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February 19, 2015

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Posted: 19 Feb 2015 12:06 AM PST

Fed Watch: January FOMC Minutes

Posted: 18 Feb 2015 04:37 PM PST

Tim Duy:

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

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

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

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

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

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

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

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

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

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

Still, they have some broad guidelines:

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

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

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

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

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

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

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

to an extreme, unreasonable, or unnecessary degree

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

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

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

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

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

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

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

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

'Basic Personality Changes Linked to Unemployment'

Posted: 18 Feb 2015 09:45 AM PST

Another potential cost of unemployment:

Basic personality changes linked to unemployment: Unemployment can change peoples' core personalities, making some less conscientious, agreeable and open, which may make it difficult for them to find new jobs, according to research published by the American Psychological Association.
"The results challenge the idea that our personalities are 'fixed' and show that the effects of external factors such as unemployment can have large impacts on our basic personality," said Christopher J. Boyce, PhD, of the University of Stirling in the United Kingdom. "This indicates that unemployment has wider psychological implications than previously thought." ...
The study suggests that the effect of unemployment across society is more than just an economic concern -- the unemployed may be unfairly stigmatized as a result of unavoidable personality change, potentially creating a downward cycle of difficulty in the labor market, Boyce said.
"Public policy therefore has a key role to play in preventing adverse personality change in society through both lower unemployment rates and offering greater support for the unemployed," Boyce said. "Policies to reduce unemployment are therefore vital not only to protect the economy but also to enable positive personality growth in individuals."

'Betting the House: Monetary Policy, Mortgage Booms and Housing Prices'

Posted: 18 Feb 2015 09:22 AM PST

How risky is it when interest rates are held too low for too long?:

Betting the house: Monetary policy, mortgage booms and housing prices, by Òscar Jordà, Moritz Schularick, and Alan Taylor: Although the nexus between low interest rates and the recent house price bubble remains largely unproven, observers now worry that current loose monetary conditions will stir up froth in housing markets, thus setting the stage for another painful financial crash. Central banks are struggling between the desire to awaken economic activity from its post-crisis torpor and fear of kindling the next housing bubble. The Riksbank was recently caught on the horns of this dilemma, as Svensson (2012) describes. Our new research provides the much-needed empirical backdrop to inform the debate about these trade-offs.
The recent financial crisis has led to a re-examination of the role of housing finance in the macroeconomy. It has become a top research priority to dissect the sources of house price fluctuations and their effect on household spending, mortgage borrowing, the health of financial intermediaries, and ultimately on real economic outcomes. A rapidly growing literature investigates the link between monetary policy and house prices as well as the implications of house price fluctuations for monetary policy (Del Negro and Otrok 2007, Goodhart and Hofmann 2008, Jarocinski and Smets 2008, Allen and Rogoff 2011, Glaeser, Gottlieb et al. 2010, Williams 2011, Kuttner 2012, Mian and Sufi 2014).
Despite all these references, there is relatively little empirical research about the effects of monetary policy on asset prices, especially house prices. How do monetary conditions affect mortgage borrowing and housing markets? Do low interest rates cause households to lever up on mortgages and bid up house prices, thus increasing the risk of financial crisis? And what, if anything, should central banks do about it?
Monetary conditions and house prices: 140 years of evidence
In our new paper (Jordà et al. 2014), we analyse the link between monetary conditions, mortgage credit growth, and house prices using data spanning 140 years of modern economic history across 14 advanced economies. Such a long and broad historical analysis has become possible for the first time by bringing together two novel datasets, each of which is the result of an extensive multi-year data collection effort. The first dataset covers disaggregated bank credit data, including real estate lending to households and non-financial businesses, for 17 countries (Jordà et al. 2014). The second dataset, compiled for a study by Knoll et al. (2014), presents newly unearthed data covering long-run house prices for 14 out of the 17 economies in the first dataset, from 1870 to 2012. This is the first time both datasets have been combined. ...

After lots of data and analysis, they conclude:

... We have established that loose/tight monetary conditions make credit cheaper/dearer and houses more expensive/affordable. But what about the dark side of low interest rates – do they also increase the risk of a financial crash?
The answer to this question is clearly affirmative, as we show in the last part of our paper using crisis prediction models. Over the past 140 years of modern macroeconomic history, mortgage booms and house price bubbles have been associated with a higher likelihood of a financial crisis. This association is even stronger in the post-WW2 era, which was marked by the democratization of leverage through the expansion of housing finance relative to GDP and a rapidly growing share of real estate loans as a share of banks' balance sheets.
Conclusion
Our findings have important implications for the post-crisis debate about central bank policy. We provide a quantitative measure of the financial stability risks that stem from extended periods of ultra-low interest rates. We also provide a quantitative measure of the effects of monetary policy on mortgage lending and house prices. These historical insights suggest that the potentially destabilizing by-products of easy money must be taken seriously and considered against the benefits of stimulating flagging economic activity. Policy, as always, must strike a fine balance between conflicting objectives.
An important implication of our study is that macroeconomic stabilization policy has implications for financial stability, and vice versa. Resolving this dichotomy requires central banks to make greater use of macroprudential tools alongside conventional interest rate policy. One tool is insufficient to do two jobs. That is the lesson from modern macroeconomic history. ...

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