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)

Thursday, February 19, 2015

Futures Forecast
January’s stronger-than-expected employment report, which was released on February 6, refocused fixed-income investors on the rising odds of a first Fed rate hike at the June 16-17 meeting of the FOMC. The 10-year Treasury bond yield is up from 1.83% on February 5 to 2.14% on Tuesday of this week. Yesterday’s release of the January 27-28 FOMC minutes, which was relatively dovish, eased the yield back down to 2.08%.

Of course, the meeting occurred before the release of February’s strong employment data. In addition, economic indicators out of Germany and Japan showed some improvement since the meeting. The price of oil has also rebounded in recent weeks. Several members of the FOMC have subsequently said that they would favor a mid-year rate hike.

The implied federal funds rate based on futures contracts traded on the CME rose sharply following January’s employment report. The 12-month contract jumped from 0.52% on February 5 to 0.66% currently. The six-month implied fed funds rate is 0.25%.

These forecasts are consistent with our one-and-done scenario for Fed rate hikes this year. So are the latest relatively dovish minutes. Here are a few key excerpts:
(1) Many participants indicated that their assessment of the balance of risks associated with the timing of the beginning of policy normalization had inclined them toward keeping the federal funds rate at its effective lower bound for a longer time.

(2) There was wide agreement that it would be difficult to specify in advance an exhaustive list of economic indicators and the values that these indicators would need to take. Nonetheless, a number of participants suggested that they would need to see further improvement in labor market conditions and data pointing to continued growth in real activity at a pace sufficient to support additional labor market gains before beginning policy normalization.

(3) A number of participants emphasized that they would need to see either an increase in market-based measures of inflation compensation or evidence that continued low readings on these measures did not constitute grounds for concern.

(4) Several participants indicated that signs of improvements in labor compensation would be an important signal, while a few others deemphasized the value of labor compensation data for judging incipient inflation pressures in light of the loose short-run empirical connection between wage and price inflation.
(Based on an excerpt from YRI Morning Briefing)

Monday, February 9, 2015

Game Changer?
Friday’s employment report was so strong that everyone came to the same conclusion at the same time: The FOMC will most likely start hiking the federal funds rate at the June 16-17 meeting of the monetary policy committee. Wage increases remain subdued, and lower than Fed officials would like to see. However, the recent impressive payroll employment gains are reminiscent of the good old days of the Old Normal economy. It’s hard to imagine the Fed coming up with any more credible excuses for not moving forward with monetary normalization given that the labor market has been moving back to normal so fast in recent months.

The question is whether the first rate hike will be followed by additional ones this year or whether one-and-done is still the most likely scenario for 2015, as Debbie and I have been thinking. It all depends on the strength of the dollar. With the Fed moving to tighten monetary policy while the other major central banks are moving in the other direction, the dollar should continue to soar. The trade-weighted dollar has had a vertical ascent, rising 14% since July 1, 2014. It could rise by another 10% in the one-and-done scenario.

That could push the US inflation rate further below the Fed’s 2% target. It could also depress US exports and boost US imports. So the trade deficit would weigh on real GDP growth, as it did during Q4-2014. The Fed might be satisfied with one rate hike at mid-year in this scenario, and then remain patient about further increases until next year.

In any event, Fed Chair Janet Yellen will spin it all together for us in her semi-annual congressional testimony on monetary policy scheduled for February 24 before the Senate Banking Committee and the next day before the House Financial Services Committee. She’ll probably say that employment gains are so strong that she and most of the other members of the FOMC anticipate that price and wage inflation should rise later this year closer to the Fed’s targets.

She is likely to say that the Fed remains “patient” about raising rates, but less so now than when the word first appeared in the January 28 FOMC statement. That would imply that the word could be dropped even from the next statement on March 18, and almost certainly from the April 29 statement. Then the June 17 statement should announce that the game of hiking rates has begun.
(Based on an excerpt from YRI Morning Briefing)