Tim Duy's Fed Watch

A Lackluster Start to the Year

Incoming data has tended to disappoint.  While weather impacts are taking part of the blame, I tend to think that part of the blame should fall on overly optimistic interpretations of data patterns at the end of 2013.  In particular, the recently downwardly revised GDP numbers were less than spectacular abstracting away from inventory effects:

Looking at real final sales, I see slow and steady, or even a modest softening, not magic acceleration.  Similarly, aggregate hours worked never signaled a dramatic change in the pace of activity (unless, of course, one suspected productivty was exploding):

 

Slow and steady is also the underlying message of the most recent Beige Book:

Reports from most of the twelve Federal Reserve Districts indicated that economic conditions continued to expand from January to early February. Eight Districts reported improved levels of activity, but in most cases the increases were characterized as modest to moderate. New York and Philadelphia experienced a slight decline in activity, which was mostly attributed to the unusually severe weather experienced in those regions. Growth slowed in Chicago, and Kansas City reported that conditions remained stable during the reporting period. The outlook among most Districts remained optimistic.

Also note that domestic demand will appear disappointing as long as trade is supporting the GDP numbers:

 

The swing in the contributions from net exports means that a smaller increase in domestic demand is necessary to boost overall GDP.  

The latest data disappointments were the weak ADP report suggesting a just 139k private sector NFP gain in March and a similarly weak reading on the service side of the economy from ISM.  Bill McBride notes that the ADP is not exactly a great predictor of the preliminary employment numbers.  Very true.  At the same time, however, they are generally consistent with the underlying trend in labor markets over time.  As such I do not discount them entirely.  In this case, the ADP report may also be confirming the softness seen in the ISM services report, particularly in the employment component:

One important anecdote:

• "The Affordable Care Act is creating significant financial uncertainty to healthcare organizations. With little warning, the negative impact on revenue has been unprecedented." (Health Care & Social Assistance)

See also Matthew Boesler at Business Insider.  I think this was already evident in the pace of health care hiring, which has slowed to a crawl:

There will be two ways to view this story.  In the near-term, it will be a negative given the constant support the sector has provided for employment over time.  In the long-term, this might be an optimistic sign that the focus of the industry is turning aggressively toward achieving productivity gains.  Higher productivity is an important to containing health care costs (it has been estimated that productivity growth was negative between 1990 and 2010), but will depress the demand for labor in the sector.  This process may already be under way.  

Inflation remains below target:

Headline inflation has edged up, but remains well below 2%, and core inflation does not show signs of acceleration:

My baseline expectation for monetary policy is that recent softer data makes little difference in the tapering plans.  The Fed wants out of asset purchases and can always fall back on the "progress toward goals" excuse to pull the plug on the program.  Moreover, as I said earlier this week, I believe Fed officials will become increasingly nervous about the inflation outlook as unemployment approaches 6%.  They want to be done with asset purchases before they have to worry about raising rates.  Weak data, particularly if it passes through to the unemployment rate, will have more of an impact on the timing and pace of interest rate hikes than tapering.  With this in mind, it is not surprising that rates have sagged since the beginning of the year:

Monetary policymakers anticipate the first rate hike will be sometime in 2015.  The exact timing is dependent on the evolution of activity and the fear of overshooting.  At the moment, the Fed's expectation of around 3% growth looks optimistic.  But even the sub-par growth to date has been enough to drive down unemployment.  This opens the door to the possibility that the Fed raises interest rates despite sub-par growth.  This depends, however, in a large part on Federal Reserve Chair Janet Yellen's opinion.  In today's swearing-in ceremony, Yellen said:

I will also continue the work of helping repair the damage done by the financial crisis to the economy. Too many Americans still can't find a job or are forced to work part-time. The goals set by Congress for the Federal Reserve are clear: maximum employment and stable prices. It is equally clear that the economy continues to operate considerably short of these objectives. I promise to do all that I can, working with my fellow policymakers, to achieve the very important goals Congress has assigned to the Federal Reserve.

That sounds like she is not worried about overshooting in the least.  My suspicion is that she will need to see real evidence that labor market slack has evaporated in the form of faster wage growth before she begins to worry of overshooting.  This suggests Yellen's expectation of the first rate hike is deeper in 2015 than some of her colleagues.

Bottom Line:  Data disappointment in part is driven by excessive optimism.  In any event, data are not sufficiently disappointing to derail the Fed's tapering plans.   Unless activity lurches sharply downward, I think the tapering process is pretty much on autopilot.  It is now all about interest rates.

Fed Talk Shifts to Higher Rates

First off, sorry for the limited blogging of recent weeks.  In the weeds at the office and the time to complete my winter to-do list before spring break is growing short.

With the end of asset purchases in sight (and assuming activity does not lurch downward) Fed officials will increasingly turn the discussion toward raising interest rates.  It is not as if the anticipated time line has been any secret.  The Fed's forecasts clearly show an expectation of higher rates in 2015 with the exact timing and pace of that tightening dependent upon each participant's growth and inflation forecast.  Fed officials would want to clearly telegraph such a move well in advance.  Hence they will pivot from talk of sustained low rates to raising rates.  Of course, we would expect hawks to be first in line, as they have been.  For instance, Philadelphia Federal Reserve President said last week (via the Wall Street Journal):

“Most formulations of standard, simple policy rules suggest that the federal funds rate should rise very soon–if not already,” Mr. Plosser told a conference sponsored by the University of Chicago‘s Booth School of Business.

Such warnings from Plosser are not new.  More notable is San Franscisco Federal Reserve President John Williams' interview with Robin Harding at the Financial Times.  Williams is generally seen as a dove, but he was also was one of the first to telegraph the end of asset purchases.  Williams on the forecast:

In his own economic forecast, Mr Williams said, the Fed will raise interest rates in the middle of next year with the unemployment rate at about 6 per cent, inflation at 1.5 per cent and “everything moving in the right direction”.

“At that point if we don’t start to adjust monetary policy there’d be a risk of overshooting,” he said. “You don’t wait until you’re at full employment before you start to raise interest rates from zero.”

There is a lot to think about in those two paragraphs.  First is a forecast of 6% unemployment 15 months or so from now.  Given the rapid drop in the unemployment rate, it is completely believable that we reach 6% before asset purchases are predicted to end later this year.  Given Williams' forecast, this suggests to me that the risk here is a more rapid tapering or earlier rate hike.  The second is the idea of raising rates when inflation is only 1.5%.  This to me suggests that Williams is expecting to reach the 2% target from below, not above.  This seems clear from the next point:  WIlliams wants to take the possibility of overshooting off the table.  

Note that Williams' position differs greatly from that of Chicago Federal Reserve President Charles Evans.  From a speech last week:

 A slow glide toward our goals from large imbalances risks being stymied along the way and is more likely to fail if adverse shocks hit beforehand. The surest and quickest way to get to the objective is to be willing to overshoot in a manageable fashion. With regard to our inflation objective, we need to repeatedly state clearly that our 2 percent objective is not a ceiling for inflation. Our “balanced approach” to reducing imbalances clearly indicates our symmetric attitudes toward our 2 percent inflation objective.

Evans is obviously willing to overshoot, where Williams is not.  Whether the consensus sides with Williams or Evans is critical to the timing of the first rate hike.  If the consensus is set on hitting the inflation target from below, then we have have to consider the Fed's own forecasts as suspect.  They will find themselves moving sooner than they expect.  

I would say, however, it is widely believed, on the basis of her "optimal control" analysis, that Federal Reserve Chair Janet Yellen leans toward Evans.  Any suggestion that Yellen leans toward Williams on the overshooting question would be notable.

Regarding asset purchases, Williams joins the chorus indicating the bar to change is high:

Mr Williams said it would take a “substantial change in the outlook” before he was willing to revisit the Fed’s plan to slow purchases by $10bn at each meeting, and despite some weak data, that has not yet happened. “We haven’t really changed our basic outlook for the economy.”...

...Mr Williams said that as long as average monthly jobs growth stays well above 100,000 then unemployment will continue to come down. “What would worry you is if you don’t have an explanation for why it’s weaker and you get multiple months below that,” he said.

I don't think this should come as a surprise.  The Fed has been looking to get out of the asset purchase business since the beginning of 2013.  The end is now in sight, and only the most disconcerting of data will change that.  They may say they are data dependent (Williams of course adds that he could envision circumstances in which the Fed slow or even reverse tapering), but the reality is they have a bias against asset purchases. 

The desire to exit asset purchases only increases as the unemployment rate falls.  I think that Joe Weisenthal is on the money here when he points out that economists are gravitating toward the idea the the changes in the labor market are largely structural.  In other words, as St. Louis Federal Reserve puts it (via the Wall Street Journal):

“I think that unemployment is really sending the right signal about the labor market” and the decline in the labor force participation rate is largely a demographic issue that will play out over a long time horizon, he said. 

I think that Fed officials have long seen the risk that this might be true, which is one factor that biases them against asset purchases.  Increasing, though, I suspect they do not see is as a risk, but as reality.  Again, the consequence is that rates might be rising sooner than Fed officials currently anticipate.  It is worth repeating this chart:

In the past, wage growth accelerates as unemployment hits 6%.  With unemployment well above 6%, it was difficult to conclusively say much one way or another about the exact amount of slack in the labor market as there was certainly enough slack to keep wage growth in check.  If the unemployment rate is no longer the appropriate indicator of labor market slack, then we should not expect to see upward wage pressure as 6% looms.  If that pressure does emerge, then I think we learn something about the amount of slack.  From the Fed's point of view, if they see wage growth, they will suspect their isn't much.  Wage growth will raise concerns about unit labor costs, which will in turn raise concerns about inflation.

Weisenthal, however, adds:

The view from the left is basically: Even if the labor market is getting tight (which they deny), the Fed should press hard on the gas pedal, so that employers start to employ the long-term unemployed.

And that might be the proper path, and if there's anyone who has the stomach to engage in the strategy, it's probably Janet Yellen.

Once again, this implies that Yellen is willing to risk overshooting.  Her views on overshooting are critical to the evolution of policy at this point.

Bottom Line:  Put aside the possibility of an international crisis-fueled collapse in activity.  The Fed's baseline view is that economic growth continues this year at a pace sufficient to end the asset purchase program.  The Fed will resist changing that plan for any minor stumble in activity.  The pace of job creation itself might not be that critical; it simply needs to be fast enough to lower unemployment to justify continuing the taper.  Moreover, we are reaching a point where the Fed will need to decide to what extent it will risk overshooting.  That was never really a risk of overshooting above 6% unemployment.  Soon it will be an interesting question.  The timing of the first rate hike and the subsequent tightening is dependent upon the consensus on overshooting.  If wage growth starts to accelerate, the Fed's focus will shift from fears of too much to too little slack.  If they are concerned about overshooting, they will need to accelerate the tightening time line.  Where Yellen ultimately falls on the issue is critical.