Tim Duy's Fed Watch

Policy Induced Mediocrity?

Why did the Federal Reserve lean against their optimistic 2014 forecast?  It seems that monetary policy over the past year can be summarized as a missed opportunity to supercharge the recovery, thereby locking the US economy into a suboptimal growth path. 

Last week's speech by New York Federal Reserve President William Dudley noted the reasons monetary policymakers expected the economy to improve this year:

Since the downturn ended in mid-2009, real GDP growth has averaged only 2.2 percent per year despite a very accommodative monetary policy.  This performance reflects three major factors—the significant headwinds resulting from the bursting of the housing bubble, the shift of fiscal policy from expansion toward restraint, especially in 2012 and 2013, and a series of shocks from abroad—most notably the European crisis. 

The good news is that all three of these factors have abated.  With respect to the headwinds resulting from the financial crisis, they are gradually becoming less severe.  In particular, the sharp decline in household wealth due to the decline in housing prices and the weakness in equity prices has been largely reversed...On the fiscal side, the amount of restraint has diminished sharply.  For 2014, the projected drag is about ½ percent of GDP, roughly half the level of 2013.  Moreover, much of this restraint was frontloaded into the beginning of the year...In terms of the outlook abroad, the circumstances are more mixed. 

The Federal Reserve could have chosen to lean into this generally upbeat forecast.  Yet instead they chose to lean against it by turning to tapering and setting the stage for interest rate hikes. And the data so far suggests that once again the turn toward policy normalization was premature.  The weak first quarter report is more suggestive of holding the recent pace of growth over the next year rather than an acceleration of activity.  What is remarkable is that the Federal Reserve understood that their forecasts have tended toward optimism.  Dudley again:

But, there remains considerable uncertainty about that forecast and, given the persistent over-optimism about the growth outlook by Federal Reserve officials and others in recent years, we shouldn’t count our chickens before they hatch. 

Yet they choose to act prior to data confirmation.  Why?  I really don't quite know.  Sure, we can tell a story about the declining unemployment rate and expected subsequent inflation pressures, but ultimately the turn toward less policy accommodation never made sense in the context of the Fed's own forecasts and questions about the degree of slack in the economy.  It makes me wonder how seriously the Fed is truly interested in closing the output gap:

It seems reasonable to believe that if the economy regains potential output by the end of at best 2016, it will be attributable only to further downward revisions to potential output.  And I even wonder whether the Fed would act to achieve their current growth forecasts or ultimately be content to continue along the current trend.  The economy appears to be already molding itself around the lower output path.  Despite the housing troubles and related weak rebound in construction, and the declines in government hiring, job growth is, on average, plugging along at a rate roughly consistent to that during the housing boom:

  

With that growth labor slack gradually steadily declines by any measure, the Fed appears reasonably comfortable with the resulting path. To be sure, arguably there still remains substantial slack. The failure of wage gains to accelerate is consistent with that story.  But the Fed seems content to use that story only to justify its current policy path rather than justify an even easier policy to more quickly reduce slack.

Given the generally consistent overall reaction of the labor market to the current growth path, it is reasonable to believe that the faster pace of growth in the Fed's forecast would accelerate the pace of labor utilization and thus place upward pressure on inflation forecasts.  In this case, we would expect the Fed to pull forward and steepen the pace of rate hikes to moderate the pace of activity.  Thus, ultimately the Fed's commitment to regaining potential output could be even less than we have come to believe.

But even more telling would be the monetary policy reaction if growth continues along its current path. The weak first quarter results already place the forecast at risk, and the housing recovery is not progressing as smoothly as initially believed. Yet neither event prevented the Fed from continuing to cut asset purchases at the last FOMC meeting.  Moreover, I still can't see any reason to expect the Fed will slow the tapering process unless the economy falls decisively off its current path.  It could be that by the time they are sufficiently convinced growth will continue to fall short of forecast, asset purchases will be almost complete anyway.  And I think the bar to restarting asset purchases would be very high.  They want out of that business.

And if neither fiscal or monetary policy makers are interested in accelerating the pace of growth, should we really expect the pace of growth to accelerate?  In other words, it appears to me that monetary policy largely amounts to setting expectations that reinforce the current growth path.  Which was a recent topic of Bloomberg's Rich Miller who, reporting on the Fed's diminished expectations, quotes me:

By lowering its assessment of how fast the economy can expand and conducting policy accordingly, the Fed runs the risk of locking the U.S. into a slow-growth path, said Tim Duy, a former Treasury Department economist who is now a professor at the University of Oregon in Eugene...

...“They offset fiscal austerity on the downside but then arguably also offset the upside,” Duy said. “They seem to have lost interest in speeding the pace of the recovery.”

Bottom Line:  The Federal Reserve has set reasonably clear expectations that rates will remain low for a long time.  That path, however, seems to be a consequence of doing too little now to ensure a stronger recovery.  In other words, the Fed seems to be taking a lower-rate future as a given rather than as a result of insufficient policy.  Instead of acting to ensure a stronger forecast, they seem more interesting in acting to lock-in the lower path of activity.  And that in turn will tend to lock in a low level of long-term rates.  This, I think, is the best explanation for the inability of markets to sustain higher rates.  It is simply reasonable to expect that the conditions which justify higher long rates will be met with tighter policy sufficient to contain growth to something closer to the current path of output than to current estimates of potential output.

Dudley Revisits Exit Strategy

Today New York Federal Reserve President William Dudley gave what was both an interesting and depressing speech.  Interesting in that he provides some new thoughts on the exit strategy. Depressing in that he outlines a case for persistently low interest rates. One wonders why, given such an outlook, the Fed is so firmly focused on the exit strategy to begin with, rather than accelerating the pace of the recovery.

Dudley tries to sound an optimistic note regarding the outlook, including dismissing the first quarter GDP report, but his optimism is tempered, very tempered:

With the fundamentals of the economy improving and fiscal drag abating, I expect the economy to get back on to a roughly 3 percent growth trajectory over the remainder of this year, with some further strengthening likely in 2015.  But, there remains considerable uncertainty about that forecast and, given the persistent over-optimism about the growth outlook by Federal Reserve officials and others in recent years, we shouldn’t count our chickens before they hatch. 

Three percent growth is not exactly anything to write home about; the only thing exciting about 3 percent is that we just can't seem to get there. Dudley specifically notes weak capital spending and housing markets as key concerns. He senses that the capital spending issue is transitory, but housing less so:

I think housing has been weaker than anticipated because several significant headwinds persist for this sector.  First, mortgage credit is still not readily available to households with lower credit scores.  Second, some people are coping with higher student loan debt burdens that have delayed their entry into the housing market as first-time homebuyers.  This, in turn, makes it more difficult for existing homeowners to sell and trade-up.  Third, there may be some ongoing difficulties increasing housing supply.  The housing downturn was very deep and protracted.  It takes time to shift resources back into this area.  Also, in some markets house prices still appear to be below the cost of building a new home.  Thus, in those markets, it remains uneconomic to undertake new home construction.  Although I expect that the housing recovery will resume, the pace will likely be slow, especially relative to past economic recoveries. 

Notice that he does not mention the mortgage rate increase over the past year, instead focusing on issues largely outside the control of the Federal Reserve. In other words, housing is a problem that they can't fix and thus will simply contribute to weak growth. Regarding inflation, Dudley is optimistic that the trajectory will prove to be in the right direction, but sees little reason to expect any sharp increases. There is simply too much slack in the labor market, evidenced by low wage growth. Here he paints a bleak picture and lays down some markers:

...the trend of labor compensation is running at only about a 2 percent annualized pace.  This is far below the roughly 3½ percent pace that would be consistent with trend productivity growth of 1 to 1½ percent and the FOMC’s 2 percent inflation objective. 

Trend productivity growth of just 1 to 1.5 percent is very, very low and feeds into the Fed's belief that potential growth is in the 2.2 to 2.3 percent range. Dudley's expected 3 percent growth thus hardly eats into excess capacity. Still surprises me that the Fed remains focused on policy firming when arguably conditions require a delay in the tapering process.  

On that inflation target, Dudley argues against the "2 percent is a ceiling" hypothesis:

...once we reach 2 percent, I would expect that we would spend as much time slightly above 2 percent as below it, recognizing that we will hardly ever be exactly at 2 percent because of the inherent volatility in prices.  If inflation were to drift above 2 percent, all else equal, then we would tend to resist such a rise.  But, if inflation were slightly above 2 percent even as unemployment remained far above levels consistent with maximum employment, then the unemployment consideration would dominate because we would be further from the unemployment objective than we are from the inflation objective.  This should not surprise anyone.  This is what our “balanced approach” implies. 

The operative word here is "slightly." What is "slightly" above 2 percent? My guess is that as long as inflation remains below 2.25 percent and employment outcomes remain subpar, the Fed will remain on a low-interest rate path (though not a zero rate path). Above 2.25 would be more disconcerting but, realistically, it is unlikely that the US economy would experience higher inflation in the absence of clear evidence that labor market slack had evaporated. In other words, I suspect that if inflation were above 2.25 percent, the Fed would not need to choose between the elements of the dual mandate; the case for a higher rate trajectory would be clear.

Dudley anticipates that the tapering process will continue, and thus turns his attention to the lift-off from the zero bound. Here he admits the reality of the situation. They really have no idea when the first rate increase will occur:

Turning first to the timing of lift-off, how the outlook evolves matters.  We currently anticipate that a considerable period of time will elapse between the end of asset purchases and lift-off, but precisely how long is difficult to say given the inherent uncertainties surrounding the outlook. 

I would congratulate him for avoiding the use of a date, but then he includes a footnote pointing to the March Summary of Economic Projections and the embedded anticipation that rates will rise in the middle of next year. Fed officials simply can't decide whether those projections are meaningful or not.   

As far as the pace of timing, that too is data dependent, although given the current forecasts Dudley anticipates a tame trajectory:

With respect to the trajectory of rates after lift-off, this also is highly dependent on how the economy evolves.  My current thinking is that the pace of tightening will probably be relatively slow.  This depends, however, in large part, not only on the economy’s performance, but also on how financial conditions respond to tightening.  

And he too expects rates will be subdued over the longer term, laying out three reasons:

First, economic headwinds seem likely to persist for several more years...Second, slower growth of the labor force due to the aging of the population and moderate productivity growth imply a lower potential real GDP growth rate as compared to the 1990s and 2000s.  Because the level of real equilibrium interest rates appears to be positively related to potential real GDP growth, this slower trend implies lower real equilibrium interest rates even after all the current headwinds fully dissipate...Third, changes in bank regulation may also imply a somewhat lower long-term equilibrium rate.

When it comes to the Fed's exit from extraordinary monetary policy, Dudley throws in a new twist.  Conventional wisdom is that the Fed would stop reinvesting the principal payments on assets held by the Fed prior to raising rates. Dudley suggests this might not be a wise decision. First, he argues that this might send the wrong signal to financial markets:

Ending reinvestments as an initial step risks inadvertently bringing forward any tightening of financial conditions as this might foreshadow the impending lift-off date for rates in a manner inconsistent with the Committee’s intention. 

Second - which seems to be in contradiction to the first - it that he prefers lifting rates to enhance policy flexibility:

Second, when conditions permit, it would be desirable to get off the zero lower bound in order to regain some monetary policy flexibility.  This goal would argue for lift-off occurring first followed by the end of reinvestment, rather than vice versa.  Delaying the end of reinvestment puts the emphasis where it needs to be—getting off the zero lower bound for interest rates.  In my opinion, this is far more important than the consequences of the balance sheet being a little larger for a little longer. 

Dudley is saying that the Fed can reduce accommodation via raising rates or reducing the balance sheet, and  they should should begin with the former to normalize policy. This reveals his confidence in being able to manage the balance sheet while raising rates, the topic of which takes up the remainder of his speech.  Note the qualifier "when conditions permit." This is not about tightening policy simply in order to get rates higher; it is about how to tighten policy - what mix of tools to use - when the time to tighten comes.  

I don't quite see the communications challenges Dudley describes. In order to prevent expectations of an earlier rate hike we should hike rates rather than end reinvestments? Not sure this makes much sense. Maybe better to just say that they will reduce accommodation further when appropriate, and that process will involve some mix of rate hikes and balance sheet reduction, the exact mix to be determined by evolving economic and financial conditions.

Bottom Line:  Dudley reinforces expectations that the low rate environment will persist long into the future. The data flow is not providing reason to think otherwise at this point; we would need to see higher inflation numbers coupled with real reason to believe labor market slack was rapidly evaporating, probably in the form of stronger wage growth. It remains interesting that the Fed does not view their own outlook as reason to accelerate the pace of activity. They seem relatively content to accept what they themselves acknowledge is an ongoing disappointment.  

 

PS:  Still in light blogging mode.  Preoccupied with teaching this term.

Difficult Labor Report

The headlines numbers from the April employment report are at first blush a challenge to the Fed's low rate commitment.  One doesn't have to dig much deeper into the data, however, to see that the near term implications are minimal as the Fed maintains its strong focus on measures of labor market slack.  Still, the rapid drop in unemployment - if it continues - will leave policymakers increasingly anxious that their one-way bet on labor market slack will quickly turn sour.

Nonfarm payrolls grew pay 288k, well above expectations of 215k.  While this numbers pushes the three-month moving average higher, the longer-term trend remains the same:

Maybe this is the month the acceleration begins.  Maybe not.  Either way, the report supports the dismissal of the weak first quarter growth numbers (now tracking in negative territory) as transitory.  Just as has been the case for the last three years, there is nothing here to suggest a dramatic change in the pace of underlying economic activity.

The unemployment rate decline was a bit more intersting as it collapsed to 6.3% on the back of falling labor force participation:

The downward trend accelerated in the second half of 2013, pushing us ever closer to levels traditionally associated with greater inflationary pressures and with those pressures tighter monetary policy.  Policymakers, however, appear to remain content dismissing the unemployment rate in favor of a wider range of labor market indicators that suggest plenty of slack left in the economy.  Federal Reserve Chair Janet Yellen's current four favorites:

The wage story is, in my opinion, the key.  It is hard to argue against the labor slack story when employees can't push wages significantly higher.  That alone should be enough to stay the Fed's hand.  And if it isn't enough, they can always draw additional comfort from the inflation figures:

Inflation is, at best, only in the process of bottoming.  

All that said, policymakers will be a little anxious that they are too quickly dismissing traditional metrics that would indicate they should be  be adjusting their inflation forecasts higher in light of the unemployment decline.  As I am relatively confident will be much discussed this week, variants of the Taylor rule suggest that policymakers should already be raising rates:

In this environment, policymakers will increasingly worry about the policy lags.  They will want to hold rates low, but the further unemployment drops, the more they will fear that they risk falling behind the curve - that by the time the pace of wages growth accelerates, inflationary pressure will already be well established.  This is especially the case if they view the 2% target as a ceiling.  Hence I remain concerned that the risk is that policy turns sharply tighter relative to current expectations.  

I am also challenged to see why I should not expect the now-infamous dots in the summary of economic projections to be pulled forward on the basis of the falling unemployment rate.  I am looking forward to the next FOMC meeting for that alone.

I emphasize, however, that any substantially tighter policy remains only a "risk," not a baseline. I anticipate that in her Congressional testimony this week, Yellen will emphasize the alternative measures of labor market slack and the Fed's expectation that policy rates will remain well below "normal" rates for a protracted period.  As a general rule one report doesn't change policy.

Bottom Line: Overall, the general contours of the employment report suggest reason to (very) modestly bring forward expected rates hikes, but little to suggest any dramatic change to the Fed's reaction function overall.  Policymakers, however, will worry that the current reaction function is overly dependent on dismissing the unemployment rate as an indicator of inflationary pressure. And there is a risk that they will move quicker than expected if that bet starts to sour.  Risk, not baseline.