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March 2, 2015

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Fed Watch: Game On

Posted: 02 Mar 2015 12:15 AM PST

Tim Duy:

Game On, by Tim Duy: Almost too much Fed news last week to cover in one post.

The highlight of the week was Federal Reserve Chair Janet Yellen's testimony to the Senate and House. On net, I think her assessment of the US economy was more optimistic relative to the last FOMC statement, which gives a preview of the outcome of the March 17-18 FOMC meeting. Labor markets are improving, output and production are growing at a solid pace, oil is likely to be a net positive, both upside and downside risks from the rest of the world, and, after the impact of oil prices washes out, inflation will trend toward the Fed's 2% target. To be sure, some challenges remain, such as still high underemployment and low levels of housing activity, but the overall picture is clearly brighter. No wonder then that the Fed continues to set the stage for rate hikes this year. Importantly, Yellen gave the green light for pulling "patient" at the next FOMC meeting:

If economic conditions continue to improve, as the Committee anticipates, the Committee will at some point begin considering an increase in the target range for the federal funds rate on a meeting-by-meeting basis. Before then, the Committee will change its forward guidance. However, it is important to emphasize that a modification of the forward guidance should not be read as indicating that the Committee will necessarily increase the target range in a couple of meetings. Instead the modification should be understood as reflecting the Committee's judgment that conditions have improved to the point where it will soon be the case that a change in the target range could be warranted at any meeting.

She is under pressure from both hawks and moderates to leave June open for a rate hike, which requires pulling "patient" from the statement. But at the same time, they don't want the end of "patient" to be a guarantee of a rate hike in June. And that is the message Yellen sends here.

More broadly, though, Yellen is signaling the end of extensive forward guidance. They don't know how the data will unfold at this point, so they are no longer willing to guarantee one particular monetary policy path or another. This was also the message sent by Federal Reserve Vice Chair Stanley Fischer. Via the Wall Street Journal:

Mr. Fischer said that while many believe the Fed will move rates steadily higher, meeting by meeting, in modest increments, it is unlikely the world will allow that to happen. "I know of no plans to follow one of those deterministic paths," he said, adding, "I hope that doesn't happen, I don't believe that will happen."

Instead, Mr. Fischer affirmed that whatever the Fed does with short-term rates will be determined by the performance of the economy, which will almost certainly offer the unexpected.

Mr. Fischer said there is value in making sure you don't take markets "by surprise on a regular basis." But at the same time, offering too much guidance can shackle monetary policy makers, and "there's no good reason to telegraph every action."

It's "game on" for Fed watchers! Figure it out, because the Fed will no longer be holding our hands.

Separately, San Francisco Federal Reserve President John Williams echoes Yellen's assessment of the US economy. Via the Wall Street Journal:

In an interview with The Wall Street Journal, Mr. Williams expressed a good deal of confidence in the U.S. outlook, especially on hiring. He said the jobless rate could fall to 5% by the end of the year, which means the central bank is getting closer to boosting its benchmark short-term interest rate from near zero, where it has been since the end of 2008.

"We are coming at this from a position of strength," Mr. Williams said. "As we collect more data through this spring, as we get to June or later, I think in my own view we'll be coming closer to saying there are a constellation of factors in place" to make a call on rate increases, he said.

He also gives guidance on why the Fed will soon be confident that inflation will trend back toward target. It's all about the labor market:

Mr. Williams said it is likely that the Fed will see a hot labor market that should in turn produce the wage pressures that will drive inflation back up to desired levels. He said much of the weakness seen now in price pressures is due to the sharp drop in oil prices, which he said isn't likely to last.

"The cosmological constant is that if you heat up the labor market, get the unemployment rate down to 5% or below, that's going to create pressures in the labor market" causing wages to rise, he said.

Williams also bemoans the failure of financial market participants to, as he sees it, catch a clue:

Mr. Williams said there is a "disconnect" between Fed officials' and markets' expectations for the path of short-term rates. He said he hopes that can be bridged by effective communication explaining central bank policy choices.

St. Louis Federal Reserve President James Bullard has often stated the same concern, and does so again in yet another interview with the Wall Street Journal:

Mr. Bullard said he is worried financial markets aren't fully taking on board the likely path of monetary policy, and are underpricing what the Fed will do with interest rates.

"The market is pricing in a later and slower and shallower pace of increases" compared to what central bankers think, the official said. "The mismatch has to get resolved at some point, and I think there's some risk it could be resolved in a violent way," which he suspects no one would like to see.

Similarly, New York Federal Reserve President William Dudley warns that the Fed will need to choose a more aggressive rate path if financial market participants don't figure it out after the Fed starts raising rates:

As an example, one significant conundrum in financial markets currently is the recent decline of forward short-term rates at long time horizons to extremely low levels—for example, the 1-year nominal rate, 9 years forward is about 3 percent currently. My staff's analysis attributes this decline almost entirely to lower term premia. In this case, the fact that market participants have set forward rates so low has presumably led to a more accommodative set of financial market conditions, such as the level of bond yields and the equity market's valuation, that are more supportive to economic growth. If such compression in expected forward short-term rates were to persist even after the FOMC begins to raise short-term interest rates, then, all else equal, it would be appropriate to choose a more aggressive path of monetary policy normalization as compared to a scenario in which forward short-term rates rose significantly, pushing bond yields significantly higher.

All of which sounds to me like the Fed wants to see the term premium start drifting higher - in other words, the situation is now the opposite of the unintended climb in term premiums during the 2013 "Taper Tantrum" incident.

When will that first hike occur? Far too much attention is placed on that question says Fischer:

He said there has been "excessive attention" paid to the issue of when rates will be lifted, and not enough to attention to what happens with short-term rates once they've been boosted off of their current near-zero levels.

That I suspect is correct; I am more interested in how the Fed proceeds after the first rate hike (June still on the table, but I don't know if they will have sufficient data to be confident in the inflation outlook) than the timing of the rate hike itself. Is the Fed really as eager to challenge financial markets as Dudley suggests? I am a little nervous this is shaping up to be a repeat of the Riksbank incident.

Bottom Line: The Fed's confidence in the US economy is driving them closer to policy normalization. The labor market improvements are key - as long as unemployment is falling, confidence in the inflation outlook is rising. The more important message, however, is as the timing of the first rate hike draws closer, the level of uncertainty is rising. And it is not just about the timing of that rate hike. The Fed is sending a clear message that the subsequent path of rates is also very uncertain, and they don't think that uncertainty is being taken seriously by market participants. In their view, financial markets are too complacent about the likely path of interest rates.

Links for 03-02-15

Posted: 02 Mar 2015 12:06 AM PST

'What is the New Normal for the Real Interest Rate?'

Posted: 01 Mar 2015 09:42 AM PST

Jim Hamilton:

What is the new normal for the real interest rate?: The yield on a 10-year Treasury inflation protected security was negative through much of 2012 and 2013, and remains today below 0.25%. Have we entered a new era in which a real rate near zero is the new normal? That's the subject of a new paper that I just completed with Ethan Harris, head of global economics research at Bank of America Merrill Lynch, Jan Hatzius chief economist of Goldman Sachs, and Kenneth West professor of economics at the University of Wisconsin...
For the project we assembled annual data on the interest rate set by the central bank (or close substitute) along with inflation estimates for 20 different countries going back in some cases to 1800, along with more detailed quarterly data since 1970. ...
We found little support in these data for two of the popular conceptions many people have about real interest rates. First, although it is often assumed in theoretical models that there is some long-run constant value toward which the real interest rate eventually returns, our long-run data lead us to reject that hypothesis, consistent with other studies...
We also found little support for the popular assumption that the long-run economic growth rate is the primary factor driving changes in the equilibrium real interest rate over time. ...
We conclude that changes in personal discount rates, financial regulation, trends in inflation, bubbles and cyclical headwinds have had important effects on the average real rate observed over any given decade. We examine the secular stagnation hypothesis in detail. On balance, we find it unpersuasive, concluding that it confuses a delayed recovery with chronically weak aggregate demand. ...
It's worth remembering that recoveries from financial crises often take many years. ... Our paper reviews a great deal of evidence that leads us to conclude that those who see the current situation as a long-term condition for the United States are simply over-weighting the most recent data from an economic recovery that is still far from complete...
Finally, our paper discusses the implications of these findings for monetary policy. ... We conclude that, given that we do not know the equilibrium real rate, there may be benefits to waiting to raise the nominal rate until we actually see some evidence of labor market pressure and increases in inflation. ...

'A Slippery New Rule for Gauging Fiscal Policy'

Posted: 28 Feb 2015 09:54 AM PST

Greg Mankiw:

A Slippery New Rule for Gauging Fiscal Policy: the case for dynamic over static scoring is strong in theory. Yet three problems make the task difficult in practice.
First, any attempt to estimate the impact of a policy change on G.D.P. requires an economic model. Because reasonable people can disagree about what model, and what parameters of that model, are best, the results from dynamic scoring will always be controversial. ...
Second, accurate dynamic scoring requires more information than congressional proposals typically provide. ...
Third, dynamic scoring matters most over long time horizons. Some policy changes, such as those aimed at encouraging capital investments, take many decades to have their full impact on economic growth. Yet congressional budgeting usually looks only five or 10 years ahead. ...
So there are good reasons for the economists hired by Congress to pursue dynamic scoring. But there are also good reasons to be wary of the endeavor. ...

Another worry is the politicization of the CBO. See here and here. Also see here and here on the application of dynamic scoring to things such as Head Start and infrastructure spending.

John Whitehead comments:

Mankiw on dynamic scoring: ...Mankiw:

First, any attempt to estimate the impact of a policy change on G.D.P. requires an economic model. Because reasonable people can disagree about what model, and what parameters of that model, are best, the results from dynamic scoring will always be controversial. Just as many Republicans are skeptical about the models of climatologists when debating global warming, many Democrats are skeptical about the models of economists when debating tax policy.

My read of the article was going just fine until the climate model analogy. Two assumptions are made:

  1. All economists agree on "the models of economists" 
  2. Reasonable people can disagree about climatology models

In terms of #1, there is significant disagreement amongst economists about macroeconomic models (i.e., have you read Krugman lately?). In terms of #2, science is different than social science. Climatology involves forecasts so it is different than tests of the law of gravity, but still, ninety-x percent of climate scientists agree. That is a bit higher than the number of economists who agree on anything macro

My stance is that we should accept that the earth is likely warming and people contribute to it (even the U.S. Senate, including those Republicans that Mankiw mentions [did he miss that vote?], overwhelming thinks so). That moves us to the debate on whether we should do anything it or learn to adapt. I think that reasonable people can disagree on that second question. 

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