Fed makes low rates vow, but traders afraid of commitment
Anyone worried that the U.S. Federal Reserve tied its policy hands with its announcement last month that it is likely to keep short-term interest rates exceptionally low through late 2014 should take heart in the market reaction to Friday’s jobs report, which blew expectations out of the water.
Bond and interest-rate futures plunged after the report, which showed employers added 243,000 jobs in December, far more than the 150,000 economists had expected. Unemployment dropped to 8.3 percent in another encouraging sign. Fed fund futures contracts began pricing in a good chance of a rate hike by the second quarter of 2014. Before the report, bets were on a first rate hike at some point in the third quarter.
Some officials and analysts have publicly worried about the chilling effects of a Fed that signaled low rates for so long, a move they say threatens confidence just as the economy is showing signs of improvement and leaves the impression that the late-2014 date is a commitment.
This is what Charles Plosser, the Philadelphia Fed’s hawkish president who opposed the move, said after the policy decision:
I often read comments in the media that the FOMC has ‘pledged’ or ‘vowed’ to keep rates at zero at least until late 2014. If the economy changes, then that 2014 date will go out the window.
Judging from Friday’s market reaction, it already has. Markets and economic data are never stagnant, and chances are that in due time something will force dealers to pare back expectations once again. Still, at least one thing is clear: traders aren’t buying the idea that the Fed is promising anything.
In Bernanke’s schedule, a hint of housing-linked QE3
Federal Reserve Chairman Ben Bernanke has made clear the central bank is considering another round of monetary stimulus. Fed officials have also suggested that if they were to embark on a third round of quantitative easing via bond purchases, or QE3, they could favor mortgage-backed securities in an effort to boost housing.
Not to read too much into anecdotal evidence, but it’s hard not to see some symbolism in Bernanke’s next public appearance, announced late on Thursday. On February 10, Bernanke will be in Orange County, California, one of the epicenters of the U.S. housing crisis. His chosen forum? The National Association of Homebuilders International Builders’ Show. The topic: Housing Markets in Transition.
The Great Stagnation
Federal Reserve Chairman Ben Bernanke’s verdict on the U.S. economy is sobering. Boiled down, this was the message delivered at his news conference today:
- Brace for roughly three more years of sluggish growth – or longer
- Some of the unemployed will not find work in the foreseeable future
- America’s economic power has downshifted
- Global financial markets could upend recovery yet again
It is a bleak outlook. Bernanke has left little doubt that he sees the United States in the midst of very long and painful period of sub-par growth, dousing some of the optimism stirred by recent reports that showed unemployment falling, the housing market hitting bottom and businesses starting to spend again.
Conditions could worsen, especially if the European crisis deepens and tips the world back into recession as the IMF warned this week. Bernanke said the central bank is ready to pump even more cash into the economy to keep it afloat if necessary. And by formally announcing for the first time that the central bank has inflation target of keeping prices at 2 percent, Bernanke has bought himself the leeway to provide extra support to growth without stoking inflationary fears.
He may need to use the wiggle room. If the Fed’s outlook proves correct, it will have taken 7-1/2 years from the time the credit bubble burst in 2007 for the U.S. economy to find its moorings – the worst performance since the Great Depression. And some of the 17 Fed policymakers are even more gloomy. Rates on hold at least until 2014 was the central view, and six of the Fed officials see no need to raise interest rates until 2015 or 2016. Think about that – a decade of virtually free money for banks.
Here are the numbers that tell the tale. The Fed lowered by a notch its assessment for trend growth to the 2.3-2.6 percent range. Only seven months ago it had estimated healthy growth in the order of 2.5-2.8 percent. Maximum employment now is seen in the 5.2-6.0 percent range in the longer run. In the boom years, full employment was under 5 percent. Bernanke also said some of the unemployment now is structural – meaning that discouraged people have permanently dropped out the workforce or lost the skills needed to get jobs today.
No wonder people are buying gold.
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.
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.
U.S. inflation: bursting through the core
Economic forecasters, including those at the Federal Reserve, have notoriously poor aim. Last month, the central bank revised sharply lower its projections for U.S. gross domestic product in 2012 – just as U.S. data began to turn in a more positive direction.
But at least one Fed call appears to be on the mark: overall inflation is coming down as energy prices ease on the expectation of slowing global demand. This, in turn, may soon lead to a curious phenomenon. The core measure of costs, which excludes energy and food prices and tends to be lower than consumer prices as a whole, may soon exceed so-called “headline” inflation.
Eric Green at TD Securities, writes in a research note:
The November CPI data was benign and captures a trend over the next six months that will become more obvious – headline is poised to decelerate through core prices. Core inflation will prove more sticky to the upside rising toward 2.3% y/y over coming months while headline prices fall toward 1% y/y by May. That will encourage a perceptible bias lower in breakevens (one that could accelerate if Europe goes Kaboom in Q1), and it provides the Fed more leeway to become more proactive should growth decelerate over H1 as we suspect it will.
Jim Baird, chief investment strategist at Plante Moran Financial Advisors, offered a similar view.
The pace of inflation has clearly moderated in recent months, and is expected to continue to ease in the months ahead. Dissipating inflation pressures should also allow the Fed more room to provide additional stimulus if the economy were to slow in early in 2012. While recent economic data suggests solid fourth quarter results, there is certainly a risk that the sharp slowdown in Europe could be a drag on the U.S. economy as well.
When it comes to forecasting (and, Fed hawks might argue, in general), inflation really is the central bank’s core competency.
The only thing that is keeping inflation in check is the continued drive among overseas suppliers (China, Mexico, et al) to supply US retailers with goods to make competitive sales targets. As demand goes down, with an almost certainly dissappointing consumer spending total for many sectors including durable goods, garments this holiday season, next years overseas purchasing will come up against a wall of dramatic price increases for almost everything, from goods to supply chain costs in all sectors in the area of 20%. That wholesale push will result in a dramatic shift to the upside on core inflation beginning with the summer seasonal spike in May, 2012. Look for 12-14% inflation on dollar purchases across the board within a 60 day period, followed by double current inflation rates in real terms spreading through the retail markets afterward without a commensurate increase in salaries and capital expense in the USA. Balance sheets for retailers will be fine with this, but intermediate suppliers and manufacturing will be squeezed badly. Car sales will plummet, causing almost irretreivable move away from two car family demographics in much of the Northeast USA that may become permanent.
i.e.: don’t speak too soon.
In good company: Bernanke backs Tarullo on housing-targeted QE3
The Federal Reserve, which on Wednesday sharply downgraded its outlook for U.S. economic growth and employment, appears to be seriously considering another round of monetary easing. In what would represent a policy U-turn, any third round of quantitative easing or QE3 appears increasingly likely to be heavily tilted toward purchases of mortgage-backed securities.
The idea was recently floated rather surprisingly by Fed Governor Daniel Tarullo, who normally focuses on regulatory issues. Some analysts had speculated Tarullo might not have broad support, but Fed Chairman Ben Bernanke’s comments on the matter during his post-meeting press conference on Wednesday suggested otherwise:
The housing sector is a very important sector. Problems in that sector are a big reason why our economy’s not recovering more quickly. I do think that purchases of mortgage-backed securities is a viable option. Certainly, something we would consider if the condition were appropriate. So the answer is yes, we will certainly look into that.
Whether any such program would have the intended effect remains to be seen. The Fed already bought some $1.25 trillion of MBS as part of its first round of quantitative easing, to only modest effect. The central bank seems to be hoping that if its actions coincide with the government’s push for broader foreclosure relief, they may raise the chances of success. The U.S. housing slump has been ongoing now for over five years, with home values having fallen by about a third nationwide.
Birds of a feather: the Fed’s hawk-dove continuum
As the Fed ponders providing another round of stimulus to a weak U.S. economy, it is difficult to keep track of the views of individual central bank officials. This newly-updated hawks-doves chart should help cut through the clutter. One good rule of thumb: keep a close eye on Ben Bernanke. The Fed Chairman is highly respected by his colleagues and his views usually carry the day.
*Update: here’s another interactive graphic focused on just the 10 current voting members on the Fed’s policy-setting panel.
The seven-percent solution to U.S. unemployment
As policymakers debate how to bring down an unemployment rate stubbornly stuck above 9 percent, Chicago Federal Reserve Bank President Charles Evans and Boston Fed President Eric Rosengren are embracing what might be called “the seven-percent solution.”
It works like this: the Fed pledges to keep rates near zero for as long as it takes to get some real improvement in the labor market – an unemployment rate, say, of 7 percent – as long as inflation doesn’t get out of hand. That way, every time some good economic news comes out, markets don’t immediately start pricing in a rate hike, undoing the very easy policy that the Fed sees as necessary to pull the moribund jobs market from its deep hole. Don’t you worry about a little bit of inflation here or there, the Fed could say – it’s steady as she goes until unemployment dips below 7 percent.
What, though, is so special about 7 percent? Certainly, it’s much better than the current 9.1 percent. But it still would leave millions unemployed, and Evans himself has said he believes that unemployment normally runs at less than 6 percent. Why settle for a bigger number?
A bit of sleuthing into recent Chicago Fed research suggests one possible answer. In a paper published as part of its “Economic Perspectives” publication, Chicago Fed senior economist Gadi Barlevy takes a deep dive into the data on job vacancy rates, which rose sharply in the early part of the recovery even though unemployment was also climbing. Some researchers say this trend suggests that firms want to hire but simply cannot find the right kind of workers – a structural fault in the economy that easy monetary policy cannot possibly cure.
Drawing on the work of Nobel Prize winners Dale Mortensen and Christopher Pissardes, Barlevy argues that only half, if that, of the increase in unemployment from the Great Recession can be attributed to mismatches between employers’ needs and employees’ skills. The rest, he says, “must be because firms find hiring less profitable.” He goes on:
While there is little monetary policy can do if firms find it more difficult to find suitable workers, there may be scope for monetary policy when firms find it less profitable to hire workers than during normal times….if jobs are less valuable because of insufficient aggregate demand on account of some market friction, there may be a role for monetary policy to stimulate demand.
Still, Barlevy says his research shows that part of the increase in unemployment does indeed come from a labor market shock that monetary policy cannot offset: “This type of shock by itself would lead to an unemployment rate of 7.1 percent.”
Corporations have shipped all of the jobs overseas. They are not coming back. Get over it.
Will Fed policy go the Swedish route?
The Federal Reserve’s long-quiet doves are becoming increasingly louder about championing more aggressive forms of monetary easing, including possibly setting employment and inflation targets and/or engaging in another round of bond purchases. Most prominent among these have been Charles Evans, the Chicago Fed president who openly favors more transparent policy guidance and Eric Rosengren, who told CNBC on Wednesday a third round of monetary easing could be in store:
If the economy were to be weaker than most people are forecasting, that would certainly be cause for doing additional monetary policy.
Rosengren also said he favors more explicit policy targets, which could take a rather controversial form known as price-level targeting. Under this arrangement, the Fed would temporarily shoot for higher inflation to make up for the almost deflationary readings seen late last year, in an effort to boost investment, spending and hiring.
Looking for precedents, Goldman Sachs offers up the interesting example of Sweden — in the 1930s. Citing the findings of Claes Berg and Lars Jonung in a 1999 edition of the Journal of Monetary Economics, Goldman economists determine that the program was successful because it was relatively simple and also temporary:
Sweden’s experience highlights a number of issues involved in adopting a price level targeting framework.
Definition of price stability: The authorities decided to stabilize the price level at the price level of the third quarter of 1931, to take place at once. Despite various requests, policymakers decided not to attempt to return the price level to pre-crisis levels and did not allow for a drift in the price level over time. Also, the Riksbank was not given any other goals, such as output or employment stabilization.
Temporary vs. permanent: The introduction of the price level target was intended and announced as a temporary step by the government. Once the conditions were at hand, a return to gold was planned for.
Choice of price index: The Riksbank primarily targeted the CPI, and started publishing consumer prices on a weekly basis to allow for better monitoring. However, it did not tie its policy solely to stabilizing consumer prices and announced that “other price indices besides the Riksbank’s own index of consumer prices will also be taken into consideration.” For example, the Riksbank also paid attention to wholesale prices.
Treatment of special factors: Policymakers stressed the need to disregard temporary factors like indirect taxes, customs duties and seasonal effects influencing inflation.
Implementation: Changes in the discount rate and operations in the foreign exchange market were the most important instruments. Immediately after leaving the gold standard, the Riksbank did not intervene in the foreign exchange market and allowed the krona to float freely. But from July 1933 the Riksbank established a successful peg of the krona to the British pound that lasted until World War II.
