Tim Duy's Fed Watch

FOMC Decision

If you were looking for fireworks from today's FOMC statement, you were disappointed. Indeed, you need to work pretty hard to pull a story out of this statement. It provided little reason to believe that the Fed has shifted its view since December. A June rate hike remains the base case.

The Fed's assessment of the current statement is arguably the best in years:

Information received since the Federal Open Market Committee met in December suggests that economic activity has been expanding at a solid pace.  Labor market conditions have improved further, with strong job gains and a lower unemployment rate.  On balance, a range of labor market indicators suggests that underutilization of labor resources continues to diminish.  Household spending is rising moderately; recent declines in energy prices have boosted household purchasing power.  Business fixed investment is advancing, while the recovery in the housing sector remains slow. 

The Fed is simply not seeing any warning signs in recent data. Regarding inflation:

Inflation has declined further below the Committee’s longer-run objective, largely reflecting declines in energy prices.  Market-based measures of inflation compensation have declined substantially in recent months; survey-based measures of longer-term inflation expectations have remained stable.

They continue to dismiss headline inflation, and I think they will continue to do so. And if you continue to insist that the Fed is paralyzed with fear over market based measures of inflation expectations, note that they do not refer to these as "expectations" measures. It is inflation "compensation." From Fed Chair Janet Yellen's most recent press conference:

There are a number of different factors that are bearing on the path of market interest rates, I think, including global economic developments. It is often the case that when oil prices move down and the dollar appreciates, that that tends to put downward pressure on inflation compensation and on longer-term rates. We also have safe-haven flows that may be affecting longer-term Treasury yields. So I can’t tell you exactly what is driving market developments. But what I can say is that we are trying to communicate our thoughts as clearly as we can.

 And:

Oh, and longer-dated expectations. Well, what I would say, we refer to this in the statement as “inflation compensation” rather than “inflation expectations.” The gap between the nominal yields on 10-year Treasuries, for example, and TIPS have declined—that’s inflation compensation. And five-year, five-year-forwards, as you’ve said, have also declined. That could reflect a change in inflation expectations, but it could also reflect changes in assessment of inflation risks. The risk premium that’s necessary to compensate for inflation, that might especially have fallen if the probabilities attached to very high inflation have come down. And it can also reflect liquidity effects in markets. And, for example, it’s sometimes the case that— when there is a flight to safety, that flight tends to be concentrated in nominal Treasuries and could also serve to compress that spread. So I think the jury is out about exactly how to interpret that downward move in inflation compensation. And we indicated that we are monitoring inflation developments carefully.

They are trying to tell us very clearly that TIPS are not giving a measure of pure inflation expectations. They do not want those measures by themselves to affect market expectations of the path of monetary policy.

Growth risks are balances and low inflation is transitory:

The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced.  Inflation is anticipated to decline further in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate.  The Committee continues to monitor inflation developments closely.

They make a small nod to international concerns when considering future policy actions:

This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.

The Fed remains patient and policy is data dependent:

Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary 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.

June remains on the table. Within the context of the current forecast, I think that June will be difficult to justify in the absence of wage acceleration. A sharp decline in the forecast, or the balance of risks to the forecast, would also prompt a delay. Importantly, at this point they see the current forecast as still the most likely outcome.

Bottom Line: At this point, the Fed does not see market turbulence as an impediment to raising rates. They are willing to hike rates even if stocks are moving sideways (which they probably think is reasonable in the context of expectations for less monetary accommodation). They do not see any data that threatens their baseline forecast. Maybe market participants have written off June, but for the Fed, June remains very much on the table. 

While We Wait For Yet Another FOMC Statement...

The FOMC will reveal the outcome of this week's meeting later today. I think Calculated Risk hits the high points - "patient" is in, "considerable time" is completely out. Beyond this, we will be looking for clues on how the Fed is interpreting the current economic environment. I suspect little change in the overall tenor of the statement as they will want to leave June open as an option. I reiterate my position: The Fed needs to see an acceleration in wage growth to be confident that inflation will return to trend if they intend to raise rates in June. 

Why is the Fed focused on normalizing policy? This is one explanation I see tossed around, from Jeffrey Gunlock via Reuters:

"The Fed seems to want to raise interest rates simply because they don't want to be at zero when the next recession occurs," he said.

A similar statement from the Economic Cycle Research Institute:

In this context, ECRI explains the reasons for the declines in both measures, but also why they may ultimately not be that important to the timing of rates hikes. Above all, the Fed wants to remain relevant in case the economy is hit by recessionary shocks that require interest rates to return to the zero-lower-bound (ZLB). By definition, once on the ZLB, they need to rise before they can fall again.

I don't think these are accurate representations of Fed thinking. The Fed recognizes that hiking rates prematurely to "give them room" in the next recession is of course self-defeating. They are not going to invite a recession simply to prove they have the tools to deal with another recession.  

The reasons the Fed wants to normalize policy are, I fear, a bit more mundane:

1. They believe the economy is approaching a more normal environment with solid GDP growth and near-NAIRU unemployment. They do not believe such an environment is consistent with zero rates.
2. They believe that monetary policy operates with long and variable lags. Consequently, they need to act before inflation hits 2% if they do not want to overshoot their target. And they in fact have no intention of overshooting their target.
3. They do not believe in the secular stagnation story. They do not believe that the estimate of the neutral Fed Funds rate should be revised sharply downward. Hence 25bp, or 50bp, or even 100bp still represents loose monetary policy by their definition.

I am currently of the opinion that there is a reasonable chance the Fed is wrong on the third point, and that they have less room to maneuver than they believe. If so, they will find themselves back at the zero bound in the next recession, very quickly I might add. This is not their expectation. They expect to remain relevant in the next recession and do not believe they need to quickly raise rates to achieve relevance. Again, they know this is self-defeating.

Whether or not they can maintain their mid-year target is of course the topic du jour. But the logic of those who believe the Fed will not have what it needs in June and thus expect the first hike much later is more convincing than those who argue that they will raise rates due to some pressing need to prepare for the next recession.

Policy Divergence

Increasingly, the Federal Reserve stands in stark contrast with its global counterparts. While the ECB readys its own foray into quantitative easing, the Bank of England shifted to a more dovish internal position, the central bank of Denmark joined the Swiss in cutting rates, and the Bank of Canada unexpectedly cut rates 25bp this morning. The latter move I found somewhat unsurprising given the likely impact of oil prices on the Canadian economy. The rest of the world is diverging from US monetary policy.  How long can the Fed continue to stand against this tide?

Late last week, Reuters reported that the Fed's resolve was stiffening. This week, the Wall Street Journal reported the Fed was staying the course. This morning, Bloomberg says the Fed is getting weak in the knees:

Federal Reserve officials are starting to reassess their outlook for the economy as global weakness and disappointing data on American consumer spending test their resolve to raise interest rates this year. 

San Francisco Fed President John Williams last week said he will trim his U.S. estimate because of slower growth abroad. Atlanta’s Dennis Lockhart said Jan. 12 that he advocates a “cautious” approach to rate increases and inflation readings “may be pivotal.” Both are voters on the Federal Open Market Committee in 2015 and repeated that rates could be raised in the middle of the year.

I doubt the Fed will place too much weight on the December retail sales report. It is fairly noisy data and there is no indication that the fundamental upward trend has been broken:

Moreover, I think they would be wary of reading too much into one data point given the upswing in consumer confidence in recent months. That, of course, only builds upon the upswing in employment data. And housing starts finished the year on a strong note - see Calculated Risk for more on that topic.

All that said, the Fed should of course be cautious about the impact of global weakness. But how does the Fed communicate such caution? The challenge I see for the Fed is that they will want to hold the statement fairly steady, with falling oil prices and global weakness as offsetting risks while holding the line on the "low inflation is transitory" story. They want to keep June alive. After all, it's still five months out - a lifetime at the speed of today's financial world. They don't want expectations to fall too far to the back of the year while they are still looking at a June hike.

Such a steady hand, however, may be viewed as hawkish, which is also a message the Fed does not want to send. My expectation is that they highlight the improving US economy, particularly the acceleration in job growth, while offering concerns about the global economy. Remember that the condition of the US job market is very different than during previous bouts of financial instability; the momentum looks more self-sustaining than it has in a long time. They may even point to policy action on the part of foreign central banks to help assuage some global weakness concerns. 

Separately, St. Louis Federal Reserve President James Bullard gives no quarter in his argument for rate hike in the first quarter of this year in this Wall Street Journal interview:

I still think we should get off zero (interest rates). The kinds of things we’re observing now, it is not the constellation of data that would be consistent with a zero policy rate. I think it is important to get started and to start normalizing policy. Even once we start to normalize, interest rates would still be extremely low. We’re talking about levels of 50 basis points or 75 basis points. That is still extremely low and that would still be putting upward pressure on inflation even if we did that. So I’d like to get going. I don’t think we can any longer rationalize a zero interest rate policy.

Bullard thinks the data is not consistent with a zero rate policy, while I fear that the data is where it is at because of the zero rate policy. Moreover, I would tend to proceed more cautiously then Bullard given the current flattening of the yield curve. But Bullard is an outlier; the FOMC consensus is in favor of caution, which is why there is no rate hike on the table next week or in March. And it is why June is in no way guaranteed; they need something from wage growth that they just aren't getting. If they want to set up for a June rate hike without wage growth, they need to start telling a compelling alternative story soon.

Somewhat disappointing is that Bullard is flip-flopping. To date he has been a fairly reliable inflation-hawk - his opinions shift consistently with the inflation outlook. Not this week:

I do worry about TIPS-based inflation compensation and it has been down a lot recently and it does concern me. What I want to do with that is wait and see what happens in global oil markets, wait and see what equilibrium turns out to be and then see what happens with breakeven inflation at that point. I want to let the dust settle on the oil market and then go back and check breakeven inflation rates and see what’s happened.

Basically, Bullard wants to ignore the market-based inflation metrics that would have in the past told him to hold off on any tightening. He really, really wants to liftoff from the zero bound, the sooner the better. I don't think this level of immediacy is felt by other FOMC members, but I do think they are hoping and praying the data gives them enough to move by mid-year.

Bottom Line: The Fed finds itself in a familiar place - wanting to change policy but not quite getting the data they need while at the same time global stress in on the rise. Luckily for them, they weren't going to move off the zero-bound next week anyways; they still have months of data to sift through between now and then. And unlike past times of turbulence, the US is coming from a position of strength, eliminating the need for any panicky moves. Next week is mostly then just about communicating how and how not they are responding to overseas developments. 

Seconded

I see Jon Hilsenrath at the Wall Street Journal seconds my take from this morning:

Federal Reserve officials are on track to start raising short-term interest rates later this year, even though long-term rates are going in the other direction amid new investor worries about weak global growth, falling oil prices and slowing consumer price inflation.

This is generally consistent with my view. The Fed is likely reacting more slowly than market participants. Hilsenrath adds something I forgot to mention:

Central to their internal deliberations ahead of the March meeting is a debate about how low the jobless rate can fall before it stirs wage and inflation pressure. Fed officials estimate the “natural rate” of unemployment—meaning the rate below which wage pressures increase—is between 5.2% and 5.5%.

Mr. Rosengren said he was considering revising this estimate down because the jobless rate has fallen to near the 5.2%-5.5% range without triggering any sign of wage pressure. He said he suspected some of his Fed colleagues also were considering moving this estimate down. The lower the estimate goes, the more patient they might be before raising rates.

Just as I think it will be hard for the Fed to raise rates if the unemployment rate continues to fall while wage growth remains subdued, it will also be difficult to justify current estimates of the natural rate of unemployment under those circumstances. Still, I would caution that lowering the estimate of the natural rate would be, I think, an implicit rejection of the "underemployment hypothesis." It would be easier to adjust estimates of the natural rate downward if measures of underemployment were more consistent with their traditional relationships with unemployment. In other words, the natural rate may be consistent with subdued wage growth due to the existence of high levels of underemployment.

My opinion is that the global disinflationary environment would support low inflation at levels of unemployment below the Fed's current estimate of the natural rate, similar to the situation of the late 1990s.

Will The Fed Take a Dovish Turn Next Week?

As it stands now, we are heading into the next FOMC meeting with the growing expectation that the Fed will take a dovish turn. Is it not obvious that global economic turmoil, collapsing oil prices, weak inflation, and a stronger dollar are clearly pointing to rapidly rising downside risks to the US economy? For financial market participants, they answer is a clear "yes." Expectations of the first rate hike have been pushed out  to the end of this year, seemingly in complete defiance of Fed plans for policy normalization. The Fed may get there as well and abandon their carefully crafted mid-year plan, but I suspect they will not move quite as rapidly as financial market participants desire.

As a general rule, the Fed tends to act in a more deliberate fashion. To be sure, this was not evident during the crisis. Indeed, "panicky" might be a better adjective during that period. But note that in comparison to past bouts of tumolt on global markets, the US economy is in a much better place, with accelerating job growth when unemployment is already near traditional mandate-levels. From their point of view, this is a whole different world compared to that of the last round of Euro-induced crisis. 

This take from Jonathan Spicer and Ann Saphir at Rueters probably saw less play than it deserved:

Tumbling oil prices have strengthened rather than weakened the Federal Reserve's resolve to start raising interest rates around midyear even as volatile markets and a softening U.S. inflation outlook made investors push back the timing of the "liftoff."

Kind of a "Fed is from Mars, markets are from Venus" situation. It is important to recognize that the Fed sees falling oil prices as a significant, unexpected development that represents the realization of an upside risk to their forecast. They are thinking of an outcome not unlike that revealed in the most recent Bloomberg/UMich read on consumer sentiment:

Through the roof, one might say. So at this point the Fed will view the external threats to the economy as just risks, but the very real move in oil is at a minimum adding upside risk to their forecasts or already pushing their forecasts to the upside. With regards to external threats, they probably think that more aggressive ECB action is in the wings to put their immediate fears to rest. And the downward push on inflation is, from their perspective, a transitory issue and therefore a non-issue. 

Consider this also from the Rueters article:

Interviews with senior Fed officials and advisors suggest they remain confident the U.S. economy will be ready for a modest policy tightening in the June-September period, while any subsequent rate hikes will probably be slow and depend on how markets will behave.

 in light of this from St. Louis Federal Reserve President James Bullard:

“The level of inflation is not so low that it can alone justify a policy rate of zero,” Mr. Bullard said in material prepared for a speech in Chicago.

and this from San Fransisco Federal Reserve President John Williams:

Placing heavy emphasis on the date of liftoff “suggests that you don’t have any other decisions to make,” Williams said. “We want to be very confident that we’re on the right path, that the data support that first move, but that first move on tightening is only one of many, many policy actions we’ll need to do during the normalization. It’s not the critical component.”

and this from Federal Reserve Chair Janet Yellen:

So, I think you raise a very important point because, although there is a great deal of market focus on the timing of liftoff, what to matter in thinking about the stance of policy is what the entire path of interest rates will look like. And I really don’t have much for you other than to say that they will be data dependent—that, over time, the stance of policy will be adjusted to try to keep the economy on a track where we see continuing progress toward achieving our goals of maximum employment and price stability.

My takeway is that the Fed sees the timing of the first rate hike as less important than everything that comes after that hike. This will leave them less eager to delay the hike. Given where the economy currently stands, I suspect they see little chance of damage from that first hike alone.

This is also interesting:

Some of those interviewed stressed that in the light of last year's strong jobs gains waiting until mid-year represented a cautious approach rather than an aggressive one, allowing the Fed to delay the rate liftoff if needed, particularly if inflation expectations turned sharply down.

The suggestion here is that at least some Fed officials view signaling a mid-year rate hike as the cautious approach because the data increasingly suggests to them that they should be moving sooner than later. 

Bottom Line: I reiterate my view that despite the generally positive data flow, and the upward boost from oil, I don't see how they can justify raising rates without some reasonable acceleration in wage growth. That said, perhaps by my own argument above they can justify it on the basis of 25bp won't hurt anyone anyways. But my broader point is this: During normal times the Fed moves methodically if not ponderously. The current state of the economy gives them room to move as such. So I would not be surpised to see a fairly steady hand revealed in the next FOMC statement.

Wage Growth - or Lack of - Continues to Surprise

The December employment report, with its surprising combination of solid job gains and decelerating wage growth, leaves Fed policy up the air. 

Headline nonfarm payrolls gained by 252k, while previous months were revised up a net 50k. Job growth continues to accelerate:

 Note the acceleration in aggregate hours worked:

Such gains suggest the recent acceleration in GDP growth is real and likely to be sustained.  From the household survey, we see that the unemployment rate continues to decline. Fed forecasts will once again soon be in jeopardy:

In the context of indicators previously identified by Federal Reserve Chair Janet Yellen:

Overall, the story is one of ongoing improvement in labor markets, including metrics of underemployment. Wage growth, however, nosedived during the month:

I would be wary of this read on wages - strikes me as an aberration that is likely to be violently reversed, but I also stick to what I wrote yesterday:

I believe that an acceleration of wage growth would do the trick, which is why this remains the data to watch in the employment report. If June rolls around with no inflation and no greater wage growth, the Fed will find it challenging to begin normalization. In that case, they would need to focus on the employment mandate or pivot to some financial stability story to justify a rate hike.

Bottom Line:  Generally a very solid report. But the wage numbers present a dilemma for the Fed. Simply put, no wage growth means the Fed can't be particularly confident that inflation will trend toward target. Not that a rate hike was imminent in any event; Fed is still looking at June, but they need some more help from the data. Of course, June is still a long way off - we have five more employment reports before that meeting. Time enough for these numbers to turn around. Note that if the wage trend does reverse quickly, policy expectations would shift just as quickly.  

Volatile Week Ahead of Employment Report

At the moment, there are many different competing threads in the tapestry of monetary policy, with another thread entering the pattern with tomorrow's employment report. In short, the Fed is balancing clear evidence of accelerating US activity in the back half of 2014 against the implications of declining oil prices and a host of international weaknesses that are roiling financial markets. The reality of volatility in asset prices was on full display this week. The Fed desire to begin normalizing policy with a rate hike in the middle of this year certainly appears in jeopardy. They very much need continued solid data on the US side of the equation to push forward with their plans.

Early 2015 US data in the form of ISM reports provides little new guidance. While the measures slipped from recent high, I would be hard-pressed to say that the underlying trend has changed after considering the volatility of this data: 

Likewise, initial unemployment claims continue to hover below pre-recession lows, signaling solid labor demand:

Plunging gasoline prices will almost certainly bolster consumer confidence:

The Fed anticipates that declining energy prices will have a net positive impact on the economy. Via the minutes of the most recent FOMC meeting:

In their discussion of the foreign economic outlook, participants noted that the implications of the drop in crude oil prices would differ across regions, especially if the price declines affected inflation expectations and financial markets; a few participants said that the effect on overseas employment and output as a whole was likely to be positive. While some participants had lowered their assessments of the prospects for global economic growth, several noted that the likelihood of further responses by policymakers abroad had increased. Several participants indicated that they expected slower economic growth abroad to negatively affect the U.S. economy, principally through lower net exports, but the net effect of lower oil prices on U.S. economic activity was anticipated to be positive.

I tend agree that the net impact will be positive, but note that the negative impacts will be fairly concentrated and easy for the media to sensationalize, while the positive impacts will be fairly dispersed. We all know what is going to happen to rig counts, high-yield energy debt, and the economies of North Dakota and at least parts of Texas. "Kablooey," I think, is the technical term. Easy media fodder. Much more difficult to see the positive impact spread across the real incomes of millions of households, with particularly solid gains at the lower ends of the income distribution. This will be most likely revealed in the aggregate data and be much less newsworthy.

The decline in energy prices, combined with the stronger dollar, confounds the Fed's inflation outlook, but for now they seem content to assume the impacts are transitory:

Participants generally anticipated that inflation was likely to decline further in the near term, reflecting the reduction in oil prices and the effects of the rise in the foreign exchange value of the dollar on import prices. Most participants saw these influences as temporary and thus continued to expect inflation to move back gradually to the Committee's 2 percent longer-run objective as the labor market improved further in an environment of well-anchored inflation expectations.

The Fed also, at least for now, is choosing to heavily discount market-based measures of inflation expectations:

Survey-based measures of longer-term inflation expectations remained stable, although market-based measures of inflation compensation over the next five years, as well as over the five-year period beginning five years ahead, moved down further over the intermeeting period. Participants discussed various explanations for the decline in market-based measures, including a fall in expected future inflation, reductions in inflation risk premiums, and higher liquidity and other premiums that might be influencing the prices of Treasury Inflation-Protected Securities and inflation derivatives. Model-based decompositions of inflation compensation seemed to support the message from surveys that longer-term inflation expectations had remained stable, although it was observed that these results were sensitive to the assumptions underlying the particular models used. It was noted that even if the declines in inflation compensation reflected lower inflation risk premiums rather than a reduction in expected inflation, policymakers might still want to take them into account because such changes could reflect increased concerns on the part of investors about adverse outcomes in which low inflation was accompanied by weak economic activity. In the end, participants generally agreed that it would take more time and analysis to draw definitive conclusions regarding the recent behavior of inflation compensation.

For example, the Cleveland Federal Reserve measure of inflation expectations over the next ten years was 1.83% in December, within spitting distance of the Fed's target. This kind of analysis, combined with survey-based measures, provides the Fed with a great deal of comfort regarding the inflation situation.

That said, inflation remains below target and, importantly, was decelerating before the impact of lower energy prices worked its way through the economy:

Shouldn't this alone keep any talk of rate hikes at bay? You might think so, but the Fed already believed there was a good chance that they would raise interest rates while core-inflation was below target:

With lower energy prices and the stronger dollar likely to keep inflation below target for some time, it was noted that the Committee might begin normalization at a time when core inflation was near current levels, although in that circumstance participants would want to be reasonably confident that inflation will move back toward 2 percent over time.

So what is the bar for "reasonably confident"? I believe that an acceleration of wage growth would do the trick, which is why this remains the data to watch in the employment report. If June rolls around with no inflation and no greater wage growth, the Fed will find it challenging to begin normalization. In that case, they would need to focus on the employment mandate or pivot to some financial stability story to justify a rate hike.

Jon Hilsenrath offers a potential interpretation of the implications of the rally at the long end of the Treasury yield curve:

If falling yields are a reflection of diminishing inflation prospects, as is typically the case, it ought to prompt the Fed to hold off on raising short-term interest rates in the months ahead. If, on the other hand, lower long-term rates are a reflection of investors pouring money into U.S. dollar assets, flows that could spark a U.S. asset price boom, it might prompt the Fed to push rates higher sooner or more aggressively than planned.

The latter interpretation is less conventional, but it is one that New York Fed President William Dudley made at length in a speech in December. He argued the Fed had the wrong reaction to lower long rates in the 2000s, a mistake that might have contributed to the housing boom that ended disastrously.

I wrote about this last month, coming to the conclusion:

A second point is that Dudley is not taking seriously the possibility that the flattening yields curve suggests the Fed has less room to move than policymakers think they do. This is something I worry about - if the Fed leans on the short end too much, they risk taking an expansion that should last another fours years to one that has just two more years left. But that might be a story for next December. 

I think the late-90's is a better comparator to the current envrionment, but that will take another post to deal with. For the moment, I will add that San Francisco Federal Reserve President John Williams hinted that current action in the bond market is in fact telling a less hawkish story.  Via Greg Robb at MarketWatch:

Williams said he thinks a rate hike this year will be appropriate, but added he is in "no rush" to tighten. He said that mid-2015 is a reasonable guess of when the Fed will first ask "should we do it now or wait a little longer."

I have interpreted Williams remarks in the past as pointing at a June rate hike. Arguably, here he hedges and says June is when they should start considering the rate hike. Perhaps falling Treasury yields are having the traditional impact on Fed thinking after all. 

Bottom Line:  Fed wants to begin normalizing policy, but sees a murkier path compared to even just last month. They need hard US data to overwhelm the oil/international driven fears. An acceleration of wage growth would help put some light on the path they want to follow.