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Food Fight at the Fed!

September 23, 2013 2 comments

Now, now, children! Stop fighting! This is unbecoming!

It is apparent now that the disagreements in the FOMC – while nothing new – are becoming more significant and the hurly-burly is spilling into the public eye. It is somewhat amazing to me that the Fed is allowing this argument to be conducted in public (traditionally, all remarks by Fed officials are first vetted by the Chairman’s office). Today Dallas Fed President Richard Fisher actually questioned the Fed’s credibility! This article is worth reading, and not just for the part where Fisher says that Yellen is “dead wrong on policy.” It’s also fascinating that Fisher attributed the decision to delay the taper to “a perceived ‘tenderness’” in the housing recovery.

Below is a chart (source: Enduring Investments) of the ratio of median existing home sale prices to median household income. If this is “tenderness” in a recovery, it only shows a lack of knowledge of history: this is the second highest ratio of home prices to income we have since this particular data begins…and the first highest ratio sunk the global economy for a half-decade and counting.

updatedhousing

On the other side of the fence were the New York Fed’s Bill Dudley and the Atlanta Fed’s Dennis Lockhart, who lamented that (Dudley) there has been no pickup in the economy’s “forward momentum” and asked (Lockhart) “Is America losing its economic mojo?” These questions, and the result of these questions during the recent FOMC meeting, illustrate two points. First, that the bar for removing never-before-seen levels of monetary accommodation has been raised so high that doves believe it is appropriate to keep the foot on the accelerator until growth is drastically above-average. As I illustrated back at the beginning of August, it is unreasonable to expect more than about 200,000 new jobs per month to be created by the economy. Repairing all of the damage is simply going to take time. We would all love to see 5% growth, but is the Fed’s job really to make sure that happens, or to try and manage the downside (or, as I personally believe, to merely manage the price level)?

The second point that the Fisher/Dudley/Lockhart comments illustrate is that the doves at the Fed are clearly in control. The hawks were completely unable even to get a marginal tapering, although the Fed had clearly indicated previously that such a taper was likely to happen.

It is a Dudley/Bernanke/Yellen Fed (and they have allies too!), and anyone who thinks that the Fed is abruptly going to find religion once CPI peeks above 2% is fighting against all historical indications. One need only consider the fact that the post-FOMC meeting statement pointed out a “tightening of financial conditions observed in recent months,” a clear reference to the rapid rise in interest rates that accompanied the initial talk about tapering. But if the Fed begged off on the taper partly because of the tightening of financial conditions, that is the rise in interest rates that was caused by an expectation that the taper would stop, then the argument circular, isn’t it? It’s impossible for them to stop, since any indication that they were going to stop is obviously going to cause interest rates to rise, which would be a tightening of financial conditions, which would keep them from stopping… Does anyone seriously think that a core inflation print of 2.1% would change that?

To the extent that cutting from 20 cups of coffee per day to 19 cups of coffee per day could be called a “bold step,” wouldn’t the best time to take such a “bold step” with monetary policy be when the equity markets are at their highs and real estate markets back above their long-term value anchors?

And yet, the initial enthusiasm for the stock market for the continuation of QE seems to have faded rapidly. The entire post-FOMC rally that caused such joy around the offices of CNBC last Wednesday has been erased. Interestingly, the initial spike in commodities prices has also been erased, which is more curious since commodities prices don’t depend on growth as much as they do on inflation. And 10-year inflation expectations are back around 2.25%, basically the highest level they have seen since the Q2 swoon (see chart, source Bloomberg). So, as usual, I am flummoxed by the behavior of commodities.

10ybei

I know that there is a great deal of confidence in some quarters that the Federal Reserve can keep its foot on the gas until such time as inflation actually rises to a level that concerns them. I cannot imagine the reason for such confidence when the drivers of the car are such committed doves. There are multiple problems undermining my confidence in such a possibility. There is the “Wesbury hypothesis” that the Fed will adjust its definition of what worries them about inflation – a hypothesis which, after this month’s FOMC meeting, should be even more compelling. There is the fact that there is no evidence I am aware of that the Fed was able to easily restrain inflation after it came unglued in any prior episode (and no one knows where and when and how it will come unglued). And finally, it isn’t clear to me how the Fed would go about restraining inflation anyway, given the overabundance of excess reserves and the fact that those reserves insulate any inflation process against the tender ministrations of the central bank.

One thing seems to be sure. The food fight at the Fed is not likely to end soon, and together with the dysfunction on Capitol Hill is raises the very real question of whether anything economically helpful is going to be accomplished in Washington DC this year.

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Transparently Dovish

January 26, 2012 4 comments

Markets are finding it a little hard to believe that the Fed really said what it said. Stocks opened the day with a rally, along with commodities and bonds and especially TIPS. All of these markets leapt forward out of the gate, which is a completely understandable response. I was pretty clear in yesterday’s comment, but there were a couple of additional points that I either ignored or gave short shrift.

The first of these is that while I mentioned that Bernanke said “we’re not absolutists” about inflation, that really doesn’t capture the idea as clearly as he said it. Here is the full quote (and thanks BN for reminding me):

We are not absolutists. If there is a need to let inflation return a little bit more slowly to target to get a better result on unemployment then that is something that we would be willing to do.

It is hard to read that as anything except probably the single most-dovish thing that a Fed Chairman has said in eons. He explicitly states, essentially, that not only is employment as important as inflation in the FOMC’s consideration of its mandate, but that at this time inflation is actually subordinate to employment. This is essentially a vague form of the Evans Rule, which Chicago Fed President Evans proposed as a way to semi-formally declare that inflation doesn’t matter until (a) it’s out of control or (b) unemployment gets down to some certain level. Formally, it would read something like “the Fed will keep rates at zero and tolerate 3% (or 4%) annual inflation until unemployment is down to 7% (or 6%).” I wrote about this back in early November, never dreaming that it had a serious chance to become policy. It’s worse than policy now – it has a mushy informality that is guaranteed to make any ultimate decision to raise rates in restraint of inflation even more difficult. Back in November, I expressed my opinion of such a rule, and I must say I don’t disagree with this comment:

If they do take such a step, though, it is an unmitigated disaster for monetary policy and a sign to grab every real investment in sight. Because allowing 3% or 4% inflation has nothing to do with the Unemployment Rate, and moreover there is no sign that the Fed has anything like the kind of power they would need to lock the inflation rate at any particular level. Such a statement would mark a surrender against inflation in order to make a Quixotic charge on unemployment. If the world’s largest central bank goes that route, then bill-printers of the world unite! You have nothing to lose but your change.

It is inexcusable that I didn’t carry the “absolutist” quote to its full length and implication. But I also missed a small subtlety that is less egregious. The Fed, in stating formally that 2% inflation “is most consistent over the longer run with the Federal Reserve’s statutory mandate,”  already nudged the goalposts a bit. For some time it has been tacitly understood and occasionally communicated explicitly in speeches that the Fed operated as if it had a target of 2%-2.25% on core CPI inflation. The Fed has long preferred the core PCE Deflator as a measure of inflation, and the PCE deflator has generally run around 25bps lower than core CPI over time, so the 2-2.25% CPI target was really a 1.75%-2.00% target on core PCE.[1] By saying that the Fed’s informal target was 2%, the Committee (a) nudged the target up slightly from 1.75%-2.00% to just 2.00%, and (b) made clear that inflation can go at least another 0.3% higher before it even gets to the target, and probably wouldn’t alarm them until it was at least 0.8% higher than the current level. That would be a core CPI inflation rate around 3.0%, well above the current level. No wonder they aren’t alarmed at the strong, steady advance in core CPI!

Investors seem to barely believe their ears. While commodities ended the day +0.4%, stocks slipped into the red. Still, the equity chart to me bears an uncanny resemblance to the chart in the months following Bernanke’s Jackson Hole speech in which he essentially announced QE2 (see Chart, source Bloomberg).

Narrow ranges, steady advancement, and all on top of markets that were not cheap to begin with. Today’s selloff of a mere -0.6% doesn’t alarm me and I think equities will continue to climb, although commodities offer much more inflation “beta” at this stage of the cycle and with negative real rates.

In my view, this action is no less clear a sign that the Fed is going to continue to pump liquidity into the markets than Bernanke’s speech was in the summer of 2010. It is much more remarkable, in that back then core CPI was preparing to print a low of 0.6% and now it is 2.2% and rising, but it is not much less clear. After all, that has become the Fed’s game: transparency, transparency, transparency.

For a very long time (as in, more than a decade) I have been railing about how Fed glasnost is a bad idea with no real upside. It has generally been pretty lonely to have that view, since “transparency” seems like a good thing and in many areas of government we could use lots more. But I was pleased today to get news of a speech from former Fed Governor Warsh in which he said the transparency has gone too far:

Central bank transparency is good, but transparency that delineates future policy breeds market complacency. It threatens to undermine the wisdom of the crowds and the essential interchange with financial markets.

Now, I’ve said similar things in the past about transparency and market complacency – overconfidence breeds over-leverage; if you want to cause deleveraging then the Fed should start doing unpredictable, random things like moving the Fed funds rate 17bps one day and then moving it back the next day, or only making moves in prime numbers, or scheduling an FOMC ‘tea’ instead of a board meeting. Act crazy and investors will keep a bigger margin of safety, which means they will use less leverage. But Warsh raises another very interesting and important point that I haven’t noticed before: if the Fed is too busy telling the market what to do, it can’t be listening to the market to learn what to do. When you think about it, aside from arrogance this conveys a mistrust of markets that is a hallmark of liberal institutions. Failed liberal institutions.

In economic data today, Durable Goods and Chicago Fed came in strong, while New Home Sales was soft but at continued low levels which makes them irrelevant in any event. Initial Claims was roughly on-target (but we’re still in the choppy year-end waters during which Initial Claims can be ignored). But all of this is back-seat stuff if the Fed is pressing pedal to the metal.

Friday introduces another weekend filled with searing promise for solutions in Europe; and the weekend precedes a Monday stuffed with bitter disappointment. It seems to happen every week, and I don’t see any reason it should differ this week.

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One quick note: in August 2010 I wrote an article called “The ‘Real Feel’ Inflation Rate,”  in which I discussed a paper I’d written discussing how economists might go about assessing quantitatively how inflation feels as distinct from how it is precisely measured. I’m pleased to report that the paper has finally been published in this month’s Business Economics, the journal of the NABE. It’s only available to subscribers, unfortunately, but membership in the NABE is only $150 per year online. (I am not a member, so consider this a public service message). I should mention that I am looking for a corporate partner who would be interested in developing the methodology and perhaps commercializing such an index – contact me if you are interested or know of someone who is.


[1] There are several differences between PCE and CPI. One important one at the moment is that the PCE deflator has a higher weight in housing, so it’s currently at 1.70% on core, but there are other differences as well covering the functional form, the items that are included or excluded for each one, and the weights for those. There may be a very slight reason to prefer PCE as a technically ‘better’ index, but there is a large reason to prefer CPI and that is that there is an explicit market price for inflation expectations in CPI form: inflation swaps. There is no such market price for PCE. So I don’t think the Fed has made the right decision anyway.

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