Resetting Expectations

Now that the smoke has cleared somewhat, we see clearly that the taper will be pushed forward to some data-dependent point in the future.  But which point?  That is tricky given the Fed’s predilection for focusing on the last employment reports when setting policy.  The Fed appears to want to shift away from asset purchases in favor of forward guidance and is looking for the right time to begin that process.  Their modus operandi has been to see six months of good employment data, send up a warning flag that the end of policy accommodation is coming, and then back down when the data turns weaker in the next three months.

If they continue that pattern, then we could be looking at mid-2014 before enough evidence of sustainability emerges that the Fed feels confident they can taper.  But if they are on a knife edge now, they may only need two or three months of good data to taper, assuming they see little risk that interest rates will get away from them.  Which gives a wide range for the taper – no sooner sooner than December, as late as mid-2014 if the data holds.  But an end to asset purchases does not mean a solid recovery.  The Fed’s expectation of a long period of low term rates suggests the healing will remain anything but rapid.

Using this week’s speech by New York Federal Reserve President William Dudley as a baseline, consider his two tests for meeting the requirement of “stronger and sustainable” labor market activity:

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.

On the first point, he notes that the unemployment rate overstates the degree of labor market improvement:

Other metrics of labor market conditions, such as the hiring, job-openings, job-finding rate, quits rate and the vacancy-to-unemployment ratio, collectively indicate a much more modest improvement in labor market conditions compared to that suggested by the decline in the unemployment rate.

It is very unfortunate from a communications perspective that the Fed keeps throwing out markers for the unemployment rate, first the 6.5% threshold for interest rates and the 7% trigger for asset purchases.  In the absence of those makers, I think most of us would agree that healing in the labor market is far from complete:

It appears pretty evident that the unemployment rate threshold is essentially meaningless as long as inflation remains below 2%.  Which seems to imply that the Evans Rule really collapses to an inflation targeting regime.

On the second point:

…fiscal uncertainties loom very large right now as Congress considers the issues of funding the government and raising the debt limit ceiling.  Assuming no change in my assessment of the efficacy and costs associated with the purchase program, I’d like to see economic news that makes me more confident that we will see continued improvement in the labor market.  Then I would feel comfortable that the time had come to cut the pace of asset purchases.

The fiscal front is coming to a head in the next few weeks – the drop dead date for hitting the debt ceiling is October 17.  So far, market participants have been fairly relaxed about the entire spectacle.  The general belief is that, like in the past, the Republicans ultimately choose not to commit political self-destruction and cave in the final hours.  We will see.

As far as the continued improvement in the labor markets, I find it curious that the Fed seems to be fairly incapable of seeing through the ebb and flow of the data to the underlying trend.  In particular, the issue of seasonal distortions is revisited by Matthew O’Brien and Matthew Klein, but you really don’t need to know about the seasonal effects to read this chart:

Too much focus on the last three months of this data is dangerous – this data has a lot of monthly variability and is subject to significant revisions.  I don’t think momentum has faded or surged.  The economy continues to grind forward at a disappointing pace.  You can argue that either the Fed needs to provide more accommodation, or that asset purchases are not a particularly effective form of easing.  The Fed is taking a middle ground – saying QE is effective, but shifting to forward guidance which they find to be more effective and more consistent with “normal” monetary policy.

Overall, although St. Louis Federal Reserve President James Bullard described the meeting as a close call and said that tapering could begin in October, it is virtually impossible for the data to meet Dudley’s requirements by that time.  December would be the earliest, and even that is pushing it.

With respect to forward guidance, the Federal Reserve is trying to push more accommodation via expectations that rates remain low far, far into the future.  Back to Dudley:

In addition, it is worth explaining why we anticipate the  federal funds rate is still likely to be quite low relative to what Committee participants consider normal over the longer run, even as the Committee gets close to its employment and inflation objectives.  For example, in the September Summary of Economic Projections, the median projection for the federal funds rate in the fourth quarter of 2016 is 2 percent, far below the median long-run federal funds rate projection of 4 percent, at the same time that the unemployment rate and inflation are close to the Committee’s long-run objectives.

The Fed’s unemployment projections:


Dudley’s first explanation:

How does one explain this? As noted by Chairman Bernanke in last week’s press conference, the still low federal funds rate projections for 2016 reflect the fact that economic headwinds—such as tight credit standards and ongoing fiscal consolidation—are likely to take a long time to fully abate.  As a result, monetary policy will have to keep short-term interest rates very low for a sustained period in order for the Committee to achieve its objectives.

I think this implies that rates would need to rise quickly once those objectives are reached, which makes 2017 interesting.  Dudley’s view differs:

My view is that the neutral federal funds rate consistent with trend growth is currently very low. That’s one reason why the economy is not growing very fast despite the current accommodative stance of monetary policy.  Although the neutral rate should gradually normalize over the long-run as economic fundamentals continue to improve and headwinds abate, this process will likely take many years.  In the meantime, the federal funds rate level consistent with the Committee’s objectives of maximum sustainable employment in the context of price stability will likely be well below the long-run level.

This line of thought seems to have somewhat different implications.  First, rates do not need to rise quickly when full employment is reached.  Second, though, it somewhat begs the question of why the Fed is not pressing harder to make policy more accommodative now to accelerate the pace of the recovery.  I think the answer is that they believe that they they are facing the limits of monetary policy in the face of fiscal restraint.

The possibility of a very long period of low rates deserves some additional attention from Fed speakers. It speaks to a period of stagnation which, interestingly, is a road Paul Krugman headed down today:

Our current episode of deleveraging will eventually end, which will shift the IS curve back to the right. But if we have effective financial regulation, as we should, it won’t shift all the way back to where it was before the crisis. Or to put it in plainer English, during the good old days demand was supported by an ever-growing burden of private debt, which we neither can nor should expect to resume; as a result, demand is going to be lower even once the crisis fades.

And here’s the worrisome thing: what if it turns out that we need ever-growing debt to stay out of a liquidity trap?…

…This is not a new fear: worries about secular stagnation, about a persistent shortfall of demand even at low interest rates, were very widespread just after World War II. At the time, those fears proved unfounded. But they weren’t irrational, and second time could be the charm.

Bear in mind that interest rates were actually pretty low even during the era of rising leverage, and got worryingly close to zero after the 2001 recession and even, you might say, after the 90-91 recession (there was talk of a liquidity trap even then). It’s not hard to believe that liquidity traps could become common, if not the norm, in an economy in which prudential action, public and private, has brought the era of rising leverage to an end.

Finally, I am a little concerned that forward guidance is being used only in reaction to disappointing outcomes and not proactively to accelerate the pace of improvement.  Here I think the conditionality on the policy forecast prevents the Fed from communicating an “irresponsible” policy path.  An upper bound of 2.5% on inflation is hardly irresponsible.

Bottom Line:  Policy expectations have been reset; tapering is not expected at the next meeting.  December at the earliest, but even that is questionable.  The Fed is looking for an opportunity to transfer accommodation from asset purchases to forward guidance.  Somewhat stronger data and obvious signs that bond market response would be muted would help clear the way for tapering.  The more we focus on the forward guidance, the easier it will be for the Fed to taper.  It is worth thinking about the implications of the Fed’s expectation of a very long period of low rates – what it says about the economy and the limits of monetary policy.

This piece is cross-posted from Tim Duy’s Fed Watch with permission.