Tim Duy's Fed Watch

Does 25bp Make A Difference?

I am often asked if 25bp really makes any difference? If not, why does it matter when the Fed makes its first move? The Fed would like you to believe that 25bp really isn't all that important. Indeed, they don't want us focused on the timing of the first move at all, reiterating that the path of rates is most important. Yet I have come to believe that the timing of the first rate hike is important for two reasons. First, it will help clarify the Fed's reaction function. Second, if the experience of Japan and others who have tried to hike rates in the current global macroeconomic environment is any example, the Fed will only get one shot at pulling the economy off the zero bound. They better get it right.

On the first point, consider that there is no widespread agreement on the timing of the Fed's first move. Odds for September have been bouncing around 50%, lower after a couple of weeks of market turmoil, but bolstered by the Fed's "stay the course" message from Jackson Hole. I think you can contribute the lack of consensus to the conflicting signals send by the Fed's dual mandate. On one hand, labor markets are improving unequivocally. The economy is adding jobs and measures of both unemployment and underemployment continue to improve. The Fed has said that only "some" further progress is necessary to meet the employment portion of the dual mandate. I would argue the Fed Vice-Chair Stanley Fischer even was kind enough to define "some" while in Jackson Hole:

In addition, the July announcement set a condition of requiring "some further improvement in the labor market." From May through July, non-farm payroll employment gains have averaged 235,000 per month. We now await the results of the August employment survey, which are due to be published on September 4.

Nonfarm payroll growth was the only labor market indicator he put a number to. He clearly intended to tie that number to the Fed statement. Basically, he said "some" further improvement is simply another month of the same pattern.

While the Fed is moving closer to the employment mandate, however, the price stability mandate is moving  further from view:

On a year-over-year basis, core-CPI is at four year lows, and the collapse in the monthly change suggests that year-over-year trends will not soon turn in the Fed's favor. One can argue that the net effect on policy should be zero. After all, the Fed has long argued that inflation will revert to target, yet inflation has only drifted away from target. What kind of central bank tightens policy when they are moving farther from their inflation target? 

Fischer, however is undeterred:

Can the Committee be "reasonably confident that inflation will move back to its 2 percent objective over the medium term"? As I have discussed, given the apparent stability of inflation expectations, there is good reason to believe that inflation will move higher as the forces holding down inflation dissipate further. While some effects of the rise in the dollar may be spread over time, some of the effects on inflation are likely already starting to fade. The same is true for last year's sharp fall in oil prices, though the further declines we have seen this summer have yet to fully show through to the consumer level. And slack in the labor market has continued to diminish, so the downward pressure on inflation from that channel should be diminishing as well.

So back to the question: What kind of central bank tightens policy when they are moving further from their inflation target? Answer: The Federal Reserve. Why? Faith in their estimate of the natural rate of unemployment. Inflation expectations hold the baseline steady, shocks cause deviations from that baseline. The shocks will all dissipate over time, including labor market shocks. The economy is approaching full employment, therefore the downward pressure from labor market slack will soon diminish and turn into upward pressure in the absence of tighter monetary policy.

Now note that, aside from the equilibrium real rate, of the four variables in a Taylor-type reaction function, only one of those variables is unobserved. The target inflation rate is defined, and unemployment and inflation are measured. The natural rate of unemployment is unobserved and needs to be estimated. How confident are policymaker's in their estimate (5.0-5.2 percent) of the natural rate of unemployment?

I would argue that the Fed will reveal a high degree of confidence in that estimate if they hike rates in the face of inflation drifting away from trend. That would be new information in defining their reaction function. I think it would be a signal that Federal Reserve Chair Janet Yellen has largely abandoned here concerns about underemployment, which remains unacceptably high. 

The clarification of the Fed's reaction function by narrowing the confidence interval around the Fed's estimate of the natural rate of unemployment would, I think, be an important new piece of information. Moreover, I think it would be a fairly hawkish signal - remember that financial market participants, as well as the Federal Reserve staff, tend to have a more dovish outlook that FOMC participants. The sooner the Fed hikes rate, the more hawkish the signal relative to expectations.

That signal, I suspect, is more important than the actual 25bp. The latter might not mean much, but at the zero bound, the former probably means a lot.

The timing of the first hike is also important because the Fed will only get one bite at the apple. That at least is what we saw with the rush to tighten in Japan, Europe, and Sweden. The downside risks of tightening too early are thus enormous, amounting to essentially locking your economy into a subpar equilibrium. This was the Fed's staff's warning in the last set of minutes:

The risks to the forecast for real GDP and inflation were seen as tilted to the downside, reflecting the staff's assessment that neither monetary nor fiscal policy was well positioned to help the economy withstand substantial adverse shocks.

Again, Fischer seems to fear the opposite risk more. Via the New York Times:

And Mr. Fischer emphasized that Fed officials could not afford to wait until all of their questions were answered and all of their doubts resolved. “When the case is overwhelming,” he said, “if you wait that long, then you’ve waited too long.”

I am not looking for an overwhelming case, just inflation that is trending toward target instead of away. Yet even that is apparently too much for Fischer as unemployment bears down on their estimate of the full employment.

You can take the central banker out of the 1970's, but you can't take the 1970's out of the central banker.

Bottom Line: I am coming around to the belief that the timing of the first rate hike is more important than Fed officials would like us to believe. The lack of consensus regarding the timing of the first hike tells me that we don't fully understand the Fed's reaction function and, importantly, their confidence in their estimates of the natural rate of unemployment. The timing of the first hike will thus define that reaction function and thus send an important signal about the Fed's overall policy intentions. 

Hawkish Rumblings

Fedspeak from the Jackson Hole conference suggests that the more hawkish FOMC participants are sticking to their guns.  Cleveland Federal Reserve Bank President Loretta Mester, via the Wall Street Journal:

“I want to take the time I have between now and the September meeting to evaluate all the economic information that’s come in, including recent volatility in markets and the reasons behind that,” Ms. Mester said. “But it hasn’t so far changed my basic outlook that the U.S. economy is solid and it could support an increase in interest rates.”

Then there is St. Louis Federal Reserve President James Bullard, via Bloomberg:

“The key question for the committee is -- how much would you want to change the outlook based on the volatility that we’ve seen over the last 10 days, and I think the answer to that is going to be: not very much,” Bullard told Bloomberg Television in an interview Friday at the Kansas City Fed’s annual conference in Jackson Hole, Wyoming.

“You’ve really got the same trajectory that the committee will be looking at that we were looking at before, so why would we change strategy, which was basically to lift off at some point,” said Bullard, who votes on the FOMC next year...

...“The committee does not like to move when there’s volatility,” he said. “If we had the meeting this week, people would probably say let’s wait.”...

...He added, “but the meeting is not this week, it’s Sept. 16 and 17.”

Bullard does not want financial market turmoil to derail his long-supported rate hike. He is hoping all this noise just fades away over the next few weeks. And he wants to open up the October option:

Bullard also said he would support scheduling a press conference following the Oct. 27-28 FOMC meeting if the committee doesn’t raise rates next month. That would make it easier for the Fed to explain a liftoff in October.

Bullard has repeatedly sought a press conference for every meeting, to no avail. I agree with him. The Fed has reinforced the view that major policy shifts are limited to only four of the eight meetings a year. Ridiculous and unnecessary. There should be a press conference at every meeting. That said, they can't now announce a press conference for October because it will be taken as a clear signal of a rate hike on that date. After they get the first hike out of the way, then they should switch to a press conference with every meeting.

Here Bullard disappoints:

“I actually think we’re OK on the inflation front,” Bullard said. “I’ve been arguing that we should get going, because interest rates -- it’s not that we’re a little bit below normal, we’re all the way down at zero, so you’ve got to think about: How is this going to play out over the next two to three years.”

I can remember when Bullard had a reliable view on inflation. When inflation deviates from trend, you act. But the inflation picture is not friendly for hawks and even less so after this morning:

Core-PCE inflation decelerated to a meager 0.87 percent annualized rate in July. The uptick in near-term inflation had provided strong support for a September rate hike as it was consistent with the view that last year's disinflation was temporary. That no longer looks to be the case, pulling apart the argument that the Fed can be confident that inflation will trend back to target. If anything, all the monthly data looks like noise as inflation slowly drifts further and further away from target.

Moreover, I would have thought that Bullard would give more weight to market-based measures: 

I believe Bullard is increasingly held by the siren-song of the Neo-Fisherians, thinking the only way to raise inflation is to hike rates. Good luck with that.

I like this from Greg Robb at MarketWatch:

Fischer just trying to show the Fed is as cool as the underside of your pillow http://t.co/6HjoYsLYsA

— Greg Robb (@grobb2000) August 28, 2015

 Fischer went into this interview with the goal of leaving September open. Via CNBC:

"I think it's early to tell: The change in the circumstances which began with the Chinese devaluation is relatively new and we're still watching how it unfolds, so I wouldn't want to go ahead and decide right now what the case is—more compelling, less compelling, etc.," he said.

Fischer was trying not to tip his hat as much as New York Federal Reserve President William Dudley did on Tuesday. Or even arguably trying to pull back Dudley's comments as they had seemed to close off September.  Perhaps more telling, when asked about the PCE numbers, Fischer reiterated his confidence that inflation will trend to target, citing the transitory nature of the oil shock. This is somewhat disappointing given the data and his dovish comments on inflation just two weeks ago. But then again, he couldn't take a dovish stance if his intent was to keep September on that table.

 

Where does Fischer get his confidence on inflation? A basic Phillips curve story. It is the story that makes a September liftoff compelling. He believes the labor market is near full employment and that you need to move ahead of the inflation curve:

Still, he added that he has not seen "much evidence" of increasing risks to staying at near-zero rates for longer, but he also said he didn't want to wait too long. 

"When the case is overwhelming, if you wait that long, you'll be waiting too long," he said. "There's always uncertainty."

The Fed very much wants to ignore the inflation data and follow the labor markets. And even as inflation drifts further away from their target, they keep doubling down on their bets. It's what the Phillips curve is telling them they should do. 

Bottom Line: The Fed doesn't want to take September off the table. Many officials had what they believed was a solid case for hiking rates at the next meeting, and they don't want market turmoil to undermine that case. And that case is not complicated. It's the Phillip curve combined with an estimate of full employment (an estimate of full employment that remains sticky despite the persistent downtrend in inflation). If they move in September, that's the story they will run with. They don't have another paradigm. 

The Right And Wrong Arguments For September

This September meeting is the gift that keeps on giving. Right now it is giving by the shear quantity of truly bad commentary arguing for a rate hike next month.

Let's back up a few weeks. Prior to the recent market rout, September looked like a pretty good bet. And the basic story that justified that view still holds. It isn't complicated. Just a straight forward Phillips curve story. The economy continues to improve, dragging the labor market along for the ride. Any questions about the meaning of a weak first quarter GDP report were wiped away by the second quarter. Neither is by itself meaningful; the average of 2.5 percent growth for the first half is just about the same as 2014 as a whole. As the labor market approaches full employment, policymakers expect that wage growth will accelerate and they must raise interest rates to prevent those wage gains from translating into above-target inflation. They feel they need to raise rates sooner than later to be ahead of the curve.

That story is not without holes, of course. The lack of widespread faster wage growth or inflationary pressures as the unemployment rate approached the Fed's estimate of full employment should be a red flag. Moreover, measures of labor underutilization remain elevated. Marked-based inflation expectations were low and falling, the dollar was rising, and commodities were tanking. And it seems that the risks of premature exit from ZIRP still outweigh the risk of holding on just a little too long. The Fed staff highlighted this risk in the July FOMC meeting. From the minutes:

The risks to the forecast for real GDP and inflation were seen as tilted to the downside, reflecting the staff's assessment that neither monetary nor fiscal policy was well positioned to help the economy withstand substantial adverse shocks.

Despite these questions, Fed policymakers were leaning toward a rate hike in September, at least in my opinion. Fundamentally, they want to start raising rates and had shifted toward looking for reasons to do exactly that. It was never, however, a done deal, at least according to the probabilities assigned by the Fed futures markets. I was fairly confident of a September rate hike, but arguments against were entirely reasonable. I still believe that the Phillips curve story justifies expecting a rate hike in September.

Then I go on a little vacation to visit an old friend, the market starts sliding, culminating is a white-knuckle thousand point drop on the Monday opening. I saw that and came to the same conclusion as fed futures markets. A rate hike probably wasn't happening. That kind of volatility cannot be ignored, and it put the exclamation point on signs that US financial conditions tightened with the end of QE3. We have been around this block before. We know how the story ends.

As a long time Septemberist (Junist, back in the day), I was not pleased. 

Many others are not pleased as well, and the commentariat is bringing forth a host of bad reasons to push the Fed into hiking rates in September. One of my favorites comes from Jon Hilsenrath of the Wall Street Journal, reporting from Jackson Hole:

Raising rates would signal that the Fed is confident about the U.S. economy, Bank of Japan Governor Haruhiko Kuroda said Wednesday in New York, ahead of the Fed gathering. “That is not only good for the U.S. economy, but also for the world economy, including the Japanese economy,” he said.

Really, the Fed needs to be taking advice from the Bank of Japan? I think you should listen to their advice and do exactly the opposite. Rushing to hike rates never did them any favors. Foreign central banks have anything but the Fed's best interest in mind. Hilsenrath knows this:

When interest rates rise in one country but not another, the currency tends to strengthen in the country where rates go up, because the higher rates offer greater returns on bank deposits and fixed-income investments.

Looser conditions abroad require looser conditions in the US, all else equal, to hold the US economy steady. Foreign central bankers, however, are looking to boost growth off of weaker currencies, and hope the Fed thinks they should just eat the consequences for the US economy. Not. Gonna. Happen.

Another anecdote from Hilsenrath:

“If you delay something that you were planning to do, then you leave the impression that your compass is different than what you led markets to believe,” Jacob Frenkel, chairman of J.P. Morgan Chase International and former head of the Bank of Israel, said in an interview Thursday. Market drama is increased by delay, he added.

No, markets know exactly what the compass is. That's why futures markets reacted so quickly Monday. Because those traders read the FOMC statements:

 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.

Monday went well beyond typical volatility. The Fed could justify hiking rates if stocks were moving sideways. Or even drifting downward slowly. But Monday? Monday was something different, something that pointed to some significant fragilities in financial markets. And if you think those fragilities will lessen by higher rates, well that's just delusional.

 From the New York Times we get this:

Lim Say Boon, the chief investment officer for DBS Bank in Singapore, questioned any optimism over maintaining interest rates at their current low level.

“If markets are unhappy about a September rate hike, would they be happy with a December hike?” he wrote in an analyst note on Thursday. “I am not sure what ‘victory’ would look like for those in the market who are ‘rioting’ against a rate hike in September. There is also a risk of the Fed being seen as hostage to an angry mob in the market — cowed because the mob is smashing up the ‘furniture.’ ”

The precedent was the taper. Former Federal Reserve Chairman balked at tapering in September 2013, let markets digest the policy change, and then moved forward in December 2013. No problem. The stuff about "hostage to an angry" mob is code for "my trade is going sideways and I need someone to blame."

 Former Philadelphia Federal Reserve President Charles Plosser offers no surprises in these comments:

“I think the Fed needs to be careful and not overreact to short-term events,” Mr. Plosser said. The Fed’s policy committee “should keep the focus on the longer term.”

I would say that Monday shocked the Fed into looking at the longer term, such as the deterioration in inflation expectations, long a favored indicator that fell out of favor  because it became inconvienent:

More Plosser:

 “The less the Fed says about [the selloff] the better, because it creates the impression that monetary policy is responsible for markets, which it’s not,” he said.

Actually, the Fed is responsible for maintaining financial conditions conducive to maximum sustainable growth so, yes, monetary policy is responsible for financial markets. And those markets are how the Fed transmits policy no less. So the Fed can't just say "it's not our problem" because it kind of is their problem.

Stephanie Rhule at Bloomberg uses the Fed's flagging commitment to September to pull out a oldie but goodie:

The Federal Reserve has had many opportunities to raise rates over the last several years and—whether it was because of too many snowstorms, too few jobs, or not enough consumers hitting the malls—the Fed didn't raise. Why? Because it didn't have to. When the unemployment rate dropped to 7 percent in 2013 and 6.5 percent in 2014, many said this was enough cause to finally raise rates off the extraordinary zero bound. The Fed kept moving the goalposts and said: not just yet.

...For those feverishly predicting September vs. December, in terms of timing, you can scratch that concern off the list. The timing on everyone's mind is simply the fear of an additional major market fall. Wouldn't it be great if the Fed had raised rates two years ago, so it would have room to cut in the event that the economy follows the markets into a recession? Now it can't hike because the markets are a mess, and it can't cut because we are already at zero.

Really, everything would be better now if the Fed had been hiking two years ago when unemployment was 6.5%?  We needed to choke off growth in 2013? Markets could barely swallow the taper by the end of 2013. In what world does anyone think the economy could have handled any level of rate hikes then that would have provided a realistic cushion now?

 Rex Nutting at Market Watch uses the week's events to moralize on the "Greenspan put":

 ...This “Greenspan put” means investing in the stock market is a one-way bet...

 ...I believe the market selloff has made a September rate hike even more compelling than it was before, because it gives Fed Chair Janet Yellen the opportunity she needs to kill the “Greenspan put” once and for all...

...if supposedly risky investments like corporate equities and bonds are actually guaranteed by the Fed’s “Greenspan put,” then investors aren’t embracing risk at all...

Hmmm...I know plenty of people who don't think that investing in stock markets is a one-way bet. Like all those WorldCom investors. Or more generally anyone caught up in 2000. Or 2008. And apparently Millenials don't trust stocks, so they didn't get the message about the "Greenspan put." So let's end this now: Way too many people have lost way too much money for this supposed "Greenspan put" to be a real thing. It is more code for "my trade is going sideways and I need someone to blame."

Nutting extends his moralizing to Fed officials:

...Officials have been obliquely warning that some stock market valuations are too high to be justified by fundamentals. In truth, the correction in the U.S. markets has been welcomed at the Marriner Eccles Building. The Fed doesn’t mind the dip in the Dow, because it punishes complacency and because the selloff has been relatively orderly. There’s been no panic on Wall Street...

I don't think a guy like Vice Chair Stanley Fisher is sitting around thinking that he needs to take a chunk out of everyone's 401k just to teach them a lesson. OK, so maybe Kansas City Federal Reserve President Esther George is thinking that, but that would be a minority position. 

Hey, it's been a hard couple of weeks. Things changed. That certain rate hike became alot less certain. Maybe that changes back by September 17. Maybe not. All of us Fed watchers probably won't come to agreement until September 16. Getting emotional and moralizing about change isn't going to stop it. I have learned through the years to heed the advice of a fictional financier:

Stocks dropped sharply. It is a clear sign, on top of other signs, that financial conditions are tightening ahead of the Fed, and arguably too much ahead of the Fed. If the Fed heeds that warning you have to remember that's their job. Smoothly functioning financial markets. Lender of last resort. All that stuff. Maybe things work out just fine if they don't heed that warning. I am not interested in taking that risk. Not enough upside for me.

But if they take that risk, it won't be because they want to send the markets a message that they are in charge, or that the "Greenspan put" needs to be put to rest, or that they can't been seen as cowering to the markets, or that they need to stay the course because they already signaled a rate hike, or because foreign central bankers are demanding the Fed hike rates, or because they need to build ammo for the next crisis, or any other reason that comes from barstool moralizing after one too many. If they hike rates it will be for one simple reason: The recent market turmoil does little to shake their faith in the Phillips Curve. That would be the heart of their argument. And if you are arguing for September, that should be the heart of your argument as well.

Dudley Puts The Kibosh On September

Monday's action on Wall Street was too much for the Fed. That day, Atlanta Federal Reserve President Dennis Lockhart pulled back his previous dedication to a September rate hike earlier, reverting to only an expectation that rates rise sometimes this year. But today New York Federal Reserve President William Dudley explicitly called September into question. Via the Wall Street Journal:

In light of market volatility and foreign developments, “at this moment, the decision to begin the normalization process at the September [Federal Open Market Committee] meeting seems less compelling to me than it did several weeks ago. But normalization could become more compelling by the time of the meeting as we get additional information” about the state of the economy, he told reporters.

While this comment was sufficiently nuanced to leave open the possibility of September, in reality Dudley pretty much ended the debate. He only reinforced expectations that September was off the table, and time is running out to pull back expectations. Incoming data, what little there is at this point, would need to come in well above expectations to bring September back into play. And that is just mostly like not going to happen.

What about October or December? I tend to think that October is off the table due to a lack of a press conference. Yes, I know the Fed claims every meeting is live, but the reality is that they have reinforced the perception that major policy shifts occur only on meetings with scheduled press conferences. If the Fed  wants eight live meetings a year, they need eight press conferences. December remains open with sufficiently strong data, but does the Fed really want to attempt the first rate hike when financial markets are already tight seasonally?

Fundamentally, the problem for the Federal Reserve is that US financial conditions have tightened since the end of the quantitative easing, and will most likely continue to tighten as the rest of the world, notably now China, eases further. In effect, easier policy in the rest of the world requires, all else equal, easier policy in the US as well. Hence this from the FT:

Interest rate futures indicate that investors now see just a 24 per cent chance of a rate increase in September, down from more than 50 per cent earlier this month. The probable path of rate rises in 2016 has also moderated markedly, according to Bloomberg futures data.

The path of rates necessary to maintain stable growth in the US will be lower in response to easing conditions elsewhere. This is something known to bond market participants who as a group have long been more dovish than FOMC participants. But it was the equity market participants that shocked the Fed into the same realization.

To be sure, critics will loudly proclaim that the Fed must hike in September if only to prove they are not governed by the equity markets. That call will be heard in the next FOMC meeting as well, but it will be a minority view. A thousand point drop in the Dow will not be ignored by the majority of the FOMC. Dismissing what are obviously fragile financial market conditions would be a hawkish signal the FOMC does not want to send. Hiking rates is not going to send a calming message of confidence. That never works. If the history of financial crises has taught us anything, it is that failure to respond with easier policy only adds to the turmoil.

Bottom Line: The Fed has long argued that the timing of the first rate hike does not matter. I had thought so as well, but that is clearly no longer the case. A rate hike during a period of substantial financial market turmoil would matter a great deal. It looks like the Fed's plans to raise rate will once again be overtaken by events.

FOMC Minutes Give No Clear Signal

The FOMC minutes from the July 28-29 FOMC meeting were released today. Arguably they are stale. Arguably they have been overtaken by events. And because the Fed has been very good about not signaling their exact intentions, arguably you can read anything into them you want. If you want to take a hawkish view, I think you focus on this and similar portions of the minutes:

During their discussion of economic conditions and monetary policy, participants mentioned a number of considerations associated with the timing and pace of policy normalization. Most judged that the conditions for policy firming had not yet been achieved, but they noted that conditions were approaching that point. Participants observed that the labor market had improved notably since early this year, but many saw scope for some further improvement. Many participants indicated that their outlook for sustained economic growth and further improvement in labor markets was key in supporting their expectation that inflation would move up to the Committee's 2 percent objective, and that they would be looking for evidence that the economic outlook was evolving as they anticipated.

When considering a rate hike, "many" participants were willing to dismiss current low inflation if they believe evidence of stronger growth supports their conviction that inflation would trend toward target over time. The data since the July meeting tends to support that view. July retail sales were healthy, and revisions to previous months points toward upward revisions to second quarter GDP growth to 3.0 percent or higher. Industrial production was higher, perhaps starting to move past the declines related to the sharp drop in oil prices. Single family housing starts continued their slow but steady rise, reaching a level last seen in 2007. Homebuilder confidence is up. While manufacturing has been soft, the service sector as measured by the ISM non-manufacturing measure is picking up the slack. And the employment report was yet another in a long line of employment reports suggesting slow yet steady gains. Overall, a picture generally supportive of sustained growth and further improvement in labor markets.

A dovish view, however, could be easily derived from the following sentences and similar portions:

 However, some participants expressed the view that the incoming information had not yet provided grounds for reasonable confidence that inflation would move back to 2 percent over the medium term and that the inflation outlook thus might not soon meet one of the conditions established by the Committee for initiating a firming of policy. Several of these participants cited evidence that the response of inflation to the elimination of resource slack might be attenuated and expressed concern about risks of further downward pressure on inflation from international developments. Another concern related to the risk of premature policy tightening was the limited ability of monetary policy to offset downside shocks to inflation and economic activity when the federal funds rate was near its effective lower bound.

Many market participants took this and related comments specifically referring to China and currency prices to argue that September was all but off the table. I would not be so quick; the former view is held by "many," whereas the latter was held by "some." Moreover, I find it hard to believe that any would think it a surprise that some officials explicitly discussed China and currencies. How could they not?  How could you not think that in a wide-ranging discussion they had not discussed all that is both good and bad in the economy? That said, as I noted earlier, the minutes are stale. The depreciation of the yuan and further declines in commodity prices since the last FOMC meeting give reason to believe that the ranks of "some" has grown.

The latter points also appealed to those inclined against a rate hike. For instance, prior to the release of the minutes, the prescient Cullen Roche argued:

There is still a lot of chatter about the potential for a September rate hike by the Fed. I have to be honest – I think this is nuts at this point.

After the minutes he added:

My guess is that the odds of a Sept rate hike are fast approaching 0%.

— Cullen Roche (@cullenroche) August 19, 2015

I am clearly sympathetic to the view that the Fed looks to be rushing with the rate hike talk. That said, it is what many officials are talking about since the last FOMC meeting while looking at the same data we are.  Via John Hilsenrath at the Wall Street Journal:

Officials speaking since the July meeting have sent conflicting signals about where the group as a whole is most likely to go. In an interview with The Wall Street Journal earlier this month, Atlanta Fed President Dennis Lockhart said he was inclined to move in September. St. Louis Fed President James Bullard said in an interview with Market News International on Wednesday he would push for it. But in an opinion piece written in The Wall Street Journal on Wednesday, Minneapolis Fed President Narayana Kocherlakota said it would be a mistake and Fed governor Jerome Powell said earlier this month a decision hadn’t been made.

Lockhart is seen as swaying with the general consensus, which argues for September. Bullard arguably shouldn't be pushing for a rate hike given his path tendency to follow the direction of market-based inflation expectations, but the neo-Fisherians seem to be making some traction with him. Powell is wisely keeping his cards close to his chest. They should not, after all, have made any decisions yet. And I would say that if Kocherlakota feels so strongly a need to argue against a rate hike in the Wall Street Journal, he must think the momentum is shifting the other direction.

Former Federal Reserve Governor Lawrence Meyer is also interesting here:

“What are you worrying about, September or December? It doesn’t matter. Just pull the trigger,” said Laurence Meyer, co-founder of Macroeconomic Advisers, a research firm, in an interview before the release of the minutes.

Just sick of the debate and wanting to move on? Or a real conviction that the Fed is set to move?

Bottom Line: I have believed that there was a better than 50% chance that the Fed would move in September and am hesitant to move much below 50%. I didn't expect the minutes would give a clear signal regarding September, and am not surprised by the dimensions of the general discussion. And I am wary the Fed may be less responsive to financial market disruption than during most of the post-crisis era given than the economy is close to their estimate of full employment. This is shaping up to be one of the most contentious meetings since the tapering debates. We will soon learn more exactly what data the Fed is data dependent on.

Some Thoughts On Productivity And The Fed

Will flagging productivity growth trigger a hawkish response from the Fed? That is a question I have been asking myself since Federal Reserve Chair Janet Yellen discounted the cyclical influences of low wage growth in her July 10 speech:

The most important factor determining continued advances in living standards is productivity growth, defined as the rate of increase in how much a worker can produce in an hour of work. Over time, sustained increases in productivity are necessary to support rising household incomes…Here the recent data have been disappointing. The growth rate of output per hour worked in the business sector has averaged about 1‑1/4 percent per year since the recession began in late 2007 and has been essentially flat over the past year. In contrast, annual productivity gains averaged 2-3/4 percent over the decade preceding the Great Recession. I mentioned earlier the sluggish pace of wage gains in recent years, and while I do think that this is evidence of some persisting labor market slack, it also may reflect, at least in part, fairly weak productivity growth. 

Goldman Sachs economists led by Jan Hatzius hypothesize that productivity growth is low only because growth is mis-measured, undercounting the value of free or improved software and digital content made possible by information technology (although see Greg Ip’s opposing view). It seems that Yellen is leaning in the direction of taking the productivity numbers at face value and seeing low wage growth as consistent with the view that the productivity slowdown is real.

Indeed, the productivity trends may be even grimmer than 1-1/4 percent that Yellen cited in her speech. Consider for example two measures of underlying productivity growth trends, a moving average measure and the result from a simple unobserved components model:

The downtrend since 2000 is more easily discerned by focusing only on the trends:

The unobserved component approach suggests that productivity growth decelerated to an annualized pace of just 0.82 percent by the second quarter of this year. That is interesting because it must be somewhat similar to the Fed staff estimates. The accidentally released Fed staff estimates of potential GDP growth range from roughly 1.6 to 1.8 percent through 2020. That is exactly what you might expect with productivity growth of around 0.8 percent and labor force growth in the between 0.8 to 1.0 percent (roughly the recent range). It seems the Fed staff have adopted the pessimistic view of the productivity numbers. It is not about measurement error.

What are the implications for policy? Yellen might think back to the 1990’s, when a surprise rise in productivity growth temporarily lowered the natural rate of unemployment. Slow wage adjustment meant higher than expected productivity growth had a disinflationary impact on the economy, allowing for then Federal Reserve Chairman Alan Greenspan to hold interest rates relatively low. Yellen might reverse that logic now and think that the arguments for tighter policy are stronger. Hence another reason why low wage growth is not an impediment to raising rates.

Any increase in the natural rate of unemployment, however, would be temporary. After wage growth adjusts, we would expect the equilibrium real interest rate to fall in response to lower productivity growth. Lower productivity growth reduces the expected return on capital, thus requiring lower interest rates to maintain neutral policy. 

The trick then is determining whether we are still in the short-run or already in the long-run. It may be that wages have already adjusted. Real wage growth was fairly high during the recession and it’s aftermath:

Real wage growth – using core-PCE as the deflator – was high as wages adjusted during the recession, but then remained high even when unemployment was above six percent. Now real wages are running low. Could it be that the wage adjustment to lower productivity growth occurred during the recession? If so, the Fed would be in error to believe that now is the time to tighten policy in response to low productivity growth. In effect, the zero bound unintentionally did that job for them. Not only did wage growth adjust, but any potential inflationary impacts were overwhelmed by the disinflationary impacts of the recession.

The bond market, with ten-year Treasury yields hovering between 2 and 2.5 percent, appears to be fiercely discounting the lower-for-longer story consistent with low productivity growth. Furthermore, low TIPS-based inflation expectations and a modest expected path for short rates also suggest little need for the Fed to tighten policy to avoid a 1970’s style inflation. The FOMC, however, has a more hawkish view, anticipating a more aggressive policy over the next few years. The Fed staff split the difference in their forecasts. The direction the FOMC ultimately takes could be the difference in an expansion that last four more years or only two.

Bottom Line: Fed policy increasingly reflects the view that the productivity growth slowdown is real. We see it in falling estimates of potential GDP growth, falling expectations for the terminal federal funds rate, and now we see it as a reason to anticipate low wage growth. The first and third reactions seem to have had a hawkish impact on policy - not only is low wage growth not an impediment to raising rates, but San Francisco Federal Reserve President John Williams argued the Fed needs to engineer a substantial slowdown in growth next year. But the FOMC has yet to act on that relative hawkishness; to date they have moved in the direction of market participants. Indeed, while I suspect the odds favor a September hike, we don’t even know they will raise rates this year at all! The question is whether they would be quick to act on that hawkishness in the face of any unexpectedly high inflation or wage growth numbers. I am thinking low-productivity growth coupled with memories of the 1970s may prime FOMC members in that direction. 

Gearing Up For Employment Day

The big event this week is the employment report. Fed watchers will eagerly dive into the data, looking for signs that the labor market made "some" further improvement. "Some" improvement appears to be an important hurdle to clear before the Fed will raise interest rates. How much "some" is necessary? I suspect it's like pornography - you will know it when you see it.

Incoming data continues a pattern general mediocrity. Today we received the June income and spending report, which one could have largely backed out of the second quarter GDP numbers. Real incomes edged up 0.2% while real spending was flat. Spending softened compared to last year, not unlike the pattern of 2004:

Recall that it was in July of 2004 that the Fed initiated the previous tightening cycle. Note also that one aspect of consumer spending, auto sales, showed no signs of softening in July.

Inflation remains below target, but arguably not far below target: 

While on a year-over-year basis, core-PCE remains well below target, recent reading are more solid. On an annualized basis, core-PCE rose 1.79% in June, within the range that I suspect most policymakers believe is consistent with their mandate (you can't hit exactly 2% all the time). The Fed will see these numbers as supporting their view that the 2014 inflation drop was driven by largely temporary factors.  

Manufacturing numbers remain on the soft side:

Stronger dollar, lower commodity prices, and softer global demand took the wind out of that sector, to be sure. Note that a sharp decline in ISM numbers from mid-2004 through mid-2005 did not deter the Fed from continuing its rate hike campaign.

Coming on the heels of last week's disastrous employment cost report, Friday's measure of wages will be closely watched. The tentative signs of wage growth acceleration we had been seeing in the ECI were quickly wiped out in the second quarter:

How will the Fed view this data? Tough call at this point. Digging into the data may lead them to conclude that this report was more smoke than fire.  Millan Mulraine via across the curve:

...I wanted to make a few observations on the ECI report following our conversation with the BLS. The key findings reinforce our earlier view that this anomalous performance in both wages and benefits has been driven by one-off factors that should unwind. As such, we believe that this report does not reflect a germane deterioration in underlying inflation dynamics, and will have little bearing on the Fed’s deliberation on policy.

 

1. The sharp deceleration in the growth rate of the wages and salaries component (which accounts for about 70% of total compensation) was driven by a sharp falloff in incentive pay this quarter versus Q1. This accounted in the sharp drop in the growth rate of private industry wages (on an NSA basis) from 0.8% q/q in Q1 to 0.2% q/q in Q2. Excluding commission sale incentives, wages and salaries were unchanged at a solid 0.6% q/q pace in both quarters.

 

2. Benefits were also affected by special factors, and the key driver was the redefinition to retirement benefits in Q2, perhaps caused by the underfunding of some retirement pension plans. The 0.8% q/q drop in unionized workers benefits was a big part of this. Here is a link of various stories highlighting this fact earlier this year...

 The Fed may also find solace in the Atlanta Fed Wage Growth Tracker:

 

Of course, maybe they don't need faster wage growth at all, as Jon Hilsenrath at the Wall Street Journal reminds us:

Given her [Fed Chair Janet Yellen] stance, Friday’s employment cost report doesn’t look like a deal breaker for the Fed in its long-running debate about when to raise short-term interest rates. Wages appear to be stagnant but not clearly weakening, which is what she set out as her threshold for not acting. Still, it creates new doubts for officials and doesn’t help them build the confidence they’re hoping to build that the job market is nearing full employment and inflation rising toward 2%.

At least one Fed official is on record saying he couldn't care less about the ECI report. That is St. Louis Federal Reserve President James Bullard, via the Wall Street Journal:

“We are in good shape” for increasing the Fed’s currently near-zero short-term rate target at the Sept. 16-17 central bank gathering, Mr. Bullard said in an interview with The Wall Street Journal. He said officials needed to see how growth data released Thursday shaped up before clearing the way to act. 

Mr. Bullard shrugged off a report Friday showing surprising tepid wage gains, saying he isn’t that worried about that situation right now.

That said, I think that most Fed officials would be more comfortable ignoring the ECI report if they see some hard evidence in the next two labor reports that wage growth really is strengthening.

Bottom Line: My general sense is that the data is falling in line in such a way that the Fed can justify a rate hike in September. Not sure I would describe the situation as being in "good shape" as Bullard does, but I see where they can find room in the data, especially if their logic is to go early so they can go slower. A 200k+ nonfarm payroll gain, a tick down in unemployment, and some wage growth would support that case. September is a hard call, however, because I doubt that the next six weeks of data will give them a clear, consistent story free of any warts or boils. If they ultimately need perfect data to move forward, then they will again take a pass on September. Perfect data will simply be hard to come by, I suspect, in a world where 2% growth is the new 4%.