Tim Duy's Fed Watch

Yellen Heading to the Senate

All eyes will be focused on Federal Reserve Chair Janet Yellen as she presents the semi-annual monetary policy testimony to the Senate Banking Committee. I anticipate that she will stick to an economic outlook very similar to that detailed in the last FOMC statement and related minutes. Expect her to indicate that the Fed is closing in on the time of the first rate hike - after all, this was clearly the topic of conversation at the January FOMC meeting. I anticipate the "Audit the Fed" movement will be on display in the Q&A, which will provide Senators the opportunity to display their ignorance of monetary policy. And with any luck, we will learn how "patient" the Fed really is.

That said, I am wary of expecting much in the way of insight on "patient." The Fed has trapped itself with that language, and I am thinking that it will take the collective power of the FOMC to devise a way out. And they have little choice but to deal with that issue at the March FOMC meeting. The basic problem is this: The hawks would be happy with pulling the trigger on 25bp at the March meeting. The center isn't ready to go along with that, but they want the option of being able to pull the trigger in June. But Yellen, in trying to signal in December that a rate hike was not imminent, linked the term "patient" to two meetings. So if they keep "patient" in the statement, it seems to imply that June is off the table, but that message will brings squeals of unhappiness from the hawks and even leave the center uncomfortable. But just pulling "patient" risks leaving the impression that a June hike is a certainty, which is a message the center doesn't want to send.  

If you think this is a dumb way to manage monetary policy, you are correct. Now that the Fed is closer to meeting their employment mandate, they simply cannot credibly signal intentions six months in advance. They need to let the data start doing the work for them, but don't know how to make that transition.  

It something of a shame that Yellen couldn't leave well enough alone in December and let financial market participants believe that "patient" would be used as it had been in 2004. In that case, "patient" would have no time horizon other than that dropping the word "patient" meant that a rate hike was likely just one meeting away. They could credibly manage such a signal. Anything more than one meeting ahead is problematic.

On the economic outlook, I would say that if Yellen were to deviate from the January FOMC meeting, it would be in a generally positive direction. I think they will take the subsequently released upbeat employment report as strong evidence that underlying trends remain solid. The news that Wal-Mart is raising salaries will likely be viewed as just the tip of the iceberg. I doubt anyone on the FOMC believes Wal-Mart leadership acted out of the kindness of their hearts. Yellen herself will probably think something to the effect that "I told you that the quits rate was important."  

Assuming the Greece situation holds together for another 24 hours, that coupled with easing by global central banks in recent weeks will lead FOMC members to believe that global risks have dissipated. And to top it off, US equities pushed back to record highs. What's not to like? Maybe the GDP numbers, but Cleveland Federal Reserve President Loretta Mester gave what I think is the consensus view on the topic:

WSJ: Putting aside the tailwinds that you’re seeing. The growth data look a little soft at the moment.

MESTER: Not really. The fourth quarter came in after two quarters of really robust growth. The employment report actually was revised up for those last couple of months. There is this tendency to look at the last data point. I’m just not that concerned. I think we’ve seen growth pickup. I think there is more momentum in the economy.

Hence why I also don't agonize about what a snowstorm means for monetary policy. It means nothing.

There is plenty on the docket beyond Yellen this week. Existing and new home sales, consumer confidence, regional Fed manufacturing indexes, durables goods orders, CPI, Case-Shiller, GDP revisions, and, if that weren't enough, speeches by Fed Presidents of Atlanta (Lockhart), Cleveland (Mester), and New York (Dudley), and Federal Reserve Governor Stanley Fischer. The fun just won't stop!

Bottom Line:  I expect the Fed will continue to walk the fine line between keeping June in play while signaling that the data will soon justify a rate hike though not necessarily in June. And watch for signs of an effort to shift the focus to the expected gradual pace of rate hikes in an effort to minimize adverse market reaction to the possibility of June. Expect generally positive views of recent data; the Fed thinks the economy is finally on the right path.

January FOMC Minutes

Minutes from the January FOMC meeting were released today. It is fairly clear that the Fed is gearing up for rates hikes:

Participants discussed considerations related to the choice of the appropriate timing of the initial firming in monetary policy and pace of subsequent rate increases. Ahead of this discussion, the staff gave a presentation that outlined some of the key issues likely to be involved...

The debate sounds familiar. On one side are those concerned that the Fed's zero rate policy will overstay its welcome:

Several participants noted that a late departure could result in the stance of monetary policy becoming excessively accommodative, leading to undesirably high inflation. It was also suggested that maintaining the federal funds rate at its effective lower bound for an extended period or raising it rapidly, if that proved necessary, could adversely affect financial stability...

while on the other side doesn't want to pull the trigger too early:

In connection with the risks associated with an early start to policy normalization, many participants observed that a premature increase in rates might damp the apparent solid recovery in real activity and labor market conditions, undermining progress toward the Committee's objectives of maximum employment and 2 percent inflation. In addition, an earlier tightening would increase the likelihood that the Committee might be forced by adverse economic outcomes to return the federal funds rate to its effective lower bound.

I would say that "many" is greater than "several," which means that as of January, the consensus leaned toward later than sooner. Indeed:

Many participants indicated that their assessment of the balance of risks associated with the timing of the beginning of policy normalization had inclined them toward keeping the federal funds rate at its effective lower bound for a longer time...

Here it would be helpful to know the expected time horizons. How long is a "longer" time? My sense is that the possibility of a March hike was on the table at the request of the hawks, and "longer" meant sometime after March. But when after March? That is data dependent, but the Fed is challenged to describe exactly what conditions need to be met before justifying a rate hike:

Participants discussed the economic conditions that they anticipate will prevail at the time they expect it will be appropriate to begin normalizing policy. There was wide agreement that it would be difficult to specify in advance an exhaustive list of economic indicators and the values that these indicators would need to take.

Still, they have some broad guidelines:

Nonetheless, a number of participants suggested that they would need to see further improvement in labor market conditions and data pointing to continued growth in real activity at a pace sufficient to support additional labor market gains before beginning policy normalization. Many participants indicated that such economic conditions would help bolster their confidence in the likelihood of inflation moving toward the Committee's 2 percent objective after the transitory effects of lower energy prices and other factors dissipate.

It seems then that "many" participants are focused primarily on the labor market. It would be interesting to see how "many" of those "many" saw their confidence increase after the positive January numbers. Others pointed to inflation measures and wages as important indicators:

Some participants noted that their confidence in inflation returning to 2 percent would also be bolstered by stable or rising levels of core PCE inflation, or of alternative series, such as trimmed mean or median measures of inflation. A number of participants emphasized that they would need to see either an increase in market-based measures of inflation compensation or evidence that continued low readings on these measures did not constitute grounds for concern. Several participants indicated that signs of improvements in labor compensation would be an important signal, while a few others deemphasized the value of labor compensation data for judging incipient inflation pressures in light of the loose short-run empirical connection between wage and price inflation.

My take is this: To get a reasonably sized consensus to support a rate hike, two conditions need to be met. One is sufficient progress toward full-employment with the expectation of further progress. I think that condition has already been met. The second condition is confidence that inflation will indeed trend toward target. That condition has not been met. To meet that condition requires at least one of the following sub-conditions: Rising core-inflation, rising market-based measures of inflation compensation, or accelerating wage growth. If any were to occur before June, I suspect it would be the accelerating wage growth.

On communication, the Fed sees that is has trapped itself:

Participants discussed the communications challenges associated with signaling, when it becomes appropriate to do so, that policy normalization is likely to begin relatively soon while remaining clear that the Committee's actions would depend on incoming data. Many participants regarded dropping the "patient" language in the statement, whenever that might occur, as risking a shift in market expectations for the beginning of policy firming toward an unduly narrow range of dates. As a result, some expressed the concern that financial markets might overreact, resulting in undesirably tight financial conditions.

If "patient" means exactly two meetings as is widely believed, then why would dropping patient imply higher rates in an "unduly narrow range of dates"? Isn't "two" two? If "two" is two, why the need for the adjective "unduly"?  The definition of "unduly" according to the dictionary is:

to an extreme, unreasonable, or unnecessary degree

So "two" is thus extreme or unreasonable? Either "two" isn't two or patient wasn't meant to imply always two meetings. Indeed, Cleveland Federal Reserve President Loretta Mester suggests that "two" is only one interpretation. Via the Wall Street Journal:

WSJ: When you say that, do you have April in mind or do you have June in mind?

MESTER: Given what we’ve communicated, June is a viable date. We have the patient language which has been interpreted as two meetings.

The language "has been interpreted" not "means" two meetings. If "two" is plainly two, how can it have any other interpretation? And "has been interpreted" by whom, for that matter?

You get the point. The Fed can't keep itself from making calendar dependent statements, and thus undermines it's own communications. Yellen should have said "patient" means "until the data says otherwise." But she couldn't help herself by not including some kind of calendar dependent qualifier. As a consequence, now the Fed is stuck with modifying the language to keep a June rate hike on the table.

Wait, is a June rate hike still on the table? Although the minutes were interpreted dovishly by financial market participants, I doubt the Fed will want to pull the plug on June just yet. Incoming Fed speak continues to signal a rate hike is coming (including Mester describing June as a "viable option" this week), the January labor report was solid, via the minutes the Fed sees external risks as dissipating, we have four more employment reports before the June meeting, and I doubt the Fed really wants to start signaling policy two periods in advance. Too early to pull June off the table, but they can't move in June without something solid on the inflation front. So the March statement, or subsequent press conference, will be about dealing with the "patient" language, and the April meeting will be about whether they really expect to move in June or not.

One more consideration. It has been noted that the length of the minutes ballooned in January. Less noted is that the FOMC has a new secretary, Thomas Laubach, who succeeds William English. The additional detail may reflect that change, and the additional detail may swing our interpretation of the minutes relative to past minutes. 

 Bottom Line: The Fed is plainly focused on raising rates. As a group, they sense the time is coming to begin policy normalization. But they don't yet know when exactly that time will be. They don't yet have everything they need to begin, and they don't know when they will have everything (which is why they need to end calendar-dependent language). We know not yet. June? Maybe, maybe not.

Fedspeak Points To June

Federal Reserve speakers were out and about today. First off, Richmond Federal Reserve President Jeffrey Lacker set a fairly high bar for NOT hiking in June.  Via the Wall Street Journal:

“At this point, raising rates in June looks like the attractive option for me,” Mr. Lacker told reporters following a speech Tuesday in Raleigh, N.C. “Data between now and then may change my mind, but it would have to be surprising data.”...

...“The economy’s clearly growing at a more rapid, sustained pace than it was a year ago,” he said. “Economies that are growing faster need higher real interest rates, and a variety of indicators point to the need for higher real rates.”

What about inflation? It is all about oil:

Mr. Lacker said the effects of lower gasoline prices on inflation should be transitory, and he expects inflation will move back toward the Fed’s 2% annual target over the next year or two. “The inflation rate was clearly moving towards 2% before oil prices began falling last summer,” he said.

Here I worry, because Lacker is clearly ignoring the data, or least weighing the year-over-year changes far too heavily. Inflation actually accelerated in the second half of 2013, but was clearly decelerating by the beginning of 2014 (right idea, wrong dates) first half of 2014, but was clearly decelerating by June, prior to the oil shock. By July, the 3-month annualized change in core was just 0.97% while oil was still above $100 and gas above $3.50:

But the Fed is close to achieving the employment mandate, so inflation data be damned! Still think the employment part of the dual mandate is really a good idea?

San Francisco Federal Reserve President John Williams digs in his heals and assures us a rate hike is coming.  Via the Financial Times:

John Williams, president of the Federal Reserve Bank of San Francisco, said the time for the US central bank to start raising rates is getting “closer and closer” amid faster-than-expected wage rises in January and “really strong” hiring. Some investors may be caught out by a rate increase, but that should not stop the Fed from tightening policy if necessary, he said.

What about inflation?  No problem, it is all about the lags:

...Economists including Lawrence Summers, a former US Treasury secretary, have urged the Fed to leave rates unchanged until there is clear evidence that inflation, and inflation expectations, are set to breach its 2 per cent target. 

However Mr Williams dismissed such calls, warning of the risk that the Fed gets behind the curve on inflation and that it could end up being forced to hike rates “much more dramatically” to rein in inflation, provoking market turmoil. Given the trails with which monetary policy operates it was better to start raising interest rates “gradually, thoughtfully”, he said.

Note that he pulled out the "if we don't hike now we will need to hike more later" argument. That, along with the financial stability argument, is how they will justify a rate increase in the absence of inflation. Williams, however, hedges on June:

A key question obsessing financial markets is whether the Fed pulls the trigger in the middle of the year or waits longer. Mr Williams did not commit himself to voting for a move in June, saying instead that the decision of whether to hike or delay a bit longer would be “in play” at that point.

Time is growing short for the wage gains necessary to begin hiking in June.

Importantly, Williams also rejects the idea that bond markets are signaling secular stagnation:

He dismissed arguments that low long-term bond yields in the US reflect fears of a gloomy outlook for the American economy, saying they more likely were a result of global financial conditions, amid slowdowns and policy easing in large parts of the rest of the world.

US policy would still be very accommodative even after the Fed raised rates, he stressed. “That first step of raising interest rates is just removing a sliver of that accommodation,” he said.

The last paragraph is key. Williams, like the rest of the FOMC argues that conditions will remain very accommodative after even a small rate hike. As I noted last night, this is not true under the secular stagnation hypothesis:

 

It would be interesting if we had William's estimate of the equilibrium rate for comparison. Wait, we do - from his January 2014 Brookings paper:

Oh my, that brownish-greenish line appears to be a fairly pessimistic estimate of the natural rate, certainly one inconsistent the assertion that conditions remain accommodative after even just a small rate hike. Perhaps some journalists should start pressing Williams on the policy implications of his research. And, for that matter, I think the Fed's view on the equilibrium real rate should be a front-and-center topic for the next FOMC press conference.

Meanwhile, soon-to-retire Dallas Federal Reserve President Richard Fisher is pegging his rate outlook to wage gains:

 “If we were to see employment continue to increase, we’re getting much, much better on that front and you begin to see the wage price pressures, that should govern what we do with interest rates.”

The Fed simply has no justification to raise rates in June absent acceleration in wage growth. Even Fisher agrees. Fisher also pushes back against the renewed "Audit the Fed" movement:

“We are — I’ll be blunt — we are audited out the wazoo. Every Federal Reserve Bank has a private auditor. We have our auditor of the system. We have our own inspector general. We are audited. That’s not what he’s talking about. What he’s talking about is politicizing monetary policy.”

That's the plain truth. It has nothing to do with economics, and everything to do with politics.

Bottom Line: The Fed wants to hike in June. They continue to dismiss the inflation data, but they still need wage growth to hike. They dismiss the secular stagnation hypothesis. I hope they are right on that, or this is going to get ugly. Quickly.

On The Fed Credibility Gap

Financial market participants do not believe the Fed will pursue their expected policy path:

 

David Wessel opines on the reasons from his post at Brookings:

First, financial markets are not interested in the median Fed official; they’re interested in Chairwoman Janet Yellen, and they assume her dot is lower than the median...Second, the markets think Fed officials and staff economists are overly optimistic about the U.S. economy, as they have been in the past...Third, there’s the inflation issue. Many do not believe that the Fed will raise rates until underlying inflation is a lot closer to its 2% target....

I will suggest another framework: Financial markets are pricing in a "secular stagnation" scenario that is at odds with Federal Reserve thinking. It is fairly easy to consider this in terms of the Taylor rule. One implication of the "secular stagnation" hypothesis is a decline in real interest rates. Suppose that the short term equilibrium real rate has fallen to zero. Consider the monetary policy implications from a basic Taylor rule:

The black dots are median Fed funds projections from the SEP; the colored dots are the Taylor rule predictions from the midpoint of SEP projections of core inflation and unemployment. In this scenario, monetary policy is only slightly loose by the end of 2015, near-neutral in 2016, and a little tight at then end of 2017.

But notice that even with the 0% equilibrium rate hypothesis, the Taylor-implied neutral Fed funds rate in 2017 is 2.5-3%, still high relative to the market implied rate of 2% at the end of 2017. So let's change the estimate of NAIRU from 5.6% to 5%. This does not appear to be unreasonable given the lack of wage response to date.  Moreover, it is close to pre-recession Fed estimates. The results:

I would say this is fairly close to market expectations, albeit with a slightly lower neutral Fed funds estimate of 1.7-1.8% at the end of 2017. It thus appears reasonable to argue that financial market participants are pricing in a secular stagnation story combined with a pre-recession level of NAIRU.

In contrast, the Fed is not seriously contemplating such a story, at least the secular stagnation part. We know this from Federal Reserve Chair Janet Yellen herself:

I know that’s a mouthful, but it says, in effect, that the Committee believes that the economic conditions that have made recovery difficult, we’re getting beyond them. They are optimistic that those conditions will lift. They see the longer-run normal level of interest rates as around 3³/₄ percent. So there’s no view in the Committee that there is secular stagnation in the sense that we won’t eventually get back to pretty historically normal levels of interest rates. But they have said, it’ll, you know, the economy has required to get where it is a good deal of monetary policy accommodation; we expect to be able to normalize policy.

The biggest risk to the expansion is a dogmatic view of the neutral Fed funds rate on the part of the Federal Reserve. Markets are pricing in a secular stagnation story. The decline in long yields is also consistent with that story. So at the moment, financial market participants are saying the Fed has less room to maneuver than monetary policymakers believe. The Fed, I fear, is not taking sufficient heed of those signals.

Would it be outrageous to think that the Federal Reserve could find itself backtracking after just 200bp of rate hikes? Not if Sweden serves as any example. The Riksbank attempted to normalize policy when long-term rates were still low, and continued despite minimal gains in those rates. The result? The Riksbank managed to get to 200bp before being forced to reverse course:

I suspect there will be disbelief if not outright hostility to the idea that equilibrium short term real rates are near zero. Monetary policy makers will not like the result because it implies a narrow range to the effectiveness of their interest rate tools. They will also fear the asset bubble implications; many market participants will lament the same. I understand. That those in the rentier business would be hostile to the euthanasia of the rentier is expected and understandable. But if (safe) real returns are indeed collapsing toward zero, then obtaining higher returns will require taking on more risk, and more of those in the rentier business using more money to chase more risk will undoubtedly yield more asset bubbles of one variety or another. Those entrusted with financial stability will counter with a more costly regulatory environment to limit the creation of those bubbles, thereby making the rentier business even more difficult. In short, the future looks challenging for the rentier business.

Bottom Line: The Fed's expected policy path, and any desire for an even more aggressive policy path pushed by some market participants, is at odds with a secular stagnation scenario. But it appears something similar to that scenario is price into bond markets. If the Fed is not open to such a scenario, they risk tightening too aggressively and turning an expansion that should last at least four more years into one with only two left.

Upbeat Jobs Report

The January jobs report came in above expectations, with nonfarm payrolls growing by 257k and, more importantly, there were large upward revisions to the previous two months. Simply put rumors of the demise of the US economy continue to be premature. 

The pace of job gains accelerated further on average:

Oil and gas extraction jobs declined by 1.9k, but we all know more are coming. But outside of that sector, the economy added 255k jobs. The oil and gas extraction sector itself is only 200k jobs. In short, the fears that this sector is going to topple the US economy are just simply not going to come to pass.

In the context of data Federal Reserve Chair Janet Yellen has previously signaled as important:

Ongoing general improvement with measures of underemployment still elevated. There was some excitement about the 12 cent gain in average hourly earnings. I myself am less impressed as to me this largely represents a correction from December's anomalous drop. Wage growth remains fairly anemic year-over-year: 

I would also like to see what happens after the impact of minimum wage hikes dissipates. The Fed, however, my take more comfort in the uptick than me. It goes without saying that a June rate hike remains on the table, although I think it is difficult to justify without faster wage growth. Still four jobs reports till then, so plenty of time to pull that number upward.

Jon Hilsenrath reiterates the view that if the Fed wants to keep the June option open they need to pull the word "patient" in March:

Second, Fed officials will decide at their March meeting whether to change or drop the language in their policy statement pledging to “be patient” in deciding when to raise their benchmark short-term interest rate from zero. That phrase means they won’t move for at least two more meetings.

After the March gathering, the Fed has meetings scheduled for April and June. If the policy makers keep the “patient” language in the statement, that would indicate they don’t think they’ll raise rates at those meetings. If they scrap the phrase, that would give them the option to move as early as June if the economic data hold up.

I doubt this is as black and white as Hilsenrath argues. I don't think Yellen intended to imply that "patient" always means two meetings. Perhaps I just have too many memories about "considerable time" first meaning six months and then not. Plus, the Fed is aware of its past history, and in 2004 "patient" turned to "moderate" just one meeting before the hike. But it was technically the second meeting after "patient" was dropped, so is that two meetings?  Also, as we saw with the "considerable" to "patient" transition, the Fed has its own unique way of wordsmithing that can deliver something for everyone. And finally, Yellen has the press conference to redefine her interpretation of "patient."  But maybe I am wrong. In any event, I am not taking a fixed stand on what "patient" means until the press conference.  

Bottom Line:  The US economy has very real momentum on its side at the moment. It is more resilient to shocks than commonly assumed. This isn't 2011. June is still on the table.  

Fed Updates

Some quick notes on monetary policy this afternoon:

1.) Another policymaker in favor of a first half rate hike.  Cleveland Federal Reserve President Loretta Mester supports a rate hike by June.  Via Michael Derby at the Wall Street Journal:

Expressing confidence weak inflation will eventually rise again, Federal Reserve Bank of Cleveland President Loretta Mester said Wednesday the U.S. central bank remains on track for raising rates in the next few months.

Noting that Fed policy isn’t on a “pre-set path,” Ms. Mester said “if incoming economic information supports my forecast, I would be comfortable with liftoff in the first half of this year.” Because Fed policy actions affect the economy over a long period of time, the central banker said the Fed will need to act before it has fully achieved its job and price mandates.

She is, however, watching the survey data:

The official told reporters after her speech that if inflation expectations began to weaken, especially ones derived from surveys, “that would give me pause” when it comes to advocating for rate increases.

While the timing of any policy move remains in flux, Mester's basic story is close to consensus: The Fed is looking at putting the economy on a glide path to achieving its mandates, which means moving ahead of those mandates.

2.) But another is pointing out the danger of low inflation. Boston Federal Reserve President Eric Rosengren doesn't speak to the timing of rate hikes, but low inflation is clearly on his mind:

Of course today, after significant labor market improvement, and with the horizon over which inflation will return to its target being uncertain, inflation has taken on a more prominent role in our deliberations.

Currently, an obvious caveat in interpreting the low inflation rate in the U.S. is the supporting role played by the recent decline in energy prices. Oil shocks have been associated with major changes in monetary policy before. The failure to control inflation in the United States during the 1970s, in the presence of an adverse oil supply shock, highlighted a serious dilemma facing monetary policy at that time. Importantly in that case, what might have been a temporary pass-through of oil to non-oil prices turned into a more lasting problem with overall inflation, as wage and price dynamics at that time helped turn increases in oil prices into fairly protracted increases in overall inflation. Former Federal Reserve Board Chairman Volcker is rightfully recognized for taking forceful action to address the situation and ultimately tame inflation in the United States.

Currently, a concern is that central banks are facing the mirror image of the problem in the 1970s. The problem of significantly undershooting inflation – a dynamic which could well keep interest rates at the zero lower bound – is likely to be a key challenge to central bankers in the first two decades of the 21st century. And I would say that as with the oil shock in the 1970s, the current shock has served to accentuate a potential monetary policy pitfall – in this case, the failure to quickly and vigorously address a significant undershooting of inflation targets, potentially leaving economies stagnant at the zero lower bound. 

He would support later rather than sooner with regards to the first rate hike.  

3.) Fed ready to lower NAIRU?  I have argued in the past that if the Fed is faced with ongoing slow wage growth, they would need to reassess their estimates of NAIRU.  Cardiff Garcia reminded me:

@TheStalwart @TimDuy Whether/extent to which Fed reverts nat-rate estimates to pre-2010 range is one of 2015's big Qs pic.twitter.com/CKieHx2zRC

— Cardiff Garcia (@CardiffGarcia) February 4, 2015

While David Wessel adds today:

JPMorgan run the Fed's statistical model of the economy and says the NAIRU (which was 5.6%+ through 2013 data) is now down to 5%.

— David Wessel (@davidmwessel) February 5, 2015

Jim O'Sullivan from High Frequency Economics says not yet:

"Hard-to-fill" @NFIB jobs series up to 26 in Jan (+1). Corroborates unempl decline, with no sign of lower #NAIRU pic.twitter.com/DVYGyGV4e6

— Jim O'Sullivan (@osullivanEcon) February 5, 2015

A reduction in the Fed's estimate of the natural rate of unemployment would likely mean a delayed and more gradual path of policy tightening, should of course the Fed ever get the chance to pull off the zero bound.  Keep an eye on this issue!

4.) Will the Fed remain "patient" in March?  Jon Hilsenrath at the Wall Street Journal says the Fed needs to remove "patient" from the FOMC statement in March if they want to move in June:

The “patient” assurance, Fed chairwoman Janet Yellen has said, means no rate increases for at least two more policy meetings. The next two policy meetings after March are in April and June. If officials think they might raise rates in June, they need to remove “patient” in March to give themselves the option to proceed if economic data justify a move by June.

Interesting - this is a stricter interpretation of "patient" than I had from Yellen's comments. I did not think that "patient" would always mean just two more meetings, only that in December "patient" meant two more meetings. During the last rate hike cycle, the Fed maintained "patient" until March, switched to "measured" in May, and hiked in June. So they hiked the second meeting after the last "patient." Does that meet the definition that Yellen gave in December? I don't know, but I am not sure she meant to imply that "patient" always and forever means no hike for the next two meetings. So I guess we have our first question for the next press conference. At the moment, following the last cycle, I don't think that keeping "patient" means they are taking June off the table.

5.) Employment report watch.  Calculated Risk notes that Goldman Sachs cut their forecast for tomorrow's employment report to a 210k gain in nonfarm payrolls and a 5.5% unemployment rate, at the low end of consensus and similar to my forecast. But the January number might be an even bigger crapshoot than usual anyway. Via Bloomberg:

 A significant risk to the January payroll print is that the seasonal adjustment may not be properly calibrated. If employers added more seasonal workers than usual based on a firmer assessment of economic conditions, then there may be more layoffs in January. If the seasonal factors do not properly account for this, then a weaker-than-expected payroll gain could result.

And note that one number doesn't make a trend:

Underlying labor market momentum is largely being sustained, as economic growth remains decent, albeit slower than the mid-year hot streak between Q2 and Q3 of 2014. As such, if January employment disappoints, it is probably an anomaly related to seasonal adjustment issues, not a meaningful downshift in the pace of hiring.

The ongoing improvement in consumer attitudes is an encouraging sign that households continue to sense a healthy labor market.

6.) Falling interest rates worldwide. The global push for easier monetary policy continues. China's central bank is now officially in easing mode, while the Danish Central Bank moves deeper into negative territory. The Fed wants to be able to move in the opposite direction, but financial markets are telling them this isn't the time to move off of zero. The Fed will resist - this isn't 2011 when the US economy was much further from reaching its employment mandate than it is today. That said, they eventually had to relent and ease in 1998, so holding steady would be familiar territory (they are not bringing QE back to life yet). But will they worry that easing then helped sustain an asset bubble, a situation they do not want to repeat? Increasingly, the Fed looks to be back in a place they hoped they had left behind - between a rock and a hard place.

And with that we await tomorrow's employment report. Sorry I don't have time to give each of these topics the time they deserve.

Employment Week

The ritual of employment week is upon us once again, that glorious time of the month when we all imagine that we possess the intellectual and spiritual capacity to devine deep meaning from a highly volatile and heavily revised number. Unable to resist the pull myself, I look forward to a fairly steady reading on the labor market that will do little to sway monetary policy in either direction. The real action is in the wage data, but even there we may find little of interest, as any gain might do little more than reverse the surprise decline of the previous month.

Let the games begin!

Early reads on the labor market given little reason to suspect much change in underlying trends. Many of the details of the ISM manufacturing report were on the weak side, but not so much the employment figure:

The anecdotal comments, however, suggest that weakness is being driven by the West Coast port slowdown snarling supply chains. Firms of course would be hesitant to lay off workers on the basis of what they expect to be a temporary issue. The ISM non manufacturing report was pretty much the polar opposite, with generally positive details but a sharp decline in the employment component:

The employment component is a little disconcerting, but a quick look at recent history indicates that such a decline is not particularly unusual. So on net I doubt neither measure is telling us much to think there is any underlying change in the labor market just yet.

The ADP number came in a bit lower than expected, with the energy sector taking some of the blame. Via the Wall Street Journal:

“Businesses in the energy and supplying industries are already scaling back payrolls in reaction to the collapse in oil prices, while industries benefiting from the lower prices have been slower to increase their hiring,” said Mark Zandi, chief economist of Moody’s Analytics, which calculates the ADP jobs numbers.

In the "give credit where credit is due" department, this fits well with the December prediction of Atlanta Fed economists David Altig and Pat Higgins.  They estimated the initial impact of the oil price decline would be modestly negative due to the rapid response of capital equipment spending relative to the consumer side of the equation. The net impact over time:

I think we should all expect some weakness in the gas and oil extraction component there are questions about ADP's January seasonal adjustment issues:

”The ADP has had some problems seasonally adjusting its January numbers because employers often wait until the new year to purge their payroll records of employees who had left during the previous year,” wrote Paul Ashworth, chief U.S. economist at Capital Economics in a research note.

Which serves as a reminder to be wary of moving your expectations too much in response to the ADP numbers. Finally, initial unemployment claims are a tad higher relative to December, but not enough to shift my view of the labor market: 

Still plumbing the depths generally consistent with solid job growth.

For added fun, we also will get the final benchmark revisions for 2014, although those are not likely to have policy impact.

Bottom Line:  I am expecting a headline nonfarm payrolls gain of 216,000, a slight decrease in the unemployment rate to 5.5%, and a reversal of December's weak wage readings. Fairly in line with consensus, although on the low side of the payrolls range (215k-268k). Nothing to pull forward or push back the Fed's timeline. We can still hope, however, for some blow out numbers to have something to write about Friday morning.

Adendumm: Clarification - given the volatility and revisions, I tend to think that anything with 50k of last month's 252k NFP is a "fairly steady" read on the labor market. 

Brief Comment

It is always interesting to see how others perceive you. For instance, I wasn't sure what to make of this from Paul Krugman:

The monetary-policy gap between insiders and outsiders — between economists at the Fed and other policy institutions, who still seem eager to raise rates, and those of us on the outside, who think this is a really, really bad idea — continues to widen. This morning Tim Duy — one of the outsiders who, commenting from his perch at Mark Thoma’s invaluable blog, has seemed most sympathetic to the urge to hike rates — joins the what-are-they-thinking chorus.

When I read that I realized that perhaps I wasn't defining my space quite right. Primarily, I attempt - albeit, admittedly, not always successfully - to understand the world as Federal Reserve policymakers see it. Failing to put your personal opinion in the background is one of the biggest mistakes a Fed Watcher can make. Right now, for example, policymakers are somewhat hawkish relative to market expectations, so my writing has a hawkish tilt, which is what I think Krugman interprets as "sympathetic." 

Occasionally, however, my opinions become more evident, which is what Krugman interprets as joining the "what-are-they-thinking chorus."  In truth I am not particularly sympathetic with the Federal Reserve's campaign to normalize policy. That campaign is predicated on the belief that the economy is close to full employment. Krugman sees the natural rate of unemployment as mostly likely below 5%. I concur. The Fed's Summary of Economic Projections, however, places the natural rate in the 5.2-5.5% range. My thinking is that is as much as 0.5 percentage points or even more too high. That is a big, big error, somewhere around 800,000 real lives impacted. A lot of jobs to risk when inflation is trending downward, in my opinion.

I also believe that the fact that we have experienced two recessions since 1991 yet no outbreak of inflation is prima facie evidence that the Fed, on average, maintains too tight a monetary policy.  Seems likely a little bit looser policy would yield significant welfare gains.

Anyway, I think readers probably get the idea at this point. My expectations of a particular Fed policy does not necessarily indicate support for that policy. In future writing I will endeavor to more clearly delineate between the two.

Fed's Preferred Inflation Measure Dives

Not only is core-PCE inflation on a year-over-year basis trending away from the Fed's target:

but the deceleration in recent months is truly shocking:

It is hard to see how the Fed can be confident that inflation with trend back to target when looking at these numbers. They need some acceleration in wage growth to justify their intentions to begin normalizing policy, and even with such acceleration, I think their case is fairly weak in the context of the current inflation environment. If they make a case, they will base it on these three pillars:

1.) With unemployment nearing 5%, they have reached their employment mandate.
2.) Monetary policy is exceptionally accommodative even if they raise interest rates.
3.) Failure to raise rates invites asset bubbles.

On point three, refer to New York Federal Reserve President William Dudley:

Quickly, let me give two examples that illustrate how variable this linkage can be.  First, during the 2004-07 period, the FOMC tightened monetary policy nearly continuously, raising the federal funds rate from 1 percent to 5.25 percent in 17 steps.  However, during this period, 10-year Treasury note yields did not rise much, credit spreads generally narrowed and U.S. equity price indices moved higher.  Moreover, the availability of mortgage credit eased, rather than tightened.  As a result, financial market conditions did not tighten.  

As a result, financial conditions remained quite loose, despite the large increase in the federal funds rate.  With the benefit of hindsight, it seems that either monetary policy should have been tightened more aggressively or macroprudential measures should have been implemented in order to tighten credit conditions in the overheated housing sector.

It may be that the Fed looks at the tech and housing bubble episodes and concludes that zero interest rates are not desirable even if inflation is below trend. Yes, I know, macroprudential before interest rates when addressing asset bubbles. But at a point when the economy is at the Fed's idea of full-employment, and given the events of recent decades? Easy to see the Fed seeing danger in putting all of their eggs in the macroprudential basket. 

Bottom Line: Below trend inflation as the economy nears full-employment is a very uncomfortable position for the Federal Reserve. It will be interesting to see how Federal Reserve Chair Janet Yellen navigates these waters at the upcoming Congressional testimony.

As of Yet, Fed Not Changing Tune

Early salvos by Federal Reserve policymakers in the wake of last week's FOMC non-event suggest that recent developments have had little impact on Fed thinking with regards to the appropriate timing of rate hikes. The middle of this year remains the internal forecast. Whether data or events cooperate is of course another question.

I think it is worth viewing Friday's two interviews with St. Louis Federal Reserve President James Bullard at Bloomberg and San Francisco Federal Reserve President John Williams at CNBC. Bullard is fairly clear in his view that financial markets are doing it wrong:

“The market has a more dovish view of what the Fed is going to do than the Fed itself,” Bullard said in an interview Friday in New York. “Markets should take it at face value” from the Fed’s rate projections, and it’s “reasonable” to expect an increase in June or July.

In contrast, I would say that Williams is a bit more cautious:

Given this projection, Williams said he thought "around the middle of this year is the time that I think, in my view, that we'll be getting closer to 'Should we raise rates now, or should we wait a little longer, collect some more data, get more confidence in the forecast?'"

The baseline story, however, is generally the same. They believe the US economy has sufficient momentum to weather any external shocks. They both view the first quarter GDP report as consistent with their underlying forecast. So did I, for that matter. You need to be able to tease out the underlying trend when parsing the data. Calculated Risk gets it right. R-E-L-A-X:

There are legitimate concerns about a strong dollar, and weak economic activity overseas, impacting U.S. exports and GDP growth.  However, overall, the Q4 GDP report was solid.

In short, neither Williams nor Bullard is seeing anything in the recent data to worry them significantly. Regarding the timing of a rate hike, I think that if you view the videos, you will see a line of logic fairly similar to what I described last week. They see unemployment falling to 5% or less this year. They do not think that such a situation as consistent with zero rates. They think they need to move ahead of actual inflation. They think that even after hiking rates, monetary policy will remain accommodative. 

A couple of clarifications and extensions:

First, my take is that the Fed wants to pull the focus off of the first rate increase to the subsequent path of policy. What comes first is not as important as what comes after. The "comes after" is one reason they want to move sooner than later given the current economic environment. Bullard views it important to narrow the gap between zero and normal rates because he fears that falling behind the curve will necessitate a steeper subsequent policy path. This thinking is probably endemic within the Federal Reserve.

Second, notice that again Bullard dismisses market-based measures of inflation expectations as distorted by the massive drop in the price of oil. And his opinion is not illogical: There is no reason to think 5y5y forward exceptions to be impacted in lock step with the collapse in oil prices. He wants to see how that situation plays itself out.

Third, Bullard says that we are 400bp below normal policy and that his view of normal policy has not changed much. There is no new normal. This too I think is endemic in Fed thinking and where I think lies the greatest potential for a policy error. They should not be holding a dogmatic view of what is normal. The bond markets are telling me that would be a mistake.

Fourth, Bullard was not disturbed by the rise of the dollar as he sees it as a natural consequence of a stronger US economy and weaker economies abroad. This contrasts with the general view that the Fed is panicking over the dollar. 

So what does Fed Chair Janet Yellen think? Well, both Bullard and Williams are coming right out of the gates of an FOMC meeting, and I doubt either would take a position that was strongly in contrast to Yellen. That said, expectations seem to be growing for Yellen to head a different direction. Via the Wall Street Journal:

“If the markets stay how they are today three months from now, the Fed would have a hard time raising interest rates,” Alan Rechtschaffen, a financial adviser at UBS, said this week. That would make Ms. Yellen’s twice-yearly testimony before the House and Senate, expected in the third week of next month, a potential opportunity for beginning to show increased concern about low inflation—particularly if measures of prices excluding energy and food costs keep moving lower.

“As early as the Humphrey-Hawkins testimony the Fed could begin to lay the groundwork for a transition in monetary policy” toward a later date for interest-rate increases, Mr. Rechtschaffen said.

Like I thought that there would be little change in the FOMC statement, I am cautious about expecting a change in Yellen's tone. It might be good to consider this anecdote from former Federal Reserve Governor Larry Meyer:

The final question is whether Janet is really a dove. Let me tell you a story. Janet and I held very similar views when we were colleagues on the Committee, despite the fact that I was immediately viewed as a hawk and she was already viewed as a dove. (I thought of myself at the time as being a “hawkish dove.”) In any case, when it comes to ensuring price stability and maintaining well-anchored inflation expectations, there are no doves on the Committee. Before the September 1996 FOMC meeting, Janet and I went to see the Chairman to talk about the policy decision at that meeting and at following meetings. This was the only time I ever visited the Chairman (at my initiative) to talk about monetary policy, before or after a meeting. Janet and I were both worried about inflation, even though it was very well contained at the time. We told the Chairman that we loved him but could not remain at his side much longer if he continued, as he had been doing for some time, to push the next tightening action into the next meeting, and then not follow through. He listened, more or less patiently. I recall, though this may have not been the case, that he just smiled and didn’t say a word. After an awkward silence, we said our good-byes. Needless to say, we didn’t win this argument. Yet, we never dissented. That is another matter of etiquette for the entire Board, at least since when I was there: The Board is a team, always votes as a block, and, therefore, always supports the Chairman.

The reason I bring this up is that if my analysis of the Fed's baseline thinking is generally correct, then Yellen will have a hard time staying a dove if her underlying framework is unchanged from 1996. And I think we are seeing that as the economy heads into more normal territory, that underlying framework is indeed unchanged. This is especially the case when she could view former Federal Reserve's Chair Alan Greenspan's 1996 bet as being a special case attributable to higher productivity, and she does not have productivity in her corner this time around. Just something to think about.

Bottom Line:  I am not convinced the Fed is changing its thinking as quickly as markets think the Fed is changing its thinking. That means that Fedspeak might continue to be hawkish relative to expectations.