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.
