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March 19, 2014

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Fed Watch: That Train Left the Station

Posted: 19 Mar 2014 12:15 AM PDT

Tim Duy:

That Train Left the Station, by Tim Duy: I was re-reading some of the recent overshooting debate and it occurred to me that it is comical that we are even having this discussion. The Fed is not going to deliberately overshoot inflation, period. That train left the station long ago. So long ago that you can't even here the rumble on the tracks.
The train left the station on January 25, 2012, with this statement by the Federal Reserve:
The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate.
On that day, the Federal Reserve locked in the definition of price stability. They locked it in specifically to prevent even the appearance they might deliberately overshoot as a result of extraordinary monetary policy. They locked it in as a commitment device to tie the hands of future policymakers as they would need to justify changing the definition of price stability, presumably a very high bar for any central banker to cross.
On that day, the Federal Reserve took higher inflation expectations off the table. They pulled it from the toolkit. They made clear there is one and only one inflation target for all time. The only tolerable deviations from that target are essentially forecast errors. That's it.
Moreover, I would argue that their behavior has been entirely consistent with maintaining that expectation. Inflation expectations - as measured by TIPS - have been more volatile than prior to the recession, but have cylced around pre-recession levels, or, arguably, a little below:


There is no reason to believe that the Fed has acted to try to sustain inflation expectations beyond those in place prior to the recession. Perhaps thay came close in late-2012, as measured by the five year, five year forward breakevens:


But that was soon met by official pushback. Via Bloomberg:
"Distant inflation expectations from the TIPS market seem to suggest that investors do not completely trust the Fed to deliver on its 2 percent inflation target," Bullard said today in a speech in Memphis, Tennessee, referring to Treasury Inflation-Protected Securities...
...The five-year, five-year forward break-even rate, which projects the pace of price increases starting in 2017, rose to 2.88 percent on Sept. 14, the day after the FOMC announced a third round of quantitative easing. That was up half a percentage point from July 26. It dropped to 2.77 percent on Oct. 2.
Soon thereafter began the tapering chatter that ultimately culminated in then-Chairman Ben Bernanke's press conference in which he introduced the 7% trigger for asset purchases. The result was a sharp snap-back in real yields:


If the Fed has already proved they can't stomach inflation expectations hovering just below 3% (remember that this is on a CPI basis by which TIPS are calculated, not on a PCE basis that is the Fed's target) for even a few months, they really can't wrap their minds around inflation actually reaching 3% as suggested by Karl Smith:
The Evans Rule was nice, but addressing the overshoot directly would be better. For example, a statement like: "In the committee's view the appropriate path for the federal funds rate would, in the medium term, allow inflation to rise above 2 per cent, but not above 3 per cent, for a period no less than three months but no greater than one year. Within those parameters the committee will continue to adjust the target for the federal funds rate so as to achieve maximum employment and keep long term inflation expectation well anchored."
And note that I am being generous by trusting that the Fed's inflation target is actually 2%. David Beckworth suggests it is actually the range of 1% to 2%.
Ultimately, I think Robin Harding correctly identifies the mood at the Fed:
Even Janet Yellen, in her "optimal control" speeches in 2011 and 2012, never argued that the Fed should promise extra inflation in the future. There has never been much support for it on the FOMC and the Fed's statement of long-run goals would have to be modified to allow for it. At this stage in the game, when the Fed is slowing down its stimulus via asset purchases, it makes little sense to add more stimulus in another way.
What remains the case is that Fed doves think there is slack in the labour market and are willing to risk some above target inflation – while targeting 2 per cent – in order to bring joblessness down more rapidly. I think the centre of the committee under Janet Yellen agrees (and their fairly aggressive forward rate path reflects that). In an ideal world, though, the Fed would gracefully stabilize inflation at 2 per cent with no overshoot or undershoot, creating a soft landing as the economy regains full employment.
The Evans rule was never about higher inflation expectations. It only clarified the acceptable range of forecast errors around the 2% target for a given unemployment rate. And note that it is clear that a forecast error in the other direction is also acceptable with below target outcomes in the labor market. That acceptability is evident in the eagerness to end asset purchases and telegraph the first rate hike. Does anyone believe that the Fed would find a 2.5% inflation rate acceptable if unemployment is at 6%? Or would it be cause of worry and hand-wringing among policymakers? The latter, I think. Yes, they are willing to risk some above target inflation, but should it actually emerge, they would act quickly to snuff it out.
Bottom Line: Expect the Fed to manage policy to contain disinflation and deflationary expectations. But overshooting in the sense of raising inflation expectations to lower the real interest rate further? It very much seems like they made clear long ago that wasn't an option.

Links for 3-19-14

Posted: 19 Mar 2014 12:06 AM PDT

Fed Watch: FOMC Meeting Begins

Posted: 18 Mar 2014 10:20 AM PDT

Tim Duy:

FOMC Meeting Begins, by Tim Duy: The FOMC meeting begins today and ends tomorrow, followed by the traditional statement and Chair Janet Yellen's first press conference. The Fed will also update its forecasts - important because ultimately the forecast drives the policy decisions. I don't anticipate large changes to the growth or inflation forecasts. We should see modest downward revisions to the unemployment rate forecast. What will be more interesting is the impact those changes will have on the interest rate forecast. The bulk of the FOMC expects the first rate hike will be in the range of mid- to late-2015, with a handful earlier or later. A lower unemployment rate forecast may prompt some to move up their forecast. That said, I do not expect large changes in either direction.
As far as policy itself is concerned, it is widely anticipated that the Fed will continue to taper asset purchases and slice another $10 billion from the monthly total. There is no reason to think that the economy has shifted dramatically in either direction to alter the Fed's current strategy for ending asset purchases. We know also that forward guidance will be on the table. Sometime soon - and I think the odds are better than even that "soon" is tomorrow - the Fed will need to address the Evans rule. My expectation is that they ditch numerical guidance for qualitative, discretionary guidance. The new guidance, however, should make it clear that rates will remain low for a long time.
Regarding low rates, I think it is worth reiterating a theme that the Wall Street Journal's Jon Hilsenrath has been pushing this week: At this point, the Federal Reserve expects a long period of low interest rates even after they initiate the first hike. From Monday's Grand Central Station:
...The central banks are projecting an economy that looks on its face like it is returning to normal in the next couple of years...Yet most Fed officials are projecting the target for short-term interest rates will be below 2%, much less than the 4% level that officials think is appropriate in normal times.
How can the Fed expect to maintain short-term rates so far below normal when its main metrics of economic vitality look like they're back to normal?...
The economy is not getting back to normal, officials like Mr. Dudley are essentially arguing. It's just getting to something a little less vulnerable. Watch out for the persistent headwinds argument in the Fed's policy statement Wednesday or in Fed Chairwoman Janet Yellen's press conference. It is the linchpin to the Fed's assurance that rates won't rise much in the next couple of years, even after they start inching up from zero. It is also one of the next battlegrounds in the Fed's policy debates.
I am not entirely sure I like this characterization. The economy could have shifted into a new normal, and that new normal is characterize by a different constellation of prices, exchanges rates, and interest rates than the old normal. The new normal for interest rates may simply be lower than the old normal. Remember that we are still in the midst of a long-term secular decline in the level of interest rates:


Peak cycle interest rates - both short and long rates - have been on a steady decline since the 1980's. And notice that the well-telegraphed Fed tightening in the last cycle had very little impact on long-rates. This raises the possibility that the big move in long-rates (after the tapering talk began) is already behind us. Thus, long-rate might not rise much if at all even as the Fed raise short rates. We will know the answer to that if buyers keep coming out of the woodwork whenever rates approach 3%.
This also implies that although the Fed may think they are running a looser policy than normal because short-rates are historically low, the reality is that the policy is equally tight in relative terms. Thus even though they will argue that rates are low even after they begin raising rates, they will still be reinforcing the continuation of the new normal.
Bottom Line: The Fed will continue with tapering by cutting another $10 billion from asset purchases. They will most likely alter the guidance but continue to signal an extended period of low interest rates. Low rates might simply be part of the "new normal" the economy is settling into, a new normal that the Fed may be unintentionally reinforcing.

'The Most Important Economic Chart'

Posted: 18 Mar 2014 09:45 AM PDT

Atif Mian and Amir Sufi at House of Debt on a subject that has come up here many, many times:

The Most Important Economic Chart, by Atif Mian and Amir Sufi: If you must know only one fact about the U.S. economy, it should be this chart:


The chart shows that productivity, or output per hour of work, has quadrupled since 1947... This is a spectacular achievement...
The gains in productivity were quite widely shared from 1947 to 1980. ... However, what we want to focus on today is the remarkable separation in productivity and median real income since 1980. While the United States is producing twice as much per hour of work today compared to 1980, a small part of the gain in real income has gone to the bottom half of the income distribution. The gap between productivity and median real income is at an historic all-time high today.
So where are all of the gains in productivity going? Two places: First,... the share of profits has risen faster than wages. Second, the highest paid workers are getting a bigger share of the wages that go to labor. ...
It is not just about inequality... The widening gap between productivity and median income has serious implications for macroeconomic stability and financial crises. Our forthcoming book takes up these issues in more detail.
We will also discuss some of these issues in coming posts.

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