Tim Duy's Fed Watch

FOMC Week

The FOMC will wrap up a two-day meeting this Wednesday.  I suspect the subsequent statement will be met with little fanfare. There simply has been little in the way of data to prompt any new policy path.  Steady as she goes.

To be sure, the Fed will be greeted by the Q1 GDP report Wednesday morning, and it is widely expected to be very weak. But incoming data (retail sales, auto sales, industrial production, and employment, for example) suggests that much of this weakness was weather related while the underlying pace of activity, albeit arguably unexciting, remains unchanged. In short, the economy is evolving largely according to the Fed's script, and thus we should expect no major policy change. I anticipate the statement will reflect a greater confidence that the first quarter growth hiccup was a weather effect, that low inflation remains a concern, and a reiteration of the Fed's commitment to a low-rate policy path as long as inflation remains a concern. And another $10 billion cut in asset purchases to push the taper further along.

 The Fed may identify housing as an area of concern. Indeed, the recent softening of that sector appears unrelated to the weather. Instead, a variety of issues are at play - higher housing prices in many areas, tight underwriting conditions, insufficient job growth, low wages relative to home prices, uncertainty about the financial benefits of being a homeowner, tight financing for new home development, and limited lot availability and other supply side issues. See Neil Irwin's excellent review of the issues. You can sum this up quickly by saying the contours of the housing market have changed dramatically in the past decade and we do not know when and if we will see a return to what in the past was considered a normal environment.

Moreover, the Fed can have little impact on these issues, with the exception of one factor not mentioned above - interest rates. The roughly 100bp rise in mortgage rates since the taper talk began likely contributed to the softening of housing markets. There was a lack of countervailing factors at play to offset the tighter policy (see also Jared Bernstein). The Fed, however, is not likely to reverse course. They want out of the asset purchase business, and higher mortgage rates was the price that needed to be paid. For now, the policy impact of housing weakness is to ensure the long-term, low rate story holds (all else equal, of course).

I have characterized the Fed's decision to taper as a desire to normalize policy by shifting attention back to their primary policy instrument of short-term interest rates. They believed at the time that they could change the mix of policies without changing the level of accommodation. The softening of housing activity, however, suggests otherwise. Intentionally or not, the decision to taper resulted in a somewhat more hawkish reaction function than is consistent with the Fed's economic forecast and policymaker rhetoric.  

This leads to a comment recently posed to me:

 I think governors will soon come under a lot of pressure to get off of the zero bound before the next recession hits.  Given the big delay in monetary impulse-response, I fear some overshooting could result.

I frequently hear similar sentiments, but I don't think this is the correct way to phrase the issue.  I think that policymakers want to be able to normalize policy further, but that ultimately the ability to do so depends on the evolution of the economy. In other words, the path of short-term interest rates is an endogenous variable determined within the context of the Fed's current reaction function. Policymakers realize they can't rush to normalize rates because doing so is counterproductive. Premature tightening will only ensure a low rate environment is sustained even longer. And note the Fed is emphasizing the low levels of rates in their forecast, explicitly acknowledging rates will remain below "normal" levels far into the future.  No rush to hike rates.

The tapering adventure and the subsequent impact on mortgage rates and housing has probably driven this point home.  Indeed, it could be argued that the recent flattening of the yield curve is an indication that the Fed already risked the ability to normalize policy by initiating the tapering process and signaling their rate hiking intentions:

 

They probably do not want to push this any further just yet.

That doesn't mean the Fed can't overshoot further on the tighter side, only that I suspect any such overshoot will be the result of a forecast error that prompts excessive tightening, not simply a desire to normalize rates. We aren't there yet. I think we could get there quickly given the Fed's relatively dovish outlook (if firmer data quickly mounted), but not yet.

Bottom Line:  I anticipate a relatively unevently FOMC meeting. The data flow appears sufficiently consistent with the Fed's forecast to hold policy in check.

When Will The Fed Change Its Reaction Function?

The March FOMC minutes were generally interpretted as having a dovish tenor, contrasting with the generally hawkish reception for the statement and ensuing press conference.  Overall, the Fed appears committed to a long period of low interest rates and I continue to think this should be the baseline view.  But actually policy seems to remain hawkish relative to the Fed's rhetoric. By its own admission, the Fed is missing badly on both its mandates. Why then the push to reduce accommodation by ending asset purchases and laying the groundwork for the first rate hike? This leaves me wary the Fed could turn dramatically more hawkish with little provocation from the data.  At the same time, one can imagine the Fed realizes that the current reaction function remains inconsistent its desired goals, and policy consequently shifts in a dovish direction.

Consider the Fed's take on labor markets:

In their discussion of labor market developments, participants noted further improvement, on balance, in labor market conditions. 

Fair enough. But where is the majority of policymakers on the issue of slack?

While there was general agreement that slack remains in the labor market, participants expressed a range of views regarding the amount of slack and how well the unemployment rate performs as a summary indicator of labor market conditions. Several participants pointed to a number of factors--including the low labor force participation rate and the still-high rates of longer-duration unemployment and of workers employed part time for economic reasons--as suggesting that there might be considerably more labor market slack than indicated by the unemployment rate alone.

The opposing view was held by just a "couple" of participants. The "high slack" contingent holds of the upper hand, in my view, given the limited wage pressure to date:

Several participants cited low nominal wage growth as pointing to the existence of continued labor market slack. Participants also noted the debate in the research literature and elsewhere concerning whether long-term unemployment differs materially from short-term unemployment in its implications for wage and price pressures.

It seems fairly clear that the dominant view on the Fed is that labor markets contain more than sufficient slack to contain wage and inflation pressures. And inflation pressures are, by their own admission, nonexistent. But this concern is not as widespread:

Inflation continued to run below the Committee's 2 percent longer-run objective over the intermeeting period. A couple of participants expressed concern that inflation might not return to 2 percent in the next few years and suggested that a protracted period of inflation below 2 percent raised questions about whether the Committee was providing an appropriate degree of monetary accommodation.

Why is the majority not concerned? Because even as they use low wages to justify claims of sufficient slack in the labor market, they use a forecast of higher wages to dismiss the inflation numbers:

 A number of participants noted that a pickup in nominal wage growth would be consistent with labor market conditions moving closer to normal and would support the return of consumer price inflation to the Committee's 2 percent longer-run goal.

But how long will the process take?  A long time:

Most participants expected inflation to return to 2 percent over the next few years, supported by stable inflation expectations and the continued gradual recovery in economic activity.

The Federal Reserve is clearing communicating the willingness to endure a sustained period of suboptimal outcomes on both the employment and price stability metrics. This suggest that actual policy - entirely directed at reducing accommodation - is considerably more hawkish than dictated by data.  It sounds like policy fatigue. The Fed wants out of asset purchases and zero rates and are willing to dismiss the dual mandate to move in this direction. No wonder then that Chicago Federal Reserve President Charles Evans is worried that policymakers will push too hard to normalize rates too early. Via the Wall Street Journal:

“One of the big risks is that we withdraw our accommodative policies prematurely,” Mr. Evans said during a panel discussion at the International Monetary Fund’s spring meetings. “I think it’s just human nature to start thinking we’ve been doing this for a long time.”

The Fed’s benchmark short-term interest rate has been pinned near zero since late 2008, which could prompt some policy-makers to think “that must have been long enough. Maybe it’s time to start the process of renormalizing,” Mr. Evans said. Most Fed officials indicated last month they expect to start raising rates next year.

Consider also the Fed's willingness to continue the taper despite persistent low inflation in the context of this from Federal Reserve Governor Daniel Tarullo:

Last week Chair Yellen explained why substantial slack very likely remains. I would add to her explanation only the observation that, in the face of some uncertainty as to how best to measure slack, we are well advised to proceed pragmatically. We should remain attentive to evidence that labor markets have actually tightened to the point that there is demonstrable inflationary pressure that would place at risk maintenance of the FOMC's stated inflation target (which, of course, we are currently not meeting on the downside). But we should not rush to act preemptively in anticipation of such pressures based on arguments about the potential increase in structural unemployment in recent years.

Arguably, tapering implies that are already acting prematurely.  Combine with this commentary by David Zeros via Business Insider:

"As the market prices in higher short-term yields and lower long-term yields, it is really making a bet that the Fed, by tapering our punchbowl drip, is increasing the risk of deflation," says Zervos.

"And at this stage of the game, with inflation BELOW target and plenty of slack in labor markets, that could very well be a mistake. The most important point here is to recognize that low long-term yields are not a sign of a healthy economy."

Indeed, it is reasonable to believe the Fed will make a mistake in the hawkish direction (or already has) given that policy already seems inconsistent with the dual mandate. In other words, the Fed has a hawkish reaction function.  

Regarding that reaction function, the now infamous dots were also a topic of discussion. Policymakers knew exactly the implications of the dots:

A number of participants noted the overall upward shift since December in participants' projections of the federal funds rate included in the March SEP, with some expressing concern that this component of the SEP could be misconstrued as indicating a move by the Committee to a less accommodative reaction function.

The next line, however, is not particularly helpful:

However, several participants noted that the increase in the median projection overstated the shift in the projections.

This begs the question of "why?" Some dots moved forward. Why does that overstate the shift? That said, some participants noted that the shift should not be cause to worry:

In addition, a number of participants observed that an upward shift was arguably warranted by the improvement in participants' outlooks for the labor market since December and therefore need not be viewed as signifying a less accommodative reaction function.

This was my interpretation - the upward shift of the dots were consistent with a change in the unemployment projections given the Fed's reaction function. But that doesn't quite explain why the reaction function is so tight to begin with. This is I think the best explanation:

In their discussion of recent financial developments, participants saw financial conditions as generally consistent with the Committee's policy intentions. However, several participants mentioned trends that, if continued, could become a concern from the perspective of financial stability. A couple of participants pointed to the decline in credit spreads to relatively low levels by historical standards; one of these participants noted the risk of either a sharp rise in spreads, which could have negative repercussions for aggregate demand, or a continuation of the decline in spreads, which could undermine financial stability over time. One participant voiced concern about high levels of margin debt and of equity market valuations as well as a notable shift into commodity investments. Another participant stressed the growth in consumer credit to less creditworthy households.

I think the Fed's reaction function now includes some financial stability variable, but the Fed is loath to discuss that variable and the related parameters impacting policy. That said, we are fairly confident that the push to end asset purchases and plan the exit from zero rates were a response to bubbling financial stability concerns at the Fed. They simply hid that behind the "progress toward goals" language.

More surprisingly is that not only did they begin the exit from extraordinary stimulus in the face of clearly suboptimal labor outcomes, they did so in the face of clearly suboptimal inflation outcomes. Now, though, they may be realizing the error of their ways. Via Jon Hilsenrath at the Wall Street Journal:

Federal Reserve officials are growing concerned the U.S. inflation rate won't budge from low levels, the latest sign of angst among central bankers about weakness in the global economy.  

So what comes next? To answer that, we again need to divide policy into movements along the reaction function and shifts of the reaction function. We should recognize that the SEP dots will shift in response to the data. If data comes in stronger than anticipated, then the dots will move forward.  If weaker, then backward.  

A more hawkish reaction function - the dots moving up and forward independent of the forecast - would most likely occur due to heightened financial stability concerns. A less likely cause is that inflation expectations suddenly jump.  

What about a more dovish reaction function? I think it was expected that new Federal Reserve Chair Janet Yellen would have already pushed forward a more dovish reaction function given her expressed concerned for the unemployed. So far, she has disappointed such expectations. Factors that could still trigger a downward shift include 1.) a desire to accelerate the pace of improvement in labor markets, 2.) a lessening of financial stability concerns, 3.) a heightened concern about the negative impacts of persistently low inflation.  

The inflation concern is my leading candidate at the moment. Still, I would not want to overestimate the chance of such a shift.  It is easy to see that ongoing improvements in labor markets could be sufficient to contain inflation concerns to low rumblings.

Bottom Line:  Fed policy - dovish those it seems - is maddenly disconnected from their actual forecasts.  What does that mean for future policy?  Given the relatively dovish forecast, I am concerned that the balance of risk lies on the upside, which implies tighter policy along the existing reaction function. But at the same time I remain open to the possibility that even if the economy evolves as expected, the Fed could extend the low interest rate horizon via shifting the reaction function down. That said, I suspect there is a fairly high bar to such a shift.  As unemployment drops further, they will become increasingly concerned about being caught behind the curve given the level of financial accommodation already in place. 

One For the Doves

The March employment report came in pretty much in line with expectations.  Nonfarm payrolls gained by 192k, and January and February were both revised higher.  If you can discern any meaningful change in the underlying pace of economic activity from the nonfarm payrolls numbers, you have sharper eyes than me:

You could almost draw that twelve month trend with a ruler.  The unemployment rate moved sideways:

In the past, sharp declines in the unemployment rate have been followed by periods of relative stability.  I suspect we are currently in one such period.  

The internals of the household report were generally positive.  The labor force rose by 503k, pushing the participation rate up by 0.2 percentage points.  And the labor market appeared to absorb those new participants nicely, with employment rise by 476k while the ranks of unemployed grew by just 27k.  Measures of underemployment remain consistent with recent trends:

 

As might be expected if there remains plenty of slack in labor markets, wage growth remained largely unchanged:

I would say that on average, this report fits nicely with the view outlined by Federal Reserve Chair Janet Yellen earlier this week.  The labor market continues to improve at a moderate pace, a pace that remains insufficient to rapidly alleviate the issues of underemployment and low wage growth.  Indeed, combined with the readings on inflation:

I think the real policy question should be why is the Fed engaged in reducing policy accommodation in the first place?  If Yellen is as concerned about the plight of labor as she purports to be, and if she and her colleagues are as committed to the 2% inflation target as they purport to be, then it seems like there is a strong argument for slowing the pace of the taper and using a rules based approach to taket the risk of earlier-than-anticipated rate hikes off the table.  In short, there seems to be a disconnect between the Fed's rhetoric and the general policy direction.  They seem to have lost interest in speeding the pace of the recovery.

Persistently low inflation, however, may push them into action.  St. Louis Federal Reserve President James Bullard opened up the door to slowing the taper if inflation does not prove to be bottoming.  Via Bloomberg:

“I still think it is important to defend the inflation target from the low side,” Bullard, who doesn’t vote on policy this year, said today in a Bloomberg Radio interview with Kathleen Hays and Vonnie Quinn in St. Louis. “If inflation takes another step down, that will put heavy pressure” on policy makers “to take further action.”

That said, take this in context of a Fed that fundamentally wants out of the asset purchase business.  Moreover, this is not Bullard's baseline forecast.  Via Reuters:

"Mine is in the first quarter of 2015, as far as liftoff for the funds rate," St. Louis Federal Reserve Bank President James Bullard told Reuters Insider television, when asked for his view on when the U.S. central bank should make its first rate hike since 2006.

"You have to keep in mind I tend to be a more optimistic member of the committee," he said. "I have a probably, a somewhat stronger forecast and a view about policy that suggests that maybe we should get up a bit faster than what some of the other members have."

This labor report, however, is not exactly consistent with such a view, but that is also still a year away.  In contrast San Franscisco President John Williams reiterated his view, which is much more consistent with the general consensus.  Via Reuters:

"Given the economic outlook, and given also my view that we need accommodative policy relative to historical norms, we need to have relatively low levels of interest rates for quite some time," San Francisco Federal Reserve Bank President John Williams told Reuters. "My own view is it makes sense to start raising rates in the second half of 2015."

But the pace of rate increases, in Williams' view, should be extremely slow, with rates ending 2016 well below the historical norm of 4 percent, "with the first digit being a '2,'" he said.

 Of course, the second half of 2015 is a fairly big window, and I suspect that any conditions that draw the first rate hike to the front end of that forecast, and certainly to Bullard's forecast, will be followed by a more rapid pace of tightening than currently anticipated.  But that again is a matter for the data to decide.  That and financial stability concerns; such concerns seem to be having a bigger impact on policy than officials like to admit.

Bottom Line: The doves win this round.  One wonders, however, why, if they hold such a strong hand, they have been unable or unwilling to stop the systematic reduction in accommodation that began with the tapering talk of last year?

Employment Report Ahead

Sorry for the light blogging this week - just getting back into the swings of things during the first week of spring term.  But nothing like an employment report to pull me out of hibernation.

It is no secret that the employment report has a significant impact on monetary policy.  And we need to make increasingly deeper dives at the data to discern the implications for policy.  Federal Reserve Chair Janet Yellen made that clear in her speech this week when she outlined a number of indicators - part-time but want full-time, wages,long-term unemployment, and labor force participation - as evidence of slack in the labor market.  Such slack is sufficient, in her view, to justify maintaining accommodative policy for a considerable period (although note that accommodative does not mean zero rates). 

Yellen, I think, outlined the most dovish case possible given the current information set.  This suggests to me that the risk lies in the hawkish direction.  Moreover, I think that Yellen and the remaining doves are losing the internal policy battle, leaving policy with a generally overall hawkish tone.  Gone is the Evans rule and explicit allowance for above target inflation, gone, it seems, is a low bar for slowing the taper, gone is quantitative guidance in favor of qualitative guidance, gone is rules-based policy in favor of ad-hockery.  And now departing Governor Jeremy Stein leaves behind an intellectual legacy that raises the importance of financial stability concerns when setting policy.  Altogether, the stage is set for the Fed to move in a sharply more hawkish direction with just a little push from the data.

That said, that little push from the data is important.  While I believe that the Fed has a hawkish bias, that bias will not be realized in the absence of data that is reasonably stronger than the Fed's forecasts.  Which brings us to the next employment report.  In general, the consensus view that the labor market shook off the winter doldrums with a 206k gain in nonfarm payrolls and 6.6% unemployment rate is probably pretty close to the Fed's expectations.  The forecast range for payrolls, however, is skewed to the upside, with a range from 175k to 275k.  The possibility of upside surprise follows from an expectation of a sharper bounce from earlier weather-related softness.  This was evident in the employment component of the ISM Services report:

 

In addition, weekly initial claims have improved in recent weeks, lending additional credence to expectations for a better-than-expected report:

 

Finally, the ADP number for private employment growth came in at a solid 191k for the month (noting of course, the less than perfect signal ADP provides).  My quick and dirty approach - which admittedly was not particularly effective in recent months - points at a nfp gain of 199k in March, in line with consensus expectations:

 

As always, usual caveats apply.  Guessing the preliminary numbers of a heavily revised data series is by itself something of a questionable game, a game we all play nonetheless.

As I noted earlier, however, headline numbers won't tell the whole story.  The Fed will be looking deeper into the numbers for evidence of greater slack than indicated by the unemployment rate.  My opinion is that if the slack is diminishing faster than the Fed doves expect, it is most likely we will see wage growth accelerate.  If wage growth remains low, then the Fed will be confident that there is little incipient inflation pressure to justify a more aggressive reduction of policy accommodation.  

Bottom Line: The baseline case remains zero rates until the middle to end of 2015, followed by a gentle pace of rate hikes.  That said, it is all data dependent, and the baseline case appears to be contingent on a particularly dovish forecast.  It seems to me that the risk thus lies in a less than dovish reality.  SIgns that wages are increasing more rapidly would suggest just that.  Still stagnant wage growth, however, gives the Fed more room to stick with the current policy path.