Inflation no obstacle to more Fed easing
Another reason the Federal Reserve may have additional room for monetary easing: Inflation expectations fell sharply in May, according to the latest Thomson Reuters/University of Michigan survey of consumer sentiment. Inflation expectations five years out dropped to 2.7 percent in May, the lowest since January. Fed officials often say expectations are a key leading indicator of actual price increases.
Daniel Silver, economist at JP Morgan:
This level of longer-term inflation expectations is towards the bottom of the range that has been reported in recent years – 2.7% has been hit on several occasions (most recently between October 2011 and January 2012) and 2.6% was only reached back in December 2008 and March 2009, early on in the crisis period. Most other inflation measures that the Fed watches (including core PCE inflation and the 5yr-5yr breakeven inflation rate) have signaled that inflation expectations are still anchored and underlying inflation pressure is modest.
The downshift comes in the wake of inflation figures for April that also pointed to a tame price environment. This is why Eric Green at TD Securities argues “U.S. inflation favors the doves.”:
In many ways the release today is emblematic of what we expect to see on the inflation front over the next six months. That is, steady disinflation on headline prices (driven by roll over and seasonal effects from energy prices) and stable core prices. Headline inflation will fall through core next month as energy prices alone virtually ensure a gain of no more than 0.1%, probably less. As headline inflation drifts to 2.0% y/y next month (from 2.3% y/y April) and 1.8% y/y by August, the inflation metric will work in favor of the more dovish contingent on the FOMC.
Still, deflation fears, a key underpinning of the Fed’s second round of quantitative easing, are not likely to make a comback, says Green:
That does not mean we are in a period of disinflation akin to the pre-QE2 period. Inflation will not be the cause célèbre of more accommodation, it will merely be removed as a potential obstacle among those favoring stronger growth, and truth be told, higher inflation.
Put your rate hike where your mouth is
Jonathan Spicer and Van Tsui contributed to this post.
This week, for the second time ever, the U.S. Federal Reserve published policymakers’ forecasts for when the central bank should start raising rates. The chart suggested a split Fed, with three policymakers expecting a rate rise this year, three next year, seven in 2014 and four in 2015. That’s useful information, as far as it goes.
But as much as the Fed has embraced transparency in recent years, it stopped short of saying which policymaker backs a rate hike in which year – a key bit of data for grasping where the voters on Fed Chairman Ben Bernanke’s policy-setting committee stand, and how their positions shift over time.
Below is the bar graph that the Fed published Wednesday, with Reuters’ best estimates of who fell where. We stand ready be convinced otherwise by readers offering evidence or insight that supports a different view. Send us an email, gives us a call, write a comment or shout us out on Twitter.
You can find more information about the policy leanings of each top Fed official in our handy interactive hawks-doves chart.
The going gets tougher for Italy and Spain
One trillion euros is a lot of money. And as we have previously noted on this blog it did a lot for stock markets early this year but not much for the real economy.
But recent bond auctions in the euro zone suggest the impact of two rounds of cheap 3-year ECB funding on the region’s struggling bond market may also be fading.
Italian three-year borrowing costs surged more than a full percentage point at an auction to 3.89 percent – its highest since mid-January.
Nick Stamenkovic, strategist at RIA Capital Markets says:
Clearly it shows investor appetite for Italian bonds even at the short end has diminished recently as the effects of the two LTROs (long-term refinancing operations) from the ECB dissipate.
That was not the only patchy bond sale recently. Italy’s one-year borrowing costs doubled at a sale of short-term bills on Wednesday and, just last week, Spain had to pay dearer to borrow through medium-term bonds.
The new jitters in the market have partly been fueled by Spain’s fiscal conundrum: austerity aimed at reducing its budget deficit risks choking off the very growth that is needed to repair the country’s fiscal position.
Spain: ¿Cómo se dice “contagion”?
It was not a good day for Spain.
The euro zone’s fourth largest economy had to pay dearer to borrow through medium-term bonds, a sign that concerns over the country´s fiscal problems was curbing appetite for its debt. It sold 2.6 billion euros of 2015, 2016 and 2020 paper – at the low end of the target range.
In contrast, Portugal’s 1 billion euros sale of 18-month treasury bills was a successful test of market appetite for the longest-dated debt since it took an international bailout. Appetite for short-dated paper has been especially supported by the one trillion euros of cheap three-year European Central Bank funding injected into the financial system since December.
The problem is that Spain is the latest country to come into the firing line of the euro zone debt crisis. This week’s tough budget was not enough to calm investor nerves and many fear too much austerity could choke an already struggling economy where unemployment rose to a staggering 22.9 percent in the fourth quarter of 2011 – the highest in the European Union. Meanwhile, the government expects Spain’s public debt to jump in 2012 to its highest since at least 1990.
And although Spain has already sold around 46 percent of this year’s planned issuance of long-term debt and therefore is in a favourable funding position compared to its peers, analysts worry it could become the next source of euro zone contagion. In the secondary market, yields on 10-year Spanish government bonds rose to their highest since January at 5.72 percent after the auction.
DZ Bank rate strategist Michael Leister says:
It was only a lukewarm auction. This shows that the LTRO (ECB’s long-term refinancing operation) effect is losing momentum and that Spain is having a much more difficult time.
Europe’s wobbly economy
Things are looking a bit unsteady in the euro zone’s economy. Just ask Olli Rehn, the EU’s top economic official, who warned this week of “risky imbalances” in 12 of the European Union’s 27 members. And that’s doesn’t include Greece, which is too wobbly for words.
Rehn is looking longer term, trying to prevent the next crisis. But the here-and-now is just as wobbly. The euro zone’s economy, which generates 16 percent of world output, shrunk at the end of 2011 and most economists expect the 17-nation currency area to wallow in recession this year and contract around 0.4 percent overall. Few would have been able to see it coming at the start of last year, when Europe’s factories were driving a recovery from the 2008-2009 Great Recession. And it shows just how poisonous the sovereign debt saga has become.
Not everyone thinks things are so shaky. Unicredit’s chief euro zone economist, Marco Valli, is among the few who believe the euro zone will skirt a recession — defined by two consecutive quarters of contraction — in 2012. This year is “bound to witness a gradual but steady improvement in underlying growth momentum,” Valli said, saying the fourth quarter was the low point in the euro zone business cycle.
That could still happen. Business surveys support the idea that the worst is behind us, while European Central Bank President Mario Draghi agrees that last year’s collapse in confidence has now steadied, albeit at low levels. So far, the ECB has not given a strong signal on whether it will take interest rates below the 1 percent level for the first time, but the bigger risk is whether a disorderly Greek default or the threat of a severe credit freeze — which the ECB’s nearly 500 billion euros in loans has so far helped avoid – come back to crush the green shoots of growth.
The ECB’s latest lending survey showed for the last three months of 2011 reinforces the concerns of a credit crunch, as banks are still not passing the money on to the real economy. Thirty-five percent of banks reported they had tightened the standards they apply to loans to businesses, compared to only 16 percent in the third quarter. The ECB is set to make its second offer of three-year loans at the end of the month and that could ease credit risks, but may also discourage banks with bad loans on their books to reform.
So, in economist-speak, the risks are still on the downside and uncertainty remains high. Basically, things are still looking wobbly.
Fed hasn’t silenced markets, Williams says
Federal Reserve policymakers have long watched markets to gauge what investors think is in store for interest rates and the economy. Some – like former Fed Governor Kevin Warsh – have worried that the Fed’s unprecedented purchases of trillions of dollars of U.S. Treasuries and its long-term guidance on the future path of interest rates shuts off a key source of policy-guiding information. The Fed’s recent decision to publish policymakers’ interest-rate forecasts will make the problem worse, he predicted in a speech at Stanford University last month.
In some sense I have partially been made blind by these asset purchases. I, for one, consider financial markets an incredibly useful source of information. If the markets take the Fed’s projections and build that into their own, then the Fed won’t have a full set of gauges in front of them. The markets will simply be a mirror to what they say.
Now comes San Francisco Fed President John Williams with a research paper that argues, to put it bluntly, that Warsh is wrong – that markets are providing just as much information about expectations for Fed policy as they did in the days before the Fed had bought $2.3 trillion in long-term securities and began signaling short-term rates would stay low for years.
In the working paper co-authored with San Francisco Fed economist Eric Swanson and quietly posted to the San Francisco Fed’s website on Monday, Williams argued that five-year and 10-year Treasuries traders still respond with as much vigor to economic news as they did before the financial crisis. As Williams explained to reporters after a speech Monday at Claremont McKenna College:
We continue to see the markets reacting to information — they still give a signal for what they are thinking about when the Fed’s going to do (what), what policy is going to be, what they think of the future path of the economy. The markets are still working, they are still digesting the information, and they are still responding to it.
Williams’ paper also adds to research arguing there’s plenty the Fed can still do to help the economy, even with interest rates near zero for the last three years – and likely to stay there for another three. It’s a view that several of Williams’ colleagues, including Dallas Fed President Richard Fisher, have taken issue with, but one that Williams says his paper backs up. If long-term interest rates can rise and fall on unexpected economic news, as Williams and Swanson show in their paper, the Fed too can make its influence felt on long-term borrowing costs, the reasoning goes. The authors write:
Even when short-term interest rates are constrained by the zero lower bound, there may still be considerable scope for monetary policy to affect medium- and longer-term interest rates and, therefore, the economy. On several occasions since 2008, the Federal Reserve appears to have done exactly that, by managing private-sector expectations of future short-term interest rates and by conducting large-scale purchases of longer-term Treasury bonds and mortgage-backed securities.
Fed-bots: Goldman models central bankers
Forecasting hard data can be difficult enough. Estimating the forecasts of individual Federal Reserve policymakers is even tougher. But, in advance of the Fed’s latest effort at policy transparency, that’s just what Goldman Sachs economists have attempted to do.
The Fed announced last week it would begin publishing policymakers’ own forecasts for the path of interest rates, in addition to the growth, inflation and employment projections they already release on a quarterly basis. Goldman uses the Taylor rule of monetary policy, which governs the relationship between economic slack and inflation, to estimate when individual policymakers would likely perceive the timing of an eventual interest rate hike.
The findings are interesting, particularly because they find that, contrary to the view chronicled in this post, the publication of Fed officials’ forecasts might actually have the effect of tightening financial market conditions.
Given a broad range of economic forecasts, the range of participants’ funds rate projections is likely to be wide. Our estimates – which rely on participants’ economic forecasts and our Taylor rule – suggest that the central tendency (the range of forecasts by all 17 participants minus the highest and lowest three) might span from zero to 2.75 percent at end-2014, with a mid-point of 1.5 percent. These estimates point to the danger that financial conditions could tighten with the publication of such forecast ranges, as the market is currently pricing only around 75 basis points of rate hikes by the end of 2014.
To counter this potential consequence, the Fed could choose to offer clarity on participants’ expectations for additional bond purchases. By highlighting the fact that some officials still see the need for further monetary stimulus, the central bank would shift the perceived mid-point of market expectations for official rates.
It will be difficult for the FOMC to ease financial conditions significantly by publishing participants’ funds rate projections. But if sufficient detail is provided—including the distribution of funds rate projections and an indication that several participants are in favor of additional asset purchases—a modest boost to financial conditions appears likely.
Austro-Hungarian troubles
Concerns about Austrian banks’ exposure to Hungary have continued to put pressure on Austrian bonds in recent days, driving 10-year Austrian government bond yields to their highest in over a month on Friday.
In focus is Hungary’s dispute with the IMF and the EU over its financial aid package. Hungarian Prime Minister Viktor Orban’s government has been chided over its stance on a law its lenders view as infringing central bank independence. That has jeopardised negotiations for a much-needed loan deal.
The concerns have led to a sell-off in Austrian government bonds, leaving the spread between their yields and those on Germany bunds within sight of a euro lifetime high hit in November. Richard McGuire, senior fixed income strategist at Rabobank explains the linkage:
Austria’s exposure to Hungary is greater then its total exposure in terms of banking sector claims to the broader periphery, so this is Austria’s periphery.
Indeed, Austrian banks are the most exposed to overall Hungarian debt, according to the latest data from the Bank for International Settlements, with $41.6 billion on their books, followed by Italy with $23.4 billion and Germany with $21.4 billion. Italian and German banks, in turn, are the most exposed to Austrian debt with $110.9 billion and $90 billion respectively.
Key to the Hungarian situation is how the negotiations develop. The government has backtracked from its initial insistence on sticking to legislation disputed by the EU and IMF and has made some concessions to lenders in order to be able to start talks quickly and secure a new financing deal .
Fed rate forecasts as a micro QE3
The Fed’s decision to begin publishing policymakers’ own forecasts for the path of policy may effectively constitute a minor easing of the central bank’s already ultra-loose monetary policy at its Jan. 24-25 meeting, according to Harm Bandholz of UniCredit. That’s because in doing so, officials will likely show that they expect the benchmark federal funds rate to remain near rock bottom levels until later than mid-2013 – the Fed’s current guidance on policy.
While the minutes do not say in which direction the forward guidance should be adjusted, we assume that mid-2013 is seen by many FOMC officials as too early. In that context, the decision for Fed officials to publish their projections of the target fed funds rate could provide an opportunity for a back door policy easing in January. If e.g. most participants would not pencil in any rate hike until the end of 2014, the market would certainly take this as a strong signal.
Along the same lines, David Hensley at JP Morgan says:
All else constant, these projections would further flatten the yield curve if the FOMC signals a later start to rate hikes than currently is discounted in markets.
Which is just as well if the Fed’s intention is to keep policy constant, since, as my colleague Mark Felsenthal aptly points out, a stated end-date for exceptionally low rates effectively means that policy is susceptible to a passive tightening with every day that passes.
Investors remain split on the prospects of another round of bond buys, particularly given a better round of U.S. economy data. But for Bandholz, the odds are still in favor of a QE3:
Despite the latest round of better economic numbers, the chances for even further monetary policy accommodation still seem to be quite high.
In search of policy options, Fed digs into recycling bin
Since the 2008 failures of Bear Stearns, Lehman Brothers and American Insurance Group, the U.S. Federal Reserve has reached deep into unconventional territory for ways to coax the economy out of its deepest slide since the Great Depression, slashing interest rates to a shade above nothing and buying trillions of dollars of long-term securities.
Now it appears the U.S. central bank is diving for new ideas in its own dumpster – or recycling bin, as the case may be. As Fed officials vet a range of communications options that could provide more certainty to markets about the Fed’s policy intentions, they are warming to the idea of providing forecasts for short-term interest rates.
Doing so, some central bankers believe, would give markets a clearer idea of the Fed’s intentions, and could head off a recovery-choking jump in rates if investors start betting on tighter monetary policy before the Fed believes such tightening is warranted.
The idea is not new, and has been adopted by three central banks globally with some success. What has been largely forgotten is that the Fed itself considered, and then rejected, just such an approach four years ago.
The U.S. central bank already publishes some forecasts. Since November 2007, it has provided a quarterly summary of projections by Fed officials for a range of economic indicators, including inflation and unemployment. In the debate leading up to that decision, Fed officials also considered releasing the expected policy rate paths that underlie their economic projections. In a January 2008 speech, then Vice Chair Donald Kohn explained why the central bank’s policy-setting committee dumped the idea:
Specifically, it worried about a tendency for the public to infer more of a commitment to following the implied path than would be appropriate for good policy. In that circumstance, deviating from the path would risk market instability, and concerns about such dynamic responses would complicate already difficult policy choices. To be sure, over time, market participants might learn how little weight they should give any published average of “appropriate” policies, but the learning process could take time and be costly, and we would not be assured of a successful outcome.
In other words, Fed officials were fearful that markets would see statements about the future path of policy as commitments to action rather than projections based on current information and subject to change.
