Tim Duy's Fed Watch

What Is The Fed's Expectation For Financial Markets?

David Keohnae at FT Alphaville points us toward a JPM research note raising the prospect of a reappearance of Former Federal Reserve Chair Alan Greenspan’s “conundrum.” From the note:

If long-term interest rates matter more than short-term interest rates, will Fed’s current and prospective rate hikes matter much? The answer is yes if long-term interest rates respond to these short-term rate hikes. But this transmission is far from given, especially given the Fed’s decision that reinvestments would not be halted until the normalization of the funds rate is “well under way”

The previous hiking cycle of 2004-2006 is a reminder of how problematic the transmission from short rates to long-term interest rates can be. At the time, the 10y real UST yield rose by only 25bp between June 2004 and June 2006 despite the Fed lifting its target rate by 425bp (Figure 1). We depict the real rather than nominal UST yield in the chart to capture the potential impact of monetary policy actions on inflation expectations. This lack of transmission or “bond conundrum” at the time was attributed to global saving forces emanating from DM corporates and EM economies. Could these saving forces prevent once again rate hikes from transmitting to longer-term interest rates?

Keohane links to fellow Alphaville write Matthew Klein, who describes the “conundrum” as bogus. Klein draws attention to the shape of the yield curve:

In addition to forgetting his own experience at the Fed, Greenspan’s confusion can also be blamed on an unusual belief in the “normal” behaviour of forward short rates.

Short rates tend to go up and down with the business cycle, which typically lasts a lot less than ten years…

When the economy is weak and the Fed is stepping on the gas, short rates should be lower than your reasonable expectation of the average for the next ten years. (Like now.) Other times, of course, short rates are higher than your reasonable expectation of the average for the next ten years because the economy is running hot and the Fed is stepping on the brakes. Longer-term yields therefore shouldn’t always move with short-term rates.

This is why people think the slope of the yield curve is a decent signal of where the economy is going.

When the economy is peaking and poised to go into recession, short rates end up higher than long rates because traders are betting that short rates will fall significantly. To use the jargon, the curve is inverted. After the economy has hit bottom and is ready to grow, the yield curve gets nice and steep, reflecting the expectation of future increases in the short rate to match the expected acceleration in nominal spending.

What happens to the yield curve, and how the Federal Reserve responds, is one of my big questions for 2016. Almost always, the yield curve flattens after the Fed begins a tightening cycle. Within a year, the spread between the 10- and 2-year treasuries is a mere 50bp or so:

An analogous situation today would be if the Fed raises the fed funds target range over the next year but longer-term yields don’t budge. How might the Fed respond? New York Federal Reserve President William Dudley often comments on this prospect. From November 2015:

Several examples will help me make these points.  During 2004 to 2007, the FOMC raised the federal funds rate target 17 meetings in a row, lifting the federal funds to 5.25 percent from 1.0 percent.  Yet, during this period, financial conditions eased, as evidenced by the fact that the stock market rose, bond yields fell and credit availability—especially to housing—eased substantially.  In hindsight, perhaps monetary policy should have been tightened more aggressively…

…In contrast, if financial conditions did not respond at all, or eased, then I suspect we would go more quickly, all else equal. 

This raises some red flags for me. While much attention is placed on the Fed’s failure to respond more aggressively to slowing activity and deteriorating financial conditions in 2008, I lean toward thinking the more grievous policy error was in the first half of 2006 when the Federal Reserve kept raising short rates after the yield curve first inverted in February of that year:

and despite clear evidence of slowing economic activity and increasing financial stress. 

So how will the Fed respond if long rates do not respond in concert with short rates? How will the Fed interpret a flattening yield curve? Do they accelerate the pace of rate increases? Do they initiate asset sales? The truth is I don’t know (or the answer is “it depends”), but I find this exchange between Federal Reserve Chair Janet Yellen and New York Times reporter Binyamin Appelbaum a bit disconcerting:

BINYAMIN APPELBAUM. Binyamin Appelbaum, the New York Times. Bill Dudley has talked about the need for the Fed to adjust policy based on the responsiveness of financial markets as you begin to increase rates. You didn't talk about that today. Is it a point that you agree with? And if so, what is it that you're looking for? How will you judge whether financial markets are accepting and transmitting these changes? 

CHAIR YELLEN. Well, there are number of different channels through which monetary policy is transmitted to spending decisions, the behavior of longer term, longer term interest rates, short term interest rates matter. The value of asset prices and the exchange rate, also, these are transmission channels. We wouldn't be focused on short-term financial volatility, but were there unanticipated changes in financial conditions that were persistent and we judged to affect the outlook. We would of course have to take those into account. So, we will watch financial developments, but what we're looking at here is the longer term economic outlook, are we seeing persistent changes in financial market conditions that would have a bearing, a significant bearing, on the outlook that we would need to take account in formulating appropriate policy. Yes we would, but it's not short-term volatility in markets. 

BINYAMIN APPELBAUM. The part [inaudible], you didn't see changes, you would be concerned and have to move more quickly. Are you concerned that if markets don't tighten sufficiently you may need to do more? 

CHAIR YELLEN. Well, look. You know, we-- this is not an unanticipated policy move. And we have been trying to explain what our policy strategy is. So it's not as though I'm expecting to see marked immediate reaction in financial markets, expectations about Fed policy have been built into the structure of financial market prices. But we obviously will track carefully the behavior of both short and longer term interest rates, the dollar, and asset prices, and if they move in persistent and significant ways that are out of line with the expectations that we have, then of course we will take those in to account. 

I don’t know that Yellen understood the question. But she should have. Dudley has been telling this story for a long, long time. Does she and/or the Committee share his expectations? Why or why not? In my opinion, this is an important question, and it looks to me like Yellen fumbled it.

Bottom Line:  We have a fairly good idea of the Fed’s reaction function with respect inflation and unemployment. Not so much with respect to financial market conditions. Who shares Dudley’s views? That is a space I am watching this year.

 

As Expected

Today, the FOMC voted to raise the target range on the federal funds rate by 25bp. The accompanying statement and the Summary of Economic Projections offered no surprises. That very lack of surprise should be counted as a "win" for the Fed's communication strategy. A little bit of extra direction since September went a long way.

The statement again described the economic growth as "moderate." Although there is some external weakness, the domestic economy is solid, hence "the Committee sees the risks to the outlook for both economic activity and the labor market as balanced." The Fed continues to expect that inflation will return to target. On the basis of that forecast and lags in the policy policy process:

Given the economic outlook, and recognizing the time it takes for policy actions to affect future economic outcomes, the Committee decided to raise the target range for the federal funds rate to 1/4 to 1/2 percent.

Importantly, the Fed does not believe policy is tight:

The stance of monetary policy remains accommodative after this increase, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.

The Fed currently expect future hikes to occur only gradually:

The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. 

But, this is a forecast not a promise:

However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.

Note that the Fed highlights the importance of actual inflation outcomes with respect to future hikes:

In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal.

The Fed will proceed cautiously if evidence suggests inflation is not behaving as expected. This doesn't mean they need to see more inflation to hike rates further. But it would be nice.

No dissents; none of the possible dissenters thought their objections were sufficient to deny Federal Reserve Chair Janet Yellen a unanimous decision on this first hike.

The median forecasts for growth, employment, and inflation were virtually unchanged. Note that the central tendency range for longer run unemployment shifted down; participants continue to shave down their estimates of the natural rate of unemployment. The median rate projection for 2017 and 2018 edged down. This understates somewhat the decline in the range of the central tendency.  

As I am running short of time today, I will leave any analysis of the press conference for a later time. Gradual, data dependent, not mechanical (not equally spaced or sized hikes), etc.

Bottom Line: Almost as exactly as should have been expected. 

FOMC Preview - Watch the Dollar and Oil

The Federal Reserve is set to raise interest rates this week for the first time since 2006.

The final days of the zero interest-rate policy known as ZIRP are upon us; the end is here.

But the end of ZIRP is the beginning of a new chapter of monetary policy. This chapter will tell the story of the Federal Reserve’s efforts to normalize policy, and that particular tale has yet to be written. You can, however, expect Fed Chair Janet Yellen to emphasize “gradually” and “data dependent” as she pens the first few lines of the narrative at this week’s press conference....

Continue reading on Bloomberg...

 

Makes You Wonder What The Fed Is Thinking

The Fed is poised to raise the target range on the federal funds rate this week. More on that decision tomorrow. My interest tonight is a pair of Wall Street Journal articles that together call into question the wisdom of the Fed's expected decision. The first is on inflation, or lack thereof, by Josh  Zumbrun:

Central bank officials predict inflation will approach their target in 2016. The trouble is they have made the same prediction for the past four years. If the Fed is again fooled, it may find it raised rates too soon, risking recession.

A key reason for the Federal Reserve to raise interest rates is to be ahead of the curve on inflation. But given their poor inflation forecasting record, not to mention that of other central banks:

 

why are they so sure that they must act now to head off inflationary pressures?  One would expect waning confidence in their inflation forecasts to pull the center more toward the views of Chicago Federal Reserve President Charles Evans and Board Governors Lael Brainard and Daniel Tarullo and thus defer tighter policy until next year.  

Now combine the inflation forecast uncertainty with the growing consensus among economists that the Fed faces the zero bound again in less than five years. This one's from Jon Hilsenrath:

Among 65 economists surveyed by The Wall Street Journal this month, not all of whom responded, more than half said it was somewhat or very likely the Fed’s benchmark federal-funds rate would be back near zero within the next five years. Ten said the Fed might even push rates into negative territory, as the European Central Bank and others in Europe have done—meaning financial institutions have to pay to park their money with the central banks...

Not a surprising conclusion given that Fed officials expect the terminal fed funds rate in the 3.3-3.8 percent range (central tendency) while the 2001-03 easing was 5.5 percentage points and the 1990-92 easing was 5.0 percentage points. You see of course how the math works. Supposedly this is of great concern at the Fed. Hilsenrath cites the October minutes:

Fed officials worry a great deal about the risk. The small gap between zero and where officials see rates going “might increase the frequency of episodes in which policy makers would not be able to reduce the federal-funds rate enough to promote a strong economic recovery…in the aftermath of negative shocks,” they concluded at their October policy meeting, according to minutes of the meeting.

The policy risks are asymmetric. They can always raise rates, but the room to lower is limited by the zero bound. But that understates the asymmetry. You should also include the asymmetry of risks around the inflation forecast. The Fed has repeated under over-forecasted inflation. It seems like they should also see an asymmetry in the inflation forecast that compounds the policy response asymmetry. Asymmetries squared.

Given all of these asymmetries, I would think the Fed should continue to stand pat until they understood better the inflation dynamics. The Fed thinks otherwise. Why would Federal Reserve Chair Janet Yellen allows the Fed to be pulled in such a direction? Partly to appease the Fed hawks. And then there is this from her December speech:

Were the FOMC to delay the start of policy normalization for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession. 

Yellen is wedded to the theory that the sooner the Fed begins normalizing policy, the more likely the Fed can avoid a recession-inducing sharp rise in rates. She follows up this concern with:

Moreover, holding the federal funds rate at its current level for too long could also encourage excessive risk-taking and thus undermine financial stability.

This is what Mark Dow calls "avalanche patrol":

What the Fed has begun to worry about is financial stability—even if not as an imminent threat. Its concerns are one part risk management, one part the ghost of crises past. FOMC members understand that financial excesses are a positive function of time. Stability sooner or later breeds instability. And the longer rates stay very low, the greater the risk they become built into the current financial architecture and baked into our extrapolations. Once you get to such a point, an eventual normalization becomes a lot riskier, in terms of both financial dislocations and economic activity.

This then becomes a story of a Fed caught between a world in which the policy necessary to meet their inflation target is inconsistent with financial stability. That is what they call caught between a rock and a hard place. And my sense is that Yellen feels the best way to slip through those cracks is early and gentle tightening. 

 Bottom Line:  Given that the Fed likely only gets one chance to lift-off from the zero bound on a sustained basis, it is reasonable to think they would wait until they were absolutely sure inflation was coming. Even more so given the poor performance of their inflation forecasts. But the Fed thinks there is now more danger in waiting than moving. And so into the darkness we go.

And That's A Wrap

If you had any doubt about the outcome of next week's FOMC meeting, Friday's employment report set you straight. When I try to think about what could stay the Fed's hand at this point, I am down to zombie apocalypse or act of God. I am not betting on either. By next week, we will be wrapping up our coverage of ZIRP, quietly filing away everything we learned for the next recession. That we return to ZIRP in the future remains my long-run view. But that is a concern for a future date.

The employment report was solid, with the economy adding 211k jobs in November while October was revised up to 298k. Some momentum has been lost since the 2014 as the cycle transitioned from late-spring to summer:

This pace of job growth remains sufficient to eat away at remaining underemployment; the Fed believes that even 150k a month would still do the job. The unemployment rate held steady and labor force participation ticked up. Even if unchanged, unemployment at 5% hovers near the Fed's estimates of the natural rate:

  It is reasonable to assume that at these job growth rates, unemployment will fall toward 4.5% in the months ahead, pushing wage growth higher. I suspect the Fed would accept unemployment stabilizing near 4.5% in the second half of next year. Optimally, it would stabilize because labor force participation picked up. Alternatively, the job growth could slow to 100k/month naturally or at the hand of the Fed. In practice, I expect some combination.

In other news, the ISM indicators came in soft: 
The service sector number continues to bounce around a respectable range. A bit less so for the manufacturing indicator. You need to go back to the mid-80's to find another time the Fed hiked with a sub-50 manufacturing ISM. But this isn't the mid-80's anymore. The Fed is betting that a.) this data is noisy and b.) that the service sector is much, much more important to the economy than manufacturing and c.) some of the weakness in manufacturing will be alleviated as the oil/gas drilling and export drag soften over the next year in relative terms. Speaking of exports, the trade report came with a larger-than-expected deficit, a factor that added another hit to GDP nowcasting models. The Atlanta Federal Reserve Bank's GDPnow indicator is currently tracking at 1.5%, a rate generally believed to be below potential growth. No fear, though, according to Fed Chair Janet Yellen, who in her speech last week highlighted total real private domestic final purchases as the number to watch:

...Growth this year has been held down by weak net exports, which have subtracted more than 1/2 percentage point, on average, from the annual rate of real GDP growth over the past three quarters. Foreign economic growth has slowed, damping increases in U.S. exports, and the U.S. dollar has appreciated substantially since the middle of last year, making our exports more expensive and imported goods cheaper.

By contrast, total real private domestic final purchases (PDFP)--which includes household spending, business fixed investment, and residential investment, and currently represents about 85 percent of aggregate spending--has increased at an annual rate of 3 percent this year, significantly faster than real GDP...

That sent everyone to FRED (the code is LB0000031Q020SBEA) to make charts like this:

When they search through the data for the happy numbers, you know they are looking to hike. Indeed, the clear takeaway from Yellen's speech was that a rate hike was coming (emphasis added):

...In particular, recent monetary policy decisions have reflected our recognition that, with the federal funds rate near zero, we can respond more readily to upside surprises to inflation, economic growth, and employment than to downside shocks. This asymmetry suggests that it is appropriate to be more cautious in raising our target for the federal funds rate than would be the case if short-term nominal interest rates were appreciably above zero. Reflecting these concerns, we have maintained our current policy stance even as the labor market has improved appreciably.

However, we must also take into account the well-documented lags in the effects of monetary policy. Were the FOMC to delay the start of policy normalization for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession. Moreover, holding the federal funds rate at its current level for too long could also encourage excessive risk-taking and thus undermine financial stability.

On balance, economic and financial information received since our October meeting has been consistent with our expectations of continued improvement in the labor market...

And this was before the employment report. In any event, we are now well beyond the issue of the first rate hike. The new questions are how gradual will "gradual" be and when will the Fed begin widening down the balance sheet by ending the reinvestment policy. On the first point, the Fed is trying to send the message that subsequent rate hikes will be data dependent and not on any fixed schedule. On the second point, Federal Reserve Governor Lyle Brainard argued to hold the balance sheet at current levels until interest rates are sufficient to provide a cushion for the next recession:

Moreover, because the Federal Reserve's asset holdings help maintain accommodative financial conditions, it would be prudent to maintain reinvestments until the normalization of the federal funds rate is sufficiently far along to allow room to cut nominal rates if economic conditions deteriorate.

Brainard knows she has lost the battle to forestall the first rate hike further and has now chosen to stake out a position on one of the next big issues. My expectation is that the Fed will begin ending reinvestment in the middle of next year. But that is just a baseline; this is an evolving topic.

Bottom Line:  Rate hike coming. This round of ZIRP is nearly wrapped up. But that end is really just a new beginning. Arguably, the end of ZIRP raises more questions than it answers. The pace of subsequent tightening, the normalization - or not - of the balance sheet, and the countdown to the next easing are all issues now on the table.