Tim Duy's Fed Watch

Final Thoughts On September

Everyone's bets are placed for the outcome of tomorrow's FOMC statement and subsequent press conference. Final thoughts heading into the meeting:

I expect the Fed will pass on raising rates this meeting. This is a highly contentious issue, and reasonable arguments can be made for either case. Economists appear to be roughly split, while financial market participants taking the under with a roughly 25% probability of a rate hike. Whatever the outcome, roughly half of the economists on Wall Street will be wrong. Good thing, as misery loves company.

I believe FOMC participants will arrive at a consensus for the timing and direction of policy for subsequent meetings. The FOMC has had something of a luxury in that economic conditions have not forced them to choose a defined policy path. I believe they no longer have that luxury. They will need to commit policy to one side of the mandate or the other. At this meeting they will decide if their Phillips curve view of the world in concert with their estimate of the natural rate of unemployment dominates the fact that inflation continues to drift away from their target.

I expect the Fed will ultimately pledge allegiance to the Phillips curve. I think they believe that stable inflation is incompatible with sub-5% unemployment if short term interest rates remain at zero. Hence, they will signal that the first rate hike is imminent.

Fed Chair Janet Yellen has the opportunity to prove her mettle. Assuming that I am correct that the Fed needs to forge a consensus, Yellen will be the guiding influence on that consensus. The best outcome for her is a consensus with no dissenting votes. That said, it may be that only an immediate rate hike would be acceptable to Richmond Federal Reserve President Jeffrey Lacker.

I expect Yellen will make a strong attempt to open the door for October. The Fed has established expectations that, outside of obvious exigent circumstances, they can only make major decisions when there is a scheduled press conference. Yellen will push back hard. Indeed, I think there is a possibility that this becomes the "rate hike" press conference in spirit, with the actual hike in October. Something to think about.

The Fed will try to take the sting out of any hawkish signals with a dovish message. I expect the terminal rate forecasts in the dot plot to drift lower. In addition, I expect Yellen will emphasize that low inflation provides room for a slow and halting pace of rate increases. (My expectation, however, is that assuming the first hike goes smoothly, subsequent hikes will come at regular intervals.) Finally, the estimate of the natural rate of unemployment may drift down further. 

If I am wrong...two potential alternatives. First is that everything above remains the same, but they pull the trigger today. They tend not to surprise, but maybe this time is different. Maybe they don't need to built a consensus, although I think that unlikely.  Second is that Yellen pushes the FOMC into a dramatically more dovish direction that re-emphasizes the issue of underemployment and shifts expectations to 2016. I don't think that is likely as I think she is fairly entrenched in the 5% NAIRU camp, but we will see tomorrow.

Enjoy the day's excitement!

Why the Fed Is Likely to Stand Pat This Week

What a week it might have been?

Speeches and interviews have made it fairly clear that Federal Reserve officials were building a case to begin normalizing interest rate policy as soon as this month, but they are increasingly wary that a misstep could derail the economy at a time when they perceive a lack of tools to address renewed weakness.

Continue reading at Bloomberg...

Flying Mostly Blind Heading Into the September FOMC Meeting

Last year, I would have said you were crazy if you told me that short-term rates would still be hugging zero even as unemployment fell to 5.1 percent. Yet here we are, gearing up for a FOMC meeting that promises to be the most contentious in years. The era of data dependence yielded substantially less clarity on the direction of policy than one would hope for, leaving expectations for the meeting’s outcome all over the place. That means this meeting is not just about 25 basis points – it’s about defining the parameters of the Fed’s reaction function. We will learn what data dependence means not just in theory, but in practice.

The argument for a move next week is straightforward. Actual and underlying economic activity remains sufficient to sustain further improvement in the labor market. Indeed, dramatic progress has been made when viewed through the eyes of Federal Reserve Chair Janet Yellen as she scoped out the economic landscape in 2013:

With unemployment at the Fed’s estimate of the natural rate, inflationary pressures will soon emerge. To be sure, wage growth remains flat, but even Yellen leans toward writing that off as an expected outcome of low productivity growth:

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.

When combined with stable inflation expectations, policymakers have good reason to be confident that actual inflation will soon reverse course and trend toward the Fed’s target. In such an environment, financial accommodation needs to be withdrawn pre-emptively to avoid overshooting the targets. As policymakers prefer to raise rates gradually, they are impelled to raise them early to avoid the risk of more rapid increases in the future.

The counterargument, however, is also straightforward. Labor markets remain far from healed if viewed through the eyes of Yellen in 2014: 

Low wage growth is thus consistent with the hypothesis that underemployment indicators are important measures of labor market health. The persistence of weak wage growth should leads to revised estimates of the natural rate of unemployment. After all, targeting 5 percent unemployment when the natural rate is 4 percent means denying jobs to roughly 1.5 million people. That’s no small responsibility.

Moreover, inflation continues to trend away from target. If you are uncertain of your estimate of the natural rate and inflation is moving away from target, why rush to hike rates? Even though Fed officials believe that inflation has been unduly influenced by the temporary factors of falling oil prices and a rising dollar, those factors reasserted themselves since the last FOMC meeting. And market-based measures of inflation expectations do not signal a revival of inflation anytime soon.

Recent financial turbulence also calls into doubt the wisdom of raising rates next week. To be sure, the Federal Reserve is not responsible for maintaining the value of everyone’s portfolio. But they are responsible for maintaining the financial stability necessary to sustain economic growth. Recent market activity, including a stronger dollar, wider credit spreads, and falling stocks, points toward already tighter financial conditions in the absence of a rate hike. A forward-looking central bank should be cautious of further tightening. Indeed, a forward-looking central bank would be expected to react to current signals with a delayed and shallower path of rate hikes.

Ultimately, the Fed will need to choose between one of these two arguments, and by doing so they will define a direction for policy. This will be important new information. Ultimately, we will learn who rules the roost at the FOMC – the Janet Yellen of 2013, or the Janet Yellen of 2014. Will it be the hawkish or dovish Janet Yellen that appears in the subsequent press conference? I tend to think the later will appear, but the case for the former is strong as well. In any event, the signaling information we receive next week is far more important than any 25 basis points could be.

If You Ever Wondered Whose Side The Federal Reserve Is On...

Catching up with Richmond Federal Reserve Jeffrey Lacker's speech. His dismissal of low wage growth numbers:

Some argue there must be excessive slack in labor markets if wage rates are not accelerating. But real wages are tied to productivity growth, and productivity growth has been slow for several years now. Wage growth in real terms has at least kept pace with productivity increases over that time period, which is perfectly consistent with an economy from which labor market slack has largely dissipated. 

Real wage growth is consistent with productivity, thus there is no excess slack in the labor market. If you think this is some crazy hawk-talk, think again. Fed Chair Janet Yellen in July:

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.

For more than three decades, the pace of productivity growth has exceed that of real compensation:

Another view from real median weekly earnings:

Real median weekly earnings have grown 8.6% since 1985. Nonfarm output per hour is up 79% over that time. Yet the instant that there is even a glimmer of hope that labor might get an upper hand, the Federal Reserve looks to hold the line on wage growth. It still appears that the Fed's top priority is making sure the cards remain stacked against wage and salary earners.