Sunday, March 23, 2014

Yellen's Dashboard
As I noted last week, Fed Chair Janet Yellen didn’t sprinkle any fairy dust on the stock market on Wednesday. However, she is still the Fairy Godmother of the Bull Market given that stocks rebounded smartly on Thursday as investors reconsidered her six-month definition of “considerable time” between the end of QE and the beginning of higher interest rates.

Some Fed watchers concluded that she wants to show the markets that she isn’t as dovish as widely believed and that she is already positioning the Fed to stop speculative bubbles by raising interest rates starting around mid-2015. Indeed, on Friday, Fed Governor Jeremy Stein presented a speech on the importance of incorporating financial stability considerations into monetary policy decision-making. Under the Dodd-Frank Act, the Fed has an implicit third mandate, namely to maintain financial stability. The Act set up the Financial Stability Oversight Council (FSOC). The Fed chair is a member of the FSOC.

In any event, speculative bubbles weren’t mention once in Yellen’s press conference last Wednesday. On the other hand, Yellen gave a fairly lengthy and detailed account of the economic indicators that are on her “dashboard.” We've compiled a chart book of them, which happen all to be focused on the labor market. (See Yellen's Dashboard.) She had mentioned most of them in previous speeches. What was new was her focus on wage inflation.
The final thing I've mentioned is wages and wage growth has really been very low. I know there is perhaps one isolated measure of wage growth that suggests some uptick, but most measures of wage increase are running at very low levels. In fact, with the productivity growth we have, and two percent inflation, one would probably expect to see, on an ongoing basis, something between perhaps three and four percent wage inflation; [that] would be normal. Wage inflation has been running at two percent. So not only is it depressed, signaling weakness in the labor market, but it is certainly not flashing an increase… and it might signal some tightening or meaningful pressures on inflation, at least over time. And I would say we're not seeing that.
(Based on an excerpt from YRI Morning Briefing)

Thursday, March 20, 2014

Fed Vice Chair Janet Yellen, who has been the Fairy Godmother of the Bull Market, didn’t sprinkle any fairy dust on the bond and stock markets yesterday. Bond and stock prices fell following the release of the FOMC statement at 2:00 pm. There weren’t any real surprises in the statement. Rather, traders seemed to be disturbed by the quarterly economic projections of the FOMC participants that were released with the statement. Their consensus outlook for the economy didn’t change much from their December projections. However, there was a slight increase in the median forecast for the federal funds rate at the end of 2015. Bloomberg reported the story as follows:
Federal Reserve officials predicted their target interest rate will be 1 percent at the end of 2015 and 2.25 percent a year later, higher than previously forecast, as they upgraded projections for gains in the labor market. Most Federal Open Market Committee participants reiterated their view that the Fed will refrain from raising the benchmark interest rate until 2015. The median rate among 16 Fed officials rose from December, when they estimated the rate at the end of next year at 0.75 percent, and 1.75 percent for the end of 2016. … A majority of FOMC participants--13 out of 16--expect the first increase in the main interest rate in 2015. One projected the first rate increase in 2014, while two forecast an initial move in 2016.
The participants’ federal funds forecasts are shown as a “dot plot” in the Fed’s projections document. In her press conference at 2:30 p.m., Yellen basically said to ignore the dot plot and focus on the statement. Then she exacerbated the sell-off when she was asked how long it might be before the Fed started raising rates.

The statement implied that the Fed would continue tapering QE, and was on course to terminate the program by the end of this year or early next year as long as the economy performed well. As for when interest rates might start rising, the statement said:
The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.
When she was asked to define “considerable time” in the press conference, Yellen said six months, triggering further declines in stock prices. I bet she regrets having been that specific, especially given that the statement junked the specific 6.5% unemployment rate threshold for the FOMC to start talking about raising interest rates. Instead, this threshold was replaced with a fuzzier set of guidelines with a “wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.”

So the FOMC seems to have dropped its “data dependent” approach specifying a threshold for a specific economic indicator and replaced it with a much more discretionary qualitative approach. Yellen’s comment suggests a slight reversion to the “calendar based” approach that had been the FOMC’s modus operandi until December 2012, when the jobless rate threshold was adopted.

In my opinion, Yellen confused herself and all of us too. My hunch is that she meant that the federal funds rate would be raised six months after the economy achieved the Fed’s mandates for inflation and unemployment. We know that the former is 2%. The latter is probably 5.2%-5.6% based on the projections crib sheet, which shows that this forecast isn't expected to be achieved until 2016! Here is how the statement framed it:
The Committee currently anticipates that, 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.
I interpret this sentence to mean that the Fed won’t start raising rates until after the mandates are achieved. I will concede that might be six months after QE is terminated, but who knows? All in all, my evaluation is that Janet Yellen’s first shot at communicating Yellenomics rates a grade of D.

Of course, Yellen talked about lots of other subjects. She confirmed that her “dashboard” of key economic indicators includes the U-3 and U-6 unemployment rates. She is also watching the number of discouraged workers and the ones who are marginally employed, as well as the share of the long-term unemployed. She sees progress in the labor market, but she also sees too much distress. She also mentioned the labor force participation rate, which may be falling for demographic reasons, but still has a cyclical component, in her opinion. She is also watching quit rates, job openings, and the hiring rate, which is still too low, in her opinion.

Yellen said that wage inflation should be running around 3%-4% given the increase in productivity. She noted that other than a small spike in one measure, wage inflation remains around 2%. No one asked her about financial bubbles or about emerging economies.
(Based on an excerpt from YRI Morning Briefing)

Monday, March 17, 2014

A Short History & the Future of Forward Guidance
The FOMC will meet this week on Tuesday and Wednesday, March 18 and 19. The important question will be how the committee tweaks its forward guidance now that the unemployment rate was down to 6.7% during February, approaching the committee’s 6.5% threshold for discussing whether or not to start raising interest rates.

That threshold was first announced in the FOMC's December 12, 2012 statement, when the previous month's jobless rate was 7.8%. Prior to introducing this new “data-dependent” forward guidance for the federal funds rate, the statements were calendar based. Since August 9, 2011, they promised to peg the rate between zero and 0.25%, adding that the committee anticipates that “exceptionally low levels for the federal funds rate” are likely to be warranted for a specified period into the future. For example, the October 24, 2013 statement anticipated that the fed funds rate would remain near zero through mid-2015.

The statements from March 18, 2009 through June 22, 2011 used the phrase “extended period” rather than specifying a date in the future for keeping the federal funds rate near zero. The January 28, 2009 statement vaguely promised a near-zero federal funds rate “for some time.” Of course, in the previous December 16, 2008 statement, the FOMC announced that the federal funds rate had been lowered to a range of 0.0-0.25% for the first time without specifying how long it might remain there. (See our searchable archive of FOMC statements.)

The forward guidance issue was raised at the January 28-29 meeting this year, according to the minutes: “Participants agreed that, with the unemployment rate approaching 6-1/2 percent, it would soon be appropriate for the Committee to change its forward guidance in order to provide information about its decisions regarding the federal funds rate after that threshold was crossed.” Various views were expressed by the FOMC’s participants:

(1) Lower the unemployment rate threshold.Some participants favored quantitative guidance along the lines of the existing thresholds….” (Emphasis mine.)

(2) Adopt a qualitative rather than quantitative approach.[O]thers preferred a qualitative approach that would provide additional information regarding the factors that would guide the Committee's policy decisions.”

(3) Put more emphasis on financial stability.Several participants suggested that risks to financial stability should appear more explicitly in the list of factors that would guide decisions about the federal funds rate once the unemployment rate threshold is crossed….”

(4) Give more weight to inflation.[S]everal participants argued that the forward guidance should give greater emphasis to the Committee's willingness to keep rates low if inflation were to remain persistently below the Committee's 2 percent longer-run objective.”

(5) Get ready to increase the federal funds rate. “A few participants raised the possibility that it might be appropriate to increase the federal funds rate relatively soon.”

Of course, much depends on how the FOMC interprets the faster-than-expected decline in the unemployment rate. Recall that former Fed Chairman Ben Bernanke at his June 19, 2013 press conference said that the Fed would start tapering QE before the end of last year and would terminate the program by mid-2014, when the unemployment rate was expected to be down to 7.0%.

In their most recent statements, both Fed Chair Janet Yellen and FRB-NY President Bill Dudley said that they are still not satisfied with the progress in the labor market. The number of people working part-time for economic reasons and the number of long-term unemployed workers remain too high. In my opinion, the FOMC is likely to devise some new data-dependent rule to justify continuing NZIRP (near zero interest rate policy). They might lower the unemployment rate threshold to 5.5% and stress that inflation must rebound back to 2% before they’ll even consider raising rates.
(Based on an excerpt from YRI Morning Briefing)

Friday, March 7, 2014

Can Janet Yellen Sing?
What does Janet Yellen have in common with Britney Spears? Nothing except that Yellen may soon be singing, “Oops!...I Did It Again.” Unlike FRB-Dallas President Richard Fisher (see previous post, dated 3/5), she is much more focused on the impact of monetary policy on the labor markets than on the financial markets. In her 3/5 ceremonial swearing-in speech, she said:
Too many Americans still can't find a job or are forced to work part-time. The goals set by Congress for the Federal Reserve are clear: maximum employment and stable prices. It is equally clear that the economy continues to operate considerably short of these objectives. I promise to do all that I can, working with my fellow policymakers, to achieve the very important goals Congress has assigned to the Federal Reserve.
Yellen has said that the Fed won’t make the same mistakes again as the ones that led to the latest financial crisis. She also has admitted that she didn’t see it coming, but claims that she will be more vigilant this time. Odds are that Fisher will see it coming before she does, given that the gentleman from Dallas is much more concerned about stopping speculative bubbles, while the lady from DC is much more obsessed about reviving the labor market.

FRB-New York President Bill Dudley, whose views tend consistently to be nearly the same as Yellen’s, spoke on Friday after the release of February’s better-than-expected employment report. He made no mention of it. Instead, he indicated that he still wants to see more progress in the labor market: “I do expect that growth will be strong enough to lead to continued improvement in labor market conditions. I must caution, however, that the outlook for the unemployment rate is unusually uncertain.” He concluded: “Hence, the continued need for monetary policy to remain highly accommodative to support the economic recovery to the fullest.”

In other words, the dovish majority on the FOMC will maintain ultra-easy monetary policy for the foreseeable future. They will probably continue to taper QE, but they’ll keep the federal funds rate near zero. Stock prices are likely to continue rising into record-high territory. Richard Fisher will give more speeches about speculative bubbles.
(Based on an excerpt from YRI Morning Briefing)

Wednesday, March 5, 2014

Richard Fisher Is Seeing Bubbles
FRB-Dallas President Richard Fisher in a 3/5 speech before the Association of Mexican Bankers in Mexico City warned that the Fed’s ultra-easy monetary policy is inflating speculative bubbles again in the financial markets:
To add insult to injury, there are increasing signs quantitative easing has overstayed its welcome: Market distortions and acting on bad incentives are becoming more pervasive. Stock market metrics such as price to projected forward earnings, price-to-sales ratios and market capitalization as a percentage of GDP are at eye-popping levels not seen since the dot-com boom of the late 1990s. In the words of James Mackintosh, writer of the Financial Times column ‘The Short View,’ a not insignificant number of stocks in the S&P 500 have valuations ‘that rely on belief in a financial fairy.’ Margin debt is pushing up against all-time records. And, in the bond market, narrow spreads between corporate and Treasury debt reflect lower risk premia on top of already abnormally low nominal yields. We must monitor these indicators very carefully so as to ensure that the ghost of ‘irrational exuberance’ does not haunt us again.
Fisher is a voting member of the FOMC this year. He is the only participant of the committee with real-world rather than academic experience working in the capital markets. According to his bio: “In 1987, Fisher created Fisher Capital Management and a separate funds-management firm, Fisher Ewing Partners. Fisher Ewing's sole fund, Value Partners, earned a compound rate of return of 24 percent per annum during his period as managing partner. He sold his controlling interests in both firms when he rejoined the government in 1997.” Let’s have a closer look at Fisher’s list of speculative bubble indicators:

(1) Financial fairy valuations. The Fed released its quarterly Flow of Funds report last Thursday. It showed that the market value of all equities traded in the US soared to a record $34.7 trillion at the end of last year, up a whopping $20.9 trillion since the start of the bull market during Q1-2009. As Fisher notes, total stock market capitalization as a ratio of nominal GDP rose to 1.25 at the end of last year, exceeding the previous 2007 peak of 1.12 and the highest since Q3-2000. The price-to-sales ratio of the S&P 500 rose to 1.54 at the end of last year to the highest reading since Q1-2002.

Fisher didn’t mention Tobin’s Q, which is another valuation metric that can be calculated using data in the Flow of Funds report. It is the ratio of the market value of equities to the net worth at market value of nonfinancial corporations. I adjust it by dividing it by the average ratio since the start of the data. It was 1.44 at the end of last year, the highest since Q2-2001.

(2) Record margin debt. I’m puzzled by Fisher's comment that margin debt is “pushing up against all-time records.” It’s actually been setting new record highs since July 2012 and was at $451.3 billion during January, exceeding the July 2007 peak by 18.3%.

(3) Narrow corporate spreads. The yield spread between high-yield corporates and 10-year US Treasuries was just 280bps on Friday. That’s the lowest since the lows of early 2007, just before the financial system started to come unglued.
(Based on an excerpt from YRI Morning Briefing)

Tuesday, March 4, 2014

Forward Guidance: BIS Warning
In an article in the 3/9 Quarterly Review of the Bank for International Settlements, Andrew Filardo and Boris Hofmann review the implementation, effectiveness, and risks of the NZIRP (near zero interest rate policy) forward guidance of the four major central banks: the Fed, the BOJ, the ECB, and the BOE. They write that while “forward guidance has been helpful in clarifying policy intentions in highly unusual economic circumstances …. the mixed evidence concerning the effectiveness of these practices, and the challenges they raise, caution against drawing firm conclusions about their ultimate value.”

The BIS economists stress that the effectiveness of forward guidance depends on the credibility of the central bank’s commitment to it and to clear communication of the policy. They warn:
However, if too complex, conditionality may end up confusing the public and leading to conflicting interpretations of policy intentions, with the risk of disruptive market reactions. Central banks then face the risk of getting involved in continuous discussions with the media and other observers about nuanced wording and technical details.
This is a significant risk faced by the FOMC in amending its guidance.

A related risk is “committee cacophony in external communication can further undermine the clarity and credibility of forward guidance.” That’s been an ongoing problem with all the divergent views expressed in the all-too-frequent speeches by the members of the "Federal Open Mouth Committee."

Of course, one of the biggest risks of NZIRP forward guidance is that this policy is prone to inflate speculative bubbles:
[P]erhaps more importantly, forward guidance can indirectly create financial stability risks if monetary policy becomes increasingly concerned about adverse financial market reactions (also referred to as the risk of financial dominance). At the current juncture, this could translate into an undue delay in the speed of monetary policy normalisation and raise the risk of an unhealthy accumulation of financial imbalances. Moreover, the mere perception of this possibility, over time, could encourage excessive risk-taking and thereby foster a build-up of financial vulnerabilities.
There are already plenty of signs that this is starting to happen. If the bubbles get bigger and burst, the central bankers will have no excuses given the timely forward guidance provided by this excellent warning from the BIS.