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Which June Did You Mean, Charles?

Yesterday, Chicago Fed President Charles Evans gave a speech in which he said that he probably leaned towards making the first tightening early next year, as there is “no compelling reason for us to be in a hurry to tighten financial conditions.” The Fed, he said, probably shouldn’t raise rates until there’s a “greater confidence” that inflation one-to-two years ahead will be at or above 2%. This isn’t a surprising view, as Evans is the progenitor of the “Evans Rule” that says rates should stay near zero until unemployment has fallen below 6.5% (it has) or inflation has risen above 2.5%. Yes, those bounds have been walked about; in particular the 6.5% unemployment rate is obviously no longer binding (he sees the “natural rate” as being 5% again). But the very fact that he promoted a rule that set restraints on a mere return to normal policy means that he is a dove, through and through. So, it should not be surprising that he isn’t in a hurry to tighten.

What I found amusing is the sop he threw to the bears. Fed speakers often try to do the “on the one hand, on the other hand” maneuver, but in Evans’ case his heart clearly isn’t in it. He said that “you could imagine a case being made for a rate increase in June.” Notice that he doesn’t say he could imagine a case being made! I am also unclear about which June he means. Does he mean…

(thru Apr) (thru May)
Q1 GDP Q2 GDP Median CPI M2 growth
June 2012? 2.3% 1.6% 2.4% 9.2%
June 2013? 2.7% 1.8% 2.0% 6.6%
June 2014? -2.1% 4.6% 2.2% 7.3%
June 2015? 0.2% 1.0% (e) 2.2% 5.4%

I am not sure exactly what he thinks those darn hawks are looking at, but it seems to me the case for tightening in June is getting worse every year.

Eagle-eyed readers will notice that I didn’t include the Unemployment Rate in the table above. That particular metric has been improving each year, but we know that the labor situation tends to lag the economic situation. The Unemployment Rate is a big political football, but it isn’t particularly useful for policy unless you believe in the concept of a “natural rate” with respect to accelerating unemployment in the overall economy. I don’t: low unemployment tends to increase wages, but has no discernible effect on consumer inflation. Moreover, it appears that the “natural rate” shifts quite a bit over time (6.5% down to 5% in Evans’ formulation, in only a few years’ time), making it look to me like a fairly useless concept.

Yes, of course it makes it more difficult politically to tighten when people are out of work, but since monetary policy is quite useful for affecting prices and not particularly useful for affecting growth, this should be a secondary effect at best. The Fed simply can’t help the unemployed worker, except by holding down inflation for him. In the real world, of course, the Fed Chair is not going to countenance an uptick in rates when unemployment is above 5% or so.

Let me be clear: I think the Fed ought to have tightened in 2012, 2013, or 2014, and they ought to tighten now. I don’t necessarily mean they should guide rates higher, but they should reduce the size of the mountain of reserves via any means a their disposal. But if you are going to argue one year over another year, I think it is hardest to argue that now is the time unless you are merely being guided by the old James Carville adage that the best time to plant a tree was twenty years ago, but the second-best time is right now.

One thing that Evans said that quickens my heart, as an inflation-watcher, is that the Fed “ought to allow” a chance that inflation overshoots 2% that is symmetrical to its chance of falling below it. While he is quintessentially unclear about how he would establish these probabilities – as I have just shown, he seems blissfully unaware that consumer price inflation is already above 2% – the mere fact of treating the costs of inflation misses as symmetrical is dangerous territory. The costs are not symmetrical. The costs of an inflation rate around 0% are very low; some frictions, perhaps, created by wage “stickiness” (even this possibility hasn’t been conclusively established until inflation gets convincingly below zero). The costs of an inflation rate of 4% are much higher, since inflation has historically had long “tails.” That is, once inflation goes up a little, it not infrequently rises a lot. Over the last 100 years, if you take the set of all year-on-year inflation rates above 4%, you find that about one-third of them are also above 10%. This means the costs of a loss of inflation vigilance is must greater than the costs of a loss of deflation vigilance.

Fed Gearing Up to Stand Down

July 30, 2014 8 comments

I guess it’s something about strong growth numbers and a tightening central bank that bonds just don’t like so much. Ten-year Treasury yields rose about 9bps today, under pressure from the realization that higher growth and higher inflation, which is historically a pretty bad cocktail for bonds, is being offset less and less by extraordinary Federal Reserve bond buying. Yields recently had fallen as the Q1 numbers doused the idea that the economic recovery will continue without incident, and as the global political and security situation deteriorated (maybe we will just say it became “less tranquil”). Nominal 10 year yields had dipped below 2.50%, and TIPS yields had reached 0.20% again. It didn’t hurt that so many were leaning on the bear case for bonds and were tortured the further bonds rallied.

Stocks, evidently, didn’t get the message that higher interest rates are more likely, going forward, than lower interest rates. They didn’t get the message that the Fed is going to be less accommodative. They didn’t even get the message that the Fed sees the “likelihood of inflation running persistently below 2 percent has diminished somewhat.” The equity markets ended flat. Sure, it has not been another banner month for the stock jockeys, but with earnings up a tepid 6% or so year/year the market is up nearly 17% so…yes, you did the math right: P/E multiples keep expanding!

My personal theory is that stocks are doing so well because Greenspan thinks they’re expensive. In an interview today on Bloomberg Television, Greenspan said that “somewhere along the line we will get a significant correction.” Historically speaking, the former Chairman’s ability to call a top has been something less than spectacular. After he questioned whether the market might be under the influence of ‘irrational exuberance,’ the market continued to rally for quite some time. Now, he wasn’t alone in being surprised by that, but he also threw in the towel on that view and was full-throatedly bullish through the latter stages of the 1990s equity bubble. So, perhaps, investors are just fading his view. Although to be fair, he did say that he didn’t think equities are “grossly overpriced,” lest anyone think that the guy who could never see a bubble might have actually seen one.

Make no mistake, there is no question that stocks are overvalued by every meaningful metric that has historical support for its predictive power. That does not mean (as we have all learned over the past few years) that the market will decline tomorrow, but it does ensure that future real returns will be punk over a reasonably-long investment horizon.

It will certainly be interesting to see how long markets can remain levitated when the Fed’s buying ceases completely. Frankly, I am a bit surprised that these valuation levels have persisted even this long, especially in the face of rising global tensions and rising inflation. I am a little less surprised that commodities have corrected so much this month after what was a steady but uninspiring move higher over the first 1-2 quarters of 2014. Commodities are simply a reviled asset class at the moment (which makes me love them all the more).

Do not mistake the Fed’s statement (that at the margin the chance of inflation less than 2% is slightly less likely) for hawkishness. And don’t read hawkishness into the mild dissent by Plosser, who merely wanted to remove the reference to time in the description of when raising rates will be appropriate. Chicago Fed President Evans was the guy who originally wanted to “parameterize” the decision to tighten by putting numbers on the unemployment rate and inflation levels that would be tolerable to the Fed (the “Evans Rule”)…levels which the economy subsequently blasted through without any indication that the Fed cared. But Evans himself recently said that “it’s not a catastrophe to overshoot inflation by some amount.” Fed officials are walking back the standards for what constitutes worrisome inflation, in the same way that they walked back the standards for what constitutes too-low an unemployment rate.

This is a good point at which to recall the “Wesbury Map,” which laid out the excuses the Fed can be expected to make when inflation starts being problematic. Wesbury had this list:

  1. Higher inflation is due to commodities, and core inflation remains tame.
  2. Higher core inflation due to housing is just due to housing prices bouncing back to normal, and that’s temporary.
  3. It’s not actual inflation that matters, but what the Fed projects it to be.
  4. It’s okay for inflation to run a little above 2% for a while because it was under that level for so long.
  5. Increasing price pressures are due to something temporary like a weaker dollar or a temporary increase in money velocity or the multiplier.
  6. Well, 3-4% inflation isn’t that bad for the economy, anyway.

I think the order of these excuses can change, but they’re all excuses we can expect to hear trotted out. Charles Evans should have just shouted “FOUR!” Instead, what he actually said was

“Even a 2.4 percent inflation rate, if it’s reasonably well controlled, and the rest of the economy is doing ok, and then policy is being adjusted in order to keep that within a, under a 2.5 percent range — I think that can work out.”

That makes sense. 2.4% is okay, as long as they limit it to 2.5%. That’s awfully fine control, considering that they don’t normally even have the direction right.

Now, although the Evans speech was a couple of weeks ago I want to point out something else that he said, because it is a dangerous error in the making. He argued that inflation isn’t worrisome unless it is tied to wage inflation. I have pointed out before that wages don’t lead inflation; this is a pernicious myth. It is difficult to demonstrate that with econometrics because the data is very noisy, but it is easy to demonstrate another way. If wages led inflation, then we would surely all love inflation, because our buying power would be expanding when inflation increased (since our wages would have already increased prior to inflation increasing). We know, viscerally, that this is not true.

But economists, evidently, do not. The question below is from a great paper by Bob Shiller called “Why Do People Dislike Inflation” (Shiller, Robert, “Why Do People Dislike Inflation?”, NBER Working Paper #5539, April 1996. ©1996 by Robert J. Shiller. Available at http://www.nber.org/papers/w5539). This is a survey question and response, with the economist-given answer separated out from the answer given by real people.

shillerQ

Economists go with the classic answer that inflation is bad mainly because of “menu costs” and other frictions. But almost everyone else knows that inflation makes us poorer, and that very fact implies that wages follow inflation rather than lead.

Put another way: if Evans is going to be calm about inflation until wage inflation is above 3.5%, then we can expect CPI inflation to be streaking towards 4% before he gets antsy about tightening. Maybe this is why the stock market is so exuberant: although the Fed has tightened by removing the extra QE3, a further tightening is evidently a very long way off.

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