Economic Monitor – Weekly Commentary
by Scott J. Brown, Ph.D.

Fed policy outlook – in *retrograde?
March 23 – 27

The question of whether the Fed would abandon the “patient” language should have not been an issue, but the financial press always tries to generate some level of tension. However, while the Federal Open Market Committee appeared to move closer to tightening monetary policy, it indirectly signaled that it would likely be much less aggressive.

In its policy statement, the FOMC noted that economic growth has “moderated somewhat.”  In her press briefing, Chair Yellen cited slower growth in household spending, weaker export growth, and a subdued recovery in housing. The Fed’s outlook is “not a weak forecast,” said Yellen. The Fed is still expecting above-trend growth. However, the outlook is less optimistic than it was three months ago.

Federal Reserve’s Summary of Economic Projections:
2015 2016 2017 long run
Real GDP (4Q/4Q) 2.3-2.7% 2.3-2.6% 2.0-2.4% 2.0-2.3%
  Dec Projections 2.6-3.0% 2.5-3.0% 2.3-2.5% 2.0-2.3%
Unemp. Rate (4Q) 5.0-5.2% 4.9-5.1% 4.8-5.1% 5.0-5.2%
  Dec Projections 5.2-5.3% 5.0-5.2% 4.9-5.3% 5.2-5.5%
PCE Price Inf.   (4Q/4Q) 0.6-0.8% 1.7-1.9% 1.9-2.0% 2.0%
  Dec Projections 1.0-1.6% 1.7-2.0% 1.8-2.0% 2.0%
Core PCE Infl. (4Q/4Q) 1.3-1.4% 1.5-1.9% 1.8-2.0%
  Dec Projections 1.5-1.8% 1.7-2.0% 1.8-2.0%  

*These are central tendency forecasts, which exclude the three lowest and three highest forecasts of the Fed governors and 12 district bank presidents.

Downward revisions to the growth outlook are nothing new. Expectations have typically been revised down in recent years.

The Fed also revised lower its inflation outlook.  The drop in oil prices has had a huge impact on headline inflation driving the year-over-year pace to around 0%.  Lower oil prices also feed through indirectly to core inflation over time.  The strong dollar has led to declines in import prices, which have restrained inflation, Yellen noted, “and will likely continue to do so in the months ahead.”  At the same time, officials see these impacts as “transitory.”  Yellen repeated that, before raising short-term interest rates, Fed officials want to see further improvement in the job market and be “reasonably confident” that inflation will move back to the 2% goal.  That should happen as the job market strengthens and transitory inflation impacts fade, but Yellen indicated that there was no precise definition of “reasonably confident.”  Fed officials will remain focused on the job market, wages, and inflation expectations.

While the dots in the dot plot continued to suggest no clear consensus on the timing and pace of rate hikes, they did generally move down, implying that most Fed officials expect the initial rate hike to arrive after the June policy meeting and further rate increases are expected to arrive more slowly.

In recent weeks, the Fed funds futures market had priced in a slower policy outlook than most Fed officials.  However, while Fed officials have now revised their policy outlooks down, so too has the market, which still expects rate hikes to come much more slowly than even the most dovish Fed officials.  The fixed income and currency markets were encouraged by the less aggressive Fed policy outlook, but the Fed is still moving toward raising rates at some point.  Short-term interest rates will still have to rise at some point.  The data will dictate when.

*When the Earth laps Mars (which is on an outer orbit around the Sun), it appears to travel backward in the night sky.  In a much better analogy, the Financial Times described the Fed’s action (appearing to move toward tightening while actually expecting to be less aggressive) as “moonwalking.”


Currency markets – too fast?
March 16 – March 20

Around the world, exchange rates fall mostly under the jurisdiction of finance ministers (U.S Treasury, Europe’s Council of Ministers), not the central banks.  However, monetary policymakers are aware of the economic and inflationary implications of currency market developments.  For the most part, the level of the exchange rate is not usually a concern.  What matters is the speed of adjustment.  Large currency moves tend to be destabilizing to trade activity and international finance.  While finance ministers can’t prevent large currency moves, verbal comments may help to slow the rate of change.

Over the last 12 months, the euro has lost about a quarter of its value against the U.S. dollar and most of that has come within the last few months.  The survivability of the monetary union has been a concern of global investors over the last few years, but the flight to safety went largely to Germany.  Hence, it stayed in euros.  Over the last several months, the euro/dollar exchange rate has been driven largely by the divergence in monetary policies.  The European Central Bank has now embarked on its quantitative easing program, purchasing €60 billion per month (expected through September 2016), while the U.S. Federal Reserve is pondering when to begin raising short-term interest rates.  The dollar has had nowhere to go but up.  The central bank policy divergence is not just between the U.S. and the euro area.  Many central banks around the world have been easing monetary policy.

Foreign trade is still a relatively small part of the U.S. economy, but over the years it’s become a larger part of the production and consumption of goods.  So exchange rate movements can have a big impact.  A strong dollar makes U.S. goods more expensive relative to foreign producers.  However, it also reduces prices of imports, including raw materials, intermediate goods, and finished goods.

There may be some parallels between the current situation and the 1997 Asian financial crisis (although there are more differences).  In the Asian crisis, the hit to U.S. exports shaved a full percentage point from GDP growth.  However, we also benefited from a drop in import prices.  The boost to consumer purchasing power helped propel personal spending and domestic economic growth.  Granted, there were a lot of other things going on at the time, including transformative developments in technology (cell phones, laptops, the Internet).  Low inflation kept the Fed from raising rates too rapidly and we saw the unemployment rate fall sharply (to below 4%).

The Federal Reserve is not going to delay a tightening to soften the dollar.  However, the inflationary impact of a stronger dollar suggests that the Fed could wait longer to hike.  That, in turn, should prevent the dollar from rising too rapidly.

The weak euro may provide more stimulus to the European economy than the ECB’s quantitative easing.  Indeed, the ECB recently updated its outlook for growth.  However, we will need to hear from finance officials if currency moves don’t slow.


February employment report – is it enough?
March 9 – March 13

Job growth remained strong in February, leading financial market participants to believe that the Fed will begin to raise short-term interest rates sooner (June) rather than later (September) and, more importantly, at a faster pace than thought earlier. The report is only one item that the Fed will consider when it meets to set monetary policy (March 17-18).

Nonfarm payrolls rose by 295,000 in February, a 3.86 million seasonally adjusted annual rate over the last four months. This is an extraordinary pace, one consistent with a sharp decline in unemployment. The unemployment rate did decline in February, but that was partly due to a decrease in labor force participation. The employment/population ratio was flat versus January, up only half a percentage point over the last year. Something’s not right with this picture.

Normally, one would put more weight on the payroll data, which are periodically benchmarked to actual payroll tax receipts (and revisions to the payroll data tend to be relatively small). Payroll estimates count jobs, not people, and an increase in multiple jobholders could overstate the payroll figure. However, the household survey asks about multiple jobs: 4.9% of employed people had more than one job in February, down slightly from 5.0% a year ago. The number of multiple jobholders rose by 58,000 over the last 12 months. In comparison, nonfarm payrolls rose by about 3.3 million.

The employment/population ratio suggests that there is still a lot of slack in the job market. Other measures, including the percentage of people working part-time for economic reasons and the long-term unemployment rate also suggest that slack is being taken up, but that a large amount remains. Note that the number of people working part time because that was the only thing available has begun to trend lower.

Average hourly earnings rose modestly in February, still at a lackluster pace (+2.0%) year-over-year. Faster wage gains are being seen for certain high-skilled positions, but there is no evidence of a broad-based acceleration in labor compensation. As slack disappears, one would expect to see faster wage growth. Productivity figures are choppy and unreliable, but the trend over the last year suggests a noticeable slowdown in output per worker. That could explain some of the lackluster pace in wages, but it’s most likely evidence of slack.

Nominal wage growth has struggled to keep pace with inflation in recent years. Most of the growth in consumer spending has come from job gains (the typical worker is running just to stay in the same place). However, the sharp drop in gasoline prices into January reduced inflation to about 0% year-over-year, boosting real earnings growth sharply. Combined with the recent strong pace of job growth, real consumer spending growth should be significantly higher in the near term. We may not see that in the February data, but is should be much more apparent in the figures for March and April.


Reasonably confident
March 2 – March 6

Fed Chair Janet Yellen signaled that officials will likely alter the forward guidance at the March 17-18 policy meeting. However, altering this guidance (the conditional commitment to keep short-term interest rates exceptionally low) is not the same as signaling that a rate hike is imminent, as Yellen made clear. She did indicate what would lead the Fed to start tightening. The Fed needs to see further improvement in the job market, it must expect even more improvement in the job market on top of that, and it has to be “reasonably confident” that inflation will move toward the 2% objective.

The Fed has relied on two extraordinary policies to provide support to the economic recovery in recent years. One is quantitative easing, the outright purchases of Treasuries and mortgage-backed securities to help push long-term interest rates lower. The other is the forward guidance. By making a conditional promise to keep short-term interest rates low for some period of time, the Fed puts downward pressure on long-term rates (long-term rates can be thought of as a series of short-term rates). The forward guidance doesn’t cost the Fed anything, making it an attractive tool to use when faced with the zero lower bound (on short-term interest rates).

Initially, the forward guidance was based on a specified time period, but some Fed officials worried that that was too vague. The Fed shifted to economic thresholds. However, as the unemployment rate approached its threshold, something had to give, and the Fed went back to a time-based directive, promising to keep rates low for “a considerable time.” That language proved useful, but as the Fed began to make plans for policy normalization, it was clear that the phrase would have to change. This created a dilemma for Fed policymakers. The financial markets could misinterpret a change in the language. Minutes from the 2014 FOMC meetings reflected a lot of anxiety among Fed officials about changing the phrase. In the mid-December policy statement, the Fed replaced the “considerable time” phrase, saying that it could “be patient” in deciding when to begin raising rates. At the same time, the Fed said that the change in language did not represent any change in the policy outlook. Thus, the Fed changed the language, but kept the sentiment, seemingly having it both ways. However, market participants soon began to speculate on when the “patient” phrase would go, believing that such a change would signal a likely rate hike at the next meeting. Yellen sidestepped that trap in her monetary policy testimony to Congress. The patient language is expected to go. However, Yellen emphasized that the change would not necessarily signal that rates would be raised within a couple of meetings. It only meant that the Fed would begin to consider the possibility of rates hikes.

The Fed is still going to rely on some forward guidance. Specifically, the Fed has indicated that short-term interest rates may remain below normal “even after employment and inflation are near levels consistent with our dual mandate.”

No surprise, the job market will play a key role in when the Fed begins to tighten. We’ve seen significant progress. However, as Yellen testified, “we’re not there yet.” Job conditions will have to improve further before the Fed considers raising rates, but it also must have sufficient momentum to improve further.

The Fed will also need to be “reasonably confident” that inflation will move back toward the 2% goal. What exactly does that mean? Fed officials are likely to differ in their views, and they’ve not done a good job in forecasting inflation in the last few years. Yellen is likely to require more substantial evidence.

Putting it all together, given the low near-term trend in inflation, most Fed officials are likely to fall into the later-rather-than sooner camp. The bigger uncertainty will be the speed of adjustment once rate hikes begin. That will be data-dependent.


Yellen’s trip to the hill, a preview…
February 23 – February 27

Fed Chair Janet Yellen will testify on monetary policy on Tuesday and Wednesday. These appearances are less traumatic for the financial markets than they used to be. The Fed releases minutes of the policy meetings on a timelier basis and the Fed chair holds press conferences after every other meeting. Hence, it’s unlikely that we’ll see Yellen signal a major change in the policy outlook. Still, the financial markets will pay attention.

The minutes of the January 27-28 policy meeting helped to clarify the outlook for monetary policy. Officials continued to prepare for policy normalization, as they worked on the technical details. The financial markets are more concerned about the timing of the lift-off – that is, when the Fed will begin to raise short-term interest rates. However, policymakers were briefed not just on possibilities for the timing, but also on the pace of rate increases. The minutes did not go into details on what the Fed staff presented or what conclusions may have been drawn, if any. Note that in her press conference in mid-December, Yellen cautioned against assuming that the Fed would raise rates at “a measured pace” (that is, 25 basis points per meeting) once tightening begins. She also emphasized that the FOMC could decide to begin raising rates at any meeting, not just the ones that have a post-meeting press conferences. So, the Fed could wait longer and raise rates more rapidly once it starts, or make larger moves on an irregular basis. Indeed, Yellen previously emphasized optimal control theory, which “calls for a later lift-off” of policy tightening.

Prior to each FOMC meeting, the Fed surveys the primary dealers, asking questions about the timing of policy firming and about the outlook for the economy and financial markets. In January, responses on the timing were all over the place, but with more than half between June and September. This is roughly consistent with the range of forecasts of the year-end federal funds rate made by senior Fed officials in December.

The FOMC minutes provided a concise picture of the Fed’s timing debate. “Several” Fed officials feared that waiting too long could lead to higher inflation. However, “many” participants (which is more than “several” in Fed lingo) worried that moving too soon could “damp the apparent solid recovery in real activity and labor market conditions.” An earlier lift-off would also leave the Fed with limited options should the economy slow (as it remains close to the zero lower bound). Many Fed officials wanted to see a pickup in wages growth or evidence that the recovery remained on solid footing, with inflation moving back toward the 2% goal “after the transitory effects of lower energy prices and other factors dissipate.”

The low inflation does not mean that the Fed won’t hike. Yellen indicated that the Fed could still raise rates as long as there is a strong expectation that inflation will move toward the 2% goal. The Fed has described the impact of lower energy prices as “transitory.” However, lower energy prices are likely to help push core inflation down in the near term.

Low inflation is also a consequence of a soft global economy. Yet, lower energy prices should help the rest of the world to eventually recover. However, the timing isn’t clear. Estimates of European growth have picked up a bit recently, due to the drop in energy prices, but there are a lot more issues in the global economic outlook besides energy.

Note that the Fed does consider the impact of a stronger dollar on growth and inflation. However, the exchange rate of the dollar is not the Fed’s responsibility (that’s the Treasury’s call). The Fed is not going to refrain from raising short-term interest rates to weaken the dollar.

Does it really matter when the Fed begins to tighten? The timing has some minor implications for longer-term Treasury yields, but it’s much more important for the middle of the curve. Forecasting the pace of policy normalization ought to be just as important as getting the start date right.


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