Thursday, September 26, 2013

Two Fed Presidents Leaning Toward Even More QE
Minneapolis FRB President Narayana Kocherlakota, who is a non-voting member of the FOMC this year and a voter next year, said in a 9/26 speech that the committee must “do whatever we can to facilitate a faster rate of improvement in labor market conditions.” He implied that more rather than less QE might be needed. If employment weakens over the next few months, then instead of tapering QE, the FOMC might vote to buy securities at a faster monthly pace, as suggested by Kocherlakota.

New York FRB President Bill Dudley would certainly vote to do so in this scenario. In a 9/23 speech, he said: “To begin to taper, I have two tests that must be passed: (1) evidence that the labor market has shown improvement, and (2) information about the economy’s forward momentum that makes me confident that labor market improvement will continue in the future. So far, I think we have made progress with respect to these metrics, but have not yet achieved success.”
George Dissents Again
Kansas City FRB President Esther George has been the lone voting dissenter at every meeting of the FOMC this year for exactly the same reason, i.e., her concern “that the continued high level of monetary accommodation increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation expectations.” In a 9/26 speech titled, “US Monetary Policy: Risks of Delayed Action,” she strongly criticized the FOMC’s no-taper decision:
I view the data has being sufficiently positive to continue with the plan the Chairman presented in June, which called for the pace of purchases to moderate this year and gradually decline for several months until they come to an end around mid-2014. Consistent with this roadmap, our previous guidance and market expectations, my preferred course of action would have been to begin tapering asset purchases at last week’s meeting.
She then summarized the risks of not tapering:
Delaying action not only allows potential costs to grow, it also has the potential to threaten the credibility and the predictability of future monetary policy actions. Policy moves that surprise the market often result in additional volatility. And by deciding that it needs to await further data, the Committee is suggesting its desire to be ‘data dependent’ involves putting more emphasis on the most recent data points, which can be volatile and subject to revision, rather than on its own medium-term view of the economy. Another risk is that markets might misconstrue the postponement of action as reflecting a Committee assessment that the broader economic outlook is substantially weaker, when that is not the case.
Fed Gov. Stein Favors 'Mechanical' Tapering
In his highly technical speech today, Fed Governor Jeremy Stein summarized the findings from recent research he has conducted on the impact of monetary policy on forward real rates. He obviously has too much free time. In the speech, he said a few words about the previous week’s FOMC meeting. He voted not to taper QE. However, he said, “It was a close call for me….” He explained his wavering as follows:
The Chairman laid out a framework for winding down purchases in his June press conference. Within that framework, I would have been comfortable with the FOMC's beginning to taper its asset purchases at the September meeting. But whether we start in September or a bit later is not in itself the key issue--the difference in the overall amount of securities we buy will be modest. What is much more important is doing everything we can to ensure that this difficult transition is implemented in as transparent and predictable a manner as possible. On this front, I think it is safe to say that there may be room for improvement.
He concluded that he would like to see tapering tied automatically to the unemployment rate:
Achieving the desired transparency and predictability doesn't require that the wind-down happen in a way that is independent of incoming data. But I do think that, at this stage of the asset purchase program, there would be a great deal of merit in trying to find a way to make the link to observable data as mechanical as possible. For this reason, my personal preference would be to make future step-downs a completely deterministic function of a labor market indicator, such as the unemployment rate or cumulative payroll growth over some period. For example, one could cut monthly purchases by a set amount for each further 10 basis point decline in the unemployment rate. Obviously the unemployment rate is not a perfect summary statistic for our labor market objectives, but I believe that this approach would help to reduce uncertainty about our reaction function and the attendant market volatility. Moreover, we would still retain the flexibility to respond to other contingencies (such as declines in labor force participation) via our other more conventional policy tool--namely, the path of short-term rates.

Wednesday, September 18, 2013

The Fed: Internal Contradictions
The Fed’s transparency policy has made it transparently clear that Fed officials are confused about what to do next. That confusion is abundantly clear when we compare what Fed Chairman Bernanke said at his press conference today and the previous press conference on June 19. Even his latest one was full of internal contradictions. Let’s review:

(1) Do markets matter? As noted above, at last week’s press conference, Bernanke said in his prepared remarks that the FOMC’s decision not to taper was heavily influenced by the backup in bond yields and mortgage rates. Yet when he was asked whether the Fed might be confusing investors and sending mixed signals, he snapped, “We try our best to communicate to markets--we'll continue to do that--but we can't let market expectations dictate our policy actions. Our policy actions have to be determined by our best assessment of what's needed for the economy.” However, the bond market's tightening of financial conditions was one of the major reasons that the Fed voted not to taper, according to Bernanke!

(2) What happened to the “stock theory” of easy money? During his press conference on June 19, Bernanke indicated that he still believed in “the stock theory of the portfolio,” which posits that if the Fed buys bonds at a slower pace that should still put downward pressure on interest rates. Indeed, he even said that just holding onto the securities that have already been purchased and reinvesting funds from maturing issues is stimulative. He did acknowledge that he was puzzled by why bond yields were rising on tapering talk. The stock theory was not mentioned by Bernanke at last week’s press conference.

(3) Is forward guidance on QE still tied to the unemployment rate? At his press conference on June 19, Bernanke specified, for the first time, that 7% is the jobless rate threshold that would mark a substantial improvement in the labor market. He said that the Fed would start reducing its bond purchases later this year if this rate continued to fall toward 7% by the middle of next year, as anticipated by most of the members of the FOMC, according to Bernanke. He expected that QE would be terminated once the jobless rate fell to 7%. Back then, the FOMC knew that May’s rate was 7.6%. Last week, they knew that it had fallen to 7.3% in August.

At last week’s press conference, Bernanke backed away from the 7% threshold: “Last time, I gave 7% as an indicative number to give you some sense of, you know, where that might be. But as my first answer suggested, the unemployment rate is not necessarily a great measure in all circumstances of the--of the state of the labor market overall.”

(4) Is forward guidance on the federal funds rate still tied to the unemployment rate? Bernanke was asked why the unemployment rate threshold for discussing raising the federal funds rate at the FOMC wasn’t lowered at the latest meeting. He chose not to answer the question, simply stating: “There are a number of options that we have talked about. But today, we--as of today, we didn't choose to make any changes to the guidance.” Meanwhile, he effectively did lower the threshold in his prepared remarks as follows:
As I have noted frequently, the economic conditions we have set out as preceding any future rate increase are thresholds, not triggers. For example, a decline in the unemployment rate to 6-1/2 percent would not lead automatically to an increase in the federal funds rate target, but would instead indicate only that it had become appropriate for the Committee to consider whether the broader economic outlook justified such an increase. The Committee would be unlikely to increase rates if inflation were projected to remain below our 2 percent objective for some time, for example; and, in making its assessment, the Committee would also take into account additional measures of labor market conditions, such as job gains. Thus, the first increases in short-term rates might not occur until the unemployment rate is considerably below 6-1/2 percent.
(5) Why is the Fed so intent on seeing inflation rise? The Fed’s inflation target (using the core personal consumption deflator) has been 2% for quite some time. It’s been below that rate since May 2012. At last week’s press conference, Bernanke said that the FOMC is considering setting an inflation floor. If inflation falls to or below this lower bound, then the federal funds rate won’t be raised even if the unemployment rate continues to decline. He added, “I mean, that we should be very reluctant to raise rates if inflation remains persistently below target and that's one of the reasons that I think we can be very patient in raising the federal funds rates since we have not seen any inflation pressure.”

It’s not obvious to me why Fed officials want to boost inflation. The recent decline in inflation has been led by such goods as airfares, used cars, and furniture and bedding. The biggest plunge has been in medical care commodities inflation. Medical services inflation has also been falling. On the other hand, tenant rent inflation rose during August to 3.0% y/y, the highest since May 2009.

Why would it be good for the economy to have rents rise faster? Do Fed officials really want medical care inflation to rebound? These are questions that the Fed chairman did not address in his press conference.

(6) Is there no exit strategy from the Fed’s QE? Bernanke did not address the implications of the Fed’s decision not to taper since just talking about doing so drove yields higher, and raised concerns about the negative impact on the economy among the members of the FOMC. Why won’t that happen again next time the Fed talks about tapering? Why didn’t the Fed proceed with the tiny taper that was widely anticipated and lower the unemployment threshold from 6.5% to 5.5%?

Thursday, September 5, 2013

No Change in ECB Policy
In his prepared remarks at today’s ECB press conference, ECB President Mario Draghi reiterated the ultra-easy forward guidance first provided in July:
Looking ahead, our monetary policy stance will remain accommodative for as long as necessary, in line with the forward guidance provided in July. The Governing Council confirms that it expects the key ECB interest rates to remain at present or lower levels for an extended period of time. This expectation continues to be based on an unchanged overall subdued outlook for inflation extending into the medium term, given the broad-based weakness in the economy and subdued monetary dynamics.
During the Q&A session, Draghi was asked about the geopolitical risks posed by the crisis in Syria. He responded as follows:
We certainly are alert to the geopolitical risk that may come out of the Syrian situation and to the economic risk that may derive from the emerging market situation, which are two different things, really. At this point, I should say something I should have said before. As you can observe, when we look at the nature or the composition of the beginning of a recovery, I am very, very cautious about the recovery. I cannot share any enthusiasm. It is just the beginning. Let us see – these shoots are still very, very green. One thing I should have said is that, for the first time in about two years, it is domestic demand that is at the root of this recovery. It is still coupled with exports, but it is domestic demand. That is very important because if it continues, it gives a sense that the dependence of the recovery on the rest of the world is somewhat balanced by domestic demand. Secondly, we certainly stand ready to act. I did say this when I was asked about what we would do if interest rate or money market developments were unwarranted in view of our assessment of medium-term price stability. We certainly stand ready to act, whichever source these developments may derive from. I have commented on that before. We have not yet discussed any coordinated action, but we have periodic exchanges anyway. One of them will be this weekend in Basel. There will be an opportunity for a meeting with the central banks of major countries.
When asked about the ECB forward guidance policy, he said:
There are two types of forward guidance: one is qualitative and the other one is quantitative, with precise state conditions. Ours is the first type. So, all in all, the Governing Council is fairly united – unanimous, actually – on the wish to maintain this type of forward guidance. I have previously mentioned the BIS paper which actually compares the results and levels of success of different types of forward guidance. As I have said before, the ECB does not score too badly. It scores very well on having controlled volatility and reduced the uncertainty within the corridor and it scores ok in controlling the levels of rates.
Finally, Draghi was asked to explain why his OMT policy has been so successful even though it has yet to be actually implemented. Here is his response in full:
Well, it’s very hard to answer this question without flattering oneself! But I suspect that the design of this measure has made it both powerful and credible. It’s powerful because it addresses a realistic objective, namely redenomination risk spreads – the spreads that are derived from redenomination risks. It’s credible because it is accompanied by conditionality. In our present situation (and in many others, I suspect), a commitment to buy an infinite amount of bonds in order to keep interest rates at a certain level is often not credible – besides being illegal in our present situation. So, I think this combination of a realistic target, accompanied by what are in principle unlimited means (but are, in fact, limited by the market’s size) and by conditionality, has made this measure very effective without it needing to be activated. But conditionality is an important ingredient, because it says that once this measure is activated, the country that is on the receiving end will actually be undertaking a series of actions – budgetary consolidation or structural reforms, or both – that will have the effect of increasing the value of the bonds issued by that country, the value of the very bonds that the ECB is buying into it. So, the conditionality, if properly activated, produces an increase in the value – if you want to use that word – of the collateral that the country posts in exchange for ECB action. I think that’s one way to look at this. Thanks for asking!

Wednesday, September 4, 2013

Williams Discusses Jobless Rate & Monetary Policy
In a speech today titled, “The Economic Outlook, Unemployment, and Monetary Policy,” FRB-SF President John Williams spent a fair amount of time discussing factors influencing the unemployment rate. Before doing so, he claimed that the Fed’s policies “have given a shot in the arm to the economy by significantly reducing longer-term interest rates.” He acknowledged that they’ve been rising lately, but said that they are “still quite low.” He then reminded his audience that monetary policy is now closely tied to the unemployment rate. If it continues to fall toward 7% by the middle of next year, then QE will be phased out and terminated by then. If it continues to fall to 6.5%, that will be the threshold for the FOMC to start discussing raising short-term rates. He observed: “Clearly, the unemployment rate plays an important role in our thinking and communication about future policy. Therefore, an important issue is whether it is giving an accurate read on where things stand relative to our maximum employment mandate.” He then went on to address this important issue as follows:

(1) Overall, he believes it is a useful measure that “closely tracks other indicators of how much slack there is in the labor market, such as data from surveys on the share of households that finds jobs hard to get and the share of businesses that say it’s hard to fill openings. This adds to our confidence in its reliability.”

(2) He is not a fan of the employment-to-population ratio, which has been much more downbeat about the labor market than the jobless rate: “Although the unemployment rate is by no means a perfect measure of labor market conditions, the employment-to-population ratio blurs structural and cyclical influences. That makes it a problematic gauge of the state of the labor market for monetary policy purposes.”

(3) He also discussed structural reasons behind why the labor force participation rate has been falling and may also exaggerate the weakness of the labor market: “The overall ranks of the unemployed have been declining because many people are leaving the labor force, rather than finding jobs. But, it’s important to remember that much of this decline in labor force participation reflects long-running demographic trends, such as retiring baby boomers leaving the workforce. In addition, in recent years there has been a big exodus of young people and so-called prime-age adults. Again, some of this is related to ongoing trends, such as an increasing share of young adults enrolling in school, and workers moving onto disability rolls.”

He summed it all up as follows:
All this gets quite complex. On the one hand, we have structural trends, like the aging of the workforce and young people spending more time in school. On the other hand, we have the effects of a weak economy, which discourages people from looking for work. From the standpoint of gauging the state of the labor market for monetary policy, it is crucial that we distinguish between structural developments in the labor market and the effects of a weak economy. Recent estimates by the U.S. Bureau of Labor Statistics and others suggest that structural factors account for most of the decline in participation over the past several years.8 According to this research, structural factors reducing labor supply are the main reason that the employment-to-population ratio has stayed so low while unemployment has declined. Therefore, the employment-to-population ratio is sending a much too pessimistic signal regarding the amount of slack in the labor market. On the other hand, this evidence also suggests that the unemployment rate probably is overstating somewhat the extent of improvement in the labor market. However, over time, as discouraged workers rejoin the labor force, this problem should go away.