MacroScope

As Federal Reserve officials debate whether to use thresholds for inflation and joblessness to guide monetary policy, Friday’s jobs report may be a cautionary tale.  The idea of thresholds is to pick markers for potential policy change – an unemployment rate of 6.5 percent, for instance, as a guidepost for when the central bank might begin to raise rates – so that the market has a better idea of where Fed policy is headed. As the unemployment rate nears that level, the theory goes, investors will gradually start to price in tightening; if the unemployment rate rises again, they’ll price it out.

But some Fed officials, notably the hawkish heads of the Richmond, Philadelphia and Dallas regional Fed banks, oppose the idea. One reason: the unemployment rate alone cannot capture the state of the labor market. Friday’s report show why.

Unemployment in November fell to 7.7 percent, the lowest in nearly four years. But the decline was not a sign of labor market strength – far from it. People were giving up looking for jobs, signaling hopelessness, not hope.

If the Fed adopts thresholds, some worry, such a decline could perversely spur some market participants to price in a bit earlier tightening, exactly what the Fed wants to avoid.

Threshold advocates are well aware of this pitfall – and have sought to defuse it. Chicago Fed President Charles Evans, an early and vocal proponent of thresholds, has repeatedly said that a drop in the unemployment rate is not the only thing the Fed will look at, even if it does adopt a specific unemployment-rate threshold. Evans said he would also need to see above-trend GDP growth and at least six months of jobs gains of 200,000 or higher. By that measure, November’s report falls short, with only 146,000 new jobs.

For the first time, Federal Reserve Chairman Ben Bernanke has given credence to the idea that America’s long-term economic potential may have been permanently scarred by the turmoil of recent years. In a speech to the Economic Club of New York, Bernanke said:

 The accumulating evidence does appear consistent with the financial crisis and the associated recession having reduced the potential growth rate of our economy somewhat during the past few years. In particular, slower growth of potential output would help explain why the unemployment rate has declined in the face of the relatively modest output gains we have seen during the recovery.

True, Bernanke came nowhere near saying monetary policy was impotent to improve the situation. Indeed, he argued that the weaker potential growth “seems at best a partial explanation of the disappointing pace of the economic recovery.”

Sometimes, communication can be the art of what not to say. Federal Reserve Chairman Ben Bernanke took pains this week to make clear that the central bank’s indication that it will likely keep rates low until mid-2015 does not mean it expects growth to remain weak for that long.

By pushing the expected period of low rates further into the future, we are not saying that we expect the economy to remain weak until mid-2015; rather, we expect – as we indicated in our September statement – that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.

The comments speak to a key problem with the notion of calendar-based forward guidance, first adopted by the Fed in August of 2011: each time officials push the date further into the future, they risk dampening financial market sentiment, thereby having the opposite effect to the stimulus it intended.

Polling data courtesy of Chris Reese

We’ll know it when we see it. That’s essentially been the Federal Reserve’s message since it launched an open-ended bond-buying stimulus plan that it says will remain in place for as long “the outlook for the labor market does not improve substantially.” Which begs the question: how much larger is the central bank’s $2.9 trillion balance sheet likely to get?

Minutes from the Federal Reserve’s October meeting point to solid support within the central bank for ongoing monetary easing via asset purchases well into 2013.

A number of participants indicated that additional asset purchases would likely be appropriate next year after the conclusion of the maturity extension program in order to achieve a substantial improvement in the labor market.

Janet Yellen, the Federal Reserve’s influential Vice Chair and possible future replacement for Chairman Ben Bernanke, delivered an important speech this week. Entitled “Revolution and Evolution in Central Bank Communications,” Yellen traces the deep shift in sentiment towards the importance of policy transparency.

In 1977, when I started my first job at the Federal Reserve Board as a staff economist in the Division of International Finance, it was an article of faith in central banking that secrecy about monetary policy decisions was the best policy: Central banks, as a rule, did not discuss these decisions, let alone their future policy intentions. While the Federal Reserve is required by the Congress to promote stable prices and maximum employment, Federal Reserve officials at that time avoided discussing how policy would be used to pursue both sides of this mandate. Indeed, mere mention of the employment side of the mandate, even by the mid-1990s, was described in a New York Times article as the equivalent of “sticking needles in the eyes of central bankers.”

In her remarks, Yellen endorsed the concept of policy thresholds first championed by Chicago Fed President Charles Evans. Her backing suggests such numerical guideposts for policy – we’ll keep stimulating until jobs improve and as long as inflation doesn’t creep too far from the Fed’s 2 percent target – are effectively a done deal, though it remains unclear how quickly policymakers can agree on the details.

Federal Reserve officials have linked their open-ended stimulus program to substantial improvement in the labor market. So now, it’s up to Fed watchers to hone in on a definition of substantial, no small task in a world of multiple and often conflicting indicators on the job market.

In a speech to the Chattanooga Rotary Club on Thursday, Dennis Lockhart offered some insights into how he’s thinking about the process:

For policy purposes, I think it’s appropriate to be cautious about relying on a single indicator of labor market trends—for example, the unemployment rate—to determine whether the condition of “substantial improvement” has been met. The official national unemployment rate published by the Bureau of Labor Statistics is the most prominent statistic in the mind of the general public. As a policymaker, I want to have confidence that a decline of this headline number is reinforced by other indicators and evidence of broad labor market improvement in its many dimensions. The challenge my FOMC colleagues and I will face is communicating in simple and trackable terms what this phrase “substantial improvement” means while respecting the complex reality of many moving parts. […]

Latin America has defied one of the most elementary rules of macroeconomics in the past decade, Citigroup economists Joaquin Cottani and Camilo Gonzalez found in a report.

Lower interest rates reduce the cost of money and therefore should encourage businesses and consumers to borrow, as we’ve repeatedly heard from analysts and government officials for decades. Puzzlingly enough, credit growth accelerated after central banks in countries like Brazil and Peru raised rates, and slowed when borrowing costs fell. Why is that?

The keyword here is confidence. In this commodity-exporter region, with a long history of deep, painful crises caused by currency devaluations and global downturns, perhaps it’s worth paying more attention to what happens abroad than to the cost of money – and how the global background might affect the local business cycle.

The Federal Reserve’s open-ended bond-buying stimulus announced last month was coupled with a promise to continue purchasing assets “if the outlook for the labor market does not improve substantially.” Central bank officials are expected to continue discussing what parameters they will take into account to define such progress, but are not expected to come to any hard and fast decisions just yet.

In a research note entitled “What the Fed didn’t say: Payrolls at 160K,” Torsten Slok, economist at Deutsche Bank, offers a few guideposts:

In terms of what the Fed will be looking at, we reckon that employment growth will be first among equals – in particular nonfarm payrolls. We estimate that the FOMC’s economic and policy projections are consistent with payrolls averaging gains of around 160,000 per month through mid-2015, when they have told us they expect the exit process to begin to get under way. There is a range of uncertainty around this estimate. But if the numbers are coming in well below that rate for a number of months (100k or less), look for the Committee to extend the mid-2015 date and possibly step up its QE purchases, and expect just the opposite if they are coming in well above that rate (200k or more).

Ben Bernanke has done it again. In his much-anticipated speech Friday, the Federal Reserve chairman managed to tell both investors and politicians what they wanted to hear – that “the stagnation of the labor market in particular is a grave concern” – all while saying next to nothing new about where U.S. monetary policy is actually headed. That the Fed, as Bernanke also noted, stands ready to ease policy more if needed was well known to anyone paying attention the last few months. We also know that the high jobless rate, at 8.3 percent in July, has long been Bernanke’s main headache in this tepid economic recovery.

Still, in Jackson Hole, Wyoming on Friday, it was like Bernanke tossed a bone to the hounds on Wall Street and in the Beltway without even getting up off his lawn chair.

For markets, hungry as they are for a third round of quantitative easing (QE3), the “grave concern” comment says the high unemployment rate and mostly disappointing job growth since March gives the Fed little if any choice but to act. U.S. stocks climbed and the dollar dropped after the speech, with traders and analysts citing the remark. “‘Grave’ concern with labor market is striking,” said David Ader, head of government bond strategy at CRT Capital Group.

1. Since the second phase of Operation Twist just got underway, “it would be strange to announce outright purchases of Treasury securities.” 2. Fed officials have publicly noted that continued purchases of long-term Treasury securities “might compromise the functioning of the Treasury market — and undermine the intended effects of the policy.” 3. San Francisco Fed President John Williams “directly advocated” mortgage purchases and Fed Vice Chair Janet Yellen has said that “beyond the Twist extension, ‘it’s more likely that [the FOMC] would do things that would take a different form.’” 4. “Purchases of mortgage-backed securities may be considered less controversial than Treasury bond purchases amidst the charged political environment, just prior to the presidential election.”