Tim Duy's Fed Watch

Williams Acknowledges Forecast Change

Earlier today I said:

Fourth, the dots undeniably moved forward and steeper, which means individual outlooks on the definitions of "considerable period" or "accommodative" did in fact change in meaningful ways.  I am surprised, however, that this was not anticipated by market participants given the rapid decline in the unemployment rate.  Along any given Fed objective function, one would expect that a more rapid decrease in unemployment would move forward and steepen the interest rate trajectory, even if just by 25 or 50pb.

The Washington Post's Ylan Mui had a sitdown with Federal Reserve President John WIlliams:

Logically, given that the unemployment rate is a little bit lower, that suggests a little bit higher interest rate in 2016. Is that a big shift in the timing of the first rate increase? We’re talking about a relatively small change in terms of the forecast, and I wouldn’t see that as a significant shift.

When I look at the SEP projections for 2015, I just don’t see much of a change in the views on policy -- definitely not the kind of change in views on policy that represents some shift in our policy framework. The fact that unemployment has come down since December a little more than we thought, this is not news. Everybody knows that.

Also, regarding financial stability, I said Friday:

In short, if you believe that the Fed will not use monetary policy to address financial stability concerns, I think you might not be paying attention.  They are already using monetary policy to address those concerns by not taking more aggressive action.  Don't look to what they will do in the future for confirmation; look to what they are not doing right now.

I meant "aggressive action" as policy to speed the pace of the recovery, whereas current policy is geared toward ending asset purchases and paving the way for rate hikes.  Williams on the topic:

I think our policies are doing about as well as we can without creating excessive risks down the road, either for the economy or financial stability. I think there is a little bit of a tradeoff between trying to push this economy now even harder and maybe having some unintended consequences down the road -- not today, not next year, probably not the year after -- and also the potential of making the exit out of our very accommodative policies a little more difficult to navigate.

Also, if you get a chance, read Gavin Davies at the Financial Times:

But in a wider sense there has been an unmistakable shift in the FOMC’s centre of gravity in the past few months. The key to this shift is that the mainstream doves who have dominated policy decisions in the past few years have now essentially stopped arguing against either the tapering of the balance sheet or the start of rate hikes within about a year from now. Only the isolated Narayana Kocherlakota remains in the aggressive dovish corner.

Bottom Line:  Those who expected Federal Reserve Chair Janet Yellen to push for a more dovish policy path continue to be dissapointed.

Post-FOMC Fedspeak

Some thoughts on post-FOMC activity as we head into Monday.

First, I did not cover Federal Reserve Chair Janet Yellen's definition of a "considerable period" as six months in my review of the FOMC statement.  I did not highlight the issue because when I went back to the tape, it looked clear to me that the bulk of the bond market response came at the release of the statement and projections.  To be sure, the equity market stumbled, but here I completely agree with Felix Salmon:

But here’s the thing: the market didn’t freak out....last Thursday, for instance, the yield fell by a good 10bp when John Kerry made noises about imposing sanctions on Russia. And overall, the yield has stayed comfortably in a range between 2.6% and 2.8%.

What’s more, the big FOMC-related move in the 10-year bond yield happened immediately at 2pm, when the statement was released. Yellen’s “gaffe” caused barely a wobble.

So why does everybody think that Yellen blundered? The answer is simple: they were looking at the stock market (which doesn’t matter), rather than the bond market (which does). Stocks fell, briefly; not a lot, and not for long, but enough that people noticed.

It is the bond market response that is important, and that response was pre-Yellen.  It is not entirely clear that the six months timeline was new information.  Or, at least, it wasn't to St. Louis Federal Reserve President James Bullard:

“That wasn’t very different from what we had heard from financial markets, so I think she’s just repeating that at that time period,” Bullard said at a roundtable at the Brookings Institution. Bullard doesn’t vote on policy this year.

Second, the more important issue appears to be the interest rate projections, the now infamous dot chart.  In her press conference, Yellen attempted to deny the projections contained much useful information in her testimony:

But more generally, I think that one should not look to the dot‐ plot, so to speak, as the primary way in which the committee wants to or is speaking about policies to the public at large. The FOMC statement is the device that the committee as a policy‐making group uses to express its – its opinions. And we have expressed a number of opinions about the likely path of rates.

Dallas Federal Reserve President Richard Fisher went further.  Via Bloomberg:

Fisher suggested investors were placing too much emphasis on the change in forecasts, which the Fed illustrates as dots plotted on a chart.

There is a “fixation if not a fetish on the dots,” he said at the London School of Economics. The change in forecasts by Fed officials came before this week’s meeting, he said.

“Somehow, this was read as a massive shift,” Fisher said. “These are our best guesses.”

The Fed wants markets to focus on the distance between the bulk of the dots and participants view of normal.  Back to Yellen:

Looking further out, let's say if you look at toward the end of 2016, when most participants are projecting that the employment situation, that the unemployment rate will be close to their notions of mandate‐consistent or longer‐run normal levels. What you see ‐‐ I think if you look, this time if you gaze at the picture from December or September, which is the first year that we showed those dot‐plots for the end of 2016, is the massive points that are notably below what the participants believed is the normal longer‐run level for nominal short‐term rates. And the committee today for the first time endorsed that as a committee view.

That said, it is clear the dots moved:

So I think that's significant. I think that's what we should be paying attention to. And I would simply warn you that these dots ‐‐ these dots are going to move up and down over time, a little bit this way or that. The dots moved down a little bit in December relative to September. And they moved up ever so slightly. I really don't think it's appropriate to read very much into it.

What should we take away from all of this?  Well, first of all, I think it is absolutely ludicrous that the Fed is trying to claim the dots have no value.  Seriously, can they work any harder to raise the act of bungling their communications strategy to an art form?  If the dots have no value, then why force feed this information to market participants in the first place?

Second, yes, the dots do not represent the FOMC consensus.  The statement represents the consensus.  But the consensus is vague about what defines a "considerable period" or "accommodative" policy.  Each individual participant has their own definition of these terms, and the dots thus provide value by quantifying the vagueness of the consensus.  That is the real problem here - as a group, the Fed wants qualitative discretionary  policy, and the dots provide quantifiable guidance.  If they want qualitative discretionary policy, they need to pull all the numbers from their communications.

Third, Yellen needs to accept responsibility for mangling communications.  She has been pushing her optimal control story for a long, long time.  In the process, she has convinced market participants on the importance of the forward projections of economic variables.  Yet now forward projections are meaningless?

Fourth, the dots undeniably moved forward and steeper, which means individual outlooks on the definitions of "considerable period" or "accommodative" did in fact change in meaningful ways.  I am surprised, however, that this was not anticipated by market participants given the rapid decline in the unemployment rate.  Along any given given Fed objective function, one would expect that a more rapid decrease in unemployment would move forward and steepen the interest rate trajectory, even if just by 25 or 50pb.

Why, why, why should Federal Reserve participants be permitted to change their outlooks but the Fed believes financial market participants are not allowed to follow suit?

Perhaps it is that while - and I believe this - the Fed's reaction function did not change, I suspect there is a very good chance that market participants expected it to change in a more dovish direction.  This follows directly again from Yellen's optimal control story.  How many analysts were expecting a September lift-off on the basis of her charts?  How many expected Yellen push for a more dovish reaction function?  I think you need to throw any analysis that explicitly allowed for above target inflation out the window - and that includes the optimal control framework.  

In my opinion, some financial market participants are resisting abandoning their dovish interpretation of Fed policy.  For instance, Jan Hatzius of Goldman Sachs continues to hold to its 2016 rate hike call.  Via the Wall Street Journal:

“Rate hikes are far off,” wrote Jan Hatzius, Goldman’s chief Fed watcher, in a note to clients late Thursday. “Our central forecast for the first hike remains early 2016, although the risks now tilt in the direction of a slightly earlier move.”

Recall, however, Goldman's view from November:

According to an analysis from Jan Hatzius, chief economist at Goldman Sachs, the two Fed papers actually would imply an earlier reduction of QE than planned—perhaps as soon as December—while the zero-bound interest rates could remain in place until 2017 and kept below normal into "the early 2020s."

Why?  Because of extensions of the optimal control framework.

"The studies suggest that some of the most senior Fed staffers see strong arguments for a significantly greater amount of monetary stimulus than implied by either a Taylor rule or the current 6.5 percent/2.5 percent threshold guidance," Hatzius wrote. "Given the structure of the Federal Reserve Board, we believe it is likely that the most senior officials—in particular, Ben Bernanke and (Chair-elect) Janet Yellen—agree with the basic thrust of the analysis."

And more from Hatzius from Bill McBride at Calculated Risk:

It is hard to overstate the importance of two new Fed staff studies that will be presented at the IMF's annual research conference on November 7-8. The lead author for the first study is William English, who is the director of the Monetary Affairs division and the Secretary and Economist of the FOMC. The lead author for the second study is David Wilcox, who is the director of the Research and Statistics division and the Economist of the FOMC. The fact that the two most senior Board staffers in the areas of monetary policy analysis and domestic macroeconomics have simultaneously published detailed research papers on central issues of the economic and monetary policy outlook is highly unusual and noteworthy in its own right. But the content and implications of these papers are even more striking.

...[O]ur initial assessment is that they considerably increase the probability that the FOMC will reduce its 6.5% unemployment threshold for the first hike in the federal funds rate, either coincident with the first tapering of its QE program or before.
...
[O]ur central case is now that the FOMC will reduce the threshold from 6.5% to 6% at the March 2014 FOMC meeting, alongside the first tapering of QE; however, a move as early as the December 2013 meeting is possible, and if so, this might also increase the probability of an earlier tapering of QE.

In comparison to these expectations, the Fed is downright hawkish despite no change to their reaction function.  The point is that, in my opinion, reality is starting to set in and financial market participants are walking back on their caricaturization of Yellen and the most dovish of all doves.  

Bottom Line:  The Fed is pushing back on the dots because they don't want quantitative guidance, and they forgot they were giving it.  Expectations that Yellen will push for a more dovish reaction function are being disappointed.  Note that the interest rates forecasts are just that - forecasts.  They will evolve in one direction or the other in response to incoming data.  But incoming data on unemployment undeniably pushes in the direction of an earlier liftoff and, subsequently, a steeper trajectory for rates.  If they want to lean against those expectations, the Fed does need to change its reaction function, but to a more dovish one.  That, I think, is not the direction of policy at this point.

Kocherlakota's Dissent

Minneapolis Federal Reserve President Narayana Kocherlakota defended his dissent at the March FOMC meeting.  I thought it was quite remarkable.  The reason of the dissent itself is not particularly unexpected:

I dissented from the new guidance for two reasons. The first reason is that the new guidance weakens the credibility of the Committee’s commitment to target 2 percent inflation. The second reason is that the new guidance fosters policy uncertainty and thereby suppresses economic activity.

I have already discussed the implications of dropping the Evans rule in regards to inflation.  It implies an intention to approach the inflation target from below as well as a lack of tolerance for above target inflation.  As far as the second point, Kocherlakota is arguing that the lack of quantitative guideposts increases uncertainty about the path of policy and that uncertainty tends to make economic agents risk adverse.  Market participants, for example, might rationally believe they should react to that risk by moving up their expectations of the first rate hike, which by itself induces somewhat less accommodative policy.

More interesting, in my opinion, was Kocherlakota's alternative language.  Consider for a moment the Evans rule as it was in January:

The Committee also reaffirmed its expectation that the current exceptionally low target range for the federal funds rate of 0 to 1/4 percent will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.

Now consider Kocherlakota's version of the Evans rule:

For example, the Committee could have adopted language of the following form: “the Committee anticipates keeping the fed funds rate in its current range at least until the unemployment rate has fallen below 5.5 percent, as long as the one-to-two-year-ahead outlook for PCE inflation remains below 2 1/4 percent, longer-term inflation expectations remain well-anchored, and possible risks to financial stability remain well-contained.”

 Kocherlakota has to come up with something he can sell to the rest of the FOMC.  It says something about the rest of the FOMC that the most he thinks he can sell is a meager 25bp bump above the Federal Reserve inflation target.  It says even more if that's the most he could sell to himself.  If the most dovish member of the FOMC can tolerate no more than a 25bp upside miss on inflation, what does it say about the other FOMC members?  Regardless of whether this is Kocherlakota's max or the best he thinks he can get, it tells you that 2% is really a ceiling, not a target.  Now, generously, it maybe that the FOMC believes that they cannot exceed 2% politically given the amount of extraordinary stimulus already in place.  But that still leaves 2% as a ceiling.

Moreover, look at the addition of the "possible risks to financial stability remain well-contained" language.  It is no longer just about the length of accomodative policy, but about the first rate hike itself.  It suggests that a rate hike to snuff out financial stability is clearly on the table.  Moreover, if Kocherlakota thinks the only way he can sell his new version of the Evans rule is address financial stability, it means that such concerns are already an impediment to even more supportive monetary policy.  This is something I noted yesterday with respect to Yellen's comments about the tapering debate last spring.

In short, if you believe that the Fed will not use monetary policy to address financial stability concerns, I think you might not be paying attention.  They are already using monetary policy to address those concerns by not taking more aggressive action.  Don't look to what they will do in the future for confirmation; look to what they are not doing right now.

Bottom Line:  Kocherlakota's dissent paints the rest of the FOMC as surprisingly hawkish.

Unintentionally Hawkish

The outcome of the FOMC meeting was pretty much as I anticipated.  Asset purchases were cut by $10 billion.  The Evans rule was dumped.  And forward guidance was enhanced to emphasize that rates would be low for a long, long time.  All seems pretty much in-line with the general consensus.  

Yet financial market participants took a hawkish view of the news.  Bonds were trounced - the 5 year Treasury yield lept almost 15bp.  Market participants clearly saw something they didn't like.  This despite what was a reasonably dovish inaugural press conference by Federal Reserve Chair Janet Yellen.  Indeed, she strongly emphasized the new forward guidance language:

When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.

This makes clear that low rates may persist after the unemployment rate hovers closer to 5.5%.  In other words, in the absence of clearly higher inflation or a reasonable forecast of higher inflation, the Fed is in no rush to push rates to a more normalish 4%.  

Low rates, however, are not the same as near zero interest rates.  And the interest rate forecasts seems to imply tighter policy in 2015 and 2016 than implied by the December projections.  But during the press conference, Yellen denied the little dots contained any meaningful forecast information.  Again, she pointed to the statement as the relevant guidance.  And the statement clearly says to expect a period of low interest rates and takes no firm position on the exact timing of the first rate hike.  Sounds pretty dovish.

Moreover, it is not clear that the patterns of the dots represent a meaningful change in policy even if taken at face value.  Consider the dots in the context of this line from the statement:

The change in the Committee's guidance does not indicate any change in the Committee's policy intentions as set forth in its recent statements.

The dots always made clear that rates would remain low even as unemployment fell.  Arguably, the Fed did nothing more in the statement than turn unofficial policy into official policy.  And the slight move forward in the rate forecast was completely reasonable given the optimistic forecast of the unemployment rate.  Assuming the Fed is following some Taylor-type rule, a lower unemployment rate would be sufficient to nudge forward the timing of the first rate hike.  That seems perfectly consistent with the Fed's reaction function as detailed in recent statements.

All in all, it seems relatively easy to make a case that this was a dovish policy decision and a dovish press conference.  Others will make the case, and offer more details, I expect, about things such as Yellen's emphasize on a wide array of labor market indicators as evidence of slack.  What about a hawkish version?

If I am making a hawkish interpretation, it starts with the end of the Evans rule.  Everyone seems focused on the unemployment part of the Evans rule, while my attention is on the inflation part.  The Evans rule allowed for the Fed to reach their inflation target from above.  It provided wiggle room on the target as long as unemployment was above 6.5%.  With the end of the Evans rule, the Fed sends a signal that they no longer find it acceptable to reach the target from above.  They intend to reach it from below.  2% is officially once again a ceiling.  Indeed this is pretty much made explicit in the statement:

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 for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.

Low rates are only guaranteed if inflation remains below 2%.  Above 2%, you had better expect a fast and furious reaction.  Moreover, Minneapolis Federal Reserve President Narayana Kocherlakota's dissent makes clear the topic on the table is a below-target approach for inflation:

Voting against the action was Narayana Kocherlakota, who supported the sixth paragraph, but believed the fifth paragraph weakens the credibility of the Committee's commitment to return inflation to the 2 percent target from below and fosters policy uncertainty that hinders economic activity.

Responding to a question about the dissent, Yellen did emphasize that she did not want to undershoot inflation, but she made no mention of a willingness to overshoot inflation.  Ceiling.

Moreover, the new-found 2% ceiling puts a cloud over the importance of Yellen's optimal control theory.  The whole point of that exercise was that the cost of allowing inflation to rise above 2% was less than the cost of high unemployment.  Seems like this idea is abandoned when you explicitly rule out the ability to reach the target from above.

The whole tenor of the policy discussion has a hawkish tone as well.  As the Washington Post's Ylan Mui notes, the policy focus has shifted entirely to the timing of the first rate hike:

The nation’s central bank said Wednesday it will look at a broad swath of indicators – including job market data, inflation expectations and financial developments – as it determines when to raise rates for the first time since the recession hit. The deliberately vague wording is a retreat from the Fed’s concrete promise to leave rates untouched. Though they disagree on when to act – targets range from this year to 2016 – the statement signals the moment has finally come within striking distance.  

There is no longer any reasonable expectation that the Fed has any interest in accelerating the pace of the recovery to more quickly alleviate poor labor market conditions. Barring a sharp change in economic conditions, the Fed is headed in only one direction. 

Finally - and I don't think that many caught this - toward the end of the press conference, Yellen explicitly states that the higher term-premiums triggered by the tapering discussion hurt economic activity by slowing the housing recovery.  But then she credited the move with reducing financial instabilities.  In other words, she willingly traded growth for financial stability.  Something to think about as equities plow higher.

Bottom Line:  If you focus on the "low rates for a long time" language, you walk away with dovish interpretation.  If you focus on the implications of the end of the Evans rule on the Fed's inflation target, I think you can walk away with a hawkish interpretation.  Moreover, if you believe that 2% is now a ceiling, you probably should think the risk of inflation triggering a Fed response is higher than under the Evans rule, and adjust your forecast accordingly.

 

That Train Left the Station

I was re-reading some of the recent overshooting debate and it occurred to me that it is comical that we are even having this discussion.  The Fed is not going to deliberately overshoot inflation, period.  That train left the station long ago. So long ago that you can't even here the rumble on the tracks.

The train left the station on January 25, 2012, with this statement by the Federal Reserve:

The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate.

On that day, the Federal Reserve locked in the definition of price stability.  They locked it in specifically to prevent even the appearance they might deliberately overshoot as a result of extraordinary monetary policy.  They locked it in as a commitment device to tie the hands of future policymakers as they would need to justify changing the definition of price stability, presumably a very high bar for any central banker to cross.

On that day, the Federal Reserve took higher inflation expectations off the table.  They pulled it from the toolkit.  They made clear there is one and only one inflation target for all time.  The only tolerable deviations from that target are essentially forecast errors.  That's it.

Moreover, I would argue that their behavior has been entirely consistent with maintaining that expectation.  Inflation expectations - as measured by TIPS - have been more volatile than prior to the recession, but have cylced around pre-recession levels, or, arguably, a little below:

There is no reason to believe that the Fed has acted to try to sustain inflation expectations beyond those in place prior to the recession.  Perhaps thay came close in late-2012, as measured by the five year, five year forward breakevens:

But that was soon met by official pushback.  Via Bloomberg:

“Distant inflation expectations from the TIPS market seem to suggest that investors do not completely trust the Fed to deliver on its 2 percent inflation target,” Bullard said today in a speech in Memphis, Tennessee, referring to Treasury Inflation-Protected Securities...

...The five-year, five-year forward break-even rate, which projects the pace of price increases starting in 2017, rose to 2.88 percent on Sept. 14, the day after the FOMC announced a third round of quantitative easing. That was up half a percentage point from July 26. It dropped to 2.77 percent on Oct. 2.

Soon thereafter began the tapering chatter that ultimately culminated in then-Chairman Ben Bernanke's press conference in which he introduced the 7% trigger for asset purchases.  The result was a sharp snap-back in real yields:

If the Fed has already proved they can't stomach inflation expectations hovering just below 3% (remember that this is on a CPI basis by which TIPS are calculated, not on a PCE basis that is the Fed's target) for even a few months, they really can't wrap their minds around inflation actually reaching 3% as suggested by Karl Smith:

The Evans Rule was nice, but addressing the overshoot directly would be better. For example, a statement like: “In the committee’s view the appropriate path for the federal funds rate would, in the medium term, allow inflation to rise above 2 per cent, but not above 3 per cent, for a period no less than three months but no greater than one year. Within those parameters the committee will continue to adjust the target for the federal funds rate so as to achieve maximum employment and keep long term inflation expectation well anchored.”

And note that I am being generous by trusting that the Fed's inflation target is actually 2%.  David Beckworth suggests it is actually the range of 1% to 2%.  

Ultimately, I think Robin Harding correctly identifies the mood at the Fed:

Even Janet Yellen, in her “optimal control” speeches in 2011 and 2012, never argued that the Fed should promise extra inflation in the future. There has never been much support for it on the FOMC and the Fed’s statement of long-run goals would have to be modified to allow for it. At this stage in the game, when the Fed is slowing down its stimulus via asset purchases, it makes little sense to add more stimulus in another way.

What remains the case is that Fed doves think there is slack in the labour market and are willing to risk some above target inflation – while targeting 2 per cent – in order to bring joblessness down more rapidly. I think the centre of the committee under Janet Yellen agrees (and their fairly aggressive forward rate path reflects that). In an ideal world, though, the Fed would gracefully stabilise inflation at 2 per cent with no overshoot or undershoot, creating a soft landing as the economy regains full employment.

The Evans rule was never about higher inflation expectations.  It only clarified the acceptable range of forecast errors around the 2% target for a given unemployment rate.  And note that it is clear that a forecast error in the other direction is also acceptable with below target outcomes in the labor market.  That acceptability is evident in the eagerness to end asset purchases and telegraph the first rate hike.  Does anyone believe that the Fed would find a 2.5% inflation rate acceptable if unemployment is at 6%?  Or would it be cause of worry and hand-wringing among policymakers?  The latter, I think.  Yes, they are willing to risk some above target inflation, but should it actually emerge, they would act quickly to snuff it out.

Bottom Line:  Expect the Fed to manage policy to contain disinflation and deflationary expectations.  But overshooting in the sense of raising inflation expectations to lower the real interest rate further?  It very much seems like they made clear long ago that wasn't an option.  

FOMC Meeting Begins

The FOMC meeting begins today and ends tomorrow, followed by the traditional statement and Chair Janet Yellen's first press conference.  The Fed will also update its forecasts - important because ultimately the forecast drives the policy decisions.  I don't anticipate large changes to the growth or inflation forecasts.  We should see modest downward revisions to the unemployment rate forecast.  What will be more interesting is the impact those changes will have on the interest rate forecast.  The bulk of the FOMC expects the first rate hike will be in the range of mid- to late-2015, with a handful earlier or later.  A lower unemployment rate forecast may prompt some to move up their forecast.  That said, I do not expect large changes in either direction.

As far as policy itself is concerned, it is widely anticipated that the Fed will continue to taper asset purchases and slice another $10 billion from the monthly total.  There is no reason to think that the economy has shifted dramatically in either direction to alter the Fed's current strategy for ending asset purchases.  We know also that forward guidance will be on the table.  Sometime soon - and I think the odds are better than even that "soon" is tomorrow - the Fed will need to address the Evans rule.  My expectation is that they ditch numerical guidance for qualitative, discretionary guidance.   The new guidance, however, should make it clear that rates will remain low for a long time.

Regarding low rates, I think it is worth reiterating a theme that the Wall Street Journal's Jon Hilsenrath has been pushing this week:  At this point, the Federal Reserve expects a long period of low interest rates even after they initiate the first hike.  From Monday's Grand Central Station:

...The central banks are projecting an economy that looks on its face like it is returning to normal in the next couple of years...Yet most Fed officials are projecting the target for short-term interest rates will be below 2%, much less than the 4% level that officials think is appropriate in normal times.

How can the Fed expect to maintain short-term rates so far below normal when its main metrics of economic vitality look like they’re back to normal?...

The economy is not getting back to normal, officials like Mr. Dudley are essentially arguing. It’s just getting to something a little less vulnerable. Watch out for the persistent headwinds argument in the Fed’s policy statement Wednesday or in Fed Chairwoman Janet Yellen’s press conference. It is the linchpin to the Fed’s assurance that rates won’t rise much in the next couple of years, even after they start inching up from zero. It is also one of the next battlegrounds in the Fed’s policy debates.

I am not entirely sure I like this characterization.   The economy could have shifted into a new normal, and that new normal is characterize by a different constellation of prices, exchanges rates, and interest rates than the old normal.  The new normal for interest rates may simply be lower than the old normal.  Remember that we are still in the midst of a long-term secular decline in the level of interest rates:

Peak cycle interest rates - both short and long rates - have been on a steady decline since the 1980's.  And notice that the well-telegraphed Fed tightening in the last cycle had very little impact on long-rates.  This raises the possibility that the big move in long-rates (after the tapering talk began) is already behind us.  Thus, long-rate might not rise much if at all even as the Fed raise short rates.  We will know the answer to that if buyers keep coming out of the woodwork whenever rates approach 3%.  

This also implies that although the Fed may think they are running a looser policy than normal because short-rates are historically low, the reality is that the policy is equally tight in relative terms.  Thus even though they will argue that rates are low even after they begin raising rates, they will still be reinforcing the continuation of the new normal.

Bottom Line:  The Fed will continue with tapering by cutting another $10 billion from asset purchases.  They will most likely alter the guidance but continue to signal an extended period of low interest rates.  Low rates might simply be part of the "new normal" the economy is settling into, a new normal that the Fed may be unintentionally reinforcing.  

On That Hawkish Wage Talk

The issue of the degree of labor market slack in the US economy is now a hot topic.  Joe Weisenthal and Matthew Bosler at Business insider have been pushing the debate forward, see here and here, for example.  This is an important concern for monetary policy as the general consensus on the Fed is sufficient slack will continue to justify an extended period of low interest rates.  Hence, rate hikes can be delayed until mid- to late-2015, or even 2016 as suggested by Chicago Federal Reserve President Charles Evans.  There exists, however, considerable uncertainty about the amount of slack in labor markets.  My feeling is that path of rates currently expected by policymakers assumes a great deal of slack.  As a consequence, indications that slack is less than expected will tend to move forward the timing of the first rate hike and, perhaps the pace of subsequent tightening.  Wage pressures are likely to be an early indicator that slack is diminishing.

I see two flavors of uncertainty regarding the amount of excessive slack.  First is the question about the value of the unemployment rate as a signal of tightness.  The decline in the labor force participation rate has clearly placed additional downward pressure on the unemployment, leading to speculation that the unemployment rate is signaling a tighter labor market than exists in reality.  Under this scenario, an improving economy will trigger a flood of entrants into the labor force to provide additional slack.  Thus, the unemployment rate is underestimating the degree of slack.

This argument, however, is becoming less persuasive by the day.  Evidence seems to be mounting (see here and here) that retirement and illness/disability are a dominant reason for labor force exits since the recession began.  Consequently, the decline in the labor force participation will be a persistent phenomenon.  The Fed, I think, has largely moved in this direction.

The next issue is the degree of underemployment with the labor market.  The dovish view is that the underemployed and long-term unemployed represent considerable slack:

The hawkish view is that this is not a cyclical problem but a structural one.  The long-term unemployed, by this theory, simply lack the currently needed skills.  This is countered by indications of discrimination against the long-term unemployed.  Such discrimination effectively means that you need to have a job to get a job.  The ability of firms to engage in such discrimination could be viewed as a cyclical problem.  Firms could not be so choosy in a stronger labor market.

Regarding underemployment, I see evidence of the structural explanation in a comparison in the reasons for part time employment:

Those employed part time for clearly cyclical reasons are falling.  Those employed part time because they could not find full time work is holding steady.  It may be that the skill set of those workers is not consistent with the current types of full time jobs.

Doves will point to the lackluster data of the Jobs Openings and Labor Turnover (JOLTS) report to support the claim of weak labor markets with plenty of slack.  The numbers are certainly not impressive: 

That said, the counterpoint is the number of unemployed to job openings:

 

My view is that wage growth will ultimately settle the debate.  Wage acceleration tends to occur as unemployment approaches 6%.  If that wage acceleration does not occur, then the degree of labor market slack remains is high.  The much longer and established data on hourly wages for production and nonsupervisory workers, however, appears to indicate some bubbling wage pressures:

My belief is that if this is happening for lower paid workers, it is only a matter of time before it happens for higher paid workers as well.  That said, I am open to the possibility that the limited improvement we are seeing may not persist.  It is, however, an issue that I think is of critical importance.

How will - versus how should - indications of tighter labor markets influence Fed policy?  As I have said in the past, the Fed typically tightens policy ahead of inflationary pressures.  In practice, that has meant hiking rates around the time wage growth bottoms out:

 

Is this time any different?  Well, let's replace "tightens" policy above with "reduces accommodation" since the Fed would not claim that a 25bp increase in rates from 1% was tightening.  They would describe it reducing the amount of financial accommodation to make policy less expansionary.  This, arguably, describes what happened when the Fed began the tapering discussion. Inflation expectations fell:

 
And real interest rates rose:

 

Higher real interest rates and lower inflation expectations looks like a less accommodative/expansionary policy.  The Fed began make policy less accommodative in the context of below target inflation and above target unemployment, but unemployment had fallen far enough that they felt it necessary to alter the level of accommodation to prevent incipient inflation pressures.  And soon after it became evident that wage growth had bottomed.  Coincidence?  Probably not.  In other words, so far the Federal Reserve is behaving just as they would in any other tightening cycle, with the only difference being that the first step is ending asset purchases rather than raising interest rates.

Moreover, it seems to be clear that the Evans rule was a diversionary tactic.  The Fed never foresaw an instance where they would raise rates above as long as unemployment was above 6.5%.  Moreover, as is clear from the tapering process, the inflation forecasts, and the interest rate forecast, there was never an intention to target inflation greater than 2.5%.  The extra 0.5% was only an allowance for forecast error under the assumption that expected inflation would remain at 2%. They always expected inflation would hit its target from below, and never intended to risk overshooting on inflation. 

Simply put, the Fed began unwinding policy pretty much exactly where you would expect given the behavior of unemployment and wage growth.  So it is reasonable to believe that if they continue unwinding policy in a historically consistent manner, then there will not be a substantial pause between the end of asset purchases and the beginning of rate hikes.  The date of the first rate hike will need to be moved forward by this theory.

They are more likely to move that date forward if they see less slack in labor markets than they currently believe.  Furthermore, accelerating wage growth is likely to be the first conclusive evidence of that outcome.  Hence my focus on wage growth.  I suspect they will argue that if they don't move forward the date, they will be at risk of having to do more later.

Is the Fed pursuing the right policy?  Should they allow wage to rise further before reducing financial accommodation?  Well, I would say it is already too late for that.  But could they delay rate hikes?  I would like to see them do so because absent running the labor market at a red hot pace, I don't see obvious way to shift the balance of power to labor and reverse this trend:

That said, I would also add that the last two cycles leave me wary about the potential financial stability issues from such a policy.   In the absence of a greater fiscal roll, however, we are left with leaning on monetary policy and risking the financial fallout.  

Bottom Line:  The Federal Reserve's policy path is dependent on a particular view of a labor market suffering from excessive slack that will continue to be a problem long into the future.  It is reasonable to expect that evidence that slack is dissapating more quickly than expected will trigger a fresh assessment among policy makers regarding the appropriate policy path.  Next week is probably too soon; later meetings are more likely.  Given that wages already appear to be on the rise - a key sign of tightening labor markets - that change could happen quickly.  This is not a call for higher rates; it is a warning that higher rates might be coming.  This is especially the case if the Fed wants to avoid overshooting.  I would argue that their actions to date - the signaling of a shift in policy when still missing on both parts of the dual mandate - suggest an intention to avoid overshooting similar to that of previous cycles.

 

Upward Grind in Labor Markets Continues

The employment report for February modestly beat expectations with a nonfarm payroll gain of 175k, leaving the recent trends pretty much intact:

Did the labor market shake off the impact of a cold and snowy winter?  No.  Aggregate hours worked turned over during the winter, sending the year-over-year gains southward as well:

Looks like the weather was less about hiring, and more about people not being able to get to their jobs.  

The unemployment rate edged up:

I suspect we are seeing something like we saw in late 2011 when the unemployment rate fell sharply and then moved sideways for a few months.  If there is less excess slack in the labor market than Fed doves believe we should soon be seeing greater upward pressures on wages.  Hints of this emerge in the acceleration of wage gains for production and nonsupervisory workers:

Note that this comes even as the number of long-term unemployed rose.  I think there is a very real possibility - as was suspected long ago would happen - that persistently high cyclical unemployment we saw during the recession and its aftermath has evolved into structural unemployment.  Former Federal Reserve Chair Ben Bernanke in 2012:

I also discussed long-term unemployment today, arguing that cyclical rather than structural factors are likely the primary source of its substantial increase during the recession.  If this assessment is correct, then accommodative policies to support the economic recovery will help address this problem as well.  We must watch long-term unemployment especially carefully, however.  Even if the primary cause of high long-term unemployment is insufficient aggregate demand, if progress in reducing unemployment is too slow, the long-term unemployed will see their skills and labor force attachment atrophy further, possibly converting a cyclical problem into a structural one.

More structural unemployment combined with evidence that the fall in labor force participation is increasingly attributable to retirement suggests less labor market slack.  Fed officials will be watching this issue very closely.  It is the most likely reason we would expect to see the expected date of the first rate hike moved forward in 2015.  (For more on the structural/cyclical issue, I recommend Cardiff Garcia here).

We will see commentators ignore the production and nonsupervisory series in favor of the all employees series.  The latter has yet to turn upward as aggressively as the former.  The all employees series, however, has a much shorter history.  Federal Reserve policymakers will be more comfortable with the longer and familiar production and nonsupervisory workers series.  Moreover, I doubt they believe we should expect meaningful and persistent deviations between the two series over time.  After all, if the wages of your lowest paid employees are rising, it is reasonable to believe that it is only a matter of time before that same trend hits your better paid employees.  

Bottom Line:  The employment report indicates ongoing slow and steady improvement in the economy sufficient to generate consistent job growth and drive the unemployment rate lower.  The report has no implications for tapering because tapering is on a preset course (New York Fed President William Dudley confirmed what was long suspected yesterday).  This one report by itself also says little about the first rate increase - still mid to late 2015.  But watch the wage growth numbers and listen to the reaction of Fed officials.  In my opinion, this is a key factor in the timing of rate policy.  Traditionally, the start tightening prior or near to an acceleration in wages.  The longer they stay still as unemployment falls and wage growth rises, the more nervous they will become that they are falling behind the curve.  And they especially don't want to fall behind the curve given the size of their balance sheet.  They talk a  good game, but I think they are more worried about unwinding that balance sheet then they claim in public.

Unemployment, Wages, Inflation, and Fed Policy

I apologize if that was a misleading title.  This post is not a grand, unifying theory of macroeconomics.  It is instead a quick take on two posts floating around today.  The first is Paul Krugman's admonishment to the Federal Reserve against raising interest rates before wages rise:

So far, no clear sign that wage growth is accelerating. Even more important, however, wages are growing much more slowly now than they were before the crisis. There is no argument I can think of for not wanting wage growth to get at least back to pre-crisis levels before tightening. In fact, given that we’ve now seen just how dangerous the “lowflation” trap is, we should be aiming for a significantly higher underlying rate of growth in wages and prices than we previously thought appropriate.

I don't think that you should be surprised if the Federal Reserve starts raising rates well before wage growth returns to pre-crisis rates.  I think you should be very surprised if the Fed were to do as Krugman suggests.  Historically, the Fed tightens before wages growth accelerates much beyond 2%:

As I have noted earlier, wage growth tends to accelerate as unemployment approaches 6 percent, and so if you wanted to be ahead of inflation, they would be thinking about the first rate hike in the 6.0-6.5% range.  That 6.5% threshold was not pulled out of thin air.  

The second point is that the tightening cycle is usually topping out when wage growth is in the 4.0-4.5% range.  One interpretation is that the Fed continues to tighten policy to prevent workers from gaining too much of an upper-hand, thereby contributing to growing wage inequality.  Of course, I doubt they see it that way.  They see it as tightening monetary conditions to hold inflation in check.  Either way, the end is the same.  It would represent a very significant departure from past policy if the Fed waited until wage growth was at pre-recession rates before they tightened policy or if they allow conditions to remains sufficiently loose for wage growth to eventually rise above pre-recession rates.

If you want the Fed to make such a departure, start laying the groundwork soon.  The best I can offer is my expectation that Fed Chair Janet Yellen is more inclined than the average policymaker to wait until wages actually rise before acting.  I have trouble believing that even she would wait until wage growth accelerates to pre-recession trends.

Second, the Washington Post's Ylan Mui has this:

But a funny thing happens once unemployment hits 6.5 percent: The behavior of inflation starts to become random, as illustrated in this chart by HSBC chief U.S. economist Kevin Logan.

 

The black line represents the average annual unemployment rate for the past 30 years. You can see that in all but two cases (both of which were temporary shocks), inflation declined when the jobless rate was above 6.5 percent. But when unemployment rate fell below that point, inflation was almost as likely to increase as it was to decrease. In other words, what happens to inflation below the Fed’s threshold is anybody’s guess.

I would take issue with the idea that inflation behavior becomes "random" at unemployment rates below 6.5%.  You need to consider this kind of chart in the context of expected inflation and expected policy.  If inflation expectations are stable, and if the Federal Reserve provides policy to ensure that stability, you would expect random errors around expected inflation.  Couple this with downward nominal wage rigidities, and you should expect the same even under circumstances of high unemployment.  Here is my version of the same chart:

 

The data is monthly.  This y-axis is the change in inflation from a year ago, where inflation is measured as the year-over-year change in core-pce.  Unsurprisingly, since 2000, changes in core-inflation vary around zero.  Stable and low inflation expectations.  During periods of the 1970's and 1980's you see the impact of unstable expectations as the relationship circles all over the place.  But you also see the general pattern of disinflation since the early 1980's with the downward sloping relationship and many inflation observations, even at low unemployment rates, below zero.

Now it is fairly easy to put both of these posts together.  The Fed, wanting to ensure stable inflation expectations, begins raising interest rates well before wage rates begin rising.  This is turn controls the growth of actual inflation so that inflation rates do not rise as unemployment falls further.  The deviations of inflation from expectations are then just noise.  But actual inflation is not "random."  It is the result of specific monetary policy.

Bottom Line:  If the Fed follows historical behavior, they will begin tightening before wages rise and in an environment of low inflation such that inflation remains stable even as unemployment falls.  In other words, in recent history that have not exhibited a tendency to overshoot.  Explicit overshooting would represent a very significant shift in the Fed's modus operandi. 

Tapering is Sooo 2013

New York Federal Reserve President William Dudley had a sit down with the Wall Street Journal in which he provides some key insights into Fed thinking.  First, regarding the tepid pace of data, it's the weather:

Mr. Dudley said that he still expects, "the economy should do better" relative to last year, growing at around 3% this year.

He said, however, it appears very likely that harsh weather slowed economic growth in the first quarter to under a 2% annual rate.

See also this Wall Street Journal report on weak February retail sales. As expected, the Fed will dismiss soft numbers as an artifact of the cold.  (although I think the acceleration at the end of 2013 was less than meets the eye to begin with).  That means the pace of tapering is not going to change at the next meeting.  But guess what?  Tapering is not really data dependent in any event.  It is more appropriately described as "outlier dependent":

"If the economy decided it was going to grow at 5% or the economy decided it wasn't going to grow at all, those would be the kind of changes in the outlook that I think would warrant changing the pace of taper," Mr. Dudley said Thursday.

How this is really any different from a fixed time-line is beyond me.  If the range of acceptable outcomes to justify tapering is anywhere between 0 and 5% growth, the FOMC statement can be reduced by simply admitting that asset purchases are on a preset course.  As I have said many times, the Fed wants out of the asset purchase business.  It's all about interest rates now:

Mr. Dudley affirmed that nothing's changed when it comes to the short-term interest rate outlook. He said "we have a long time to go before we have to think about raising short-term interest rates."

Sometime in 2015.  The weaker the data, the deeper into 2015 is the first rate hike, all else equal.

Finally, look for changes in the next FOMC statement to reflect what has been true for some time:

The 6.5% marker "is already a little bit obsolete in the sense we are really close to it," Mr. Dudley said. The level is "not really providing a lot of value in terms of our communications."

The meeting later this month would be a "a reasonable time to revamp (the) statement to take out that 6.5% threshold," he said. The Fed has amended its guidance to say rates could stay near zero well past that point as long as inflation remains in check.

The 6.5% marker is not a "little" obsolete.  It is a "lot" obsolete.  It became obsolete the minute the Fed made clear it was irrelevant as they had no intention of raising rates at that point.  The are not going to replace it with another numerical guide.  It will be replaced with qualitative, and ultimately discretionary, guidance.

Meanwhile, Dallas Federal Reserve President Richard Fisher made clear his view that asset bubbles are brewing left and right:

...there are increasing signs quantitative easing has overstayed its welcome: Market distortions and acting on bad incentives are becoming more pervasive.

Stock market metrics such as price to projected forward earnings, price-to-sales ratios and market capitalization as a percentage of GDP are at eye-popping levels not seen since the dot-com boom of the late 1990s. In the words of James Mackintosh, writer of the Financial Timescolumn “The Short View,” a not insignificant number of stocks in the S&P 500 have valuations “that rely on belief in a financial fairy.” Margin debt is pushing up against all-time records. And, in the bond market, narrow spreads between corporate and Treasury debt reflect lower risk premia on top of already abnormally low nominal yields. We must monitor these indicators very carefully so as to ensure that the ghost of “irrational exuberance” does not haunt us again.

Interestingly, former Federal Reserve Chairman Alan Greenspan writes today that such bubbles are just part of the territory:

 Successful financial policy, in my experience, ironically spawns the emergence of bubbles. There was never anything resembling financial euphoria, or the bubbles it creates, in the old Soviet Union, nor is there in today’s North Korea. At the Federal Reserve during my tenure, we often joked that our greatest fear was that policy might be too successful. Achieving an underlying stable rate of growth and low inflation appears to have been a necessary and sufficient condition for the emergence of a bubble. We would conclude with mock seriousness that optimum monetary policy for bubble prevention was to create destabilizing inflation.

There is much of interest in the Greenspan piece (including his claims that the 1994 tightening was an attempt to derail the bubble of the 1990s) and little time to take it up now.  As if on cue, the Federal Reserve release the latest flow of funds data.  Check out net worth:

 

Approaching the high seen in the last asset price bubble.  Doesn't mean it can't go higher.

Tomorrow is employment report day.  The general expectation is that weather played a starring role in depressing job growth while the ACA had a supporting role.  Consensus is for 150k gain in payrolls with forecasts ranging from 80k to 203k.  My recent track record has been a little (lot) shaky on this number of late, but maybe third time is a charm.  Usual caveats apply about the insanity of forecasting a heavily revised rounding error of the massive monthly churn in the labor market.  I will take the under this month and am looking for a gain of 118k:

More interesting will be the unemployment rate (what is the impact of the end of extended benefits?) and wage growth (are we seeing any yet?).  

Bottom Line:  Barring the outlier outcomes of either recession or explosive growth, tapering is on autopilot.     Rate guidance is now qualitative and actual policy is discretionary. Incoming data is interesting for what it says about the timing of the first rate hike.  So far, though, it is not telling us much given the Fed's belief that weak data is largely weather related.  The degree to which asset bubbles are a concern varies greatly accross Fed officials but the general consensus is that such concerns are of second or third order magnitude compared to missing on both sides of the dual mandate.