Suggestions anyone?  And yes, I know one suggestion will be an NGDP target.  I don't think the Fed is there yet.

Bottom Line:  Another Fed speaker downplaying the December nonfarm payroll number, essentially giving the green light for another $10 billion cut in the pace of asset purchases.  Pencil in $10 billion a meeting.  But that's not really the big story at this point.  The big story is the communications strategy.  The era of transparency has arguably delivered only more complicated and confusing targets, thresholds, and statements.  With the Evans rule turning into a pumpkin soon, they will need to decide if they want to double-down on this strategy or move onto something else.  But what is that something else?  Whatever it is, it must be near the top of incoming Chair Janet Yellen's to-do list.

Employment Report Keeps Policymakers on Their Toes

Just about everyone (myself included) who ventured a payrolls forecast was crushed by the scant December gain of just 74k. How much should you adjust your outlook on the basis of just this one number?  Not much, if at all.  It is important to watch for trends in the data, and always keep Barry Ritholtz's warning in the back of your mind:

 ...we know from each month’s revisions that the initial read is off, often by a substantial amount. It’s a noisy series, subject to many errors and subsequent corrections.

To put this into some context, consider what it is we are measuring: The change in monthly hires minus fires. A monthly change in a labor force of more than 150 million people. That turns out to be a tiny net number relative to the entire pool -- about one tenth of one percent.

This is why I continually suggest ignoring any given month, and paying attention to the overall trend. That is the most useful aspect of the monthly NFP data...if you focus on the monthly numbers, you will be given so many false signals and head fakes that you cannot possibly trade on this information in an intelligent manner.

Indeed, the December number was mitigated by an upward revision to November, leaving the growth pattern looking very familiar:

One interpretation of the December outcome was that it was largely weather related.  One would think, however, that such an event would have a forecastable negative impact on payrolls.  Regardless, the bigger message is that the monthly change in payrolls is a volatile series, and one should be wary of putting too much emphasis on either small or large gains.

Perhaps the real story then is that another existing trend in the data, the downward pressure on the unemployment rate from a falling labor force participation rate, continues unabated:

Moreover, the pace of improvement in alternative measures of labor utilization is not accelerating and arguably appears to be slowing as might be expected if the formally cyclically unemployed increasingly become structurally unemployed:

Altogether, I think the report can be neatly summed up as 1.) indicative of a more modest improvement in activity than suggested by actual and estimated GDP numbers for the final half of 2013 and 2.) suggestive of structural change in labor markets.  

The employment report generally complicates monetary policymaking.  Not the nonfarm payrolls numbers so much; that number will largely be written off as anomalous in the context of the overall trend.  Indeed, this was the first word from Fed officials.  St. Louis Federal Reserve President James Bullard, via the Wall Street Journal:

"I would be disinclined to react to one month's number. I think it's important to get future jobs reports and see if new trends are developing," said Mr. Bullard at a press briefing following remarks here to local business leaders.

Richmond Federal Reserve President Jeffrey Lacker offered similar sentiments:

“As a general principle, it’s wise not to overreact to one month’s employment report,” Lacker said. “Employment has been growing along a pretty steady trend this year. It takes a lot more than one labor-market report to be convincing that the trend has shifted, and in my experience one employment report rarely has an effect by itself on monetary policy.”

I think the Fed is generally committed to winding down asset purchases this year, and will not want to be overly sensitive to just one report (that said, they will be overly sensitive to one number if it fits their preferred policy path).  Only a more significant change in the overall tenor of the data will alter the pace of tapering.  

The drop in the unemployment rate, however, is something more of a challenge.  The Evans rule simply isn't looking quite so clever anymore:

Monetary officials generally believed not only that 6.5% unemployment was far in the future, but also that policy would become much more obvious as we approached that target because inflation pressures would be evident.  Neither has been true.  Not only has unemployment fallen more quickly than anticipated, but inflation remains stubborningly low.  With regards to the former, officials increasingly see the decline in labor force participation as largely structural and outside the purview of monetary policy.  Bullard, via the article quoted earlier:

Mr. Bullard signaled he wasn't particularly alarmed by a decline in labor force participation, saying it appears at the right level given current demographics.

And, via a nice Wall Street Journal interview with San Francisco President John WIlliams by Jon Hilsenrath:  

We’re still working hard on this issue of employment-to-population. Everybody is struggling with the puzzle of why the employment-to-population ratio has stayed low. To what extent are movements in labor force participation structural or cyclical? And to what extent can monetary policy have an influence on those developments? I think the majority of the decline in the participation rate is due to structural factors related to the aging of the population and people going into disability. Very few people come back into the labor force from that. I do think part of it is cyclical. The data in the next year or so are going to inform us better about what is the trend.

With each passing month policymakers are increasingly comfortable taking the unemployment rate at face value.  That means they increasingly expect the inflation numbers to pick up.  Back to Williams:

As the unemployment rate continues to come down, utilization continues to go up, as the economy continues to improve, I would expect the underlying inflation rate to track back towards 2%.

But he clearly recognizes the potential for inflation to remain low:

The second question is why is inflation so low? To what extent does it reflect just some transitory influences, such as health care costs, and to what extent is it really reflecting a persistent ongoing inflation trend that is too low? And again how can monetary policy affect that? We’re in this world where inflation doesn’t move around a lot around 2%. It has become hard to model and to know exactly what are the factors causing inflation to be too low and which are the ones that are going to help bring it back to 2%. That gets to the downside risk question. If inflation does stay stubbornly low, that obviously is an argument for more monetary accommodation than otherwise. 

Likewise, Bullard shares these concerns:

Mr. Bullard said he continues to watch inflation closely, saying it should rise as the economy picks up and the jobless rate continues to fall. But the central banker added he wants to actually see that rise come to fruition as the Fed assesses further tapering of its bond-buying.

"If inflation stepped lower in a clear way, I think that would give me some pause," Mr. Bullard said. "I'm looking for signs inflation is going to come back."

So where does this leave us?  First of all, I think the Evans rule is already for all intents and purposes defunct.  The unemployment rate is just a hair away from 6.5%, and the Fed has no intention of considering raising rates anytime soon. Second, there probably isn't a replacement for the Evans rule in the works.  Bullard:

He expects the Fed for now to hold its threshold for unemployment at 6.5%. The Fed has said it won't increase interest rates until the jobless rate falls below that level so long as inflation stays contained.

"Moving (thresholds) around too much is likely to damage our credibility," Mr. Bullard said

And Williams on not setting a lower bound for inflation:

My view is the current [Fed policy] statement does a good job of capturing the fact that once unemployment gets below 6.5%, then obviously we’ll be taking seriously what is happening in inflation, we will be looking at what is happening with employment and growth and everything, and then we’ll be judging what is the appropriate stance of policy. It just gets very complicated quickly when you start adding more and more clauses about what conditions would you or would you not raise interest rates. Unfortunately, that is the game we’re playing … the FOMC statement has gotten awfully long. It has gotten awfully complicated. The statement is probably better used to try to emphasize the key points as opposed to trying to explain everything in our thinking.

My sense is that they thought the Evans rule was clever and simple, but it turns out that fixed numerical objectives are not quite so simple.  Well, multiple numerical objectives are not quite so simple.  The ironic outcome to the Evans rule experiment is that policy communication would arguably have been smoother if the Fed simply emphasized an inflation target.  Policymakers could have been agnostic on the reasons for the declines in labor force participation; it was irrelevant given the path of inflation.  Perhaps the focus on the unemployment rate was something of an unnecessary complication that now needlessly leaves the impression that policy will soon turn more hawkish than is the case.  

Thus, the third takeaway is that policy is now largely about inflation (although arguably it always is always about inflation).  Ann Saphir and Jonathon Spicer at Reuters:

Stubbornly weak inflation is shaping up as the wild card for U.S. monetary policy makers this year, with top Federal Reserve officials stumped by why it has lingered so low for so long and at odds as to what to do about it.

As the Fed wrestled through last year with deciding when to start trimming its massive bond-buying stimulus, the bulk of attention was focused on the unemployment rate, which until recently has been slow to fall following its spike up to 10 percent during the recession.

By last month, policy makers had grown confident enough in the job market to dial back on the program. Figures released Friday showed the jobless rate fell to a five-year low of 6.7 percent in December, despite the smallest monthly job gains in three years. With much of the hiring slowdown attributed to bad weather, however, many analysts say the Fed will stay on track with plans to end bond buying by late this year.

But there is a hitch: inflation has been drifting down for much of the last two years, measuring a feeble 1.1 percent in November by the Fed's preferred gauge.

As long as inflation reverts to target slowly (with a caveat to be noted below), the Fed will not be quick to hike rates.  But the Fed will be increasingly nervous that a sudden burst of inflation means they are behind the curve.  WIlliams:

Whether we cut purchases by 10 billion a month or not, we still have a very accommodative stance of policy and that is going to stay with us for quite some time. That is where I worry. If the economy really picks up or inflation or risks to financial stability really do start to emerge in a serious way, we need to be able to move policy back to normal, or adjust policy appropriately, in a timely manner. It’s always a difficult issue. This time it is just a much greater risk because we’re in a much more accommodative stance of policy.

I think it will be the sensitivity to positive inflation surprises that has the potential to add a hawkish tenor to policymaking.  WIthout those surprises, policy will continue along current expectations.  There is a caveat - note that Williams essentially admits that the possibility and willingness to use monetary policy to address financial stability.  Triple mandate.  Watch for it.

Bottom Line:  I don't see much in the employment report to indicate any fundamental change to existing trends.  Nor do I anticipate any change in policy.  Tapering is likely to continue at its modest pace.  As expected, the Evans rule is defunct, and it doesn't seem like policymakers are inclined to replace it with another set of fixed numerical guidelines.  The primary driver of policy is now the pace of incoming data relative to the inflation outlook.  Financial stability is probably something like a third-order concern at this point, at least as far as monetary policy is concerned.  But that could change.  

Next Up: Employment Report

Another quick post between appointments.  Tomorrow is the all-important employment report release day for December.  I say "all-important" partly in jest.  I would caution against placing too much weight on a preliminary number that is well-known to be heavily revised.  But the Federal Reserve seems to place an unusually high weight on the most recent month of data, so we must too.  

Since it worked well last time, my quick-and-dirty estimate is a 245k gain for nonfarm payrolls in December:

Use with caution, usual caveats apply.  Forecasting the preliminary nonfarm payroll gain is akin to throwing darts.  And my prior is that something that worked well last month probably will not work well this month. That said, while this technique might not predict the exact number, I think it tells us that:

1. The labor market is improving modestly.
2. Any large deviation from a gain of 245k - either positive or negative - is likely not indicative of the underlying trend in labor markets.

For comparison, this is a decidedly above consensus forecast.  Consensus is for 200k with a range of 120k to 225k.  245k would be a large upward surprise.

Finally, when considering the policy implications of the report (unless I happen to be up at 5:30am tomorrow, I won't get a chance to review the report until well after the market closes), consider the tension between incoming chair Janet Yellen's preferred preferred measures of labor market slack/tightness:

The improvement on the left exceeds that on the right.  That argues for policy inertia unless policymakers shift their focus toward on side or the other.  The obvious concern is that improvement on the left becomes too much for policymakers to easily ignore.

FOMC Minutes - The Quick Review

Running short on time tonight (a problem that I don't think will be resolved until the next week).  Still, I want to make some quick comments - disjointed as they may be - on the minutes of the December 2013 FOMC meeting.

Near the beginning of the minutes, the staff presents a survey on the expected costs and benefits of the asset purchase program.  I feel I need to highlight this section since I have complained that the Fed is leaving us in the dark on the cost/benefit calculus.  Now I know why they are leaving us in the dark - they are pretty much in the dark themselves.  They sense that the math still favors ongoing purchases:

Most participants judged the marginal costs of asset purchases as unlikely to be sufficient, relative to their marginal benefits, to justify ending the purchases now or relatively soon; a few participants identified some possible costs as being more substantial, indicating that the costs could justify ending purchases now or relatively soon even if the Committee's macroeconomic goals for the purchase program had not yet been achieved.

Still, they are worried about financial stability:

Participants were most concerned about the marginal cost of additional asset purchases arising from risks to financial stability, pointing out that a highly accommodative stance of monetary policy could provide an incentive for excessive risk-taking in the financial sector.

And they really don't know what they are doing:

It was noted that the risks to financial stability could be somewhat larger in the case of asset purchases than in the case of interest rate policy because purchases work in part by affecting term premiums and policymakers have less experience with term premium effects than with more conventional interest rate policy.

Some continue to think of the Fed's balance sheet like that of a regular bank:

Participants also expressed some concern that additional asset purchases increase the likelihood that the Federal Reserve might at some point suffer capital losses.

But common sense prevails:

But it was pointed out that the Federal Reserve's asset purchases would almost certainly provide significant net income to the Treasury over the life of the program, especially when the effects of the program on the broader economy were taken into account, and that potential reputational risks to the Federal Reserve arising from any future capital losses could be mitigated by communicating that point to the public.

I think it silly to complain about potential future losses without acknowledging the current profits; the asset purchase program needs to be evaluated across its entire lifespan.  Moreover, it's silly to think the Federal Reserve needs to make a "profit" as if it were a regular bank.  The Federal Reserve does not exist to make a profit.  It exists to conduct the monetary policy of the nation.  But I digress.  In any event, policymakers should actually understand this, and hopefully recognize that the only reason for concern on this point is the public optics.

Then comes the issue of exit:

Further, participants noted that ongoing asset purchases could increase the difficulty of managing exit from the current highly accommodative policy stance when the time came.

But in general they feel prepared:

Many participants, however, expressed confidence in the tools at the Federal Reserve's disposal for managing its balance sheet and for normalizing the stance of policy at the appropriate time.

The success with the "reverse repo" facility (noted in the minutes) probably bolsters their confidence on this point.  Regarding the benefits of the program, they understand the communications value of quantitative easing:

Regarding the marginal efficacy of the purchase program, most participants viewed the program as continuing to support accommodative financial conditions, with a number of them pointing to the importance of purchases in serving to enhance the credibility of the Committee's forward guidance about the target federal funds rate.

Still, their faith in the program is wavering:

 A majority of participants judged that the marginal efficacy of purchases was likely declining as purchases continue, although some noted the difficulty inherent in making such an assessment.

Basically, they don't really have any basis for quantifying the marginal benefits of the program now.  That said, there is push back:

A couple of participants thought that the marginal efficacy of the program was not declining, as evidenced by the substantial effects in financial markets in recent months of news about the likely path of purchases.

The great QE debate of 2013 was evidence of the program's communication value, but arguably if they change the policy mix such that  communication is provided by forward guidance, then the benefits of the asset purchase program will fade, and with them the rational for the program.  Overall, I don't see a lot of cohesion around any method to quantify the cost/benefit trade-off of the program.  It seems they are just taking the position that they will know the math has shifted against the program when they see it.  Which of course make assessing their likely policy path something of a challenge.

Participants still struggle with the reasons for the drop in labor force participation.  Structural or cyclical? Really just covering much of the same ground:

Some participants cited research that found that demographic and other structural factors, particularly rising retirements by older workers, accounted for much of the recent decline in participation. However, several others continued to see important elements of cyclical weakness in the low labor force participation rate and cited other indicators of considerable slack in the labor market, including the still-high levels of long-duration unemployment and of workers employed part time for economic reasons and the still-depressed ratio of employment to population for workers ages 25 to 54. In addition, although a couple of participants had heard reports of labor shortages, particularly for workers with specialized skills, most measures of wages had not accelerated. A few participants noted the risk that the persistent weakness in labor force participation and low rates of productivity growth might indicate lasting structural economic damage from the financial crisis and ensuing recession.

The healthy debate on this topic likely leaves them wary to change the unemployment threshold.  Unsurprisingly, inflation was also a topic of conversation.  They remain convinced that the current trend will soon be reversed:

Inflation continued to run noticeably below the Committee's longer-run objective of 2 percent, but participants anticipated that it would move back toward 2 percent over time as the economic recovery strengthened and longer-run inflation expectations remained steady.

That said, there were broad concerns on this outlook:

Nonetheless, many participants expressed concern about the deceleration in consumer prices over the past year, and a couple pointed out that a number of other advanced economies were also experiencing very low inflation. Among the costs of very low or declining inflation that were cited were its effects in raising real interest rates and debt burdens. A few participants raised the possibility that recent declines in inflation might suggest that the economic recovery was not as strong as some thought.

Inflation isn't just low in the United States - it's low in many parts of the world.  Europe, in particular comes to mind.  They must be concerned that low inflation abroad will translate to low inflation at home, even if the economy is strengthening as expected.  And then there is another possibility.  Although everyone is getting warm and fuzzy about the pace of the recovery, perhaps the inflation numbers are telling the real story.  I still think it is odd that they overlooked such concerns and pulled the trigger on the taper, justifying it, as I thought they would, with the forecast and stable inflation expectations.  Indeed, the inflation concern was prominent in the taper debate:

...most participants saw a reduction in the pace of purchases as appropriate at this meeting and consistent with the Committee's previous policy communications. Many commented that progress to date had been meaningful, and some expressed the view that the criterion of substantial improvement in the outlook for the labor market was likely to be met in the coming year if the economy evolved as expected. However, several participants stressed that the unemployment rate remained elevated, that a range of other indicators had shown less progress toward levels consistent with a full recovery in the labor market, and that the projected pickup in economic growth was not assured. Some participants also questioned whether slowing the pace of purchases at a time when inflation was running well below the Committee's longer-run objective was appropriate. For some, the considerable slack remaining in the labor market and shortfall of inflation from the Committee's longer-run objective warranted continuing asset purchases at the current pace for a time in order to wait for additional information confirming sustained progress toward the Committee's objectives or to promote faster progress toward those objectives.

Ultimately, the tiny taper combined with discretion in the pace of future reductions won the day:

Among those inclined to begin to reduce the pace of asset purchases at this meeting, many favored a modest initial reduction accompanied by guidance indicating that decisions regarding future reductions would depend on economic and financial developments as well as the efficacy and costs of purchases. Some other participants preferred a larger reduction in purchases at this meeting and future reductions that would bring the program to a close relatively quickly. A few proposed that the Committee lay out, either at this meeting or subsequently, a more deterministic path for winding down the program or that it announce a fixed amount of additional purchases and an expected completion date, thereby reducing uncertainty about the trajectory of the purchase program.

They simply were uncertain enough about the cost and benefits of the asset purchase program that they wanted to use the "progress toward goals" provision as an excuse to do a trial run on the exit. 

Stepping back a bit in the minutes, the issue of financial stability makes another appearance:

Participants also reviewed indicators of financial vulnerabilities that could pose risks to financial stability and the broader economy. These indicators generally suggested that such risks were moderate, in part because of the reduction in leverage and maturity transformation that has occurred in the financial sector since the onset of the financial crisis.

What are policymakers looking for?

In their discussion of potential risks, several participants commented on the rise in forward price-to-earnings ratios for some small-cap stocks, the increased level of equity repurchases, or the rise in margin credit. One pointed to the increase in issuance of leveraged loans this year and the apparent decline in the average quality of such loans.

And what will financial stability issues means for future policy? Read carefully:

A couple of participants offered views on the role of financial stability in monetary policy decisionmaking more broadly. One proposed that the Committee analyze more explicitly the potential consequences of specific risks to the financial system for its dual-mandate objectives and take account of the possible effects of monetary policy on such risks in its assessment of appropriate policy. Another suggested that the importance of financial stability considerations in the Committee's deliberations would likely increase over time as progress is made toward the Committee's objectives, and that such considerations should be incorporated into forward guidance for the federal funds rate and asset purchases.

The idea of using monetary policy tools to combat financial instability is in its infancy, but is certainly something to watch.  My sense is the majority of the FOMC believes they can address financial stability via macroprudential regulation.  Hence I believe the Fed is a long way from turning the dual-mandate of monetary policy into a triple-mandate.  But the baby was born alive and well on Constitution Ave.  

Finally, at least for me tonight, the idea of lowering the unemployment thresholds was considered and rejected in favor of enhanced forward guidance:

Participants debated the advantages and disadvantages of lowering the unemployment rate threshold provided in the forward guidance. In the view of the few participants who advocated such a change, a lower threshold would be a clear signal of the Committee's intentions and was an appropriate adjustment in light of recent labor market and inflation trends. In contrast, a few others expressed concern that any change in the threshold might be confusing and could undermine the credibility of the Committee's forward guidance. Most were inclined to retain the current thresholds for the unemployment and inflation rates and to instead provide qualitative guidance regarding the Committee's likely behavior after a threshold was crossed.

Bottom Line:  I am not sure the minutes provide many surprises.  Overall, I think they reveal a very divided Federal Reserve, and the result is that every policy choice is a middle ground.  This strikes me as a recipe for policy inertia.  No abrupt changes to the pace of tapering.  No abrupt changes to the interest rate outlook.  No abrupt changes to the Evans rule.  But I wonder if the middle ground is more like a knife edge - that general policy fatique means the FOMC would shift its stance rapidly if the data broke decisively higher.  This, I think, is something that might keep a bond trader up at night. 

How Divided is the Fed?

The minutes of the December 2013 FOMC meeting will be released Wednesday.  I am looking for divisions within the FOMC on key topics, notably likely timing of the first rate hike, likely pace of rate hikes, and discussion of what follows the Evans rule.  I am not so much concerned with the tapering process at this point. In my mind, that is now something of a dead issue.  Barring any large shifts in the pace of economic activity, I think the Fed is largely committed to winding down that program this year.  And I think that the Fed is likely committed to low interest rates through 2014.  It's in the 2015 policy outlook that the real divisions start to show.

As far as quantitative easing is concerned, I think the Federal Reserve is looking to end the program.  Although they have not fully explained the calculus in the background, I think the cost/benefit analysis shifted against asset purchases.  Moreover, the markets did not collapse after policymakers pulled the trigger on the taper, and everyone (all right, everyone but Boston Federal Reserve President Eric Rosengren) seems relatively comfortable with the pace at with asset purchases are expected draw to a close.  Sure, arguably the hawks would like to see it brought to a close sooner than later, but are really just happy to see a path out, a clear indication that there is no such thing as QEInfinity.  

With regards to interest rates in 2014, here again I think the vast majority of FOMC members are comfortable with the idea that short term rates will most likely hold near zero for the remainder of the year.  Even if the US economy receives a faster than expected burst of cyclical activity, the still large output gap and high unemployment rate suggest there is room to let the growth engine run on all cylinders for awhile  This is especially the case given the inflation numbers.  

There is enough uncertainty about inflation, however, that I think the Fed will hesitate to lower the unemployment threshold.  Unless they change the threshold, the Evan's rule becomes defunct in just 0.5 percentage points.  I tend to think that the Fed does not want to change the threshold, and would like to let such specific, numerical rules-based guidance die a quiet death.  Of course, that leaves as an open question of what would be the nature of any rules based guidance going forward.  

This could be a place where fundamental divisions among policymakers would be important.  Most policymakers could get on board with Evans rule considering the special circumstances - the ongoing Great Recession - and the reality that a 6.5% threshold was in some sense not likely to be meaningful in the first place.  I doubt more than one or two policymakers thought that the Fed would be hiking rates anytime before 6.5%.  In effect, it was a promise that was easy to keep.  Not changing the threshold, however, suggests they they can't agree on any other promise would be easy to keep.  In any event, I am watching the minutes to see if there is more support for a specific change to the Evan's rule than I currently expect.

That leaves 2015.  Here, I think, we tend to be overlook the wide range of expectations for 2015 (and 2016, for that matter): 

Yes, in 2015 there is a weight on the dovish side of the Fed - but even within that side there is a range of 100bp.  Which means some relatively dovish policymakers still think a rate hike toward the beginning of 2015 is likely.  And 2016 offers an even wider spread of rate expectations - forecasts of the pace of rate hikes vary widely across policymakers.  This suggests deep divisions.

But what is the source of these divisions?  If the divisions simply represent different economic forecasts, they might not be very interesting.  Presumably, as economic forecasts converge so too would the rate forecasts.  In other words, as long as most FOMC members are working with roughly the same reaction function, they really won't be divided when it comes to actually setting policy - they will line up on the dovish or hawkish side as data dictates.  So your view of rate policy is driven by your forecast, and how strongly the Fed leans against that view is dependent how closely they believe the incoming data matches that forecast.

More interesting is the possibility that some of the difference represents fundamentally different reaction functions.  To be sure, this is already likely the case to some extent, and is visible in the 2014 forecasts.  Even more interesting is the possibility that some of the difference is attributable not just to differing reaction functions regarding inflation and unemployment, but to difference opinions regarding the importance of financial stability in the formation of monetary policy.  In other words, do some policymakers desire to accelerate the pace of rate increases to step in front of potential financial instabilities that may be brewing?  

Such a camp would be expected to include Kansas City Federal Reserve President Esther George and Dallas Federal Reserve President Richard Fisher.  Neither of them, however, have sufficient intellectual weight to move the needle.  Governor Jeremy Stein, however, is another matter.  He is an intellectual force.  And while there is a widespread hope that macroprudential regulation is sufficient to address stability concerns, Stein has already shown a willingness to consider using the tools of monetary policy as an alternative:

Nevertheless, as we move forward, I believe it will be important to keep an open mind and avoid adhering to the decoupling philosophy too rigidly. In spite of the caveats I just described, I can imagine situations where it might make sense to enlist monetary policy tools in the pursuit of financial stability....

Importantly:

Second, while monetary policy may not be quite the right tool for the job, it has one important advantage relative to supervision and regulation--namely that it gets in all of the cracks.

Could Stein bring incoming Chair Janet Yellen and others along to accepting a more aggressive policy to prevent the financial instabilities we have seen in recent cycles (assuming he heads in that direction himself)?  The presumption is that Yellen will shy away from using the tools of monetary policy to achieve financial stability.  Neil Irwin at the Washington Post, however, see this as Yellen's greatest challenge:

...Yellen confronts an old dilemma, the same one that she and current chairman Ben Bernanke have been wrestling with for the last three years or so. The tools they have to try to pump up growth are deeply flawed and can create dangerous side effects. But the central bank is the only policymaking entity in Washington focused on encouraging growth at all.

So the debate has been this: Do we use the tools in our arsenal, even aware of the risks? Or do we allow growth to underperform its potential, leaving millions of jobless by the wayside when we may just be able to help, out of fear of some theoretical risks of a new credit bubble and ensuing crisis.

The Fed's answer this past three years -- with strong support from Yellen -- has been that the unemployment crisis is so severe and the risks from interventionism are small and theoretical enough that, yes, the Fed should employ its full set of tools to try to boost growth. But as financial markets get closer to levels that suggest they are fully valued, and flirt with bubble territory, the cost-benefit analysis may well change.

I don't know where Yellen's thoughts will evolve on this topic.  What I do know is this:  She has been built up as an dove of the highest order.  Consequently, I can't help but think there is only one surprise she could possibly deliver.  Since I think it would be virtually impossible for her policy direction to be more dovish than anticipated (the outcome of optimal control-based policy orientation), the only surprise that seems possible is that she is more hawkish than anticipated. 

Bottom Line:   What I am watching for in the minutes - signs of division.  Division on the forecasts themselves will make it hard to agree to a successor to the Evans rule.  Divisions on the reaction function will make it even harder.  And the possibility that monetary policy could have a role in pouring cold water on financial markets; it is hard to see how they lower the unemployment threshold while keeping that option open.  And, of course, I am wary of the opposite as well - maybe they surprise me and lean toward lowering the unemployment threshold soon.  There may still be more dovish tricks in the old magic hat after all.

On Respect and Income Equality

Noah Smith laments the days of yore, hypothesising that what we need is not a redistribution of income, but of respect:

I want this to change. I want to move back toward a society where the hard work of an unskilled laborer is considered worthwhile in social interactions, regardless of how many dollars it brings home. I want to move back toward a society where being a good parent or a friendly neighbor earns as much respect as making a hundred million dollars on Wall Street.

In other words, I want our "democracy" back. We need to redistribute respect.

My first thought was "Did such a world ever exist?"  Perhaps someone with a little more vintage than me can add to that conversation, but I worry that such an idyllic view of the past is what one gets watching sitcoms of the 1950's that leave out inconvenient issues like apartheid in the American South.   

My second thought was that if respect was more equally distributed in the past, this was almost certainly because incomes were more equally distributed.  Chris Dillow at Stumbling and Mumbling latches onto the theme:

...I fear that Noah is under-estimating the extent to which inequality of respect is endogenous. It arises out of the forces that generate and sustain inequalities of power and wealth.

My third thought was that this is not exactly a new topic.  The underlying tendency to treat the poor with contempt has been around a long, long time.  Indeed, it seems like an opportunity to curl up with an old friend, Adam Smith's Theory of Moral Sentiments.  Smith recognized that inequality of incomes would result in inequality of respect:

This disposition to admire, and almost to worship, the rich and the powerful, and to despise, or, at least, to neglect persons of poor and mean condition, though necessary both to establish and to maintain the distinction of ranks and the order of society, is, at the same time, the great and most universal cause of the corruption of our moral sentiments. That wealth and greatness are often regarded with the respect and admiration which are due only to wisdom and virtue; and that the contempt, of which vice and folly are the only proper objects, is often most unjustly bestowed upon poverty and weakness, has been the complaint of moralists in all ages.

Adam Smith continues in a paragraph so beautiful it can be read time and time again:

We desire both to be respectable and to be respected. We dread both to be contemptible and to be contemned. But, upon coming into the world, we soon find that wisdom and virtue are by no means the sole objects of respect; nor vice and folly, of contempt. We frequently see the respectful attentions of the world more strongly directed towards the rich and the great, than towards the wise and the virtuous. We see frequently the vices and follies of the powerful much less despised than the poverty and weakness of the innocent. To deserve, to acquire, and to enjoy the respect and admiration of mankind, are the great objects of ambition and emulation. Two different roads are presented to us, equally leading to the attainment of this so much desired object; the one, by the study of wisdom and the practice of virtue; the other, by the acquisition of wealth and greatness. Two different characters are presented to our emulation; the one, of proud ambition and ostentatious avidity. the other, of humble modesty and equitable justice. Two different models, two different pictures, are held out to us, according to which we may fashion our own character and behaviour; the one more gaudy and glittering in its colouring; the other more correct and more exquisitely beautiful in its outline: the one forcing itself upon the notice of every wandering eye; the other, attracting the attention of scarce any body but the most studious and careful observer. They are the wise and the virtuous chiefly, a select, though, I am afraid, but a small party, who are the real and steady admirers of wisdom and virtue. The great mob of mankind are the admirers and worshippers, and, what may seem more extraordinary, most frequently the disinterested admirers and worshippers, of wealth and greatness.

I think the tendency to equate poverty with "vice and folly" is a long-standing tradition.  What may have changed is this:

In equal degrees of merit there is scarce any man who does not respect more the rich and the great, than the poor and the humble. With most men the presumption and vanity of the former are much more admired, than the real and solid merit of the latter. It is scarce agreeable to good morals, or even to good language, perhaps, to say, that mere wealth and greatness, abstracted from merit and virtue, deserve our respect. We must acknowledge, however, that they almost constantly obtain it; and that they may, therefore, be considered as, in some respects, the natural objects of it.

I am not sure that it is now considered "scarce agreeable to good morals" to openly proclaim that wealth and greatness by themselves deserve respect.  Or worse, that poverty alone deserves our contempt. Indeed, the "War on the Poor" seems now to be pretty much out in the open.  This I think is a result of ever greater income inequality and the need of the wealthy to justify that inequality.  One such justification is that which Adam Smith lamented: Wealth must be an indication of moral superiority, luck doesn't have anything to do with it.

Moreover, Noah Smith points to the 1980's as the time respect disappeared from the public discourse:

I feel like the America I grew up in could learn a thing or two from Japan in this regard. I don't know if the word "loser" was a common insult before the 1980s, but in recent decades it has become ubiquitous. People who work in the service industry almost always seem ashamed when they tell me what they do for a living. Low-skilled workers are treated in a peremptory way, constantly reminded that they are "losers".

It shouldn't be a surprise that disrespect toward the poor grows beginning in the 1980s - that is also when inequality starts to explode. It doesn't take long for the rich/poor theme to appear in popular culture.   I just watched "Trading Places," a 1983 movie that leverages off the disrespect for the poor on the part of the rich.  That theme is also critical to the 1986 movie "Pretty in Pink."  A memorable scene, after Blane attempts to take the "girl from the wrong side of the tracks" Andie to the rich Steff's party:

Steff: Look, that was very uncool of you last night, Blane.
Blane: What?
Steff: [mockingly] What?
Blane: You mean Andie?
Steff: Yeah, I mean Andie.
Blane: What's the big deal? I like her. Matter of fact, I was pissed off at you guys for being so nasty to her.
Steff: It was way out of order for you to force her on the party.
Blane: [disbelievingly] Steff, do you hear yourself? Do you hear the same asshole shit I hear?
Steff: What, do I have to spell it out for you?
Blane: [pissed off] I guess so.
Steff: Nobody appreciates your sense of humor, you know. As a matter of fact, everyone's just about to puke from you. If you've got a hard-on for trash, don't take care of it around us.

The social pressure becomes too much for Blane:

Blane: What do you want to hear?
Andie: Tell me!
Blane: What?
Andie: You're ashamed to be seen with me.
Blane: No, I am not!
Andie: You're ashamed to go out with me. You're terrified that you're goddamn rich friends won't approve.
[Andie hits Blane]
Andie: Just say it!
[Andie hits him again]
Andie: Just tell me the truth!
Blane: You don't understand that it has nothing at all do with you.
[Andie runs away]
Blane: [wipes a tear] Andie!

As movies often conclude, Blane comes to see Adam Smith's point that he should not automatically equate wealth and greatness with virtue and wisdom:

Blane: You couldn't buy her, though, that's what's killing you, isn't it? Stef? That's it, Stef. She thinks you're shit. And deep down, you know she's right.

Since, 1986, however, income inequality has only grown, and with it contempt for the poor.  Life rarely ends in the way of a John Hughes movie.

So while I agree with Noah Smith that we should seek equality of respect, I think, like Chris Dillow, that this will come only after greater equality of incomes.  Greater income equality would reduce the ability to make moral comparisons against one another on the basis of income alone.  It forces us to look toward other factors ("... real and solid professional abilities, joined to prudent, just, firm, and temperate conduct...") as a basis for respect.

****

Addendum I:  In the past, my students were required to use "Pretty in Pink" to explain Marx.  The obviously well-trained students soon revolted, pointing out that it was a much better fit with Smith.

Addendum II:  I now dutifully await the smackdown to be delivered by Gavin Kennedy for what will be shown to be a questionable understanding of Adam Smith.

 

A Weekend of Fedspeak

Federal Reserve speakers were out in force this weekend at the American Economic Association's annual meeting in Philadelphia.  The first rumblings from Fed speakers came from the hawkish-side of the aisle.  Via MarketWatch:

Philadelphia Fed President Charles Plosser warned Friday that the central bank may have to be "aggressive" in lifting interest rates and may have to chase market rates higher, if banks were to quickly release reserves. He also suggested the expectations of his colleagues by the end of 2016 that calls for Fed funds rates to be below 2% even when the job market is back to normal may be too low.

This should come as no surprise - Plosser has tended to be wary of the Fed's accommodative stance.  There is nothing here we don't already know.  As it stands today, the Fed is comfortable with a steep yield curve.  They are willing to tolerate rising long-rates to the extent that the increases are not driven by shifting expectations of Fed policy.  But clearly, if the economic circumstances improve markedly, the Federal reserve will be inclined to raise short-term rates sooner than expected.  That's how monetary policy works.  So all Plosser is telling us is that his inflation forecast differs from the FOMC as a whole, and if his forecast is realized, then policy will change accordingly.  

More interestingly, in a later speech Plosser challenged incoming Federal Reserve Chair Janet Yellen's preferred policy framework:

...there are several different ways to interpret the economic dynamics we have seen in recent years, and those perspectives would call for different policy responses. Some view the shocks hitting the economy as transitory and potential GDP as stable. Others view the shocks as being more permanent, affecting both actual and potential output.

In addition, there are alternative concepts of the output gap itself, some of which focus on the efficient level of output instead of potential output...

This state of affairs has led me to be skeptical of relying on gaps in general as well as optimal control exercises that are derived from specific models. Instead, I have long advocated that we should think in terms of robust policies that yield good economic outcomes across a variety of models and frameworks.

What such framework would Plosser suggest?  From 2010:

So, if we have problems in measuring output gaps, what type of rule should we use? I believe it makes more sense to use an interest rate rule that responds aggressively to movements in inflation relative to a target and, if it responds to real economic activity, responds to a measure of the change in economic activity itself rather than some deviation from unobserved potential.

But, but, but...why then is Plosser so hawkish?  Inflation has been moving away from target, so it would seem that he should be taking a dovish stance.  How exactly is he going to mount a challenge to a Yellen Fed's basic policy approach?  By jointly arguing that policy is too loosely and suggesting a rule that, if followed, would loosen policy further?  I am just not seeing it, and thus not seeing how Plosser would be effective in affecting Fed policy.   As such, I am not convinced that Plosser's ascension to voting status this year will make much difference other than providing journalists/economists/etc. with a dissenting voice.

Outgoing Federal Reserve Chair Ben Bernanke took his victory lap with an overview of his tenure.  Too much here to cover adequately in this post, so I will skip to some of his comments on tapering:

...the FOMC's decision to modestly reduce the pace of asset purchases at its December meeting did not indicate any diminution of its commitment to maintain a highly accommodative monetary policy for as long as needed; rather, it reflected the progress we have made toward our goal of substantial improvement in the labor market outlook that we set out when we began the current purchase program in September 2012.

No surprise here either.  The Fed has been pushing to divorce asset purchases from interest rate policy, and are cautiously optimistic they have done so successfully.  Regarding the ability of the Federal Reserve to extricate itself from its current position:

Once the economy improves sufficiently so that unconventional tools are no longer needed, the Committee will face issues of policy implementation and, ultimately, the design of the policy framework. Large-scale asset purchases have increased the size of our balance sheet and created substantial excess reserves in the banking system. Under the operating procedures used prior to the crisis, the presence of large quantities of excess reserves likely would have impeded the FOMC's ability to raise short-term nominal interest rates when appropriate. However, the Federal Reserve now has effective tools to normalize the stance of policy when conditions warrant, without reliance on asset sales. The interest rate on excess reserves can be raised, which will put upward pressure on short-term rates; in addition, the Federal Reserve will be able to employ other tools, such as fixed-rate overnight reverse repurchase agreements, term deposits, or term repurchase agreements, to drain bank reserves and tighten its control over money market rates if this proves necessary. As a result, at the appropriate time, the FOMC will be able to return to conducting monetary policy primarily through adjustments in the short-term policy rate.

All sounds so easy, doesn't it?  In contrast, Mike Derby at the Wall Street Journal reports that the person responsible for making it happen isn't quite to confident:

Speaking as part of a panel in Philadelphia on the activities of the regional Fed banks, Mr. Dudley acknowledged a lot is still unknown about how the bond buying works. His observation is important because he has long been a supporter of aggressive Fed actions to help the economy.

The New York Fed leader has for some time expressed support for continuing the purchases, even as he also voted in favor of the Fed’s decision last month to cut back.

Referring to the Fed’s stimulus program, Mr. Dudley said, “we don’t understand fully how large-scale asset-purchase programs work to ease financial market conditions—is it the effect of the purchases on the portfolios of private investors, or alternatively is the major channel one of signaling?”...

...Mr. Dudley also said that when it comes time to unwind the Fed’s easy-money stance, uncertainty is again a major issue facing central bankers.

“There could be unintended consequences” about moving to a more normalized state of monetary policy, he said.

I tend to think that such uncertainty runs deeper than it appears at the Fed, which is why policymakers are eager to end asset purchases.  The more they buy, the more they risk "unintended consequences" at exit time.

Bernanke also threw cold water on the long-run forecast even as his was relative optimistic for faster growth in 2014:

For example, over the past year unemployment has declined notably more quickly than we or other forecasters expected, even as GDP growth was moderately lower than expected a year ago. This discrepancy reflects a number of factors, including declines in participation, but an important reason is the slow growth of productivity during this recovery; intuitively, when productivity gains are limited, firms need more workers even if demand is growing slowly. Disappointing productivity growth accordingly must be added to the list of reasons that economic growth has been slower than hoped...The reasons for weak productivity growth are not entirely clear: It may be a result of the severity of the financial crisis, for example, if tight credit conditions have inhibited innovation, productivity-improving investments, and the formation of new firms; or it may simply reflect slow growth in sales, which have led firms to use capital and labor less intensively, or even mismeasurement. Notably, productivity growth has also flagged in a number of foreign economies that were hard-hit by the financial crisis. Yet another possibility is weak productivity growth reflects longer-term trends largely unrelated to the recession. Obviously, the resolution of the productivity puzzle will be important in shaping our expectations for longer-term growth.

Richmond Federal Reserve President Jeffery Lacker offered similar concerns:

...Adding up all these categories of spending yields a forecast for GDP growth of just a little above 2 percent — not much different from what we've seen for the last three years.

That's my forecast for this year, but when thinking about growth prospects, I believe it's important to keep an eye on longer-run trends as well. To do that, it's useful to break down real GDP growth into the sum of the growth in labor productivity — that is, output per worker — and the growth in the number of workers. It turns out both of these components have slowed since the Great Moderation. If growth in overall output is going to rise substantially, then we would need to see an increase in labor productivity growth, or in employment growth, or both.

Lacker sees 1% growth in both labor force and productivity combining to deliver roughly 2% underlying growth for the near future, which is also his 2014 forecast - he is less optimistic about a cyclical burst of activity than Bernanke.  The central issue is that there is widespread uncertainty about the breakdown of cyclical versus structural factors in the current environment.  This is not an impediment to accommodative policy with unemployment at 7%.  And the Fed forecasts give the cyclical issues the benefit of the doubt, which allows for policymakers to believe they can delay any rate hikes until 2015.  But the uncertainty over the structural/cyclical divide is sufficient to prevent policymakers from dropping the unemployment threshold to 6% or lower and shifting their forward guidance from a forecast to a promise.  As of yet, there is no replacement for the Evan's rule, leaving forward guidance more vulnerable to challenges from markets.  Markets get ahead of the Fed, Fed beats them back, markets get ahead of the Fed, etc.

Bottom Line:  Fedspeak over the weekend was generally consistent with my priors.  Policymakers don't want to undershoot the recovery, but I don't sense they want to overshoot either.  That points toward cautious withdrawal of accommodation.  Pencil in somewhat stronger growth in 2014.  Pencil in a steady reduction in the pace of asset purchases until the program winds down at the end of the year.  Pencil in an extended period of low rates.  But also recognize that the tide of monetary policy is now receding - albeit ever so slightly - with the Fed's first step of ending the asset purchase program.  They don't want to do more if they can avoid it, and I don't think the risks are weighted toward a reversal of of their current expected policy path.  The data flow would need to turn sharply weaker to prompt the Fed to turn tail and increase the pace of asset purchases.  Same too, I think, for changing the unemployment threshold.  They would need to be very confident that a new threshold was not locking them into a policy they thought to be too accommodative.  Instead, I tend to think the risks are weighted in the other direction, that a positive change in the pace of activity would precipitate a more aggressive withdrawal of accommodation.  This is especially the case given the Fed's concerns over the size of the balance sheet, uncertainty with regards to the degree of structural changes to the economy, and resulting hesitancy to lower the unemployment threshold.  That said, there will be limits to the degree of hawkishness the Fed would be willing to adopt in the absence of a real change in the inflation outlook.  The challenge for the Fed will be containing the idea of a more hawkish policy stance to a risk to the outlook rather than allowing it to become the baseline scenario.  With the high tide of policy now in the past, and the discussion turning back to when will policymakers do less, expect financial market participants to keep testing and retesting policymaker resolve.