Monday, March 30, 2015

Fed: Talking Heads
The FOMC certainly has lots of talkative personalities. They love to share their opinions with us on a regular basis, especially just before and just after their meetings, and in between. The only time we ever seem to get a break from them is during the “quiet period” of five business days in which they stop talking publicly about monetary policy as they prepare for their next policy meeting. It didn’t take them long to start yapping away after the latest meeting ended on March 18. The FOMC clearly has a split personality on the issue of when to start raising interest rates, a.k.a. “liftoff”:

(1) Lockhart. In a NYT interview on Wednesday, FRB-Atlanta President Dennis Lockhart said the following about the timing of liftoff: “So for me to say June-July-September [with] full confidence is probably overstating it, but I think it’s quite likely.” On Thursday, he hedged a bit, saying that he is paying more attention to the rising dollar to see if it’s weighing on the economy.

(2) Bullard. In a speech on Thursday in Frankfurt, FRB-SL President James Bullard said that current low levels of US inflation are likely temporary and the risks of keeping the federal funds rate zero for too long “may be substantial.” He believes that the FOMC should start tightening: “Now may be a good time to begin normalizing US monetary policy so that it is set appropriately for an improving economy over the next two years.”

(3) Evans. FRB-Chicago President Charles Evans warned that there were considerable risks in raising rates too early in an environment where core inflation is persistently below 2%. “Some say we are behind the curve, that interest rates are unusually low but we’re not at a point of business as usual,” he said during a FT interview.

(4) Yellen. In a speech on Friday, Fed Chair Janet Yellen said, “Like most of my FOMC colleagues, I believe that the appropriate time has not yet arrived, but I expect that conditions may warrant an increase in the federal funds rate target sometime this year.” She concluded her speech by saying, “Nothing about the course of the Committee's actions is predetermined except the Committee's commitment to promote our dual mandate of maximum employment and price stability.”

(5) YRI. Debbie and I are now assigning the following subjective probabilities to the three possible scenarios for the Fed’s liftoff this year: Normalization (20%), One-and-Done (60), and None-and-Done (20). I’m still expecting the one and only rate hike this year in June, while Debbie thinks September is more likely. The FOMC isn’t the only organization with split personalities.
(Based on an excerpt from YRI Morning Briefing)

Tuesday, March 24, 2015

Yellen: On Bubbles
Once the Fed starts to normalize monetary policy, stocks could stumble or even tumble on fears that rising interest rates will pose more of a competitive challenge for stocks or, worse, cause a recession. However, in her press conference last week, Fed Chair Janet Yellen reiterated that when rate hikes start they are likely to be small and gradual:
Once we begin to remove policy accommodation, we continue to expect that--in the words of our statement--"even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run."
There’s certainly no reason for monetary policymakers to raise interest rates in an effort to bring down inflation given that inflation remains below their 2% target. If so, then the current economic expansion isn’t likely to end anytime soon as a result of tighter monetary policy.

Last Wednesday, at Fed Chair Janet Yellen’s press conference, Peter Barnes of Fox News asked:
I wanted to check in again with you on whether or not you see or have any concerns about bubbles out there in the economy, particularly the financial markets, debt and equity markets and I want to refer to your most recent Monetary Policy Report to Congress last month in which you said overall equity valuations by some conventional measures are somewhat higher than their historical levels, valuation metrics in some sectors continued to appear stretched relative to historical norms. In the same report last year, in July, the reports specifically mentioned biotech and social media stocks as being substantially…stretched. Do you still feel that way, and can you comment on bubbles and particularly these sectors?
Her answer was short and a bit curt:
Well, I don't want to comment on those particular sectors. You know, as we said in the report, overall measures of equity valuations are on the high side, but not outside of historical ranges. In some corporate debt markets, we do see evidence of unusually low spreads. And that's what we referred to in the report.
Let’s have a closer look:

(1) Sure enough, the July 2014 report stated:
Nevertheless, valuation metrics in some sectors do appear substantially stretched--particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year.
In her prepared remarks for her July 15, 2014 congressional testimony on monetary policy, Yellen said:
While prices of real estate, equities, and corporate bonds have risen appreciably and valuation metrics have increased, they remain generally in line with historical norms. In some sectors, such as lower-rated corporate debt, valuations appear stretched and issuance has been brisk.
During the Q&A, she warned about biotechs and social media stocks being overvalued as well.

(2) In the February 2015 report, there was no mention of any specific “stretched” sectors, though:
“[o]verall equity valuations by some conventional measures are somewhat higher than their historical average levels, and valuation metrics in some sectors continue to appear stretched relative to historical norms.
Now, during her latest press conference, Yellen said, “equity valuations are on the high side, but not outside of historical ranges.”

Yes, P/Es are on the high side of their historical ranges. Yes, they are not outside their historical ranges. However, doesn’t the high side of the historical range suggest that stocks might be a wee bit overvalued? Back in July of last year, Yellen said that valuations seemed a bit “stretched.” Now she doesn’t want to discuss the subject.

Yellen’s number-one priority remains the labor market. She acknowledged that it has improved, but said last week that she sees “room for further improvement.” If postponing or slowing monetary normalization is necessary to achieve her goal, so be it, even if it leads to a melt-up in stocks.

On Friday, a day after retiring as president of the Federal Reserve Bank of Dallas, Richard Fisher appeared in an interview on CNBC. He warned:
Are we vulnerable in my personal opinion to a significant equity market correction? I do believe we are, and the reason for that is people have gotten lazy. They've depended totally on the Fed.
He added that in the event of a market correction, the Fed should not intervene because the market is “hyper overpriced.”

Fisher, unlike Yellen and his other colleagues at the Fed, has had some experience actually managing money. His resume includes stints at Brown Brothers, where he was assistant to former Undersecretary of the Treasury Robert V. Roosa. He specialized in fixed income and foreign exchange markets. From 1978 to 1979, he served as Special Assistant to Secretary W. Michael Blumenthal at the US Treasury, where he worked on issues relating to the dollar crisis. In 1987, Fisher created Fisher Capital Management and a separate funds management firm, Fisher Ewing Partners, managing both firms until 1997.
(Based on an excerpt from YRI Morning Briefing)

Monday, March 23, 2015

No Shortage of Guidance
Prior to last week’s FOMC meeting, several members of the committee suggested that the first rate hike was likely to be approved at their June 16-17 meeting. Now the latest statement and Yellen’s comments at her press conference suggest that this guidance is no longer valid.

Yellen said:
Let me emphasize again that today’s modification of the forward guidance should not be read as indicating that the Committee has decided on the timing of the initial increase in the target range for the federal funds rate. In particular, this change does not mean that an increase will necessarily occur in June, although we can’t rule that out.
So the latest guidance is that anything is possible. Furthermore, consider the following:

(1) The FOMC members’ median estimate for the fed funds rate target at the end of this year was lowered to 0.625% from 1.125% at the end of December. The median projection at the end of 2016 is 1.875%, down from 2.500%, while the longer-run estimate of the fed funds target rate held steady at 3.750%. (Notice that the Fed is forecasting the rate to three decimal points!)

The Fed’s latest guidance tends to confirm our view that “none-and-done” or “one-and-done” are more likely than a normalization of monetary policy over the rest of this year. A fed funds rate of 1.000% by the end of this year would be more normal than 0.625%.

(2) I first raised the possibility of one-and-done in our 10/6 Morning Briefing last year. I based this scenario on the possibility that the dollar might be almighty:
If the dollar continues to strengthen on expectations of a Fed rate hike, it could go to the moon on the first actual hike and threaten to slam the brakes on the economy just as the Fed is finally convinced that it has achieved escape velocity. If so, then that could be ‘one-and-done’ for rate hikes. Conceivably, it could also be ‘none-and-done.’ When the FOMC finally votes to implement its exit strategy from ultra-easy monetary policy, they might find that the door is locked and no one has the key. In this scenario, stock prices could very well melt up.

I’m just thinking outside the box here. Other than last year’s taper tantrum in the financial markets, the Fed has succeeded in exiting QE. The Fed might succeed in normalizing monetary policy starting next year by raising the federal funds rate in a gradual fashion. What’s changed recently for the FOMC, and could complicate the committee’s exit strategy, is the strength in the dollar, which bears watching.
The JP Morgan trade-weighted dollar is up 10% since I wrote that, and up 16% since July 1 of last year. The “dollar” was mentioned nine times in Yellen’s latest press conference. It was mentioned once at her previous press conference on December 17, 2014. The word was mentioned 15 times in the Fed’s February Beige Book of Current Economic Conditions. It was mentioned eight times in the January Beige Book.
(Based on an excerpt from YRI Morning Briefing)

Wednesday, March 18, 2015

Yellen’s Mindbender
In her congressional testimony on February 24, Fed Chair Janet Yellen reiterated that Fed policy is data dependent:
Provided that labor market conditions continue to improve and further improvement is expected, the Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when, on the basis of incoming data, the Committee is reasonably confident that inflation will move back over the medium term toward our 2 percent objective.
There’s no doubt that labor market indicators continue to improve. Since her testimony, we learned that the total number of job openings rose to 5.0 million during January, the highest since January 2001. Quits rose to 2.8 million, the highest since April 2008. The NFIB reported that the percentage of small business owners with job openings soared to 29% during February, the highest since April 2006.

Nevertheless, in their meeting yesterday and today, the members of the FOMC must have voiced some concerns about whether the recent weakness in other economic indicators is weather related or not. They are dependent on data that may be hard to read right now. Can they be reasonably confident that the economy is doing well enough to push inflation back toward 2% over the medium term (whatever that means)?

As we await the Fed’s latest decision this afternoon, let me highlight this priceless quote from Yellen’s latest testimony:
The FOMC’s assessment that it can be patient in beginning to normalize policy means that the Committee considers it unlikely that economic conditions will warrant an increase in the target range for the federal funds rate for at least the next couple of FOMC meetings. If economic conditions continue to improve, as the Committee anticipates, the Committee will at some point begin considering an increase in the target range for the federal funds rate on a meeting-by-meeting basis. Before then, the Committee will change its forward guidance. However, it is important to emphasize that a modification of the forward guidance should not be read as indicating that the Committee will necessarily increase the target range in a couple of meetings. Instead the modification should be understood as reflecting the Committee’s judgment that conditions have improved to the point where it will soon be the case that a change in the target range could be warranted at any meeting.
Let’s see how Yellen updates this mindbender at her press conference this afternoon.
(Based on an excerpt from YRI Morning Briefing)
What's the Rush?
A 3/6 NYT editorial opposed any monetary tightening for now: “The Fed should hold off until wages are growing in tandem with inflation and productivity.” In a speech in India yesterday, IMF Chief Christine Lagarde warned of a repeat of high market volatility and capital outflows when the Fed hikes rates next time and asked India and other emerging market economies to be prepared for such an eventuality. Amir Sufi, an economics professor at the University of Chicago, was widely quoted yesterday saying that inflation doesn’t justify a Fed rate hike this year.

What’s the rush? Well, the federal funds rate has been at zero since December 16, 2008. That’s over six years. One of these days, the Fed will need to lower interest rates to avert or moderate the next recession. To be prepared for that eventuality, the Fed should start raising interest rates.

We think that’s the main reason why the Fed will do so at the June 16-17 meeting of the FOMC. However, it may still be “one-and-done” for Fed rate hikes this year since there is no rush to raise interest rates rapidly. We are expecting a “patient pace” of rate increases. Stocks and bonds should respond positively to that. The dollar might stop soaring as well.
(Based on an excerpt from YRI Morning Briefing)

Wednesday, March 11, 2015

In Dollars We Trust
Over the past few years, several Fed officials have said that they would start raising interest rates only when they believed that the economy had achieved “escape velocity.” In recent months, they’ve been preparing the launching pad for “lift-off” around mid-2015. To do so, they tapered QE last year and terminated it last October. They dropped the “considerable time” language from the January 28 FOMC statement, indicating that since QE bond purchases were finished, the time for hiking rates was drawing near.

The result so far has been that the JP Morgan trade-weighted dollar lifted off from last year’s low of 83.75 on July 1 to 98.33 yesterday. The dollar immediately achieved escape velocity, rising almost vertically by 17% over this period to the highest level since September 3, 2003. The Fed’s “major” and “broad” measures of the trade-weighted dollar are following the same path as the JP Morgan version--which includes Australia, Canada, China, Denmark, Eurozone, Hong Kong, Japan, Korea, Mexico, New Zealand, Norway, Singapore, Sweden, Switzerland, Taiwan, and the UK.

Adding rocket fuel to the almighty dollar have been moves by the ECB and BOJ towards ultra-easier monetary policies, which further weakened their currencies. Let’s review recent developments that have sent the dollar soaring and consider the implications for Fed policy:

(1) Euro getting trashed. The ECB’s Governing Council agreed at the June 5, 2014 meeting of the committee to “targeted longer-term refinancing operations” (TLTROs). At his monthly press conference on August 7 last year, ECB President Mario Draghi said, “the fundamentals for a weaker exchange rate are today much better than they were two or three months ago.” At the time, the euro was at $1.30.

On October 11, Bloomberg reported that ECB President Mario Draghi told reporters in Washington that expanding the ECB’s balance sheet is the last monetary tool left to revive inflation, although there is no target for how much it might be increased. He said, “I gave you a kind of ballpark figure, say about the size the balance sheet had at the start of 2012.” That would be a remarkable increase of €1.0 trillion. The euro was at $1.26.

On November 21, in a keynote speech in Frankfurt, Draghi said that the ECB will “do what we must to raise inflation and inflation expectations as fast as possible.” In effect, he backed US-style quantitative easing. On January 22, the Governing Council voted to implement QE, with bond buying starting this week. The euro was down below $1.07 yesterday, probably on its way to parity with the dollar.

(2) Yen is stir fried. On October 31 of last year, the BOJ announced a significant increase in bond and stock purchases. During April 2013, the BOJ implemented a similar program that was supposed to revive Japan’s economy and end deflation as part of Abenomics. The BOJ upped the ante at the end of October 2014. According to the BOJ’s press release, the bank would triple the pace of its buying of stock and property funds, extend the average maturity of its bondholding by three years to 10 years, and raise the ceiling of its annual Japanese government bond purchases by ¥30 trillion to ¥80 trillion. The yen has declined by a whopping 36% since late 2012.

(3) Commodity exporters freefalling. Also jumping off the currency cliff since last summer have been the commodity producers. The Canadian and Australian dollars are down 12% and 15% on a y/y basis. The Brazilian real is down 25% y/y. The South African rand is down 13% y/y. The Mexican peso is down 15% y/y.

(4) Downside of depreciation. Some of the currency depreciation pressures are home brewed. However, adding to everyone’s misery is the anticipation of monetary normalization in the US. While the US economy might be ready for it, the rest of the world may not be so ready. Indeed, plunging currencies are offsetting some of the benefit of falling oil prices for oil-importing countries. Rising US interest rates might also unsettle foreign bond and stock markets, especially in the emerging economies. The risks that something will break are increasing as the dollar continues to soar.

(5) Risky business for US. There are also risks for the US in a soaring dollar. It gives a competitive advantage to our trading partners. That means it stimulates our imports while depressing our exports. In addition, it depresses the dollar value of profits from overseas. Profits drive employment and capital spending. So weaker profits attributable to the strong dollar can slow the economy down.

There is a strong correlation between the y/y growth rates in S&P 500 forward earnings and aggregate weekly hours worked in private industry. The y/y growth rate of capital spending in real GDP is also driven by this profits cycle.

(6) Fed’s tough exit act. The bottom line is that the Fed has a problem. The FOMC rarely considers the impact of the dollar on the US economy. The subject is almost never discussed at the FOMC meetings. The members of the committee may need to give more weight to the soaring dollar in their deliberations. They have three options for the rest of this year. They can proceed to normalize monetary policy and raise interest rates a few times this year. “One-and-done” is another option. So is “none-and-done.” Debbie and I still believe that the last two are more likely than normalization given that the dollar will continue to soar if the Fed doesn’t back off.
(Based on an excerpt from YRI Morning Briefing)

Monday, March 9, 2015

Central Banks: Diverging
China’s government is predicting a “new normal” for the Chinese economy with growth continuing to slow. The PBOC started lowering interest rates late last year, signaling that China’s central bank will do whatever it takes to slow the slowdown. At the same time, the US monetary authorities are preparing to transition from the new normal of NZIRP (near-zero interest rate policy) back to the old normal of rising interest rates as the US economy shows signs of stronger self-sustaining growth, led by the labor market.

The ECB and the BOJ remain committed to their ultra-easy monetary policies. Last week, the ECB confirmed that its new QE program will start today. The BOJ remains on course with its QQEE, which is the expanded and extended version (since October 31, 2014) of its QQE program (first announced on April 4, 2013). The resulting freefalls in the euro and the yen may be starting to boost the exports of both the Eurozone and Japan, as we discussed last week. Here’s a brief review of the latest developments among the major central banks:

(1) US. The 2/27 WSJ reported that after Fed Chair Janet Yellen’s congressional testimony on February 24 and 25, Fed “officials fanned out to drive home the message that they are likely to start raising short-term interest rates later this year.” They included Fed Vice Chairman Stanley Fischer and the leaders of the Atlanta, St. Louis, and San Francisco Fed banks.

I’m sure we will shortly hear from many of them about their reaction to the latest stronger-than-expected employment report. In his Barron’s column this week, Randy Forsyth probably expressed the widespread consensus view:
When the Fed’s policy-setting panel gathers on March 17 and 18, there’s a good chance the ‘patient’ will be gone. That would leave the path open for the FOMC to lift its target for the federal-funds rate at the June 16-17 confab from the near-zero level that has prevailed since the crisis days of December 2008.
That assessment was instantly discounted in the bond market on Friday.

(2) Eurozone. Even though the ECB’s QE program will start this week, ECB President Mario Draghi came close to declaring “Mission Accomplished” at his press conference last week:
First of all, let me say, our monetary policy decisions have worked, and it’s with a certain degree of satisfaction that the Governing Council has acknowledged this. … The market reaction to the announcement, the expectation first and the announcement second, of our asset purchase program has also been quite effective and quite positive.
The ECB said it expects real GDP to grow 1.5% this year, 1.9% in 2016, and 2.1% in 2017. That 2017 forecast marked the first time since the end of 2007 that ECB economists have been so bullish. They also predicted that inflation, which is forecast at zero this year, should gradually move towards the ECB’s target of just below 2% by 2017.

Last August, Draghi indicated that QE was coming and that the goal was to devalue the euro to stimulate exports and revive inflation. The euro is down 22% since last year’s high of $1.39 on May 6 to $1.09 currently. That mission was certainly accomplished.

(3) Japan. The BOJ has also accomplished a dramatic depreciation of the yen, which is down 36% since late 2012. Haruhiko Kuroda, governor of the BOJ, never specifically stated that the bank’s goal was to devalue the yen. How do you say, “Who is kidding who?” in Japanese. Despite the plunge in the yen, which lifted import prices, the BOJ hasn’t accomplished its goal of boosting inflation.

As noted in the 3/7 issue of The Economist:
The BOJ’s target, laid down in 2013, was to raise core inflation (a measure that includes energy but excludes fresh food) to 2% by April. It remains far short of that goal. In January, core prices rose by a mere 0.2% year on year, excluding the effect of a recent increase in the consumption tax.
The “core core” CPI, which excludes energy as well as fresh food, was at 0.4%, much closer to zero than 2%.

(4) China. Last Thursday, Reuters reported:
China plans to run its biggest budget deficit in 2015 since the global financial crisis, stepping up spending as Premier Li Keqiang signaled that the lowest rate of growth in a quarter of a century is the ‘new normal’ for the world's No.2 economy. Speaking at the opening of the country's annual parliamentary meeting on Thursday, Li announced a growth target of around 7 percent for this year, below the 7.5 percent goal that was narrowly missed in 2014.
Li actually sounded quite alarmed:
The downward pressure on China's economy is intensifying. Deep-seated problems in the country's economic development are becoming more obvious. The difficulties we are facing this year could be bigger than last year.
The article noted:
The fight against pollution and corruption have contributed to the slowing economy, as Beijing has clamped down on dirty industries, and the fear of being caught in the anti-graft net has had a chilling effect on some business activity.
On February 28, the PBOC cut interest rates for the second time in three months. Last week, the WSJ Grand Central observed:
For much of last year, the PBOC, under long-serving Governor Zhou Xiaochuan, insisted on targeted efforts rather than broader moves like rate cuts out of concern that broadly easing credit would worsen debt problems. The central bank is acceding to demands from the Chinese leadership to reduce financing costs for businesses and bolster growth, according to officials and advisers to the bank. A rate cut in November was the first such move in two years and was followed last month by an across-the-board measure lowering the amount of money banks need to hold in reserve, thereby freeing up more funds for lending.
(Based on an excerpt from YRI Morning Briefing)

Wednesday, February 25, 2015

Yellen: A Dash of Fairy Dust
There really weren’t any surprises in Fed Chair Janet Yellen’s semiannual congressional testimony and report on monetary policy yesterday. She signaled that while the normalization of monetary policy might begin around mid-year, the FOMC is likely to do so very gradually. Both stock and bond prices responded positively. The S&P 500 rose to 2115, another record high. The Nasdaq rose to 4968, only 1.6% below its record high of 5048 on March 10, 2000. Let’s review what she had to say:

(1) Labor market. Fed policy remains dependent on “incoming data.” Despite the awesome employment report released on February 6, Yellen said in her prepared remarks that “a high degree of policy accommodation remains appropriate to foster further improvement in labor market conditions and to promote a return of inflation toward 2 percent over the medium term.”

(2) “Patient.”. She didn’t say when or under what conditions the word “patient” would be deleted from the FOMC’s forward guidance. However, she reiterated that the “FOMC's assessment that it can be patient in beginning to normalize policy means that the Committee considers it unlikely that economic conditions will warrant an increase in the target range for the federal funds rate for at least the next couple of FOMC meetings.”

This does suggest that the word could be dropped from the March 18 statement if the FOMC anticipates liftoff at the June 16-17 meeting. I still think the FOMC might keep the word, but change its context to suggest that the Fed will be patient about raising interest rates further after the first rate hike.

(3) Normalization. Now, I challenge you to decipher the following from Yellen’s prepared remarks, which seems to have been written in Greenspan-speak:
If economic conditions continue to improve, as the Committee anticipates, the Committee will at some point begin considering an increase in the target range for the federal funds rate on a meeting-by-meeting basis. Before then, the Committee will change its forward guidance. However, it is important to emphasize that a modification of the forward guidance should not be read as indicating that the Committee will necessarily increase the target range in a couple of meetings. Instead the modification should be understood as reflecting the Committee's judgment that conditions have improved to the point where it will soon be the case that a change in the target range could be warranted at any meeting. Provided that labor market conditions continue to improve and further improvement is expected, the Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when, on the basis of incoming data, the Committee is reasonably confident that inflation will move back over the medium term toward our 2 percent objective.
The main point seems to be that the FOMC might continue to normalize monetary policy even if inflation remains below 2%, as long as the committee expects it will move back up there in a reasonable time.

However, the federal funds rate is likely to remain below “normal” for quite some time:
It continues to be the FOMC's assessment that even after employment and inflation are near levels consistent with our dual mandate, economic conditions may, for some time, warrant keeping the federal funds rate below levels the Committee views as normal in the longer run. It is possible, for example, that it may be necessary for the federal funds rate to run temporarily below its normal longer-run level because the residual effects of the financial crisis may continue to weigh on economic activity
(4) Bubbles. In her prepared remarks during her previous semiannual testimony on July 15, 2014, Yellen mentioned that she had some concerns about speculative excesses as some investors “reach for yield.” She didn’t mention that this time. However, the formal report observed:
Overall equity valuations by some conventional measures are somewhat higher than their historical average levels, and valuation metrics in some sectors continue to appear stretched relative to historical norms.
There was no specific mention of stretched valuations for smaller firms in the social media and biotechnology industries, as there was in the July 2014 report. Back then, overall valuations seemed consistent with historical norms for the prices of real estate, equities, and corporate bonds
(Based on an excerpt from YRI Morning Briefing)

Tuesday, February 24, 2015

Yellen: Shades of Grey
Fed Chair Janet Yellen and I have something in common. We both studied under Professor James Tobin, a Nobel laureate, in the graduate economics department at Yale University. She graduated with a PhD degree six years before I did. I actually studied from a Xerox copy of the neat and meticulous notes she took in Tobin’s course on macroeconomics. They were called the “Yellen notes.” We also both have grey hair, though I have more shades of grey.

Today and tomorrow, Yellen will testify before two congressional committees on monetary policy. It will be interesting to see how she shades the outlook for Fed policy. The minutes of the January 27-28 FOMC meeting, released last Wednesday, was widely perceived to be dovish, suggesting that the committee’s members are in no rush to raise interest rates. They remained “patient.” However, on February 6, January’s employment report was so strong that everyone concluded that the Fed will commence “lift-off” at the June 16-17 meeting of the FOMC.

That means that the FOMC will have to decide whether to drop the “patient” clause in either the March 18 or April 29 statement to prepare the markets for a rate hike on June 17. The latest minutes noted:
Many participants regarded dropping the ‘patient’ language in the statement, whenever that might occur, as risking a shift in market expectations for the beginning of policy firming toward an unduly narrow range of dates. As a result, some expressed the concern that financial markets might overreact, resulting in undesirably tight financial conditions.
My hunch is that Yellen will suggest that labor market conditions have improved sufficiently so that the FOMC can proceed with the first rate hike at mid-year. However, she is likely to also say that the Fed will remain patient about further rate hikes, increasing the likelihood of “one-and-done” for this year. Here is a possible scenario for the evolution of the “patient” clause in the FOMC statements:

(1) Dec.17 actual:
Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy. The Committee sees this guidance as consistent with its previous statement that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program in October …
(This was the first time that the word “patient” appeared in the statement.)

(2) Jan. 28 actual:
Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy.
(This was the first time that the “considerable time” phrase was deleted from the statement since it first appeared in this context on September 13, 2012.)

(3) Apr. 29 hypothetical:
Based on its current assessment, the Committee judges that it can be patient in normalizing the stance of monetary policy once it begins.
(In other words, rate hikes will begin soon, but will proceed at a patient pace. That would be similar to, but more gradual than, the “measured pace” of tightening from June 30, 2004 to June 29, 2006.)

If that’s the way things go, then stock prices should continue to move higher. They could even melt up. That’s especially likely if Yellen doesn’t mention any serious concerns about overvaluation in the financial markets as she did during her July 15, 2014 semiannual monetary policy testimony to Congress. Back then, she said in her prepared remarks:
The [FOMC] Committee recognizes that low interest rates may provide incentives for some investors to ‘reach for yield,’ and those actions could increase vulnerabilities in the financial system to adverse events. While prices of real estate, equities, and corporate bonds have risen appreciably and valuation metrics have increased, they remain generally in line with historical norms. In some sectors, such as lower-rated corporate debt, valuations appear stretched and issuance has been brisk. Accordingly, we are closely monitoring developments in the leveraged loan market and are working to enhance the effectiveness of our supervisory guidance.
The monetary policy report that accompanied her testimony specifically noted:
Nevertheless, valuation metrics in some sectors do appear substantially stretched--particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year.
Previously, I’ve noted on numerous occasions that Yellen has been the “Fairy Godmother of the Bull Market.” The S&P 500 has tended to rise after she spoke publicly about monetary policy and the economy. Let’s see if she sprinkles more fairy dust today and tomorrow.

By the way, Jon Hilsenrath, the WSJ’s ace Fed watcher, observed last Thursday that the latest minutes weren’t as dovish as widely believed:
The central bank held a special ‘policy planning’ session to discuss the appropriate timing of interest rate increases. Officials had a long and detailed briefing from staff on the tools it would use once it started raising interest rates. In addition the staff briefed officials on the alternate interest rate paths it might choose for a series of interest rate increases, with historical and international comparisons. Moreover officials discussed removing the assurance from its policy statement that it will be patient before raising rates. Fed Chairwoman Janet Yellen is a methodical planner known since her childhood for doing her homework. Her Fed has clearly entered an intensive planning stage for interest rate increases.
(Based on an excerpt from YRI Morning Briefing)

Monday, February 23, 2015

Central Banks: Market Dependent
Central banks have added “forward guidance” to their bag of monetary policy tools since the financial crisis of 2008. The idea has been to guide financial markets in the desired direction without any surprises that might trigger financial turmoil.

Central bankers, particularly the ones at the Fed, have consistently declared that their policy moves will be “data dependent.” That makes forward guidance a very questionable exercise in practice because communicating it can very quickly degenerate into the old joke about economists, as first delivered by President Harry S. Truman: “Give me a one-handed economist! All my economists say, ‘On the one hand, on the other.’”

Making the situation even more amusing is that both the Fed and ECB have stated that their policymaking is also market dependent--on the third hand. That approach can easily (and can often) conflict with the data-dependent approach. Or at least it can be very confusing. In other words, there may be (and have been) plenty of times when no guidance might be better than forward guidance. Consider the following:

(1) Fed. There are certainly lots of two-handed economists at the Fed. Their two-handed guidance was most recently expressed in the 1/28 FOMC statement:
Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy. However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.
What an amazing insight! The full minutes of the 1/28 FOMC meeting included the following punch line:
It was also suggested that maintaining the federal funds rate at its effective lower bound for an extended period or raising it rapidly, if that proved necessary, could adversely affect financial stability.
In other words, policy needs to be market dependent, i.e., it needs to factor in the likely market reaction to policy changes.

The minutes indicated that the FOMC may have some regrets about using the word “patient” in the previous statement and using it again in the latest one:
Many participants regarded dropping the ‘patient’ language in the statement, whenever that might occur, as risking a shift in market expectations for the beginning of policy firming toward an unduly narrow range of dates. As a result, some expressed the concern that financial markets might overreact, resulting in undesirably tight financial conditions.
Again, monetary policy is market dependent, not just data dependent.

Apparently, the FOMC is no longer amused by forward guidance and looking forward to ending it:
A number of participants noted that while forward guidance had been a very useful tool under the extraordinary conditions of recent years, as the start of normalization approaches, there would be limits to the specificity that the Committee could provide about its timing. Looking ahead, some participants highlighted the potential benefits of streamlining the Committee's postmeeting statement once normalization has begun.
In other words, there might be less guidance in the future.

(2) ECB. Following its meeting on July 4, 2013, the ECB’s Governing Council communicated that it expects the key ECB interest rates to remain at present or lower levels for an extended period of time. According to the ECB’s Monthly Bulletin:
The Governing Council’s expectation is based on the overall subdued outlook for inflation extending into the medium term, given the broad-based weakness in the real economy and subdued monetary dynamics. At the current juncture, forward guidance contributes to the ECB’s pursuit of its mandate of maintaining price stability effectively, within the framework and in full respect of its strategy.
At its June 5 meeting last year, the ECB cut the rate on its deposit facility for banks from 0.00% to minus 0.10%--the first time that a major global central bank has moved rates into negative territory. On January 22, the ECB announced a QE program that will start buying €60 billion per month in bonds during March until at least September 2016.

Last Thursday, for the first time ever, the ECB released the minutes of the Governing Council’s meeting. At the latest one on January 22, the members of the committee were aware that QE largely was priced into financial markets, and were concerned about the potential fallout if they didn’t deliver:
A large part of the very substantial financial price adjustment observed over recent weeks would most likely rapidly unwind if no monetary policy action were taken at the current meeting.
Policymaking is market dependent, not just data dependent.

(3) BOJ. Last Wednesday, Bank of Japan Governor Haruhiko Kuroda focused on the currency market’s reaction to QQE, which was introduced on April 4, 2013 and extended with QQEE on October 31, 2014. He ruled out additional near-term monetary easing in an effort to stabilize the yen, which may have fallen too much. It is down roughly 35% relative to the dollar since late 2012. That’s been great for exporters. But it has also depressed consumer spending by boosting import prices.

(4) PBOC. The People’s Bank of China is also watching the currency markets. Chinese officials, who have been pegging the yuan to the US dollar, must be increasingly concerned about the strength of their currency relative to the euro and the yen. This, along with weakening economic data, explains why the PBOC lowered interest rates last November and reserve requirements in January.
(Based on an excerpt from YRI Morning Briefing)