Tim Duy's Fed Watch

Another Kocherlakota Dissent

Minneapolis Federal Reserve President Narayana Kocherlakota released a statement regarding his dissenting vote at this week's FOMC meeting.  He does not share his colleagues faith that inflation will return to target anytime soon:

...In my assessment, the medium-term outlook for inflation has shown no overall improvement since last December and, indeed, is arguably worse. Failing to act in response to this subdued inflation outlook increases the downside risk to the credibility of our 2 percent inflation target. Market-based measures of longer-term inflation expectations have fallen recently to unusually low levels, a decline that I believe reflects that kind of increased downside risk...

Today's reading on inflation is supportive of Kocherlakota's concerns:

 

He reiterated his preferred policy outcomes:

There are a number of possible actions that I would have seen as responsive to the evolution of the data. Let me describe two in particular. First, the Committee could have continued to buy $15 billion of longer-term assets per month. Second, it could have committed to keeping the target range for the federal funds rate at its current level at least until the one- to two-year-ahead inflation outlook has risen back to 2 percent, as long as risks to financial stability remain well-contained.

I find this interesting compared to his preferred language after his dissent in March:

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.” 

Notice that earlier this year the best he thought he could get from his colleagues was an allowance for 2.25% inflation. Now the best he could hope for has been downgraded to a 2%, suggesting - you guessed it - that the rest of the FOMC considers 2% a ceiling.   

I think the inflation downgrade in Kocherlakota's suggested policy language suggests that low inflation is less of a concern for FOMC members now that unemployment is below 6% and measures of underemployment are improving. I believe that Kocherlakota is hearing from his colleagues that 1.) inflation will almost certainly move toward target as the unemployment rate falls further and that 2.) even if inflation remains below 2%, declining slack in the labor market suggests that less financial accommodation is necessary and failure to reduce accommodation will result in undesirable financial instability.

Bottom Line:  Kocherlakota's dissent raises the possibility that labor data will trump inflation data in policy considerations. It also suggests that given the pace of labor market improvement, they are not writing off the possibility of a March rate hike (although that is not my baseline).  

FOMC Recap

In broad terms, the FOMC meeting concluded as I had expected. To the extent there were any surprises, they were on the hawkish side. Or, I would say, hawkish mostly if you believed the events of the last few weeks justified a radical revision of the Fed's anticipated policy path. I didn't, but was too busy those same past few weeks to scream into the wind.

As I anticipated, the Fed dismissed the decline in market-based inflation expectations. They clearly believe  financial markets over-reacted to the decline in oil prices, and that that decline would ultimately prove to be a one-time price shock rather than the beginning of a sustained disinflationary process.

This is why we watch core-inflation.

And note that the Fed sent a pretty big signal along the way. In contrast to conventional wisdom, they do not hold market-based measures of inflation expectations as the Holy Grail. Especially with unemployment below 6%, pay more attention to survey-based measures. And recognize they will discount even those if they feel they are unduly affected by energy prices in either direction.

Somewhat more hawkish than I anticipated, they did not explicitly hold out the hope of future asset purchases. The statement shifts directly to the issue of rate hikes. On that point, they did as I had expected, emphasize the data-dependent nature of future policy:

However, if incoming information indicates faster progress toward the Committee's employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.

In my opinion, this suggests that they want to retain the baseline expectation of a mid-2015 rate hike with the option for an earlier hike. I don't think they see recent data or market action as by itself justifying the shift to the latter part of 2015. If anything, remember that recent data is pointing to accelerating growth and a rapid decline in unemployment.

And that rapid decline in unemployment is important, as I have trouble imagining a scenario in which the Fed is content to watch unemployment fall below 5.5% without at least beginning the rate hike cycle. Remember that they think that even as they increase rates, they believe that policy will continue to be accommodative. In other words, they do not fear raising rates as necessarily a tightening of policy. They will view it as a necessary adjustment in financial accommodation in response to a decline in labor market slack.  Hence the line:

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.

I anticipated at least one dissent. In all honesty, this would have been a more impressive call if I had also indicated the direction of the dissent. I expected a hawk to reject the retention of the considerable time language. No such luck - quite the opposite, with noted-dove Minneapolis Federal Reserve President Narayana Kocherlakota protesting both the considerable time language (wanting a more firm commitment to ZIRP) and the decision to end QE. The hawks, in contrast, were generally comfortable with the direction of the discussion. Expect Dallas Federal Reserve President Richard Fisher to say as much soon.

The acceptance of the hawks with the general tone of the meeting is also important. Clearly hawkish in contrast with the shift in market expectations. Time will tell.

Bottom Line:  Despite the market turbulence of recent weeks, the general outlook of monetary policymakers remain generally unchanged.  In general, they continue to see the direction of activity pointing to a mid-year rate hike.  The actual date is of course data dependent, but they have not seen sufficient data in either direction to change that baseline outlook. 

FOMC Meeting

I have been buried the past few weeks.  So blogging has been, and will be, at least for a little longer, light. That said, I have trouble letting an FOMC meeting pass without at least few words before and after - even if there already exist broad agreement on the outcome.

The general expectation is that the Fed ends its bond buying program at the conclusion of the meeting tomorrow. That alone promises to knock down the FOMC statement to a more manageable size. While St. Louis Federal Reserve President James Bullard offered up the possibility of retaining the program for another meeting, there is little indication that other FOMC members are similarly inclined. They have long wanted to get out of asset purchase business, and see no shift in activity sufficient to delay that objective. Moreover, as Boston Federal Reserve President Eric Rosengren has noted, the remaining $15 billion is effectively a rounding error. If the Fed really wants to do something, they need to go bigger. But that is not on the table.

Regarding the statement, here is what I anticipate:

1. The general description of the economy will remain essentially unchanged, expanding at a "moderate pace." This would be consistent with expectations that the economy is currently on track to post 3%+ growth in the third quarter.

2. That said, they will mention they remain watchful of foreign growth.

3. They will acknowledge the further decline in unemployment rates yet retain the view that labor market indicators still suggest underutilization of resources. I would not be surprised by specific mention of low wage growth as evidence of underutilization.

4. I expect the Fed will acknowledge the decline in market-based measures of inflation expectations, but ultimately dismiss those measures for now in favor of stable of survey based measures. In general, I think they will take the approach of Rosengren in this Washington Post interview:

"Inflation breakevens," Rosengren explained, "are based on the pricing of Treasury securities and Treasury Inflation-Protected Securities (TIPS). So if you think about what the implication of significant financial market turbulence is, particularly about Europe, it's for foreign investors to buy Treasury securities. They disproportionately buy regular Treasury securities, so the flight to safety is going to start changing the relative prices of Treasury securities" and make it look like markets expect less inflation. But "if you look at inflation expectations based more on surveys, there's been a little bit of softening, but certainly nothing consistent with the kind of movements we've seen in the [Treasury] breakevens. So I wouldn't overreact to one or two weeks of sharp movements, because I think there are plenty of other reasons to explain" them.

5. I expect the risks to growth and employment will remain balanced, and the risk of persistently low inflation will continue to be "somewhat diminished."

6. They will announce the end of the asset purchase program, but emphasize continued reinvestment of principle and that the sizable asset holdings will continue to provide support for the recovery.

7. They will note that despite the end of asset purchases, such purchases remain in the monetary toolbox and could be revived if conditions warranted.

8. The "considerable time" language will remain. I don't anticipate any tweaks to the interest rate guidance, but I would expect if there are any such tweaks, they would be to emphasize the data-dependent nature of future policy decisions.

9. I expect at least one dissent.

Bottom Line:  I am anticipating a pretty straightforward result from this FOMC meeting. 

The Methodical Fed

Just a few months ago the specter of inflation dominated Wall Street. Now the tables have turned and low inflation is again the worry du jour as a deflationary wave propagates from the rest of the world - think Europe, China, oil prices. How quickly sentiment changes.

And given how quickly sentiment changes, I am loath to make any predictions on the implications for Fed policy. The very earliest one could even imagine a possible rate hike would be March of next year, still five months away. But since that month is the preference of Fed hawks, better to think that the earliest is the June meeting, still eight months away.

Eight months is a long time.  We could pass through two more of these sentiment cycles between now and then.  Or maybe the story breaks decisively one direction or the other.  Given the uncertainty of economy activity, it is clearly dangerous to become too wedded to a particular date for liftoff.  At best we can describe probabilities.

But what I think is often missing is a recognition that through all of the ups and downs of last year, the Fed has sent a very consistent signal: The ongoing improvement in the US economy justifies the steady removal of monetary accommodation. To be sure, we can quibble over the timing of the first move, but consider the path since last May:

1. In May of 2013, then-Federal Reserve Chair Ben Bernanke opens the door for tapering of asset purchases.
2. The actual tapering begins in December of that year, two meetings later than expected. I think it is heroic to believe those 12 weeks were materially important. By that point, the underlying expectation was well established.
3. Although they claimed that the pace of tapering was data dependent, they proceeded on a very methodical path of $10 billion cuts at each meeting. They proceeded on this path despite persistent below target inflation.
4. They clearly established that this month's meeting is very, very likely to be the end of the asset purchase program. Again, they stated this expectation despite low inflation.  
5. Despite the current turmoil, I still expect the asset purchase program to end. I think hawks and doves alike want out of that program. They want to return to interest rate-based policy.
6. Even as inflation bounces along below target, they formulated and announced the path of policy normalization. That normalization includes the expectation that the expansion of the balance sheet was temporary and thus will be reversed.  
7. Even as inflation has bounced along below trend, they have repeatedly warned via the Summary of Economic Projections that rate hikes are just around the corner, and that market participants should plan accordingly. 
8. And while New York Federal Reserve President William Dudley foreshadowed the minutes and a week of Fedspeak that was generally interpreted dovishly, the key takeaway was although the US economy was not expected to accelerate further, the current path was sufficient to believe in the "consensus view is that lift-off will take place around the middle of next year.  That seems like a reasonable view to me"  even "if it were to cause a bump or two in financial markets." Those remarks were seconded by San Francisco Federal Reserve President John Williams. So the moderates and hawks both continue to send signal rates hikes by the middle of next year, leaving the voices of doves Minneapolis Federal Reserve President Narayana Kocherlakota and Chicago Federal Reserve President Charles Evans sounding very lonely. Fed Chair Janet Yellen has been somewhat absent from the current debate, although we suppose she sympathizes more with the dovish position.

Given the consistent, methodological approach to policy normalization witnessed over the past year, is it wonder that inflation signals all look soft? For example:

 

Fed signaling resulted in consistent, downward pressure on inflation expectations. Hence what they view as a dovish policy stance, I view as a hawkish policy stance. And most remarkable to me is that they never realized what I always thought was obvious - that they were setting the stage for a return trip to the zero bound in the next recession. Matthew C Klein at the Financial Times points us to this from the Fed minutes:

For example, respondents to the recent Survey of Primary Dealers placed considerable odds on the federal funds rate returning to the zero lower bound during the two years following the initial increase in that rate. The probability that investors attach to such low interest rate scenarios could pull the expected path of the federal funds rate computed from market quotes below most Committee participants’ assessments of appropriate policy.

The most hawkish projection for the long-term Federal Funds rate is 4.25%.  During the downside, cutting cycles are generally in excess of 500bp. The math here is not that complicated. I struggle to find the scenario by which policy does not revert to the zero lower bound. That would imply that the Fed allows conditions to evolve such that the appropriate Fed Funds rate is well in excess of 6%. But given the Fed thinks that the equilibrium real rate has fallen, this implies a willingness to support higher inflation expectations, which is something I just don't see at this point.  

And I don't think it is just me. I don't think Wall Street sees the path out. Hence the high probability assigned to a return to the zero bound. Hence also the flattening of the yield curve since tapering began:

I think the Fed should very much change its messaging if policymakers want to lift us from the zero bound for more than a couple of years. I think they should drop the calendar-based guidance they are all now giving. I think they should drop the SEP dot plot, because that clearly sends a hawkish message. I think they should drop reference to the labor market outcomes in terms of quantities in favor of price signals (wages, a direction they seem to be moving). I think they should define their policy strategy to make clear they intend to lift the economy off the zero bound permanently, but that I believe requires them to abandon their 2% inflation fetish (and note that on this I believe their behavior is clearly more consistent with a 2% ceiling then a symmetrical target). They also need to adandon their claim that the balance sheet will be reversed.  The size of the balance sheet should not be a policy objective, only the economic outcomes yielded by the size of the balance sheet.

That said, I am also beginning to expect that a return to the zero bound is almost guaranteed. I fear the time has passed for the appropriate mix of fiscal and monetary policy that leaps the economy to a higher equilibrium. But that is a topic for another post.

Bottom Line:  Fed policy might sound dovish this week, but take note the the underlying tone has been methodically hawkish for a long, long time. And markets have responded accordingly, including anticipating a return to the zero bound when the next recession hits. Nor should this be unexpected. Monetary policymakers have yet to set clear objectives that includes a high probability that the zero bound is left behind for good. 

The Labor Market Conditions Index: Use With Care

I was curious to see how the press would report on the Federal Reserve Board's new Labor Market Conditions Index.  My prior was that the reporting should be confusing at best.  My favorite so far is from Reuters, via the WSJ:

Fed Chairwoman Janet Yellen has cited the new index as a broader gauge of employment conditions than the unemployment rate, which has fallen faster than expected in recent months. The index’s slowdown over the summer could bolster the argument that the Fed should be patient in watching the economy improve before raising rates.

But its pickup last month could strengthen the case that the labor market is tightening fast and officials should consider raising rates sooner than widely expected. Many investors anticipate the Fed will make its first move in the middle of next year, a perception some top officials have encouraged.

Translation:  We don't know what it means.

Now, this is not exactly the fault of the press. The Fed appears to want you to believe the LMCI is important, but they really don't give you reason to believe it should be important. They don't even release the LMCI - the charts on Business Week and US News and World Report are titled erroneously.  The Fed releases the monthly change of the LMCI, as noted by Business Insider. But wait, no that's not right either. They actually release the six-month moving average of the LCMI, which means we really don't know the monthly change.¹ What the Fed releases might actually be more impacted by what left the average six months ago than the reading from the most recent month. And you should recognize the danger of the six-month moving average - the longer the smoothing process, the more likely to miss turning points in the data.  Unless of course the Fed released the raw data to follow as well.  Which they don't. [Update:  Commenter Ernie Tedeschi reads through the confusion and believes that the reported number is simply the monthly change.  It would be helpful to have the raw data in levels to clarify this point further.]

The LCMI becomes even more confusing because it has been impressed upon the financial markets that it must have a dovish interpretation. From Business Insider:

The index was first "made famous" by Fed Chair Janet Yellen in her speech at Jackson Hole, when she said, "This broadly based metric supports the conclusion that the labor market has improved significantly over the past year, but it also suggests that the decline in the unemployment rate over this period somewhat overstates the improvement in overall labor market conditions."

Recall that at Jackson Hole, Yellen spoke about the labor market puzzle of a steadily declining unemployment rate and strong payroll gains against the backdrop of declining labor force participation and flat wages.

Consider this in light of this from the Fed:

The first part of the associated commentary:

Table 2 reports the cumulative and average monthly change in the LMCI during each of the NBER-defined contractions and expansions since 1980. Over that time period, the LMCI has fallen about an average of 20 points per month during a recession and risen about 4 points per month during an expansion. In terms of the average monthly changes, then, the labor market improvement seen in the current expansion has been roughly in line with its typical pace...

If you look closely, the average monthly change during this expansion is faster than every recovery since the 1980-81 expansion. How does this fit with the conventional wisdom that we are experiencing a slow labor market recovery?  Indeed, look at the chart:

According to this measure, the pace of improvement in this recovery exceeds than much of the 1990's.  Think about that.

Moreover, consider the next sentence of the commentary:

...That said, the cumulative increase in the index since July 2009 (290 index points) is still smaller in magnitude than the extraordinarily large decline during the Great Recession (over 350 points from January 2008 to June 2009).

OK - so the Fed thinks the cumulative change is important. They think it is relevant that the LCMI has not retraced all of its losses. Let's take this idea further. Rather than using the recession dating, consider the even larger move from peak to trough. Between May 2007 to June 2009, the cumulative decrease in the LCMI was 398.4. Since then, the cumulative increase is 300.7, so the LCMI has retraced 75% of its losses.

Now consider the unemployment rate. The unemployment rate increased 5.6 percentage points from a low of 4.4% to a high of 10%. SInce then it has retraced 4.1 percentage points of that gain to last month's 5.9% rate.  4.1 is 73% of 5.6.  In other words, the unemployment rate has retraced 73% of it losses.

The LCMI has retraced 75% of its losses. The unemployment rate has retraced 73% of it losses. So the LCMI shows the exact same amount of improvement in labor market conditions peak to trough as implied by the retracement of the unemployment rate.

You see the problem. The LMCI (or the data made available to the public) suggests the same amount of improvement in labor market conditions as implied by the unemployment rate. The LMCI suggests a faster pace of improvement than that seen in the previous three recoveries. So how exactly does Yellen reach the conclusion that "the decline in the unemployment rate over this period somewhat overstates the improvement in overall labor market conditions"? I am not seeing it on the basis of the data provided. Indeed, where exactly is the research showing the LCMI has some policy relevance?  

Then again, this could be exactly why Yellen uses the modifier "somewhat" in the above quote. Perhaps she has no conviction that the LMCI provides information not already in the unemployment rate.  If that's the case, then expect the LMCI to die on the vine, eventually relegated to be computed by whoever still has the p-star model on their list of assignments.

Bottom Line:  Use the Fed's new labor market index with caution.  Extreme caution.  They are not releasing the raw data. They don't appear to have research explaining its policy relevance. Yellen's halfhearted claim that it provides information above and beyond the unemployment rate is questionable with a simple look at the cumulative change of the index compared to that of unemployment. And her halfhearted claims are even more telling given that she was the impetus for the research. If it was policy relevant, you would think she would be a little more enthusiastic (think optimal control). Moreover, the faster pace of recovery of the index compared to previous recessions - as clearly indicated by the Fed - seems completely at odds with the story it is supposed to support. Simply put, the press and financial market participants should be pushing the Fed much harder to explain exactly why this measure is important.

 

1. The LCMI data provided by the Fed is described as the "average monthly change." I am not sure why they don't explicitly provide the span of the averaging, but the website describes it as "Chart 1 plots the average monthly change in the LMCI since 1977. Except for the final bar, which covers the first quarter of 2014, each of the bars represents the average over a six-month period."

Is There a Wage Growth Puzzle?

Is there a wage growth puzzle?  Justin Wolfers says there is, and uses this picture:

 

to claim:

This puzzle isn’t entirely new, as the usual link between unemployment and the rate of wage growth has totally broken down over recent years.

​The recent data have made a sharp departure from the usual textbook analysis in which a tighter labor market leads to faster wage growth, and subsequent cost pressures feed through to higher inflation.

But has the link between wage growth and unemployment "totally broken down"? Eyeball econometrics alone suggests reason to be cautious with this claim as the only deviation from the typical unemployment/wage growth relationship is the "swirlogram" of fairly high wage growth relative to unemployment through the end of 2011 or so. But is this a breakdown or a typical pattern of a fairly severe recession? While, it might seem unusual if you begin the sample at 1985 as Wolfers did, so let's see what the 1980-85 episode looks like:

Same swirlogram. Compare the two recessions:

Fairly similar patterns, although in the 80-85 episode there was more room to push down the inflation expectations component of wage growth. It would appear that in the face of severe contractions, wage adjustment is slow. Now consider the 1985-1990 period:

Notice that wage growth is stagnant until unemployment moves below 6% - past experience thus suggests that we should not expect significant wage growth until we move well below 6% (you could argue the response actually began at 6.5%). Thus, it is premature to believe that there has been a breakdown in this relationship. So far, the response of wages is exactly what you should have expected in light of the 1980's dynamics. Which leads to two points:

1. I am no fan of Dallas Federal Reserve President Richard Fisher.  That said, he did not pick 6.1% out of a hat when he said that was the point at which wage growth has tended to accelerate in the past.  That number fell out of his staff's research for a reason and surprises me not one bit.
2. There is a reason the Fed picked 6.5% unemployment for the Evan's rule.  There was absolutely no chance that that would be a meaningful number as far as labor market healing is concerned.  

Consider now the sample since 1990:

 Note four points:

1. Notice the minor "swirlogram" associated with the early-90's recession. Again, not a breakdown.
2. After 1992, wage growth tends to move sideways until unemployment sinks below 6%.
3. Since 2012, the relationship is as traditional theory would suggest, a point that is actually evident on Wolfer's chart as well. The R-squared on the regression line is 0.75. Although notice that again, as wage growth moves into that 2.5% range, it appears to once again move mostly sideways.  No mystery - nothing we haven't seen before.
4. Clearly, there is some noise in the relationship. You should be able to extract away from the noise and recognize that there is no sudden acceleration in wage growth. 

Now let's take another step and consider the relationship between unemployment and real wages (note that the series ends in 2014:8 - we don't have the September PCE price data yet):

 

The period of the Great Disinflation was generally associated with negative real wage growth. The period of the mid-90s to the Great Recession was generally associated with positive real wage growth. The swirlogram of the Great Recession is again evident, but notice that as unemployment approached the bottom end of the black regression line (R-squared = 0.65), real wage growth actually accelerated before returning to trend. I now have additional sympathy for firms that have complained in the past two years that they could not push wage growth through to higher prices. It does appear that real wage growth was faster than might be expected given the pace of economic activity and, by extension, the level of unemployment.

Oh - and real wage growth has reverted to the pre-Great Recession trend - pretty much exactly where you would expect it to be given the level of unemployment. Honestly, this one surprised me.

Which suggests that labor market healing has progressed much further than many progressives would like to admit. Many conservatives as well.

Which also means a lot of people are not going to like this chart.

And before you complain that the all-employee average wage data holds some great secret that is not in the production and nonsupervisory wage series (I have trouble taking seriously any sweeping generalizations of the business cycle dynamics of a series we only have through one business cycle), here is that version:

 

Same swirlogram. Pretty much the same idea with wage growth heading right back to where you would expect prior to the great recession.    

Bottom Line:  Be cautious in assuming that this time is different. The unemployment and wage growth dynamics to date are actually very similar to what we have seen in the past. Low wage growth to date is not the "smoking gun" of proof of the importance of underemployment measures. There very well may have been much more labor market healing that many are willing to accept, even many FOMC members. The implications for monetary policy are straightforward - it suggests the risk leans toward tighter than anticipated policy.